What do the government pension changes mean?

As the government unveils its proposed changes to the pensions market – which includes a cap on fees – we take a look to see what more can be done to help savers get the most from their pension pots.

The number of people saving into a pension in the UK is pitifully low – according to the Office for National Statistics, just 46% of British workers are saving into their company pension. That’s the lowest since records began in 1997.

The government’s solution to tackle this problem, getting companies to automatically enrol their staff into these schemes, is about to kick off in earnest. So far, 1.6 million people working for large companies have been automatically enrolled into a workplace pension. And less than one in 10 have decided to opt out. This is far better than expected, but the real test will come when millions more workers at 29,000 medium and small firms join a pension scheme – many for the first time in their careers.

Taking a pay cut to save for a pension

Today the government announced its plans to consult on a cap to charges on workplace pensions. We welcome this but the government must take the opportunity to scrutinise the market to see if the proposed cap could be set any lower. Even a fraction of a per cent can have a significant impact on pension funds. And at a time when we’re all feeling the squeeze, we need to feel confident that our pension schemes are giving us the best value for money.

Now, on the whole, people saving in modern pension schemes do get a better deal. But Office of Fair Trading (OFT) studies have revealed a myriad of problems – the most shocking revelation was that £40bn worth of retirement savings were languishing in poor-value legacy workplace pensions.

Hiking charges for leaving a pension scheme

The OFT also identified seven providers that hike up charges when you leave a pension scheme. You’re effectively punished for leaving your job – with 60% of people stopping contributions to a pension within four years, the majority will be hit by these penalty fees.

The pensions industry is now entering a crucial period – millions of us are relying on it to save for a comfortable retirement. The government must seize this opportunity to help us save for our futures by ensuring stronger regulation so these charges can’t simply be hidden elsewhere.

william says:

30 October 2013

I warned about pension fees on https://conversation.which.co.uk/money/banking-scandal-libor-mis-sold-ppi-cpp-mortgage-endowments/

If pension providers have been as bad as the OFT is suggesting, will my pension providers be forced to repay me some of the fees back ? Cos I’ve being paying into pensions for over 30 years and I’m fast wishing I hadn’t bothered.

Em says:

An effective cap on management charges should not be a fixed percentage of the pension fund value, but needs to taper down over time and as the fund grows in value.

A 1% annual pension charge may not seem that much, but it is exactly that – a recurring annual charge of 1%. So your initial pension contributions will have 40-45 annual deductions of 1% made against them by the time you retire, plus 1% on any capital growth you may have enjoyed on those initial investments (or what’s left of it).

As your pension fund gradually increases to a worthwhile amount, the 1% charge could amount to an eye-watering £2,000 – £4,000 deduction every year – possibly more than you can afford to contribute to the pension in your final years of employment.

So basically a fairer fund charging structure would reduce to 0.5% or less as the value of your pension pot increases beyond, say £50,000.

Additional charges are deducted from the investment funds themselves, so the management change only needs to cover the costs of administering your pension, which doesn’t vary as the value of the fund increases.

Building up a pension fund is like filling a leaky bucket. You want it to be full by the time you retire, but if you start filling it too quickly you will spend your later years just replacing the water that seeps away in higher management charges. Start too late and you may never fill the bucket in time. Intuitively, the optimal strategy to reduce leakage (management charges) is to put more water in the bucket the closer you are to retirement.

The OFT could do us all a favour by making available a bucket with the unusual property that it leaks less the fuller it gets, and it stops leaking all together when it is not being filled.

John Ward says:

31 October 2013

Thank you, Em. You have explained in an easy-to-understand way something that I have never quite been able to get my head round. A pension bucket makes a lot more sense than a pension pot. Presumably, the primary purpose of the management charges is to cover the actual cost of running the pension fund including the costs of buying and selling investments, stamp duty, research and analysis, actuarial assessments and fund valuations, reserves, compliance and regulatory costs, fixed overheads, fees, salaries and other remuneration. Some of those are directly proportionate to each individual fund but others can be spread over thousands [and in some instances hundreds of thousands] of individual accounts. Historically, a flat percentage charge was a rough-and-ready way of recouping these costs, but with modern computing power at our fingertips it should be possible to be much more precise and to be sensitive to the degree of management activity and actual performance involved. This might not be what people want, of course: percentage charges can have the effect of smoothing out fluctuations, athough there are still great uncertainties in the system and the recent history of annuities has focussed attention on the essential significance of entry and exit timing in any investment-based provision [and there is virtually no credible alternative, of course]. Easing that quandary, if possible, would also be a welcome move – once the hole in the bucket has been mended [. . . dear Henry].

Thank you John. Of course the bucket analogy is not perfect, because it ignores some of the effects of long-term investment gains. But I generally take the view that investment growth is no more than sufficient to keep up with inflation, and I’m certainly not banking on stellar investment returns funding my retirement.

The annual pension management charge covers a lot of things, but it does not cover the costs of buying and selling investments, stamp duty, fund management, etc. These are attributed to the individual funds you invest in, and are recovered by deductions from the fund assets as they fall due. In other words, the calculated unit price is less than it would otherwise be and, without any investment return, the value of your fund would decrease over time, even if no units were deducted to cover the pension management charges. If you want to stretch the bucket analogy even further – water evaporates.

The following link clarifies the various charges and where the money goes:

https://www.aviva.co.uk/pensions-and-retirement/pension-charges.html

1 November 2013

Thank you for that link. It gives quite a list of clerical and administrative functions that are obviously essential and have to be paid for. Given that pension schemes are normally long-term plans it is not unreasonable that the costs are aggregated and equalised across all participants. However, since many of these expenses do not move pro rata to value, the more successful the management is in delivering better fund performance [and thereby attracting more investors] the more likely they are to be able to lower the annual percentage charge rate . . . but does that ever happen I wonder?

Theo says:

Why do you never mention that the relatively small income people will earn from their work place pension when they retire, will be completely offset by the loss of pension supplements.

Vanguard and other unit trusts have annual charges below 0,25% and no other charges, why do you support charges of 0.75%?

Why are you not asking for a refund of any charges people paid on leaving their jobs? Is that not misselling?

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