Trust must be restored to our pensions system
We are about to undergo a pensions revolution in this country, a revolution that hopefully will trigger a renaissance in the long-term savings habit.
Beginning this October, workers will start to be automatically enrolled into a pension scheme by their employer. It's a process that will impact on all British businesses - big firms first, small firms last - and few workers will be excluded.
For the first time in their lives, some 10 million workers - part-timers, the lower paid - will begin to build a stake in a low-cost pension that ultimately will provide them with an income in retirement to supplement their state pension. It's empowering and it's welcome.
Yet, the imminent arrival of this new world of pension autoenrolment, with its emphasis on value for money, is also putting the spotlight on the existing pensions regime that now sees a majority of workers build retirement funds through a so-called defined contribution scheme.
The current pension system
These plans deliver a pension based primarily on the performance of the underlying fund assets. They are more risky than traditional defined benefit pension schemes where the final pension delivered is determined by the number of years worked and a worker's final salary at retirement.
These latter schemes, alas, are now primarily the preserve of public sector workers - they are too expensive for most British businesses to maintain.
Recently, a mix of politicians, worker representatives and pension commentators have begun to question whether the pensions industry can continue to justify the charges it heaps on investors in defined contribution plans, especially in an era of uncertain stockmarkets, economic stress and low annuity rates. Pension investors, they say, deserve a better deal.
The next big scandal
Ed Miliband, Labour leader, got the debate started when he referred to pensions charges as the next big scandal to affect financial services. Not only are charges too high, he said, but many pension fees remain undisclosed. He called for fees to be capped and for all charges to be disclosed so that investors could compare charges across providers with confidence.
Meanwhile, pensions minister Steve Webb accused pension companies of "tearing the heart out of people's pensions". Yet the most thought provoking work on pension fund charges is that published by the Royal Society for Arts (RSA). It calls for managers of company pension funds to provide more meaningful and regular information about the charges that diminish pension pots.
The RSA says pension providers get away with murder because they couch all their charges in percentage terms, which is hugely misleading. A 1.5% annual management charge (AMC) may seem reasonable but when its impact on returns is expressed in pounds and pence it is debilitating.
For example, a 25-year-old saving £1,000 a year in a pension scheme for 40 years without charges would see that sum grow to £248,170, assuming an annual return of 6% and premiums increasing by 3% a year in line with inflation.
This fund would in turn buy an annual inflation-linked income of £16,080. But if the fund were subject to an AMC, the RSA says the income would be reduced to £9,900 - so someone who paid no fees would get a 60% higher pension than someone who pays 1.5% a year.
The RSA concludes that pension savers should be given annual statements that show how their scheme is doing – with everything expressed in pounds and pence.
Such transparency, it says, would bring pressure on fund managers to offer more competitive charges as empowered investors question the value they are getting. And the RSA is spot on. The public deserves nothing else. If we are going to be encouraged to take up the savings habit, then we must be able to trust those who manage our money to give us a fair deal.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
Defined benefit pension
Often referred to as a “final salary” pension, benefits paid in retirement are known in advance and are “defined” when the employee joins the scheme. Benefits are based on the employee’s salary history and length of service rather than on investment returns. The risk is with the employer because, as long as the employee contributes a fixed percentage of salary every month, all costs of meeting the defined benefits are the responsibility of the employer. (See also Final Salary).
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
Annual management charge
If you put money in an investment or pension fund, you’ll not only pay a fee when you initially invest (see Allocation Rate) but also a fee every year based on a percentage of the money the fund manages on your behalf. Known as the AMC, the actual percentage varies according to the particular fund, but the industry average for active managed funds is 1.5%.