The government has been urged to take action to stop and reverse the proliferation of small pension pots, after a report from the Institute for Fiscal Studies (IFS) suggested that there is a strong case for deferred small pension pots to be consolidated by default.

The report, produced in partnership with the abrdn Financial Fairness Trust, argued that the current status quo is not fit for purpose, pointing out that, in 2023, there were an “astonishing” 12.1 million defined contribution (DC) pension pots worth under £1,000 that were no longer being contributed to.

It also warned that these numbers have increased rapidly in recent years and will continue to grow further without policy action.

Perhaps, "most ridiculously", the report pointed out that the current system often leads to some individuals having more than one pension pot with the same provider.

It also highlighted the impact this can have on savers, noting that the proliferation of these small pension pots is costly for pension providers due to the fixed costs of administering a pension, which leads to higher charges and lower returns for savers.

In addition to this, it warned that having savings spread over many small pension pots makes it easier for people to lose track of their savings, and harder to make sensible decisions on how to use their wealth through retirement.

Given this, the report argued that there is a strong case for deferred small pension pots to be consolidated by default, with people being given the option to opt out of this consolidation if they wish.

This, according to the report, would reduce the stock of uneconomical pension pots, and make it easier for people to manage their savings.

It suggested that this could be done by automatically moving all the money in someone’s deferred small pension pots into either the scheme run by their current employer, or into one of a number of default funds, which would avoid increasing the administrative burden on employers.

However, the report said that there are also merits to going further than just consolidating small pots, and moving towards a system where people end up with one DC pension pot, or only a very small number of these, as they approach retirement.

The report said that this would help people make good decisions on drawing their pension savings through retirement.

The IFS acknowledged, however, that there are several ways to achieve this, each with their own set of trade-offs and potential impacts on the DC market, suggesting that the preferred policy will depend on the weight policymakers put on ensuring all individuals end up with a single pot as well, as the government’s aims for the future structure of the DC market.

Commenting on the findings, IFS research economist and report author, Laurence O’Brien, said: “Automatic enrolment has been a huge success in getting more employees to save in a pension.

“However, without policy action, many will end up with their savings scattered across several small pots by the time they reach retirement.

“This status quo is not fit for purpose: it is uneconomical for pension providers, leading to higher charges for savers, and it makes it harder for individuals to make good decisions on how to use their savings.

“Policymakers should help savers out by ensuring that, by default, their deferred small pots are consolidated together. This would lead to lower average charges and make it easier for individuals to keep track of all their savings.

“One potentially attractive option is for an individual’s pensions to be combined, by default, into their most recent pension. What is not attractive is the status quo that generates many millions of pensions worth under £1,000.”

Adding to this, abrdn Financial Fairness Trust chief executive, Mubin Haq, said: “In recent years there has been a rapid rise in the number of small pension pots. This particularly affects lower earners and women.

“The new pensions dashboard will help many to keep track of their pensions, but it will not necessarily lead to consolidation of these pots.

“Further action is needed to reduce the complexity of managing small pension pots, which should result in gains for employees as well as providers.”

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