Pension fees can leave you shortchanged
It’s somewhat shocking to realise that much of the tax relief you get for saving into a pension fund can be eaten up by the various charges and fees levied on that money by pension providers.
But this is what a report by the Department of Social Protection on charges in the industry found late last year – it revealed that the average annual charge of 2.18 per cent can diminish your final pension pot by as much as a third.
And the higher the charge, the more severe the impact.
As Marc Westlake, head of wealth management with Goldcore notes, a differential in fees of 1-2 per cent “absolutely kills you over 30 to 40 years”.
So what’s going on? And can anything be done about it?
Firstly, the opacity of the market means it’s very hard for pension savers to work out exactly what they’re being charged.
“A lot of people are not aware [of charges] and there’s sometimes a lack of transparency about these things. People don’t understand the information they get,” says Pensions Ombudsman Paul Kenny.
“Where the system breaks down is that, effectively, we’re not given the information in a way that’s meaningful,” says Westlake, adding: “The current system of delivering pension products attempts to conceal some of those costs”.
While it’s fairly straight forward to ascertain the annual management charge on a fund, a plethora of other charges, such as allocation rates and early exit penalties, can also apply.
Paul Delaney, senior financial planning consultant with IFG Private Clients, notes that trail commission, whereby an adviser receives commission on an annual basis years down the line from having sold the policy, is one charge of which people are often unaware.
Kenny refers to a recent incident where a pension customer was aggrieved to learn that he was being charged fees of 5 per cent on his pension – in return, the fund had given him an allocation rate of 102.5 per cent. That reduced the impact of the higher fees but the problem was that the pension saver couldn’t understand the charges being levied.
In this regard, a “cleaner approach” in disclosing charges would be of benefit to savers, notes Kenny, who adds that, at present, pension fund providers aren’t in breach of any legal requirements when it comes to disclosing all the charges levied on a pension. Under the Pensions Act disclosure regulations, only certain minimum information is required to be given.
So would a total expense ratio, or TER, as is used in instruments such as exchange-traded funds (ETFs) to calculate charges, solve the problem?
“It’s only half the picture,” says Westlake, adding that if the fund is actively managed, the TER will only disclose administration costs – not operational costs such as transaction fees etc.
Another measure which might be more useful, is a Reduction in Yield, which was used in the Report on Pension Charges Ireland 2012 to indicate how much pension savers were losing as a result combined charges.
Whatever the measure used, it is clear that some standardised assessment of total charges is needed.
“I don’t think you can fully standardise charges, but you could standardise the way in which charges are being disclosed,” says Kenny.
After all, higher charges don’t always mean a lower pension fund – sometimes, opting for a more expensive fund manager can lead to a better performing fund and therefore a better outcome for your pension fund. The difficulty is where you don’t realise that you’re paying over the odds.
And it’s fair to say that consumers, as well as the financial services industry, have to up their game.
“The client has to take a more aggressive role in these meetings and ask questions to ensure that they are getting good advice, and that their retirement plan will not be lining the adviser’s pocket until the client’s retirement age,” says Delaney.
This has always been a thorny subject, with the broker industry often in favour of the commission-type structure while customers have wondered whether or not it was in their best interest. However, almost all were happy to get financial advice for no upfront cost. So who is right?
In the UK, commission has been banned since the start of this year, In Ireland, however disclosing commission payments is as far as it has gone, which means that conflicts of interest can remain.
“Your adviser will only get paid if he sells you a product, so he will be motivated to do so, even if paying off some debt might be better for you,“ cautions Westlake.
Kenny has some scare stories on the issue. One pension fund client was advised by his accountant to set up a pension scheme. After a few years, he noticed that commission was still being deducted from his fund. When he queried the charges, he discovered the commission was being paid not to the accountant but to his wife, who had her own financial services company.
In other cases, Kenny has been dubious about the reasons why people were sold longer than average term products, such as a pension that doesn’t kick in until the age of 70.
“I can’t avoid the suspicion that the commission rate is X per cent multiplied by the number of years to go in the policy,” he notes.
So should commission be abolished altogether? Or would such an approach mean that people simply wouldn’t avail of any financial advice if they had to pay an up-front fee for it?
“I certainly wouldn’t like to see the whole broker community driven out of business,” notes Kenny, while Delaney is uncertain about the market for a fee-paying service.
“I don’t know if there’ll be an appetite for people to pay for advice,” he says.
