Wednesday, 18 July 2012

Pensions

How much of your money is taken up charges?
Considerably less than what you get in return.

The old chestnut of pensions has hit the headlines again, with Labour calling for greater transparency and a reduction in charges in the pensions industry. This follows on from a report by the RSA, which states that a large number of pension providers are failing to disclose their charges properly.

They might have wanted to look a little bit more closely at the financial services industry generally. I have, because I work in it. And it is astonishing how disingenuous some of the press coverage has been on this issue.

First things first. CHARGES ARE NOT EVERYTHING. Having a lower-charging pension contract does not automatically mean that you'll have a better pension in retirement. In most pension contracts, your payments are invested into a fund, which accumulates until you retire. That fund is then converted into a guaranteed income for life, which in the technical jargon is called 'purchasing an annuity'.

Therefore, the income that you get in retirement depends on three things:
  1. The charges on the plan;
  2. The investment performance of the fund;
  3. Economic conditions when you retire.
By far and away, Number Three is the most important issue. When you purchase an annuity, you give your pension fund to an insurance company. They use it to buy gilts (Government IOUs which pay interest at a fixed rate) and other income-generating assets, which will provide your income. They use prevailing gilt yields to set their annuity rates. If gilt yields are ridiculously low, then the annuity rates will be lower as well.

So, if you have a fund of £100,000, and you buy a 5% annuity, you'll get £5,000 a year for the rest of your life. Annuity rates can fluctuate significantly. A change of 1 percentage can result in a 20% drop in the income a pensioner can expect.

What affects gilt yields? Well, what drives them down is when gilts are in high demand. Like when the Bank of England is printing money and using it to buy gilts, pushing the capital value of gilts up and the yields down, for example. Cough, cough, Quantitative Easing, cough, cough.

Right, onto investment performance.

This is the second-most important issue. Even if the charges on your pension plan are zero, if the investment return is also zero, then anything you pay into your pension fund is not going to increase in value. Indeed, with the effects of inflation, it will actually lose its value. Long term inflation rates are estimated to be 2.5% - that means anything you pay into a pension has to grow at 2.5% after charges just to retain its value. People being invested in shit funds that offer pitifully low returns, especially old-style With Profits funds which often have 0% growth rates and transfer penalties, are a much greater issue than charges.

Finally, we get onto charges.

The issue is one of transparency, according to the RSA. They've done a study on the pensions industry over the last three years, and concluded that not all of the charges are declared.

In that, they're right.

But they have made two major omissions from their work:
  1. They contacted pension providers directly to obtain information. This is a bit daft, as 50% of all retail financial services in the UK is transacted by Independent Financial Advisers. The IFA would be in the consumer-facing role - why didn't they talk to IFAs? They would have been in a far better position to disclose details of any pension contracts, whereas the numpties in the insurance company's call centre don't give a flying fuck;
  2. They failed to take account of the massive regulatory change afoot in financial services in the form of the FSA's Retail Distribution Review (RDR). This mandates the clear separation of pension charges from advice, and improves disclosure and transparency. It's going to do a lot of other things that are unspeakably shit as well, such as allowing product providers to simply keep their own charges the same, even though those same charges previously included the cost of advice, paid in commission.
Specifically, the RSA said that pension providers only disclosed the Annual Management Charge (AMC) of pension funds, rather than the Total Expense Ratio (TER), which is the total headline annual charge applied to pension funds.

This is a common tactic used by pension providers. They should have spoken to an IFA - an IFA, when transacting a pension transfer, is required to use the TER figures. The providers' help-desk numpties won't know them, but an IFA will, because he has to.

They next said that the TER still isn't sufficient, because it doesn't include the cost of switches and advice. Well, no, it doesn't - because it doesn't pay for switches and advice. The TER pays for the management and the administration of the investments, which needs to be done on an ongoing basis. As such, the TER is expressed as an annual percentage.

Advice and switches are often ad-hoc. They don't need doing all the time, just once in a while. Typically, an IFA will charge between 3-4% for arranging a pension transfer. That covers the cost of gathering the data, conducting research and analyses, writing an extensive and comprehensive Suitability Report, producing quotations, submitting the application, liaising with the ceding provider to get the money across and finally completing the plan. It's a lot of work, most of which is mandated by regulations from the FSA. That 3-4% pays for that regulation.

But that's a one-off cost, not an ongoing charge. So the providers don't factor it into their TER, because every adviser charges a different amount. What an adviser would do is factor it into the TER over the term of the plan. That's called a critical yield. If a proposed contract is unlikely to outperform the critical yield of the old one, the IFA won't do the transfer.

Switches, again, are ad-hoc. In many pension contracts, switching funds internally is free. In which case, they have no bearing on the overall cost of the plan. In some cases, they're subject to a 0.25% charge to cover the provider's administrative costs in switching funds. Some advisers will also charge extra for switching. Most don't.

But how often will a client switch funds during the lifetime of a pension contract? Who knows? How long is a piece of string? It's a completely unknown quantity, and therefore cannot be factored into the TER.

