PensionsSep 29 2015

The price of freedom

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by
The price of freedom

This summer has provided a rude awakening for pension investors who opted for drawdown over annuities since the new pensions freedoms came into force in April. From 6 April to 15 September, UK equities were down 9 per cent, world equities down 11 per cent and even UK corporate bonds down 3 per cent. The mainland Chinese stock market was down 25 per cent., as shown in Graph 1.

With even index-linked gilts losing money over the period there was only one safe place for drawdown investors: cash. Welcome to the new dawn of pensions freedom.

The helpful words written in friendly large letters on the front cover of the ‘Hitchhiker’s Guide to the Galaxy’ would serve drawdown novices well: “Don’t Panic”. In the wake of Black Monday on 24 August, when world markets were decimated after what had already been a bad month, it has been estimated by Metlife that more than £160m was lost by the 27,000 people who had started drawdown since April.

Institutional investors were widely reported to have used the sell-off as a buying opportunity, hovering up shares that had suddenly become much cheaper. But that activity was not enough to trigger a sustained recovery, and by mid-September most markets were still marginally behind the level they had been on the Friday before the crash. Hopefully the drawdown newbies will have time to wait for a recovery. But this environment could hurt their income in the meantime, serving as a timely reminder that the guaranteed income levels offered by annuities were not quite such a bad deal as they seemed when the freedoms were first launched with such a fanfare.

Bewildering charges

On top of the volatility in the markets, drawdown investors also have to contend with a bewildering array of charges and charging structures as an FT Money survey revealed last month. Unfortunately explicit charges are only a part of the problem; there are far more costs than most investors and advisers realise in these products and this goes some way to explaining why they often do not perform as well as clients hope.

The first challenge when trying to compare products on fees and charges is to get a grip of explicit costs. Typically drawdown products will have an initial or set-up fee (often a fixed amount), product fees (percent of assets on a sliding scale) plus platform costs, switching costs and underlying investment management fees.

But in addition to that there could be withdrawal charges and there will almost certainly be additional investment fund costs in the form of bid-offer spreads and additional fund costs. The bad news is that there is more to it than that as actively managed funds will also incur trading costs every time they make an investment decision – costs which are extremely difficult to assess.

Advisers who are find themselves fielding questions from clients who insist on knowing the price of what they are buying, not unreasonably, will find themselves struggling to come up with a consistent answer. In an effort to resolve this, they might want to consider setting up benchmark portfolios with consistent assumptions that can help them and their clients to assess value for money. Unfortunately the only way to get a proper answer is by modelling.

Testing the theory

As an example consider the case of a £500,000 portfolio invested in this fictitious drawdown Product A (as shown in Graph 2). The product has no set up fee, 0.5 per cent pa product fee, 0.25 per cent pa platform fee, 0.4 per cent pa annual management fees on funds, a £10 switching charge, 0.5 per cent bid-offer spread on initial funds, and 0.3 per cent pa additional fund costs (to make a proper ongoing charge calculation on the funds).

If we model the impact of these charges over 25 years, assuming investment growth gross of charges of 6 per cent a year, income of £30,000 a year being drawn down, and one switch a year, the total costs are £134,048. This is equivalent to costs of 2.1 per cent in the first year and then 1.5 per cent a year thereafter.

What happens if the fixed costs were higher, for instance initial set up fees of £500 and switching charges of £100as in a hypothetical Product B? Total fees rise by £1,832 over the life of the arrangement but the impact is minimal; annual fees in the first year are a hefty 2.7 per cent but after that they fall to a level only 0.02 per cent higher than the original product.

Only if the portfolio is being regularly changed do the fixed charges have an impact – 10 switches a year would mean that Product B costs nearly £18,000 more, reducing the total finishing pot by £40,000. So while fixed costs can have an impact if they are being incurred regularly, they do not make a massive difference otherwise.

The same cannot be said of the annual percentage costs. Consider Product C, which is identical to Product A in its charges but has only 0.1 per cent additional fund costs and a 0.3 per cent fund AMC – so annual fees are 0.3 per cent less overall (at 1.15 per cent). The impact of this is that after 25 years the client has a pot £62,000 larger and has paid out £20,000 less in fees.

Take a final hypothetical example of Product D, which is the same as Product C but with no platform fee (so 0.25 per cent a year less) but a whopping £5,000 initial set up fee. The pot size is smaller for the first few years due to the hefty initial charge, but overall fees are actually £16,000 lower and the final pot £35,000 larger.

The moral of the story is clear: for a product with such a long lifespan, don’t worry about initial or other one-off charges; it is the regular annual percentage costs that really add up.

Positive outcome

The positive message from this for advisers is that this complexity does highlight the need for expert help in choosing the right product and all other elements of drawdown. But in order to provide meaningful support, advisers should offer detailed cost modelling.

This need not be complicated or time consuming on their part; setting up a simple spreadsheet with details of the products available and which can calculate a cost based on assumptions about income, lifespan and frequency of switching can be extremely useful without eating up too much adviser time.