Charges cap is important to protect smaller firms’ workers

Will eventually need to control all charges, not just AMC

Disappointed that NEST two-tier structure will continue to prevent easy comparison

by Dr. Ros Altmann

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• 0.75%pa charge cap on auto-enrolment default funds from April 2015
• Banning penalty fees on leavers from April 2016
• Banning commission payments from April 2016
• As auto-enrolment spreads to smaller firms, their workers need protecting from high fees
• Pot follows member can’t work without a control on fees
• Full disclosure of all other costs, including transaction costs, by 2017
• Ultimately need cap on TER, not just AMC otherwise providers can just circumvent the cap
• NEST’s charge structure doesn’t fit with a cap – shame it will not have a single annual charge to allow customers to compare costs properly

Cap on charges from April 2015: As the Budget measures that rocked the pensions industry begin today, another major piece of the pension reform jigsaw is put in place. Pension providers will have to improve their practices, and while they are still reeling from the ending of captive annuities and introduction of new flexibility, the Government announces its long-awaited cap on pension charges.

0.75% charge cap is at lower end of proposals: Steve Webb has decided introduce a cap on the charges for default funds in new auto-enrolment pension schemes. Having consulted on a cap of 0.75%, 1.0% or no cap at all, the DWP has decided to go for the lowest figure. The cap will be introduced from April 2015. The average Annual Management Charges (AMC) for all trust-based DC schemes are currently around 0.8%. Pension providers will therefore have another change to cope with, in order to improve the way they treat their customers.

Charges can significantly deplete pension funds: It is important to cap charges on pension funds. The impact of charges on pension savings may be small in each individual year but are significant over a lifetime. DWP figures show an auto-enrolled worker on average earnings, contributing for 46 years will pay charges that amount to 13% of their fund with a 0.5% annual charge, 19% of their total fund if charges are 0.75%pa, 24% of their fund with a 1% charge and 34% of their fund will go in charges if there is a 1.5% AMC as shown below:

Charge level per year	% reduction in final fund
0.5%	13%
0.75%	19%
1.0%	24%
1.5%	34%

Cap will not apply to all costs though: So far the 0.75% cap only applies to the Annual Management Charges (AMC). AMCs cover asset management costs but exclude many other ongoing charges such as legal fees, administration and accounting and do not include transaction costs. The OFT identified 18 different charges that have been imposed on pensions. These additional charges can add significant extra sums to the costs of workers’ pension schemes, therefore it will be vital to include other charges in any long-term cap. Initially, the DWP will require full disclosure, then once the evidence of the level of extra charges emerges by 2017, the cap may be changed. Capping Total Expense Ratio (TER or Ongoing Charges) would ultimately be better than AMC to prevent providers simply circumventing a cap with new charges.

Government is right not to be lulled into false sense of security by low charges for new schemes: The OFT recently found that new auto-enrolment schemes have average AMC of just 0.51% with multi-employer schemes even less, so some say that a cap is not required. However, it is important not to be lulled into a false sense of security. So far only the larger employers have auto-enrolled. These employers have the wherewithall to negotiate good terms for their workers, and more management time to devote to these issues than smaller employers starting auto-enrolment in the next few years. Most micro employers have no experience in pensions and providers will be less keen to compete for their business so there would be a danger of much higher charges.

As auto-enrolment proceeds, workers in small employers need protection: DWP figures confirm that members in smaller schemes, with low paid workers pay higher charges, so as smaller firms are brought into auto-enrolment, the need to protect workers from high fees is clear. Average AMC for smaller schemes (12 to 99 members) were 0.91%, compared with only around 0.5% for larger schemes (over 1000 members).

Principal agent problem – employers choose, but workers pay : It is important to control charges to protect workers in new auto-enrolment schemes. Unlike traditional Defined Benefit schemes, where employers covered all the management costs, members must cover these in Defined Contribution (DC) schemes. However, their employers choose the scheme they are auto-enrolled into, so members are in a weak position to protect their own interests. The OFT expressed concerns about this principal-agent problem. A charge cap will provide some protection for workers as they cannot choose or change the scheme their employer uses.

End of Active Member Discounts – about time too!: So-called ‘Active Member Discounts’ (AMD), which, in reality, are penalty charges on people who have left their employer scheme will be banned from April 2016. These penalty charges are particularly damaging for many women who need to take career breaks for caring responsibilities. When they leave their employer scheme they face much higher charges which the OFT estimated could be almost an extra 0.5%. 94% of pension schemes that have AMDs are still open for auto-enrolment so it is important to ensure they are ended. The industry is being given an extra year to make the changes. The Government’s current proposals for ‘pot follows member’ will not work unless there is a clear minimum standard for all auto-enrolment schemes.

Ban on commission-based fees : From April 2016, the DWP will ban all commission based schemes. This will help reduce pension fees for many schemes, since where employers use a commission-based adviser, charges were on average 0.4% higher. The industry will, however, have to retrospectively change those schemes that have already been set up on this basis.

NEST charge structure undermines effectiveness of any charge cap: The charge structure of the taxpayer-backed NEST scheme does not properly fit with the aims of a simple charge cap. For a charge cap to work most effectively, customers must be able to easily compare schemes with each other. Two-tier charge models make this difficult. NEST has an initial contribution charge of 1.8% plus a 0.3% AMC annual fee, while NOWpensions charges an £18 initial fee, plus 0.3% AMC – these cannot easily be compared with schemes that have a TER of 0.5%. The Pensions Policy Institute calculates that older workers in NEST are particularly disadvantaged. Those who are auto-enrolled at age 60 and contribute until their state pension age will pay far more in charges with NEST than with a 0.75% cap. As it is older workers who will retire first under auto-enrolment, it is disappointing that reform of NEST’s charges has not been included.

Need for a measured approach: Introducing an immediate cap for schemes already set up could interfere with roll-out of auto-enrolment and divert industry resources away when they will be vitally required to service the coming capacity crunch in the industry. Therefore, allowing some time for the cap to fully develop makes some sense and will give providers time to cope with new demand while also adapting older schemes.

Overall a cap will help make our pension system more user-friendly: The introduction of a charge cap, following on from increased flexibility and auto-enrolment, should help restore confidence in pensions as a fair long-term savings vehicle. Labour has been calling for such a cap on TER, not just AMC, which would be even better for members and this may yet come.

 

ENDS
Dr. Ros Altmann