Pension charges – don’t be lulled into a false sense of security
18 February 2014
by Dr. Ros Altmann
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- DWP report on pension charges shows importance of introducing a cap
- Workers in small firms need protecting from rising charges as small funds pay higher fees
- Labour TER cap for new schemes makes sense but don’t set too low initially
- NEST reforms needed- and AMDs should be banned
- DWP report on pension charges shows large schemes have lowest charges
- As auto-enrolment spreads to smaller firms, their workers need protecting from high fees
- Labour is right that we need a cap on charges in new auto-enrolment default funds
- OFT Report showed new auto-enrolment schemes average charges are 0.5% or less but don’t be lulled into a false sense of security as charges will drift up for smaller employers
- Cap TER (not AMC, nor dealing costs)
- TER cap of 0.75% (possibly 1%) from 2015 for new schemes, with existing schemes capped after 2017 to avoid capacity issues for providers and cap falling in future as assets rise
- Active Member Discounts should be banned as they penalise too many members and pot follows member can’t help
- NEST’s charge structure doesn’t fit with a cap – should be a single annual charge to allow customers to compare costs properly.
The DWP has just released a Survey of pension scheme charges which shows that members in smaller schemes pay higher charges. The Survey highlights that larger schemes pay lower fees and those with commission based advisers and lower paid workers pay more. The case for controls is clear.
Findings of DWP Survey: The Survey shows average Annual Management Charge (AMC) for trust-based schemes was 0.75% in 2013, slightly higher than the 0.71% in 2011. Among contract-based schemes, average AMC fell from 0.95% in 2011 to 0.84% in 2013. Members of smaller schemes (12 to 99 members) paid higher AMCs in both trust-based and contract-based schemes – 0.91% and larger schemes (over 1000 members) paid significantly less – 0.42% in trust-based and 0.51% in contract-based schemes. Schemes with higher-paid workers also have lower charges as their contributions were larger. Where employers use a commission-based adviser, trust-based schemes paid on average 0.4% higher charges, and 0.2% higher in contract-based schemes. Older scheme charges were higher, with trust-based pre-1991 schemes charging on average 0.81% but 0.71% for schemes started after 2001. Average charges for contract-based schemes set up before 1991 were 1.0%, but fell to 0.80% after 2001.
Charge cap in the long grass?: However, despite its recent consultation proposing to cap auto-enrolment pension Annual Management Charges (AMC) at 1% or 0.75% perhaps from April 2014, the DWP subsequently announced there would be no cap before April 2015 and there are now rumours that nothing will happen at all before the next Election.
Workers do need protection: April 2014 was certainly too soon, as it could have meant employers who had prepared early for auto-enrolment (as urged to do by Government) might have to start again if their chosen scheme did not fit with the cap. But, as millions of workers in smaller firms will be enrolling into employer pension schemes, they do need protection. A charge cap would be helpful for such new schemes.
Principal agent problem- employers choose, but workers pay- so just requiring disclosure of charges is not enough protection: Unlike traditional Defined Benefit schemes, where employers covered all the management costs, members must cover these in Defined Contribution (DC) schemes. However, members are in a weak position to protect their own interests because their employers choose the scheme they are auto-enrolled into. The OFT report expressed concerns about this principal-agent problem. Merely requiring full disclosure of charges is not sufficient to protect workers, since they cannot choose or change the scheme their employer uses.
Dangers of being lulled into false sense of security by recent improvements: Recent evidence of lower charges may be encouraging (the OFT reported that new auto-enrolment schemes have average AMC of just 0.51% with multi-employer schemes even less), but it is important not to be lulled into a false sense of security. So far only the larger employers have auto-enrolled. These employers have HR or finance departments to negotiate good terms for their workers, and more management time to devote to these issues than smaller employers who will start auto-enrolment next. Most micro employers have no experience in pensions and providers will be less keen to compete for their business. Industry moves such as the Investment Management Association’s ‘Enhanced disclosure of fund charges and costs’ or the ABIs agreed standards for charges and a ‘joint industry code of conduct’ cannot be relied on as they are only voluntary.
However, don’t set cap too low initially: The danger of being too draconian on charges is that innovation and new investment approaches will be stifled. There needs to be a balance between protecting customers and damaging their longer term interests. Sometimes, slightly higher charges may be justified and it is inevitable that smaller schemes will have higher charges due to problems of economies of scale. If paying a little more in charges delivers better or less volatile returns or pays for more effective information and engagement with members, they might be justified. But controls are still needed to avoid unfair practices and the DWP research suggests charges are still high in some areas.
Clarify what charges are capped- not just AMC, need TER cap: Just imposing a cap on AMCs is inadequate protection. AMCs cover asset management costs but exclude many other ongoing charges such as legal fees, administration and accounting- indeed the OFT identified 18 different charges that have been imposed on pensions. Capping Total Expense Ratio (TER or Ongoing Charges) is better than AMC to prevent providers simply circumventing a cap with new charges. It may be better to have no cap at all, than to lead members to believe charges are controlled while providers can increase costs in other ways.
Start with 0.75% (or 1%) cap on TER ongoing charge basis and signal a reduction in future: Labour suggests a 0.75% TER cap which seems reasonable for new schemes (although 1% initially might also be considered) but it is important to signal that the cap will be reduced in future years. As assets under management in auto-enrolment schemes increase, economies of scale should enable lower charges.
Don’t cap dealing costs but ensure full disclosure: I think capping dealing costs is a step too far. One would not want to hamper the ability of fund managers to actively trade their holdings if considered necessary. However the costs of dealing do need to be properly reported in a clear, comprehensible fashion, so members can see what they have paid.
Removing Active Member Discounts is even more urgent than charge caps as ‘pot follows member’ can’t help those with career breaks: Another urgent reform is to clamp down on so-called ‘Active Member Discounts’ (AMD) which are basically penalty charges on people who have left their employer scheme. Approximately 94% of pension schemes with AMDs are still open for auto-enrolment. The OFT says workers who leave their employer can be hit with extra charges of around 0.5% a year. This will particularly affect women who take career breaks for caring responsibilities. The Government’s current proposals for ‘pot follows member’ will not solve this problem because people taking career breaks have no new scheme to transfer to, so banning AMDs is important.
NEST charge structure undermines effectiveness of any charge cap: The charge structure of the taxpayer-backed NEST scheme does not fit with the aims of a simple charge cap. For a charge cap to work properly, customers must be able to easily compare schemes with each other. Two-tier charge models make this too difficult. NEST has an initial contribution charge of 1.8% plus a 0.3% AMC annual fee, while NOWpensions charges an £18 initial fee, plus 0.3% AMC- these cannot easily be compared with schemes that have a TER of 0.5%. The Pensions Policy Institute calculates that older workers in NEST are particularly disadvantaged. Those who are auto-enrolled at age 60 and contribute until their state pension age will pay far more in charges with NEST than with a 0.75% cap. As it is older workers who will retire first under auto-enrolment, reform of NEST’s charges would seem desirable. Without standardisation of reporting and fee structures (including NEST reform), capping auto-enrolment charges will be less effective
Dr. Ros Altmann