Dangers of being lulled into a false sense of security on charges

by Dr. Ros Altmann

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Workers in small firms need protection

To cap or not to cap – will disclosure do the trick?

Proposed cap on pension charges: A few months ago, the Government issued a consultation document that proposed capping the fees on pension default funds used for workplace pension auto-enrolment, promising of an imminent ‘full frontal assualt’ on charges. A 1% or 0.75% Annual Management Charge (AMC) cap was suggested.

Industry views split: That led to a furious flurry of activity among pension providers. Some declared that charges should be capped at a much lower level, such as 0.5%, while others warned that introducing a cap would create huge problems for providers who wanted to offer more than just basic passive default options. It also became clear that trying to impose a cap as early as 2014 would mean many employers who had prepared early (as urged to do by Government) for auto-enrolment might have to rip up their plans and start all over again if the scheme they intended to use did not fit with the cap.

Decision delayed: Having listened to all the feedback, the DWP has now announced that it will not impose any cap in April 2014 and there will be at least 12 months notice of such a move – with the earliest start date being April 2015. This sounded rather like ‘long grass’ territory for the charge cap idea. What are the implications of this?

Damning OFT inquiry into pension charges: The OFT produced a damning report last year, highlighting the poor practices which have blighted people’s pensions. Legacy schemes from the ‘bad old days’ (pre-2001 when stakeholder started) are still being used for auto-enrolment by some employers. The OFT identified 18 different types of charge that have been imposed, so it has called for a proper audit of these and a move towards standardised charge structures that will allow comparison without confusion.

Is now the right time to cap charges?: There is no doubt that paying lower fees for pension fund management is preferable to paying higher fees, but does that automatically mean a charge cap is the right way forward? Given the potential capacity crunch for the pensions sector as millions of workers will be enrolled into employer pension schemes over coming months, is now the time to attack both new and existing as the consultation proposed?

Let’s look at some of the important issues in this debate.

Is a cap really necessary?:

Many may think this debate is no longer important. Charges for new auto-enrolment schemes do not seem excessive. Indeed, newly established contract based DC schemes have an average AMC of 0.51% (down from an average of 0.79% in 2001), with many multi-employer schemes at under 0.5%. This fall in charges is partly due to increased assets under management and improved back office efficiency, but also due to regulatory requirements such as the initial stakeholder pensions 1% AMC cap and recent changes to commission payments.

Industry initiatives already addressing disclosure of charges: There are already industry initiatives to establish standards for disclosure of all charges and clear information for employers, to facilitate cost comparisons between schemes. The Investment Management Association’s ‘Enhanced disclosure of fund charges and costs’, a ‘joint industry code of conduct’, and an ABI initiative on agreed voluntary standards for disclosing charges, all aim to improve disclosure and transparency, but as the Work and Pensions Select Committee rightly pointed out, these are only voluntary so they are not enforceable.

Why do charges matter?:

Sometimes, slightly higher charges may be justified: If paying a little more in charges delivers better or less volatile returns or pays for more effective information and engagement with members, then they might be justified. Traditionally, employers with defined benefit schemes covered all the costs of managing their pension schemes. In newly-established Defined Contribution schemes, however, it is now members who pay the explicit charges for managing their pension fund and they are in a weak position to protect their own interests in this regard.

Principal agent problem – employers choose, but workers pay: Fees has become particularly important because although the members pay the charges, it is the employers who choose the scheme they are auto-enrolled into. As they do not pay the charges themselves, they may have less interest in ensuring value for money.

Dangers of being lulled into false sense of security by recent improvements: Recent figures showing much lower charges may be encouraging but it is important to remember that the very largest employers have auto-enrolled first and these employers offer pension providers more members and much more money under management than smaller firms who will be automatically enrolling workers in the coming years. Larger firms should have HR or finance departments to negotiate better terms for their workers, greater buying power and more management time to devote to these issues. Micro employers, however, who have never before engaged in pensions and have small staff numbers, will be relatively unattractive to pension providers. Workers in those companies need protecting against an upward drift in charges as providers will be less keen to compete for their business. Government needs to ensure that proper safeguards and controls are put in place before the smallest employers start reaching their staging dates after 2015.

