Millions of people with pensions stuck in paltry life insurance funds will be given the freedom to take control of their investments from October.

The rule change, announced by the government this month, has given savers the green light to unlock as much as £50 billion of pension money that has been tied up for years, and that many may have forgotten about.

The move affects more than 10m who contracted out of the state second pension (S2P), formerly known as Serps, since the option was introduced in 1988. Their national insurance contributions were then diverted into personal pensions rather than staying in the state system.

It also affects hundreds of thousands more who moved final-salary schemes away from employers and until now had to invest funds with life insurers.

“We come across high earners, particularly in the City, who want to be able to invest directly into equities and gilts, or to put all their pension fund into hedge funds,” says Lee Smythe, director of financial planning at Killik & Co. “Until this rule change came along, this was not possible but, from October, it will be. Transferring out of final-salary pensions is not for everybody but, if you do decide to switch, in a few months you will have the freedom to do so into a Sipp."

Until now, the rules classified contracted-out pension savings as well as transferred final-salary schemes as “protected rights”, requiring them to be held in pension funds run by life insurers. Much of these assets are held in poorly performing with-profits or managed funds that have suffered years of below-average returns few financial advisers expect to improve.

The Department for Work and Pensions announced last week that from October, investors will be free to invest these assets in self-invested personal pensions (Sipps), which offer the freedom to put funds into a much wider range of assets

Mike O’Brien, the pensions minister, said: “These changes will give more flexibility and investment choice to people taking an active interest in the management of their pension funds. It will also be easier to transfer funds between different types of pension schemes, and to consolidate pension rights in one place.”

This rule change prompted many financial experts to predict a steady stream of investors moving protected rights funds out of moribund life insurer funds to Sipps to get a wider range of investment options.

“We believe there are millions of people out there with dormant pensions that are definitely worth reviewing,” says Tom McPhail, head of pensions policy at Hargreaves Lansdown.

The value of assets held in protected rights funds may come as a surprise to some. AJ Bell, a specialist Sipp provider, estimates that average earners could have built funds of between £25,000 and £30,000 if they had stayed contracted out since 1988.

Billy Mackay, the marketing director at AJ Bell, believes the majority who contracted out will not have checked investments for some time. “My wife contracted out on the basis of a coupon she cut out of a magazine and then never thought about it for years,” he says. “This rule change should act as a wake-up call for those who have not reviewed their contracted out benefits.”

However, switching to a Sipp will not suit everyone. Nearly all life insurers now offer a wide range of investment options from top fund managers, often cheaper than Sipps. "If you just want to invest in a handful of different funds, there are plenty of options with most pension providers, and you may get those funds cheaper through them than through a Sipp,” says Lee Smythe. “But if you want the wider flexibility of Sipps, then this rule change gives you that for your protected rights.”

Sipps from pension companies tend to be more expensive than supermarket Sipps from Hargreaves Lansdown, Alliance Trust and Killik & Co, which allow savers to run a Sipp for a zero or very low cost and take revenue from underlying fund charges. These can beat personal pensions on some funds.

However, watch out for one-off charges for other services such as share dealing and interest paid on cash held. Depending on how a Sipp is used, these could soon add to your costs.

There may also be contract terms that make it difficult to leave. McPhail said: “Watch out for exit penalties on with-profit funds, as this may make it not worthwhile leaving. Similarly, it would be foolish to give up guaranteed annuity rates if you are entitled to them.”

Advisers recommend asking pension providers what exit penalties there are and what other benefits could be lost by switching. Improved performance may outweigh the cut in fund value.

In a Sipp, you can invest in commercial property, shares, hedge funds, traded endowment policies, futures and options. “People who transfer their protected rights into Sipps can also borrow up to 50% of their fund value, an option that some high net worth individuals are using to gear up their investment portfolios,” says John Lawson, senior technical manager at Standard Life. This option is often used by those who want to buy their business premises, although a specialist Sipp provider is needed for that.

The simplification of the rules is not completely straightforward, however. Any protected rights funds held within a Sipp will be separately defined in your plan, and if married at the time pension benefits are taken, that part of your fund will have to bne used to buy an annuity that provides a 50 per cent spouse's benefit after your death. It is predicted that this will be removed in 2012.

I'll switch into a Sipp

Tony Arkinstall, 49, an IT director from Henley-on-Thames, contracted out of the state second pension in 1991. He now has a protected-rights fund of £50,000 in a managed fund with the Co-op.

‘When I contracted out I simply went into the default fund, and its performance has not been great. When you look at the projected income on retirement it does not look promising, so I am planning to switch it out to something with the potential for better returns.

‘It feels like a good time to invest in equities at the moment so I am planning to move it across to a Sipp \ with Killik & Co in October when the rules change,’ said Arkinstall.

He took out a personal pension at the same time he contracted out. This pension carried high charges and had been mis-sold to him, and he was given compensation in the pensions review. He said: "I got another £90,000 paid into that plan as compensation following the review. I plan to consolidate that pension and my protected rights fund in one place through a Sipp.’

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