How to reduce knock-on effect of pension charges

If you read nothing else, read this…

• Employers can negotiate lower annual management charges with their provider if they have a big workforce.
• Charges on GPPs tend to be more competitive than Sipps because their funds tend to be less specialised.
• Charges associated with contract-based pensions could increase after auto-enrolment takes effect from 2012
because the large numbers of lower paid employees in such schemes will make them less profitable for providers

Case study: Peel Hunt finds harmony in retirement planning

After a staff buyout from KBC Bank, broking house Peel Hunt had the opportunity to create its own reward strategy to increase employee engagement. Over the years, Peel Hunt had accumulated three pension schemes with
different providers, and it turned to Thomsons Online Benefits to help it harmonise these schemes to provide a
more consistent approach to retirement planning.

An employee focus group highlighted a broader-than average range of needs. Some staff required retirement
planning, simple charges and passive investment, while others needed specialist tax planning and investment functionality.

A new group personal pension (GPP), launched with Scottish Widows, has adopted an active member discount (AMD) to virtually halve charges for most scheme members.

By using the AMD structure, employees that remained at Peel Hunt would no longer cross-subsidise the provider’s costs for those who left, and those who left could continue to contribute or transfer without penalty.

For more sophisticated investors, Scottish Widows provides a self-investment option that offers a discounted fund supermarket and share-dealing facilities within a low-cost wrapper. The GPP can act as an accumulation vehicle for those wanting to use the self-invested personal pension (Sipp) in future.

Peel Hunt says this approach has allowed it to deliver better value to employees, while catering for the more sophisticated investor willing to pay for extra flexibility.

Annual management charges for workplace pensions can be costly but there are ways to keep them down, says Ceri Jones

Charges on workplace pension schemes have been in the news lately, with debate around the government’s decision to settle on an initial charge of 1.8% on the value of each contribution and a 0.3% annual management charge (AMC) for the national employment savings trust (Nest). This has prompted Danish pension provider ATP to say it will undercut Nest with lower charges.

AMCs currently incurred on workplace personal pensions vary from about 0.3% to 1.75%. Charges have fallen significantly in recent years; a decade ago, 1.3% was the typical mid-point, compared with 0.55% today.

Employers can generally negotiate lower AMCs with their provider if they have a large workforce, particularly if other factors are favourable, such as low staff turnover and healthy contribution levels.

John Lawson, head of pension policy at Standard Life, says: “Big is good. A few thousand employees is large enough to justify a reduction in costs because of the economies of scale in obtaining and managing data.”

Promoter Live Nation Entertainment, for example, was able to reduce charges for employees after its merger with Ticketmaster last April by using its combined 1,500-strong workforce to negotiate a better deal.

Michael Whitfield, chief executive officer at Thomsons Online Benefits, explains Live Nation amalgamated 12 different schemes into a group personal pension (GPP) provided by Friends Provident. For some schemes, charges were cut from 1.5% to 0.5%, while some were already charging the lower rate. “This is possible because of the economies of scale and improved IT,” says Whitfield.

Low staff turnover can also be a factor in negotiating charges. Annual turnover for the average UK employer is about 14% – down from a more typical 18%, reflecting the economic climate. Turnover in the 5%-10% range is therefore helpful in negotiations.

Another factor is the average age of staff, because younger members will accrue larger savings pots over their lifetime, compared with those who join a scheme just a few years before retirement.

Other assets joining the scheme

Insurers also consider the prospect of other assets coming into the scheme, such as a tranche of members switching from a legacy final salary scheme.

Employer profiles vary greatly and have a big impact on the profitability of pension plans. “Some retailers turn over their entire, and poorly paid, staff every year so there are only small pots on which the provider can levy a charge,” says Lawson.

At the other end of the spectrum, where, for example, highly paid IT specialists or fund managers are contributing 10-15% of salary, the insurer may be able to levy charges on average yearly contributions of £30-£40,000.

Douglas Baillie, director of independent financial adviser Douglas Baillie, says: “Larger schemes use buying power to negotiate lower charges, but I doubt any employer could negotiate on job mobility alone.”

Typically, employers cover the cost of everything other than the AMC, which is picked up by members. The active member discount is a popular model, with members charged a lower rate while still working for the employer. If they move to a new employer, they either pay a higher percentage of the charge or an additional set charge, such as £10 a month, on top of the existing fee.

Currently, commission for advisers is ultimately paid by the insurer, with the charges spread over many years. This often results in higher AMCs for employees. However, it will no longer be allowed under the Retail Distribution Review (RDR) from January 2013. From then on, all fees must be transparent and advisers must agree with employers in advance how much they will be paid.

So financial advisers’ cashflow does not dry up completely, they will be allowed to take trail commission from any products they sell between now and 31 December 2012. There has been a lot of churning in this market recently as advisers try to grab business before the deadline, despite the Financial Services Authority’s promise to monitor the market to ensure this does not happen.

The irony is charges on group personal pension plans (GPPs) are already competitive, and much lower than those often applied to self-invested personal pension plans.

Going off piste with investments

Tom McPhail, head of pensions research at Hargreaves Lansdown, says: “This is because the funds on offer in GPPs are typically large general funds or trackers, nothing too specialised. Very high charges usually occur only when a member decides to go off piste with their investments.”

The villains of the piece are investment funds and multi-manager funds, which charge as much as 1.5% in AMCs, plus fund expenses of about 0.3%, as well as AMCs for all underlying funds – a total of 3% or more. This is a lot to try to make up for in investment out-performance. Barclays Equity Gilt Study 2010, published in February indicates, over time, investors are on average 4% better off from investing in equities compared with risk-free assets such as cash deposits.

Some specialist and active funds have total expense ratios equal to three times their annual charges, usually incurred by the manager trading excessively. Such funds typically perform poorly. Ironically, auto-enrolment, which comes into effect from 2012, might create upward pressure on charging for GPPs because more lower-paid staff will join their employer’s scheme, making it less profitable for the provider.

Auto-enrolment will also result in increased joiner and leaver activity, which will push up administration costs.The government’s estimates for Nest suggest it will spend about £15 per head per year on administration. ATP, which in February said it would challenge Nest with a more cost-efficient product, has kept the running costs of Denmark’s national pension fund to less than £5 per member per year.

However, ATP could find it hard to gain a foothold in a market where the main competitor is mandated by the UK government. But rival GPPs will score over Nest in one crucial respect: they can be part of a salary sacrifice arrangement.

Compounding effects of pension charges

• The compounding effect of charges has a surprisingly big impact over time. For example, if member A invests £5,000 a year in a fund that grows on average by 7%, they will amass a fund of £490,000 after 30 years. But if member B has a plan that returns 7% but costs 3% more in charges, this would slash the savings pot to just £278,400 – some £211,600 less than member A.

• Although a better-performing but higher-charging fund will be preferable because the returns will be much bigger than the extra charges, in practice, investment returns cannot be predicted with any accuracy, while charges are a known figure.

Read more articles on annual management charges