The charges encountered by members of defined contribution (DC) pension schemes, which ultimately reduce the size of the pot that can be converted into a retirement income in later life, have been in the spotlight this week.
Clearly, as the introduction of automatic enrolment fast approaches, rebuilding trust in the pensions industry is a decisive element in encouraging people to save more for retirement. As such, full disclosure of all charges is paramount. Part of the problem, however, is that not everybody agrees on what constitutes a charge.
Ed Miliband got the ball rolling last week, at least in the mainstream press, by arguing that many savers are being ‘ripped off’, warning that practices in parts of the industry will be seen in the same vein as the scandal currently engulfing the banking sector.
Miliband’s speech trailed the publication this week of the paper Pensions People Can Trust, published as part of the Labour Party’s policy review, which demanded action to make charges transparent, and as low as possible. The paper also offered support for various proposals to reform DC pensions, such as a ‘clearing house’ for annuity purchases, ending the restrictions on NEST, and moving towards the kind of trust-based governance arrangements which are the hallmark of traditional defined benefit pension schemes.
The campaign against charges was picked up again in the latest output of the RSA’s Tomorrow’s Investor project, led by David Pitt-Watson and Harinder Mann. In their report Seeing Through British Pensions, Pitt-Watson and Mann call for limits on the charges that can be taken out of occupational pensions saving pots.
They also call for much greater clarity on the nature and impact of charges, with information provided to consumers pre-sale and at the end of each year. Pitt-Watson and Mann reject the distinction between direct charges like annual management charges (AMCs), which is typically what the industry believes constitutes a charge (and which, although they remain high in many cases, appear be falling) and the costs incurred through trading of the investments made with an individual’s pension pot.
AMCs charged by fund managers may be supplemented by various administration charges, and then by charges incurred by subcontracting some of the investment activity to other funds. Zero charges are of course unrealistic, but even a low charge of 0.5% per year is likely to result in a pension which is a third higher than a scheme with a (fairly typical) charge of 1.5% per year, according to Pitt-Watson and Mann’s calculations. But this is before we even begin to calculate the impact of the various ‘hidden’ charges associated with trading financial assets, including taxes, broker commissions, the differential between bid and offer prices, and stock lending fees.
And crucially, the more assets are turned over, the more such costs build up. In a survey conducted by Pitt-Watson and Mann, 21 of 23 pension providers declared that no charges other than AMCs and administration costs are levied on individual pots.
The NAPF is of course currently compiling a code of conduct on DC pension charges. But it remains to be seen whether trading costs will be included in the disclosure regime. Furthermore, the code is designed to improve the clarity of communications on charges between providers and employers choosing a workplace pension scheme on behalf of their employees. It will not therefore enable workers themselves to develop an understanding of the kind of charges being taken from the saving pots.
Pitt-Watson and Mann do acknowledge that trading costs are not zero-sum: the financial services industry’s (or HMRC’s) gain is not necessarily the investor’s loss. Simply, these costs may be accrued in the course of improving the performance of an asset portfolio, producing better returns than a low-cost, passive investment strategy would have done. This is debatable, but even if we accept the logic of this argument, it is not justification for a lack of disclosure. The days of financial services providers masking their activities under the veneer of complexity are surely over.
Incidentally, if the government proceeds with its plans for ‘pot follows member’ as a solution to the likely creation of millions of small pension pots following automatic enrolment, it could see workers’ pensions saving being transferred quite frequently between schemes with various different charging structures. An automatic transfer from a scheme with low charges to a scheme with high charges will almost certainly not be in the best interests of individual savers.
The Association of British Insurers, perhaps understandably, makes the case that it is low contributions, rather than high charges, that has the most significant, detrimental impact on the size of pensions saving pots. This is certainly true, and contributions – particularly from employers – into DC pots must rise over the medium-term. But charges are something that the pensions industry itself has some control over. Meeting the challenge of providing low-cost, reliable and easy-to-understand products will go a long way to restoring trust in the industry.