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Q&A: pension charges explained

Labour leader Ed Miliband has attacked pension charges for being too high, but what exactly are you paying for?


by Michelle McGagh on Jul 24, 2012 at 09:30

Q&A: pension charges explained

If you've ever tried to work out how much you pay for your pension you'll know the charges can be confusing, but the row around costs led by Labour's Ed Miliband isn’t helping to make things any clearer.

The Labour party has a long and chequered past with pensions. When it came to power in 1997 it chivvied along a pensions mis-selling review that had been dragging on since 1994.

This review led to the birth of stakeholder pensions. Stakeholder pensions were a far cry from the standard products offered by the pension providers: fund manager charges were capped at 0.5% for the first 10 years, and at 1% after that. You could switch pension providers without charge, make contributions from as little as £20 when you like, and stop and start contributions whenever you wanted without charges.

The problem with stakeholder pensions was that providers didn’t want to sell them because there was no margin to be made. The good news, however, was that providers had to start competing and pension charges started to fall.

So how did we end up fighting the same fight on charges 15 years later? Well, in those 15 years there has been no move to increase transparency in charges, which mean that providers can still levy high charges without you knowing about it.

Miliband's example

Miliband uses Which? research that was carried out in November last year to illustrate the impact of high charges.

A person who saves £50 a month for 40 years into a pension that has a 2% real rate of return will only have £15,964 in their pension pot at retirement if their annual pension charge is 4%. Someone who pays 0.5% a year in charges, meanwhile, will have £32,398 in their pot on retirement.

The figure is shocking, but it is slightly disingenuous as this isn’t just a product charge, it incorporates a number of different charges.

So what are the different charges?

So how do you get to a position where you are paying 4% of your pension fund a year in charges? Here’s how the charges add up, and what sneaky costs you may incur:

Wrapper charge: This is a charge you pay for the pleasure of having a pension. This can include an initial set-up charge, an annual charge or other quarterly charges, and essentially covers the administration of your pension. How much you are charged depends on the provider of your pension. Many charge a set cost, and others will take a percentage of your pension fund as a fee.

These wrapper charges are sometimes known as policy fees, particularly in older policies.

Annual management charge (AMC): This charge relates to the cost of having your money managed by a fund manager. The AMC is a percentage of your fund that is taken each year to cover the costs of running the fund. When it comes to the AMC you should be aiming to pay no more than 1.5%, as anything above this is bad value.

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6 comments so far. Why not have your say?

Rose G

Jul 17, 2012 at 15:19

The defined pension schemes may have been value for money, but now that they are on their way out, I do not believe ordinary people benefit from investing in a pension simply because the pensions industry is just as greedy as the rest of the financial services, and your investment is just as likely to enable the pension fund managers live their champagne lifestyle with paying out peanuts to you.

Milliband may not be trustworthy, but the pensions industry has more untrustworthy individuals - so no points for either, I'm afraid!

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A Sick SIPP Owner

Jul 17, 2012 at 18:04

From the example (s) given it's the 0.3% pa that causes pain - 40 years @ 0.3 is still 12% of the early years input.

I would look on something like the folowing to be a reasonable charging concept:

Paying-in fee - flat rate for each regardless of the amount.

Investment fee stamp duty + applicable taxes such as VAT

Annual fee - Associated documented government induced costs plus a small portion of the applicable PII and organisations running costs

That covers the costs of running the 'pot'

Add to that a percentage - 10%, or maybe 20% of the increase (or a deduction for a loss) of the fund's value over the - investors choice made at investment time - FTSE100, RPI CPI - LIBOR BoE Fixed term deposit rates rates - whatever fund type the investment was placed into as selected by the investor.

The idea being that input and running costs are covered and the managing organisation makes their money on a value-added basis.

No value added and the management get no pay and no profits.

Now - as an ARM investor I was expecting the management to take whatever was left after they returned the capital, with the specified growth or having paid me the agreed income,.

By my, admittedly rough, caclulations that should have left them with an anticipated income of at least 50% of the invested money from the later paying policies, less the effect of 10 years inflation and whatever extra premiums they had to pay for them .