Charges can significantly deplete pension funds?: The impact of charges on people’s pension savings can be substantial. DWP figures show an auto-enrolled worker on average earnings, contributing from age 22 in 2018, until state pension age, will pay a total of £91,800 in charges over the 46 years if fees are 0.5% a year (which is 13% of their total fund), £132,300 (19% of their total fund) if charges are 0.75%pa, £169,700 if they are 1% (amounting to 24% of their fund) and £236,000 if they are 1.5% (or 34% of the fund). These calculations assume £1200 is contributed in the first year, a 7% investment return each year and a 4% annual rise in contributions. The figures are not inflation adjusted and in real earnings terms they are lower, but as a percentage of the total fund the impact of fees is clearly significant.

Impact of charges – average worker contributes 46yrs from age 22 [initial contribution £1200, 7%pa investment return, 4%pa contribution increase]
Charge level	Reduction in fund value Nominal terms	% reduction in final fund
0.5%	£91,800	13%
0.75%	£132,300	19%
1.0%	£169,700	24%
1.5%	£236,000	34%

The unfairness of Active Member Discounts – increase charges by around 0.5%, penalise women in particular, ‘pot follows member’ can’t help here: There is one type of charge that is particularly dangerous and the Government has so far failed to clamp down on. So-called ‘Active Member Discounts’ (AMD), which, in reality, are penalty charges on people who have left their employer scheme. They are particularly damaging for many women who need to take career breaks for caring responsibilities. They will leave their employer scheme and then be hit with higher charges, leaving them with a much lower fund than if they had remained employed. The OFT says AMDs often impose an extra 0.47% pa charge on the pension fund of those who have left their employment. It is estimated that 94% of pension schemes that still have AMDs are still open for auto-enrolment. The Government’s current proposals for ‘pot follows member’ will not solve this problem because they have no new scheme to transfer to when they take their career break.

Will better disclosure and transparency be sufficient? Former Tory Chancellor of the Exchequer, Lord Lawson, is supporting Labour on this issue, although he is calling for full disclosure and transparency on charges as a possible alternative or precursor to a cap. Dame Anne Begg, the indomitable Chair of the Work and Pensions Select Committee is engaged with the topic too. Of course, a cap is worthless if it can just be bypassed, or if it drives charges up and there is certainly a case for merely requiring full disclosure of all charges, on a consistent clear basis, and leaving customers to decide what they wish to pay once they have all the information. The danger is, however, that if employers are selecting the scheme, they may not be as concerned as members themselves would be, because it is the members that pay the charges, not the employer.

A cap must clarify which charges are included: It is vital to identify which charges would be included in any cap. Just imposing a cap on AMCs is unlikely to prove worthwhile. AMCs are only the costs of managing the assets, but many other ongoing charges are deducted from pension funds such as legal fees, administration, accounting and so on. It may be better to have no cap at all, than to lead members to believe charges are controlled while the costs that are not included in the cap can keep rising all the time. The Total Expense Ratio (or Ongoing Charges) does include most of the other costs that are regularly imposed and would be a much fairer measure to control.

Could a cap lead to worse member outcomes? – important to prevent lower charges from creeping up: There are fears that imposing a cap of, say, 0.75% or 1%, would actually lead to worse member outcomes, if schemes that currently charge less then decide to increase their fees. I would therefore urge the Government to combine a cap with a requirement that no fund will be permitted to increase charges for two years from current levels.

What about dealing costs? – Don’t cap them, but ensure full disclosure: One of the big areas for debate is whether or not dealing costs should be included in any cap. My own view is that this is a step too far. One would not want to hamper the ability of fund managers in an actively managed default fund to trade their positions. But the costs of dealing need to be properly reported in a clear, comprehensible fashion, so members can see what they have paid. If dealing costs are capped, it is likely that all default funds would be just passively run vehicles, which would be dumbing down to the lowest common denominator.

