Navigating the pensions maze

October 4, 2013 6:26 pm

Navigating the pensions maze

By Josephine Cumbo

Less than a generation ago, millions of workers began saving for their retirement in company pensions which, as long as their employer stayed afloat, caused them very few headaches. Aside from the sacrifice of the monthly pension deduction, their employer largely took care of building up the pension and then paying an income for their former employees when they finally retired. That income was usually based on their salary at retirement, and the length of their service. But very few of today’s workers outside the public sector are afforded the comfort of these “golden era” pensions. More common nowadays is a company pension which lays the responsibility for investing contributions, and turning them into an income, squarely on the shoulders of the employee. Employees bear all the risk, even though they have no control over the pension scheme they save into, with this choice entirely up to the employer.Over the past year, more than a million workers have been signed up into these “defined contribution” schemes, as the government compels UK companies to enrol their employees in pension schemes automatically. “Auto-enrolment” – a year old this week – is designed to re-establish UK plc as a key pillar of private pension saving.

But a recent report by the Office of Fair Trading raised significant concerns over whether many tens of thousands of workplace schemes are fit for purpose. The watchdog identified about £40bn in savings that was at risk of poor value because they were held in company pensions that are poorly governed or that levy high charges.

The OFT has told regulators, the government and industry to put things right, but its recommendations won’t transform the industry overnight, and much of the responsibility will still sit with the employee.

With so much at stake, we set out how you can take control of your money by getting it out of poor value, poorly run schemes – or how to make sure those responsible for running them do so responsibly.

Because a pension is a long-term savings vehicle, it’s crucial to keep charges to a minimum. Over two or three decades, high costs will make a massive difference to the end result. Charges at 1.5 per cent can knock off £70,000 from the final value of a pension fund, compared with charges at 0.51 per cent, which are standard today (see table).

If you were paying into a workplace pension before 2001, alarm bells should be ringing. This is when the government introduced a type of pension known as “stakeholder”, which capped annual management charges (AMCs) at an initial 1.5 per cent, falling to 1 per cent after 10 years.

However, the rules did not apply to pensions which started before that date. According to the OFT’s workplace pension market study, about £30bn of savings in old and/or high-charging contract and bundled-trust schemes may not be good value for money.

Effect of charges on pension investment
Charges	0.51%	1%	1.50%	2.30%
Final fund value	£290,565	£255,381	£223,728	£180,802
Income (in today’s terms	£9,340	£8,209	£7,192	£5,812
Based on a 40-year-old male, single premium pension investment of £50,000, retirement age of 68, assumed investment growth rate of 7% per annum before charges, assumed inflation of 2.5% per annum
Source: Chase de Vere

It calculated that about 186,000 pension pots – with £2.65bn in assets – are still held in schemes with an AMC above 1 per cent.

“If you enrolled into a scheme before 2001, then certainly you should check your charges as they are likely to be higher than stakeholder,” says Peter Maher, director with Smith & Williamson Financial Services

“It is possible that some pre-2001 pensions will have AMCs below 1 per cent, but there may be ‘hidden’ charges which push up costs and make them expensive.

“Many schemes sold before 2001 also have other additional charges, such as initial charges on contributions and other fixed charges that are regularly levied on members. If you pay a monthly administration fee, that will also weigh on your returns.”

Members who aren’t paying in – for instance, because they have moved job – could be paying charges as much as 0.47 per cent above those who are active. These are often referred to as “deferred member charges” or “active member discounts”.

Not just about charges, but quality

The final value of your pension pot at retirement does not only depend on whether you have minimised charges, but who is keeping an eye on the scheme on your behalf.

In a “contract-based” scheme, the employer has responsibility for choosing the plan, often with the help of an adviser, but after that has no legal responsibility to check whether the scheme delivers value for staff. There is a layer of scrutiny in “trust-based” schemes where trustees are appointed and have a duty to act in members’ best interests.

But the OFT found significant concerns, with about 2,900 small and medium- sized trust-based schemes (defined as those with between 12 and 999 members) holding about £10bn in assets, many of which appear to be at risk of delivering poor value for money, due to neglectful or unskilled trustees not doing their jobs properly.

The OFT said it was also possible that some of the 36,000 “micro” schemes with between two and 11 members, holding about £160bn might also be affected by similar issues – although a significant proportion of those schemes are likely to be executive type or member-directing schemes run by their members, which are of less concern.

“Small schemes are less likely to be operating effectively, because they are less likely to have trustees capable of making good decisions,” says Helen Forrest, head of policy and advocacy with the National Association of Pension Funds (NAPF). “This is not always the case, as we know some very well run trust-based small schemes, but in general the larger schemes are more professionally run.”

Beware of moving out too quickly

If alarm bells are sounding about an old pension, either due to high fees or how it is managed, you can consider transferring your money to another workplace pension, or to a personal pension. But first check that your current provider does not offer any of these features, as they can be valuable:

● Guaranteed annuity rates, also known as Gars, which guarantee to turn the pension pot into an income at retirement. That income is likely to be much better than the annuity rate you could get on the open market today. But do check whether these Gars have restrictions, such as the income being used for a single life only, and not to be used to provide an income for a spouse.

● “Cash guarantees” or “guaranteed rates of return” where certainly is offered over the level of pension or income.

● Some pensions pay loyalty bonuses to customers who pay into their plans until the end of term.

“This is where it gets very tricky,” says Sean McSweeney, principal consultant with Chase de Vere, a financial advice firm.