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Chartered Accountant

Jul 17, 2012 at 18:58

It is sad to read comments like those made by Rose G. It is understandable why such views might be held, but nevertheless some additional comments might help. Firstly, long-term investors need to be invested in growth assets such as Equities or Property rather than Fixed Income, as it is only such growth assets that have any chance of providing real rates of return i.e returns that exceed inflation. However such assets are expensive to administer particularly if actively managed to try to beat benchmarks such as Equity or Property indices. Active management costs include both research analysts and investment managers who may often have remuneration structures that include a base salary plus a bonus that is tied to the results achieved and therefore has some equation with the interests of the investing clients. On top of this will be the cost of Record Keeping including regular reports to clients for which the rule of thumb number is usually 0.5% although increasing Compliance demands are driving that figure higher. Then there is an initial set-up charge which may vary between organisations and here the NEST figure of 1.8% will be at the low end of the market but this will be because they are offering quite simplistic and standardised indexation type products. The foregoing are costs within investment management organisations. On top of this will be charges by third party custodian banks which may be around 0.3%pa. Custodian banks are important because they hold the actual share certificates and therefore need to be notified whenever a trade takes place and these dealings are the subject of periodic reconciliations between the investment organisation and the custodian bank.

The point I am making above is that the whole investment process is not cheap. When markets are buoyant, such charges seem like money well spent. When markets decline, as recently, in say 1987, 2000 and 2008, the charges become a huge drag on what may often be already poor returns. One solution is not to invest anyway and just be content to receive interest on money in the bank. Not clever and if held in banks that themselves are in trouble, may also be highly risky. Another solution is to hold Fixed Income stocks that are widely touted as safe investments but may look anything but safe come the day when interest rates return to realistic levels of say 3-4%pa. Holding Equities in index funds may also be a low cost solution but again not ideal as the manager will take no action to disinvest or shift to other markets or sectors when economic storm clouds gather. With regard to active investment in say Equities, which commands the highest fees, when major market downturns occur, it is difficult for all but the smallest managers to disinvest as market liquidity dries up - but all the work in research and in making investment decisions will still have been made and may still be worth paying for if losses are mitigated against the alternative represented by index funds.

Financial services seem to be tainted by the actions of the massive short-term trading operations conducted mainly by the big banks although hedge funds may sometimes also be a disorderly factor in markets. However, the truth is that while normal active fund managers are well paid - particularly if they develop good performance track records - their remuneration is nothing like the examples being reported for traders out of the banks. However, if politicians genuinely wish to help pension fund returns, they could consider slowing down the incessant drip-drip of new tick-box type regulatory requirements which is causing Compliance to become a major cost; they could try to create an environment in which businesses (in which pension funds are invested) might flourish and if they feel that trading costs are too high, they could consider eliminating all dealing and other taxes within the investment process.

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Jul 17, 2012 at 22:36

1) The reason Nest will be index tracking is not the lower cost, it is because no end of studies in many countries have shown that over the long term such funds over perform 90% of the actively managed funds. Further more, Index trackers perform around the average while active funds are a gamble. The insurance against great loss comes free.

2) The AMC is of no concern to the investor and including it here defeats your purpose of simplifying things.

3) In spite of the existence of nearly all the different charges you have listed, there is no compelling reason why they cannot be combined in one.

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Jul 18, 2012 at 01:02

Stakeholders fees were not 0.5%. They were 1% AMC initially but then 1.5% AMC was allowed for first 10 years to help pay for advice/commission. But most IFAs preferred Personal Pensions with their more generous rewards etc. including residuals.

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Rose G

Jul 19, 2012 at 09:03

Hi Chartered Accountant

Thank you for trying to clarify the charging structure. Fresh as my mind is this early in the morning, you lost me completely.

I do believe that the pensions industry makes everything as clear as mud, just so that we will be forced to get advice from consultants whose vested interests are not declared, whose idea of investing is to loose client's money, while still continuing to charge for their services - if and when I am ready to invest my money, I will consider the risks and probably feel safer with leaving my money in a bank or building society in the UK, with the guarantee that upto £85K or so of my money will be safe.

I do not buy lottery tickets and so not likely to win a huge sum of money, I have a modest income of 30K or, have cleared all my debts except for the one credit card I use for travel and bigger purchases etc. My son & lodger's contributions I intend to save in an ISA towards a deposit for my son when he is ready to purchase his own home in the UK.

Being a low risk taker regarding finance, I certainly would look long and hard at any investment I make within the wider financial services industry.

That said, I did, sometime ago invest in an M&G fund, and would have liked to have continued, but life & the unexpected surprises it holds, meant that I cashed it in - I cannot remember the exact small sum I got in return for just over a years monthly contribution, but it definitely paid me back a little more than I would have got from an ordinary savings account.

I am by no means against investment, only it appears that rather than getting a return on your fairly safe investment, many people are making losses which they had not reckoned for.

To my mind the pensions industry has only itself to blame for the poor returns and for its equally poor reputation.

Having mades AVC into my occupational pension for the last 4 yrs, with another 4 to go, I am having to stop this as it was explained to me that I only got £ for £ of my contribution, with nothing to induce me to continue with this. This additional £250 or so a month will make a welcome contribution towards the saving for my son in a competitive ISA product, or I might just start paying into another investment product, which has a fairly low risk.

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