Pension charges need to take account of annuity costs, not just AMC
by Dr. Ros Altmann
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- Pension fund charges – don’t get obsessed with lowering charges too far, too fast
Difference between 0.5% and 0.75% AMC equates to about 5% of final pension fund over 46 years –
People lose far more than this when buying poor annuities which have no controls at all
- Cap new scheme charges to protect smaller firms but leave legacy schemes till after 2018 – and reform NEST charges to allow proper comparison
As the Government’s consultation on pension scheme charges closes today, there is significant focus on how low fees need to be to offer good value. Of course, there is no ‘right’ answer to the question of what is a fair fee level. The days of rip-off charging for newly established schemes are gone – charges have already fallen dramatically, which is good news. I believe it is important, however, not to become too obsessed with charges on the accumulation phase of pensions as there is a danger of dumbing down investment approaches by trying to lower fee levels too far, too fast.
I also believe that the current obsession with charges is missing a much more important issue, which is that there are no controls at all on the fees charged, or value for money offered, at the other end of the pension system when people can buy poor annuities, which are the wrong product at a bad value rate and pay high fees to do so.
The DWPs own figures show that the difference between an Annual Management Charge (AMC) of 0.75% instead of 0.5% would reduce the final pension fund value by around 5% for the average worker after 46 years of saving. This is a small fraction of the amount that people can lose at retirement if they buy the wrong annuity, at a poor rate and pay high fees in the process.
Buying a standard annuity from an existing provider can lead to charges of 3.5% of the fund value being paid when firms have tie-ups with one company and are paid a referral fee for each annuity sold. There are no controls to ensure that the annuity bought in this referral is the right product or offers a best rate.
Standard charges for buying an annuity, even from existing providers are around 2% of the fund value which is taken in one go. That equates to eight years of charges at 0.5% instead of 0.75%.
Buying a standard annuity from an existing provider, when someone is entitled to an impaired life rate, can often mean a 30%-50% lower income for life.
Buying a standard annuity, even after ‘shopping around’ for a better rate, when a person fails to cover their partner can mean losing over half the value of their pension fund when they die and leave a widow or widower with nothing, as the insurer keeps the balance of the funds not yet paid out.
I have put in a response to the Government’s consultation on workplace pension fund charges. There are several important points that need to be considered.
I recommend that the DWP should introduce controls on charges for new schemes urgently, as small employers will not be able to negotiate such good rates for their workers and a cap of 0.75% seems reasonable. We should not be obsessed with charging levels – a 0.75% charge is not a ‘rip-off’, and driving charges down to just 0.5% is probably too low to allow for innovation in investment approaches for default funds. Just forcing everyone into a passive tracker fund or an inflexible lifestyling approach is not necessarily an optimal investment strategy. Firms have to make enough money for it to be worthwhile innovating.
New schemes that have been set up for auto-enrolment so far generally have much lower charges, but that reflects buying power of large firms. As smaller employers start auto-enrolling next year and up to 2018, Government needs to ensure charges do not drift up too much. The Government should focus initially on capping new auto-enrolment scheme charges (and the cap should be on all charges excluding transaction costs, (with transaction fees fully reported separately on annual basis).
I believe it is right to ban the practice of preferential fees for current workers (so-called Active Member Discounts) and that new schemes should be required to offer the same terms to all members, whether active or deferred. It is also necessary to ban the practice of moving workers into higher charging schemes when they leave a firm.
In the near-term, however, introducing a cap for schemes already set up could interfere with roll-out of auto-enrolment and divert industry resources away when they will be vitally required to service the coming capacity crunch in the industry. Therefore, the immediate priority should be to ensure new schemes are established with fair value terms, while aiming to change those which are already in use at a later date.
As it is far more complex to change existing schemes, the government should delay introducing controls (other than perhaps a requirement that charges on existing schemes cannot be increased for the first 4 years) and then deal with charge caps on legacy schemes after the ABI audit and after auto-enrolment and pot-follows-member reforms are up and running around 2018. The urgency to change new schemes is much greater than for those already established.
In any charge cap change, I believe the Government should address the problem of NEST’s high initial charge. Currently, NEST takes 1.8% of each contribution made plus an additional 0.3% of the contribution value each year. For older workers being automatically enrolled into NEST, this amounts to a very high fee level – far greater than any proposed cap. Not only will this be bad value for workers who do not contribute to NEST for many years (for example for those who are close to retirement when they start contributing), but having a two-tier charge structure makes is much more difficult to compare charges across different schemes. It would be much easier for employers and workers to understand the impact of charges on their auto-enrolment pension funds if there was just a single charge, reported in a standard format, which could be compared across all schemes. A flat-rate charge of, say, 0.5% for NEST, would set a good benchmark for the industry.
This is the summary of my response:
1. Reform of annuity charges and value for money is even more important than capping charges during accumulation – 0.5% lower annual charge could mean 11% larger pension fund after a lifetime of saving, but poor annuitisation risks losing far more than this in one go at retirement
2. It is vital to have charge controls to ensure charges don’t drift up as small firms start auto-enrolment
3. Not necessary to mandate reform of both past and future scheme charges simultaneously – but charge controls on new schemes are urgent and easier to implement
4. Changing charge structures for existing schemes is more complex and could be delayed till after 2018
5. Auto-enrolment requires economies of scale to operate most efficiently and charge controls should help consolidation
6. Government intervention is required to protect workers from principal-agent problems especially as small firms stage
7. All charges should be disclosed in a mandatory format, covering all the fees paid, but transaction costs should be disclosed separately
8. NEST’s charge structure undermines the principle of clear, simple, comparable charges and should be simplified
9. Active and deferred members of a scheme should face the same charge levels, with no more Active Member Discounts or Deferred Member premiums
10. It’s impossible to say what a ‘fair fee’ is and there is no one right answer. However 0.75% excluding transaction costs may be a suitable compromise figure.
Dr. Ros Altmann
28 November 2013