Protect your ISA and pension from greedy middlemen

Investors have the right to know exactly what they are paying when they invest. While it would be wrong to choose investments on the basis of cost alone, it is vital that investors take account of charges as they can act as a significant drag on future performance.

When challenged, companies with high charges often argue that investors are paying for a better product or better returns, yet they often obfuscate when it comes to declaring those charges.

They frequently declare some but not others, hiding them in the small print. In this article, we are shining our spotlight on popular tax-efficient investment wrappers and products that investors use to save for their own or their families' futures.

Tax reliefs can sometimes blind people to looking at costs carefully, even though they could end up offsetting the tax advantages.


All in the total expense ratio

With cash ISAs there are no explicit charges but there are significant differences in interest rates.

Recent comparisons of fixed-rate accounts found that some banks, such as Lloyds TSB, were effectively charging ISA savers by paying them lower interest rates than they were offering on ordinary accounts.

Charges on stocks and shares ISAs are often the same as those on the underlying investments which are frequently funds.

The government tried to limit charges when ISAs were first introduced in 1999 by introducing a so-called "CAT standard" ISA with a maximum annual charge of 1.5% but CAT standards were abolished in 2005. Now ISA managers can charge as much as they like.

Most ISA investors choose investment funds, where there is no additional charge for the ISA "wrapper", so investors need to look carefully at the fund charges themselves, which isn't particularly easy.

Fund charges are anything but clear. The annual management charge is not calculated on a consistent basis and only tells part of the story.

A more important yardstick is the "total expense ratio" (TER) which includes all the annual operating costs, but many managers bury this in the "key features documents".
The TER can be as much as double the annual management charge. An increasing number of funds also carry a performance fee which can push up the TER further.

The expenses of buying and selling the investments are another cost borne by the funds which is not even revealed to investors.

Investors who choose to hold investment companies or shares direct in their ISAs will usually be charged an extra fee. Investment trust and self-select share ISAs normally have an annual administration fee.

Sometimes it is a flat rate fee, regardless of the size of your holding. Aberdeen, the investment trust manager, charges £24, for example, while online stockbroker Selftrade has a flat fee of £35. Interactive Investor, on the other hand, charges nothing.

Others charge a percentage which means your charges will go up as your investment increases in value, though it may be capped.

Halifax Share Dealing, for example, charges 0.6% per year for its ISA but limits it to a maximum of £99.96. The Share Centre, on the other hand, has a 0.5% fee with no maximum.

When there is an extra charge to pay, investors should think twice. Basic rate taxpayers who are not in retirement are likely to end up paying more than they gain in tax advantages.

Action plan for ISAs

  • Buying an investment fund ISA does not normally cost any more than investing directly but fund charges can be high. Index tracker ISAs are a cheap option but if you prefer actively managed funds avoid those with performance fees which push up total expense ratios.
  • Paying extra for an ISA wrapper for investment trusts or other shares erodes tax advantages and is not worth it if you are a basic rate taxpayer. Avoid extra annual charges on investment trust and share ISAs by investing through the Alliance Trust Savings or Interactive Investor platforms.


A fifth of your pot could go

In the past, personal pension plans were notoriously expensive with charges that were multi-layered and opaque. Plans often had initial and annual charges, policy fees, capital units and varying allocations levels, all of which were used to disguise their true costs.

The government's introduction of stakeholder pensions in 2001 resulted in a big improvement to personal pensions as well as stakeholder schemes.

Annual management charges on stakeholder pensions were originally capped at 1%, but were later increased to 1.5% for the first 10 years and 1% thereafter. There are no cost controls on personal pensions.

It does not mean that personal pensions are necessarily more expensive. But they tend to offer a wider selection of external investment fund choices, which may have annual charges in excess of 1.5%.

Their charges may also be structured differently to accommodate payment of commission to advisers.

A good way of comparing costs on personal and stakeholder pensions is to look at projected fund maturity values.