Many advisers now also charge an additional 0.5% per year for the provision of ongoing advice. The ongoing advice will typically include periodic valuations of the pension fund, in addition to those provided by the pension company, and a review of the quality of the funds and portfolio, together with any associated work.

I am involved with such reviews as part of my job. It does cost the client a bit extra in the form of charges. But when a client actually deigns to respond to a review, and switches out of a poor fund into a good one, the difference it can make to their portfolio in terms of performance is significantly in excess of the 0.5% they are being charged for the service. I recently calculated it at approximately 2% extra performance per year on average.

Another criticism levied is that some funds have a 'bid-offer spread' - a form of initial charge, which is not fully disclosed. What they did not say is that bid-offer spreads only apply to Unit Trust funds, a specific type of investment fund. Unit Trusts are not often linked to by pension providers - instead, they are invested in mutual funds, which have a completely different charging structure. In many cases, bid-offer spreads will not apply to pension funds at all.

Furthermore, there has been an increasing trend over the last 20 years of Unit Trusts converting into Open Ended Investment Companies (OEICs), which have far simpler charging structures with no bid-offer spread.

Pension charges - a drag on growth?
Maybe - but without them, you wouldn't HAVE growth.
And lastly, it has been alleged that the cumulative effect of these fees can halve the value of your pension fund. Mathematically, that is possible. If the cumulative effect of all the charges is a 1.5% TER, plus a 0.5% annual adviser charge, plus a 3% initial charge and maybe a dozen or so 0.25% switching charges on a plan with a 25-year term, you're probably looking at a critical yield of around 2.5%. The longer the plan, the more that figure will tend towards the headline annual figure of 2%.

If you assume that your investment return is 5%, then that yield will be reduced to 2.5% after the cumulative charges have been deducted. Low and behold, half the value. But what it fails to take into account is what those charges are paying for.

On the adviser charge of 0.5%, I've already said that you can conservatively expect it to add 2% per year to investment performance, simply by picking the best funds. So you're already up by 1.5% a year. Next, the TER. About 1% of that goes in administrative and transactional fees - that's the cost of actually running the fund. You don't like it, talk to the regulator - most of the costs are Compliance-based. The other 0.5% goes to the fund manager.

And he deserves every fucking penny.

He's the one that identifies which companies to invest in, and what proportions to hold in each. He's the one who has to dip in and out of the markets as timing demands. He's the one who could ultimately go to prison if he screws up. The value a good manager can add to a portfolio - the Alpha, the difference between what he does and the market does - is about 2% on average.

So those extra charges you pay account for almost all the growth on your pension fund. If you weren't paying those charges, you would not get the performance. If you don't believe me, stick your money in a tracker fund and see how well it does. I can tell you right from the off. It'll do FUCK ALL.

If you consider the FTSE All Share index, which is often used for tracker funds, it has produced returns of -6.63% per year, on average, over the last 20 years. Your average tracker fund will cost you 0.3% in charges, so if you invested in a FTSE All Share tracker 20 years ago, you'd have lost 6.93% on average every year.

The UK All Companies sector average - an average of all funds in the IMA UK All Companies sector, which all invest in the same stocks as the FTSE All Share index - which includes all the crap managers as well as the good ones, produced returns of -4.64% on average per year over the same term. When you take off an average TER of say 2%, you'd still be better off investing in an average, run-of-the-mill managed fund instead of a tracker.

If you invested in the best fund in that sector - and by best, I mean the one with the highest average quartile position, lowest volatility and highest financial strength, measured by independent credit ratings agencies - the average annual performance would have been +9.26%. Take your 2% TER off that, and you're still at +7.26%, 14.19% PER YEAR HIGHER than the tracker.

If you pay peanuts, you get monkeys. Pay low fund charges, you'll get shit performance, and performance is MORE IMPORTANT than charges. What matters is WHAT YOU'RE LEFT WITH at retirement, not HOW MUCH IT COST to get there.

The last time there was a major drive to reduce pension charges to try to get people saving was in 2001, when the last Labour Government introduced Stakeholder contracts. These are effectively cut-price Personal Pensions, with a 1% AMC limit. Did they work? No. We still have a savings gap. Why did Stakeholder not work? Because charges aren't the problem.

People not saving enough are the problem. And the reason they don't save is because pensions are insufferably shite. You pay into it throughout your life, and when you retire you can get at a QUARTER of the fund, with the rest being dribbled out to you as an income with a pitiful conversion rate. Oh, and that income's taxed. If anyone wants to do anything about pensions, bloody well LOOK at the problem, don't just jump on the nearest passing band-wagon.

And if people still want to bang on about charges, even though they're not actually the problem, it is worth bearing in mind that about half of the total cost of pension charges are there to meet the cost of the regulatory burden that is placed on the financial services industry by the Dear Regulator, the FSA.

You know, the one set up to protect consumers.

And regulate the banks.

By Gordon Brown.