Many pension funds also typically impose fees should you leave the scheme early. If, for example, you’re invested in an equity fund, you will take a hit on the bid/offer differential – or the difference between the price to buy into the fund, and to sell out.
Where it gets more troublesome, however, is when it comes to other types of funds, such as with profits arrangements. The surrender value of these funds may be impacted by a market value adjustment to reflect the underlying value of assets.
“And it can be quite a heavy reduction,” notes Kenny.
Exit charges hit the headlines a few years ago when people found themselves locked into property funds. The property crash meant the value of the underlying assets had been slashed and funds imposed high exit charges on customers looking to get out in order to stop a run on certain funds.
The issue of exit charges particularly comes into play for personal pension holders who have belatedly realised that they’ve been sold a pup.
“They subsequently realise they’ve made a mistake, but it’s too late and they’re locked into a contract that’s very inflexible,“ says Westlake.
Indeed Delaney notes that some older- style personal pension policies might have trail commission of as much as 1 per cent a year, on top of management charges of 2 per cent, and allocation rates of as low as 92 per cent. If this sounds like your pension policy, it might be time to change.
“It’s hugely important. Whether you have two years to go to retirement or 20 years to go, it doesn’t matter. You should be reviewing them,” he says of pension funds, especially personal arrangements.
“You should be looking at new contracts. A new contract would be more transparent, with contributions made closer to a 100 per cent allocation rate.
“There may be the same management charges, but I’d say that anything over 1.5 per cent is astronomical.”
But while the incentive to move might be there, the cost of doing so might be prohibitive.
“The irony is it may be a case of damned if they do and damned if they don’t,” says Westlake. “The provider of the pension has costed it in a way that they’ll make money whether you stay or go.”
And as with the need to monitor charges in your current fund, it is also important to be assured of the value of moving. There is little point in switching one bad value investment for another.
Churning has been an issue for the investment industry for years and while no definitive finding was made in relation to churning in the Department of Social Protection report, it did note an unusually high amount of pension customers being switched out of one plan and into another.
Passive v active
Is it worth paying more for an investment manager to “actively” manage a fund, by seeking to out-perform a market? Or is a low-cost passive approach, which aims to replicate the performance of a particular index or basket of securities, the better option?
There’s nothing new about the dilemma, but it’s one that nonetheless affects almost every investor.
“There are merits to both: it really depends on the fund in question,” says Sheena Frost, senior associate with Mercer.
“Generally, you would find that active management has higher fees attaching. What a [pension] trustee needs to be comfortable with is: are they satisfied that this higher charge is justifiable, that the fund can add value to the member and their ultimate balance at retirement”
For Westlake, there is a lot to be said about a passive approach.
“Passive works. It is better, it is cheaper therefore it works – on average. It’s not possible for us all to beat the market and be above average,” he says.
Value for money
Paul Giblin, director of investment selection with Davy Private Clients, agrees.
“There are a lot of passive instruments available, including a huge range of ETFs, that are cheap and tend to provide people with a lot of the exposure that they want,” he says, although it’s not the whole story.
“I would also say that it is true that the active industry does have a lot of skilled people in it and there are a lot of talented active managers out there who do justify their fees,” he says, adding: “It’s a question of value for money rather than just costs”.
By sacrificing the potential for outperformance, any saving on management fees can quickly become immaterial, notes Ryan.
“Investors forgo the benefit of the fund manager’s judgment – an ETF or index fund does not respond to changing market conditions and will continue to hold securities as their value declines,” he says.
But if this is true, how can one distinguish the wheat from the chaff – especially if one is to believe that oft-quoted statement “past performance is no guarantee of future performance”.
“It’s not an easy task,” agrees Giblin, noting that an advisory service can help investors make such a decision.
Westlake is less convinced, however. “While there will be managers that beat the market from time to time, chances are it’s down to luck rather than skill,” he says.
Long-term investment performance, especially in the US where these things are more closely studied, tends to bear him out.
Charges checklist: what to ask your fund provider
Annual management charge:This covers the costs of administering the fund. It typically ranges between 1 and 2 per cent of the value of the fund.
Allocation rate:The percentage of each contribution that goes into a pension fund, with the remainder going to the provider as fees. It typically ranges from 90 to 105 per cent.
Bid offer spreads:Similar to the allocation rate where not all member contributions are invested in the fund; a typical spread would be 5 per cent.
Policy fees:A monthly or annual fee levied by a life assurance company to cover administration costs, typically of the order of about €3 a month.
Exit penalties:These fees apply for early exit from the policy.