“Pension providers will offer transfer desks to assist with the transfer but they won’t give you advice. You have to be very sure that you are doing the right thing and should get specialist advice.”

Mr McSweeney adds that some plans, such as with-profits, can levy exit penalties on members who transfer funds. Exit penalties shouldn’t put you off leaving a bad scheme, but you should check how much it will cost first.

Finding a new home for your savings

Consolidating pension savings from previous jobs with those of your existing employer will make it easier to manage your retirement saving and could lower charges.

But before consolidating, it is worth checking whether the range of investments offered by your existing employer is suitable.

Most workplace pension money is held in “default” funds, which are for members who haven’t made an active choice about where to save. These funds tend to be “one size fits all” and are usually managed cautiously. They may be lower risk, but not deliver the returns needed for a comfortable income in retirement.

“Most of these funds follow the herd and don’t invest too differently from the average balanced managed fund, which is reflected in their performance,” says Laith Khalaf ofHargreaves Lansdown, the FTSE 100 financial services group.

“There’s about £50bn invested across these funds in total. They are all doing a similar job, largely performing in line with the sector average. If you are invested in one of these funds you shouldn’t expect too much more from them.”

Mr Khalaf says the message for pension savers is pretty clear: if you want outperformance, you normally have to go outside the default to find it.

“Employers could select better-quality defaults, but these cost more, and the trend is in the opposite direction: to lower cost – even if this means turning down a fund with superior performance prospects,” he adds.

Pensions of the future

The industry and the government are now working to implement a range of measures to ensure millions being automatically enrolled into a company pension in future can be confident about saving in the workplace.

Among the measures, insurers have agreed to audit older “legacy” pensions to check they are delivering value for money. This will be overseen by an independent project board.

The Pensions Regulator has been tasked with investigating the significant concerns about smaller trust-based schemes.

Going forward, independent governance boards will be introduced into “contract-based” pensions, to embed a new layer of scrutiny for savers.

In addition, the OFT has recommended that the Department for Work and Pensions DWP consults on preventing schemes being used for auto-enrolment that contain inbuilt adviser commissions, or that penalise members with higher charges if they stop contributing into their pensions.

But while welcoming this action to protect people who are automatically enrolled, some argue that all savers should be protected.

“The market failures require a tough independent regulatory investigation and strict requirements imposed on life offices to bring their legacy member charges in line with the charges they use for their modern auto-enrolment schemes – meaning 50 basis points (0.5 per cent),” says Debbie Harrison, a visiting professor at The Pensions Institute, part of Cass Business School.

“They should also remove any penalties on transfers out and eliminate trail commission.”

However, Prof Harrison adds that if the OFT plan of action is effective, and if the government’s plans for improvements to auto-enrolment scheme governance and charges are effective, then future auto-enrolment schemes should be a big improvement on what has been sold to employers in the past.

“The challenge is to get assets languishing in the older schemes and plans into the new schemes,” she concludes.

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Taking it on trust

Most older UK pension schemes are organised under trust law, a legal framework dating back to the Crusades, writes Norma Cohen. Knights rampaging around the Holy Land would appoint trustees to oversee their property on behalf of heirs too young to inherit it – and the defining quality of trustees, as ruled by successive courts over the years, remains that they should be independent.

Trustees can only make decisions about property held in trust that are in beneficiaries’ best interests – as opposed to their own or anyone else’s. A trustee cannot be a beneficiary. A trustee must also make decisions with due care.

In the case of defined benefit or “final-salary” pensions, however, it became apparent by the 1990s that most trustees had vested interests in the assets held in trust. Employer representatives often tried hard to minimise the cost of pension promises to the company. Trustees appointed by members had an incentive to try to improve benefits for themselves and their colleagues. Larger schemes have been required to have member-appointed trustees since the Pensions Act of 1995, but there is little clear evidence that schemes have become better run since then.

When the Pensions Regulator was created in 2005, among its first endeavours was to reduce those conflicts through better scheme governance. It instituted online training and accreditation programmes so that trustees are at least informed about their responsibilities and equipped with skills to discharge them.

Trustees are still the first port of call for scheme members concerned that they may not be getting a fair deal. The Pensions Regulator has recently introduced a code of practice for trustees of defined contribution or “money purchase” schemes – those that will deliver a lump sum at retirement that can be converted into an income.

The code is not legally binding, but it does provide principles, examples and benchmarks against which trustees can consider whether or not they are reasonably complying with their duties.

Among their responsibilities are monitoring the investment performance of funds on the scheme’s “platform” of offerings, as well as the quality of its administration and its costs and charges.

Scheme members should consider not only the quality of these offerings while they are contributing to an employer’s scheme, but also what they will be like should they change jobs. The Office of Fair Trading recently highlighted the way that charges on those who are no longer contributing typically rise, despite the fact that the cost to the fund manager falls when a member moves to a new employer’s scheme.

By law, trustees have a duty of care to all members, even those who are no longer employed by the plan sponsor, and members should insist that trustees take account of this, as well as the price and quality of services for current workers, when selecting managers.

Newer pension schemes tend not to be trust-based. Instead, they operate plans under contract with a single provider, usually an insurance company such as Aviva or Prudential. There are about £93bn of assets housed within contract-based schemes, compared to £180bn with trust-based schemes. Employers providing contract-based schemes are under no ongoing legal duty to consider whether the scheme is performing in members’ best interests. They are also generally regulated by the Financial Conduct Authority, rather than the Pensions Regulator.