How well the charge cap fits is crucial

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by

According to the Office for National Statistics, just 46 per cent of employees are now a member of a workplace pension scheme, the lowest level since records began in 1997.

Auto-enrolment presents the industry with a huge opportunity to reverse the decline in pension saving. But in order for the policy to be a success, two fundamental issues need to be addressed: cost and quality.

At the most basic level, pensions should provide a lifetime income in retirement that is fair value relative to the contributions paid. High charges eat away at pension pots, foster mistrust in the industry and act as a disincentive to savers.

The impact of the charges levied on people’s pension savings over their lifetime can be significant. Data from the department for work and pensions shows that over a 46-year period of saving, an individual paying an annual management charge of 0.5 per cent would lose 13 per cent of their pension pot to charges, while someone paying a 1 per cent annual management charge would lose 24 per cent – a significant differential.

Research recently revealed that 56 per cent of pension savers do not know the charges levied on their pension pots, while 22 per cent know some but not all. With engagement in pensions persistently low, it is right that the government takes a proactive approach to protect savers and help ensure that pots are not needlessly eroded. But the reality is that a cap on charges will not necessarily ensure a better deal for pension savers.

Historically, the industry has proved very adept at side-stepping charges, raising costs in other areas to compensate. With the launch of this consultation, naysayers have been quick to warn of a potential ‘levelling up’ of charges to the cap, while others have cautioned that it will stifle product innovation as the margin is too tight.

I am not convinced that either of these risks is too real, as most auto-enrolment providers’ charges are already below the 0.75 per cent cap, with the higher charges to be found in older style schemes that are not included in this consultation.

However, I am concerned that one of the unintended consequences of a cap is that it might reduce the number of players operating in the auto-enrolment market. We have already seen some players pulling out of the workplace pensions market as they simply do not view it as profitable, while others have been selective, cherry picking only the best business, not wanting to concern themselves with serving the mass market.

As auto-enrolment gathers pace with high volumes of small to medium-sized businesses and micro employers staging, the need for strong competition in the marketplace is imperative in order to deal with the huge demand. But this low-margin business, which many players already deem unattractive, will now look even more unappealing.

A question also needs to be asked about the sensibility of a flat AMC model. With this charging structure, regular savers with larger pots end up cross-subsidising members who are in the scheme for a short period of time or who have smaller pots.

Scheme

The reason for this is that the actual charges involved in running a DC pension scheme are split into fixed and variable elements. The fixed elements include the initial costs involved in setting up a scheme and the annual cost of administration. The variable costs are largely those of asset management. If these costs are split out and members are charged a small fixed fee for administration and a low AMC, the costs are spread more evenly across all savers. For long-term savers, this approach proves much more cost effective than a flat 0.75 per cent AMC. In fact, over a 46-year period of saving, just 8.16 per cent of the pot would be lost to charges.

My belief is that a monthly pounds and pence administration charge is more transparent and easier for savers to understand than a flat percentage charge, as employees can easily calculate what they will pay each year for their pension.

Rather than the government focusing on what the AMC should be, the cap should apply to the overall percentage of the pot lost to charges over the lifetime of the scheme. This would enable scheme providers to offer greater flexibility in the way that charges are structured while ensuring that the costs remain fair and reasonable.

For employers selecting a pension scheme, charges should be high on their priority list, but of equal importance should be the quality of the default fund and the governance of the scheme.

With auto-enrolment, 98 per cent to 100 per cent of people will end up in the scheme’s default fund, so it is vital that this fund is fit for purpose and is actively managed to mitigate risk.

With charges under pressure, it is almost inevitable that many providers will be tempted to push members into cheap, passively managed default funds, which will not necessarily deliver the risk managed returns savers deserve. This could potentially threaten the long-term success of auto-enrolment, as employees will become disillusioned if they see the value of their fund falling, and this could result in them opting-out of their scheme.

Long-term performance is as important as cost, and it is imperative that the initiatives that have been launched with the aim of raising standards are pursued with as much vigour as the charges cap.

If a consequence of the cap is a fall in standards and a reduction in choice, employers and their employees will not be well served. Action also needs to be taken to improve the comparability of schemes. Employers need to be easily able to compare not only costs, but also quality.

Options

While advisers are well placed to help employers sift through the options that are open to them, as the small and micro-employers reach their staging date, these firms are going to want a self-service option. For these employers, being able to identify a high quality scheme with low charges easily is going to be imperative.

For the pensions minister, the success of the cap will come down to the skill of the execution. Implemented too bluntly, the capacity crunch could be inadvertently exacerbated and scheme quality could suffer, which is in no one’s interest. Done right, it could help to build confidence in pension saving and ensure a better deal for savers both today and in the future.

Morten Nilsson is chief executive of NOW:Pensions

Key points

The impact of the charges levied on people’s pension savings in their lifetime can be significant.

We have already seen some players pulling out of the workplace pensions market as they simply do not view it as profitable.

With charges under pressure it is almost inevitable that many providers will be tempted to push members into cheap, passively managed default funds.