The table below shows the proceeds of pension plans, funded by monthly premiums of £200, at retirement after a 20-year term and after all charges and commissions are deducted. It assumes that the premiums have been invested in a managed fund and have grown at 7% a year.

With no deductions for charges, the premiums would accumulate into a fund worth over £100,000. If stakeholder charges are deducted they amount to over £13,000. But average pension charges are actually somewhat lower at £12,740.

This is due to the wide range of charges on personal pension plans, which are among the cheapest and most expensive, as the table shows. The cost of stakeholder plans is more consistent.

The cost of the most expensive pension over 20 years is more than four times higher than the cheapest one, with investors in Scottish Equitable's Flexible Personal Pension paying just £5,292, while savers who take an HSBC Life plan will have to sacrifice £22,506.

The figures also show it is not just commissions paid to advisers that can push up costs. Pensions sold directly by the banks, such as HSBC and Halifax, can be even more expensive.

Action plan for personal pensions

  • Charges on stakeholder pension plans are limited to 1.5% per year for the first 10 years and 1% thereafter.
  • Charges on personal pension plans are variable. They may work out cheaper than a stakeholder plan or be considerably more expensive.
  • Companies may offer more than one charging structure on their personal pensions. If in doubt, seek independent advice.


Demand charging clarity

In recent years, many people have been encouraged to move away from stakeholder or personal pensions and take out SIPPs instead.

Pension funds accumulated in individual or company pension schemes can be transferred into a SIPP which provides the investor with the opportunity to pick and choose their own investments.

SIPPs have appealed to investors who may have been disappointed with the returns they have received from traditional insurance company pension plans, or who have wanted to cut their ties with a previous employer.

However, the cost structures of SIPPs are extremely complex. They can involve around 10 different sets of potential charges including initial charges, transfer charges, annual management charges, transaction charges, VAT, and vesting charges.

Because there is no standard terminology, comparisons of charges are made even more difficult. And investors who have an adviser to monitor the investments in their SIPP will have a further set of expenses to pay.

The Financial Services Authority (FSA) became so concerned about whether SIPP investors were being treated fairly that it conducted a survey of 60 smaller SIPP providers.

Last September, it wrote to the companies informing them that one of its main areas of concern was "the accuracy and transparency of illustrations and the disclosure of charges".
Among its criticisms was that some SIPP operators were levying unclear time-cost charges. Although they had told investors of their hourly rate, they had not given any indication of what the final cost was likely to be.

The FSA also also commented on interest paid on cash held in SIPPs which has been an area of some controversy recently due to the low amounts paid by some SIPPs.

The FSA points out that SIPP operators must state whether they retain a proportion of the interest payable and also whether they receive any commission from the SIPP bank account provider.

SIPP providers are not currently required to express their expenses in the form of a traditional annual management charge, or to give projections that would enable investors to make easy comparisons of net charges.

Moreover many people who take out SIPPs also use them for income drawdown (unsecured pensions) in retirement, which is when other charges come into play.

Calculations by Hargreaves Lansdown show that over a 10-year period these charges alone can vary from a few hundred to a few thousand pounds on a pension fund of £200,000.

Action plan for SIPPs

  • SIPPs are more expensive than stakeholder and personal pensions. Investors should only pay for one with maximum investment flexibility if they are going to use it. The cheapest SIPPs are those which are mainly fund focused, such as the Hargreaves Lansdown SIPP.
  • SIPP charges are complex. Differences in terminology make direct comparisons difficult. The FSA has criticised providers for not always making charges clear.
  • Low interest rates on cash, additional fees for investment advice and the extra costs of taking income drawdown must be taken into account.


Don't get charged for the tax break

Parents of children born since September 2002 have received money from the government to invest in a CTF until they are 18 years old. Besides the basic £250, parents and other relatives can invest another £1,200 each year. The investments in the CTF are tax-free.

CTFs come as cash or stockmarket investments. The stockmarket route is recommended for the long term, and the government requires providers to offer a stockmarket "stakeholder" option with a maximum annual charge of 1.5%.

