Solving the 'small pots' dilemma in UK defined contribution pensions

Deferred DC pots under £1,000, known as ‘small pots’, are a problem worth solving. The cost of administering a small pot can be excessive in comparison to the benefit for scheme members. It is easier for members to plan their retirement if they do not have a large number of separate pension arrangements to track down and deal with.

Consolidation would also lead to economies of scale for investments, and would support the government’s headline of investing in productive finance, boosting the UK economy. In July 2023 the Department for Work and Pensions (DWP) launched a formal consultation (463KB PDF) on the framework for a solution.

The multiple default consolidator model

The government has decided to move forward with the multiple default consolidator model, leaving behind the ‘pot follows member’ approach that it had preferred – and legislated for – nearly a decade ago. Under the multiple default consolidator model, eligible deferred small pots would automatically transfer to a consolidator scheme chosen by, or allocated to, the member. Members would be able to opt out. 

One of the potential objections to the consolidator model had been the impact on market competition of transferring pension assets to a group of authorised consolidators. However, the DWP has said that if all the small pots were “consolidated into a single provider, this is only 4% of the master trust market, and the likelihood is that the chosen provider would already have a large share of these existing assets”.

Master trusts acting as default consolidators

The government proposes setting up a “proportionate” regime to allow a small number of schemes to act as authorised default consolidators. This fits with the government’s objective of a “considerably more consolidated” master trust market. Every master trust would be required to apply for this new authorisation, suggesting that all master trusts might become small pot consolidators.

That presumably means that if someone moves jobs and is auto enrolled into a new master trust, they will be able to choose for their previous small pot to be moved into that trust or a consolidator. If they don’t respond, it will be defaulted into a consolidator.

In this context, the DWP’s consultation paper contains a statement that the DWP will review the wider master trust authorisation regime. It is unclear what this means and whether it is likely to lead to any changes, although the consultation paper hints at gradually stricter ‘Value for Money’ requirements.

Practicalities of a default regime

The consultation proposes that pots of £1,000 or less would become eligible for automatic consolidation 12 months after the last contribution was made. The clearing house or the central registry model would identify whether relevant members already had a consolidator. If they did not, they would be asked to select a consolidator or take the opportunity to opt out of consolidation. Where members neither opted out nor actively selected a consolidator, a consolidator would be allocated at random.

The process for members who already have a consolidator is less clear. They would also presumably need to be contacted to be given the opportunity to opt out – or maybe to choose a different consolidator from their current one, including the trust that they are now paying into. Only then would they see their pot transferred automatically to a consolidator.

The rationale for the 12-month deadline is that a full-time employee on National Living Wage would take just under a year to build up a pot of £1,000. The deadline is also designed to allow for career breaks, family leave, seasonal workers returning to a previous job, and employees opting back into their pension scheme after opting out.

The current proposals appear quite onerous, given that communication requirements will apply in respect of members even with tiny pots, since the government has decided there will be no minimum pot size. Quite how onerous they will be for consolidators will depend on whether the clearing house or the central registry is chosen to operate the new framework, and exactly what processes will need to be followed.

Member exchange and same-scheme consolidation

The government has encouraged schemes to identify whether any small pots can be consolidated within the same pension scheme, such as where the member has joined, left and re-joined the same scheme. The government has not ruled out future legislation to drive same-scheme consolidation.

The government is also supportive of an industry group, which has been exploring the ‘member exchange’ model. Under this model, pension schemes would use a third-party data service to identify whether they hold a deferred small pot for a member who is an active member of another scheme. Master trusts have been testing this model. It has, however, encountered problems in ensuring members would not be worse off as a result of the transfer, especially because of potential loss of tax protections.

Separate consolidation regime for contract-based schemes

The government has indicated that it will work with the FCA on whether “contract-based providers could seek authorisation to act as a consolidator in relation to a contract-based scheme that they operate”. There are no further details on what exactly is envisaged.

Supporting infrastructure

The multiple default consolidator model requires either a clearing house or a central registry to identify the small pots. The core proposal is for a clearing house, which would communicate with members about choosing a consolidator, or allocating members to a default consolidator if no choice is made. The clearing house would then instruct the original scheme to begin the transfer of the small pot to the relevant consolidator. The consultation paper does not address who would operate the clearing house.

A central registry is still under consideration as an alternative. Pension schemes would themselves access the registry to match pots with the member’s consolidator or ask members to choose a consolidator if they have not done so. This matching could potentially be achieved using the pensions dashboards infrastructure – although this would require an extensive system redesign. The central registry approach would place a greater burden on schemes than the clearing house model, and there are potential competition problems where schemes are involved in members’ choice of consolidator.

The proposals need refining

Consolidation of small pots is clearly the right approach, but these proposals still need some refining. They have not been without controversy because of the market implications of transferring substantial assets to a relatively small group of consolidators. Exactly how a clearing house or a central registry would operate is still unclear. The government is right to consult on its approach and seek to get the pensions industry onboard. If the government takes proper account of input from pensions industry, these proposals could be made to work.

The consultation paper acknowledges that the proposals do not address the problem of more small pots arising in the future. It states that a “more fundamental change to the automatic enrolment framework may be needed” to address this. Australia has a system of “stapling”, in which an individual’s pension scheme is retained as a pot for life unless they actively choose a different one. The government has stated that “this would create an environment which is easier for a member to engage with but is clearly some way off in the UK”. Indeed, the introduction of such a system might transform DC provision but would involve a significant amount of systemic change.

Technical complications to address

There are a number of technical complications that are not even mentioned in this consultation paper. On a transfer, for example, some members risk losing tax protections – both in relation to protected pension ages and lump sums – although no longer in relation to pension payments, given the changes to the lifetime allowance.  Although this is not stated in the consultation paper, giving members the ability to opt out of an automatic transfer goes towards addressing this problem, in a similar way to the right to opt out of auto enrolment, but this relies on members being aware of their protections.

This area is particularly complex because, although current proposals to abolish the lifetime allowance do reduce the impact of tax protections, the Labour Party has stated it will reinstate the lifetime allowance if it wins the next general election. One solution proposed by the Small Pots Cross-Industry Co-ordination Group is that all transfers under the new consolidation regime should be treated as block transfers, ensuring that protections are not lost. However, this would increase administrative complexity for the consolidators.

Another potential problem is that members could be consolidated into a scheme which, for one reason or another, is less beneficial than the scheme in which they built up their small pot. For example, the consolidator could have higher charges or take an approach to environmental, social and governance (ESG) investments considered by a particular individual to be less appropriate. Although not mentioned in the consultation paper, the government presumably takes the view that this point is addressed by the master trust and consolidator authorisation regimes, and by the fact that members will have the ability to opt out.

There is also a risk of matching errors, resulting in small pots being transferred to the wrong consolidator, or when they should not have been transferred at all. The dashboards programme has had to address the same risk. Some errors are inevitable, but properly designed systems and processes offer some mitigation.

Other potential technical points, such as trustees’ legal right to make an automatic transfer and GDPR issues, will likely be addressed in the legislation implementing the new consolidation regime.

Timing and next steps

The initial consultation period ran only until 5 September 2023.  The DWP is taking steps to form an industry delivery group to develop an automatic consolidation transfer process in autumn 2023. Primary legislation implementing the automatic consolidation framework will be brought forward “as parliamentary time allows” – and regulations will be subject to further consultation.

Even though the new consolidation regime is most unlikely to be in place before the next general election, any new government is likely to wish to build on the progress made so far. Given the importance of getting the technical detail right, gradual progress with input from the pensions industry is better than swift progress in the wrong direction.