Dangers of setting too low a cap, at least initially: The danger of being too draconian on charges is that innovation will be stifled and new investment approaches that could deliver good value to members will not occur. There needs to be a balance between protecting customers and damaging their longer term interests.

Start with 0.75% (or 1%) cap on TER ongoing charge basis and signal a reduction in future: My favoured option is that charges (TER/ongoing charges) should be capped at perhaps 0.75% now, with a signal that the cap will be reduced in future years. As the size of assets under management in auto-enrolment schemes grows over time, it should be possible to benefit from economies of scale and drive down charges.

Initial cap should only be for new schemes, leave existing schemes till 2018: I would also only cap charges for newly established schemes, rather than changing terms for existing schemes at the same time. A clear signal that charges for schemes already set up will have to come down to the cap once auto-enrolment is fully rolled out around 2018, would give fair notice to the industry of the need for change, without causing potentially damaging disruption to their ability to service new customers as the capacity crunch of auto-enrolment hits.

NEST charge structure undermines effectiveness of any charge cap: Another vital change that is required for any charge cap structure to work effectively is to revisit the charges imposed by the taxpayer-backed NEST scheme. Currently, NESTs charging structure would not fit with a 0.75% cap for many members. For a charge cap to work properly, customers must be able to easily compare the costs of each scheme against other schemes. This is not possible with NEST.

Standardisation of charges – not easy to compare NEST or NOWPensions with other schemes: A simple single figure for a cap on charges, expressed as a percentage of the assets in the fund, is the optimal approach to capping. However, currently there are different charge structures that have more than one component, which makes it impossible for workers or inexperienced employers to compare one scheme with another. Some schemes have a simple annual ongoing fee, while others charge fixed fees and flat fees, combined with initial or ongoing charges. NOWpensions charges an £18 initial fee, plus 0.3% AMC, while NEST also has a 0.3% annual fee, but imposes an initial contribution charge of 1.8%.The controls on fees and the requirements for transparency and disclosure will be far less effective if there is no standardisation of reporting.

NEST charge higher than 0.75% cap for many older workers: The Pensions Policy Institute has highlighted the unfairness of the NEST charge, particularly for older workers – who will be the first to retire with pensions under auto-enrolment. The PPI research shows that NEST savers who start saving at age 60 in 2018 and continue to contribute until their state pension age, would be better off with a 0.75% AMC cap, rather than NESTs current 1.8% plus 0.3%. A 0.75% cap would reduce their auto-enrolment pension fund by an estimated 13%, but NEST’s charges will reduce their fund by a larger 14%.

Annuity charges can undo all the benefits of any charge cap: So much time and energy is being spent on deciding how or whether to change auto-enrolment pension charges by 0.25% or 0.5% a year, but the impact of a lower fee could be more than wiped out for many by the effect of high charges or buying poor value products at the point of retirement. The case for capping annuity costs and ensuring good value for money is even stronger than for introducing charge caps on AMCs or ongoing expenses.

SUMMARY

• My view is that we do need to cap charges for auto-enrolment pension schemes in future.
• We need to protect workers in small firms whose employers may not be able to negotiate low charges that have been achieved by big firms so far.
• We should not be lulled into a false sense of security by the low charge figures for auto-enrolment schemes so far.
• Active Member Discounts penalise too many members and pot follows member will not address this, they should be banned.
• A decision must be made clarifying all the charges that must be included in the cap, without leaving room for new charges to be invented to circumvent the cap.
• Dealing costs should not be capped, but must be fully disclosed to members.
• The charge cap should not be set too low, otherwise it will risk stifling innovation and dumbing pensions down to the lowest common denominator.
• A cap of 0.75% (possibly1%) on an ongoing charge (TER) basis should be introduced initially – but only for newly established schemes from 2015. Existing schemes will be capped once auto-enrolment is fully operational for all.
• The Government should signal that charge caps will fall over time.
• NEST’s charge structure needs to be changed, to express it as one single annual charge, so that all schemes can be compared.
• Controlling annuity charges and value for money are even more urgent and important than pension fund charge caps.