While well intentioned, the maximum charge has led some managers to actually increase their charges on funds held within a CTF. Examples include Engage Mutual's Investment Growth fund that normally has a 1% management charge but increases to 1.5% in its CTF.

Similarly, the Legal & General UK Tracker, which otherwise costs 1% per year, increases to 1.5% when offered as the CTF stakeholder option by Healthy Investment or The Share Centre.

What's more, the charges that managers actually take from CTFs can be even higher than 1.5%. This can be seen initially by looking at the TER. Take the Santander (formerly Abbey) CTF.

While its key features document clearly states "we cannot charge more than 1.5%", the TER on its stakeholder fund is in fact 1.62% according to Lipper. The same fund is used for the Family Investments CTF.

Even the TER does not take into account the "portfolio turnover rate". As Santander's own key features document points out, this rate, which refers to how often investments are bought and sold, reflects the amount of dealing costs incurred within the fund.

Ironically, holding non-stakeholder funds in a CTF can be cheaper. At F&C Management, for example, CTFs can be invested in the UK's oldest investment trust, Foreign & Colonial Investment Trust, which has a total expense ratio of just 0.53%.

Action plan for CTFs

  • Annual charges on CTF stakeholder funds are capped at 1.5%, but some providers increased charges on their funds for this reason and their total expense ratios (TERs) may be even higher.
  • Consider a non-stakeholder CTF, such as Foreign & Colonial Investment Trust, which has a lower TER of 0.53%.
  • Instead of a high-cost tracker CTF, put the money directly into a tracker fund, such as Fidelity MoneyBuilder UK Index which has a TER of just 0.27%.


Charges often outweigh tax benefits

VCTs have two big attractions. They provide investors with access to the high risk/high return world of business start-ups and they also provide very generous tax reliefs.

Investors buying newly issued VCT shares receive 30% income tax relief on their investments up to £200,000. Dividends and capital gains from shares are also tax-free regardless of whether they are purchased new or second-hand.

VCTs are not cheap. When newly issued shares are purchased, part of the capital raised will be used to cover issue expenses. Annual management fees may be 2 to 2.5% and when other charges are added TERs average around 3.5%.

On some trusts they are considerably higher at around 4 to 5% according to data from the Association of Investment Companies.

It is also the norm for VCT managers to receive performance fees over and above the annual management charges. Performance fees may be 20 to 25% but ideally managers have to clear a hurdle rate first, such as growth of 8%, before taking the fee.

Artemis recently attracted criticism by introducing a performance fee on its VCT which is based simply on an increase in its net asset value.

Action plan for venture capital trusts

Investors in VCTs receive generous tax reliefs for backing new and growing companies. When investing in new issues some money is absorbed by start-up costs.

Annual costs usually exceed 3%. Performance fees charges are higher. Look for trusts with capped TERs and realistic hurdle rates for performance fees.

10-point agenda for investment cost transparency

1. All potential investment charges should be listed on a single sheet supplied to new investors.

2. Investors should be informed of typical buying costs for investment trusts, exchange traded funds, OEICs and unit trusts in all literature relating to the funds.

3. All types of funds should publish basic total expense ratios (TERs) prominently in their literature.

4. The previous year's portfolio turnover rate should be published with the estimated cost of dealing and stamp duty, where applicable, expressed as a percentage charge.

5. Where performance fees are levied, regular annual management charges should be set at a minimum of 0.5% below the market average. Maximum fee limits should be introduced.

6. Performance fees should be shown separately and as part of an overall TER.

7. Performance fee structures should be made consistent or standard growth illustrations given so fee outcomes can be compared.

8. Improved benchmarks should be developed with performance fees based on a minimum of three years' outperformance, and fee clawbacks should be introduced.

9. High water marks should be compulsory so managers can only charge another
performance fee when their returns exceed a previous high point.

10. Potential dilution levies should be made clear for OEIC investors, and typical selling costs for investment trusts, exchange traded funds, OEICs and unit trusts should be prominently displayed in fund literature.

This article was originally published in Money Observer - Moneywise's sister publication - in March 2010