Should I leave my ‘with profits’ pensions where they are or move them?

I have three small pension pots and don’t know whether to combine them or leave them as is. I am 56 and not thinking of using them until I am at least 67.

The pensions are:

1. Scottish Widows with profits transfer value £15,000

2. Standard Life with profits transfer value £39,000

3. Legal & General multi asset fund £7,000

Someone told me that with profits pots are hindering my fund and I should move them into a fully flexible Liverpool Victoria account but it will cost me £2,500 to do this. 

What do you think I should do for the best?

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Steve Webb replies: Large numbers of so-called ‘with-profits’ policies were sold years ago, and those who still hold these old-style policies need to understand how they work and think very carefully before cashing them in.

By way of background, one of the problems with investing your money is that it can be rather volatile.

If you are investing to get a decent rate of return you are probably taking an element of investment risk which means that you will have a mix of good years and bad years.

Many people are uncomfortable with seeing the value of their investments moving up and down and would prefer something that smoothed out the peaks and troughs.

This is what ‘with profits’ policies are designed to do. (There are more modern policies which also attempt to smooth returns but do so in a rather different way).

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In brief, when you put money in a with-profits pension or investment it is invested across a range of assets in the usual way. However, the return on your investment is calculated in a slightly different way.

As part of your overall return, you are awarded an ‘annual bonus’ which is added to the value of your policy. This is usually in two parts.

The first is a bonus which is ‘locked in’ – it cannot be taken away from you. This is sometimes known as a ‘reversionary bonus’.

Second, you may receive an additional ‘indicative’ annual bonus but this is not guaranteed and can be withdrawn later if investments do less well than expected.

This variable annual bonus is designed to smooth the returns on the investment.

In a good year the bonus may be less than the actual return on the underlying investments and in a bad year it may be more than the actual return.

By smoothing in this way, the value of your policy will generally rise much more steadily than if it exactly the tracked the underlying value of the investments.

At the end of the life of the policy you then get something called a ‘terminal bonus’.

During the life of the policy you may receive forecasts as to how much this will be, but those forecasts are for information only and are not guaranteed.

When you come to the end a calculation will be done and a final bonus will be added. This is the amount that you can take out.

As you can see from this simple description, ‘with profits’ policies are designed to be run for the full length of the policy.

The smoothing from year-to-year and the adjustment of the terminal bonus are all part of the management of the policy.

For that reason, there are often significant penalties associated with taking out your money early (sometimes referred to in paperwork as ‘market value reductions’), and that appears to be the case with your two ‘with profits’ policies.

Given that you have said that you don’t plan to use these funds for another decade, this would be a good reason to think very carefully before you consider transferring out.

Obviously, if the investment performance has been poor and the charges are high then you might consider transferring to another more modern pension, but you should be very careful about transferring prematurely just because it feels tidier to combine your pensions in one place, especially if you would have to pay a penalty for doing so.

With profits policies can be quite complex to understand, and these days providers generally employ committees of experts whose role is to make sure that the different with profits policy holders are all being treated fairly.

There have been examples of ‘with profits’ policies going badly wrong (notably the very particular circumstances of the Equitable Life scandal), but other people have had good value from such products and have benefited from the way in which they smooth out the ups and downs of investing.

I would encourage you to get more information about your two policies and to ask the two different providers to give you information about how these funds have performed, how much are the charges and what would be the penalty if you did decide to move the money out now.

You should also find out if your policies have valuable features like ‘guaranteed annuity rates’ which could be lost if you cashed out.

But if there is no pressing need to take the money out, and if the funds are performing well, then you should be careful of moving them just on the basis of something you have been told.