Are pension caps the answer?

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      Are pension caps the answer?

      Chancellor George Osborne recently announced that he had asked the Financial Conduct Authority (FCA) to look into creating a cap on exit penalties, which he said were preventing people from accessing the new pension freedoms.

      In this article I will consider three questions: What are exit penalties? Are they a barrier to pension freedoms? Should they be capped?

      What are exit penalties?

      Exit penalties generally arise from the product provider’s charging structure, but they may also arise because the assets held in the pension plan are worth less than the ‘face value’ of the policy.

      Back end loading

      Historically insurers have struggled with telling policyholders that the establishment costs of setting up a long-term product – including the sales commission to the adviser – have actually been borne by the customer at the start of the plan.

      Sending out a statement on the first policy anniversary showing that little or nothing has been invested does not encourage future savings, so there will have been a notional allocation to units for the purposes of showing the ‘face value’ of the policy. This would usually be the value paid on death but not on early termination or surrender of the plan.

      So the concept of ‘back end loading’ was introduced to give customers something which made for easier reading, while reflecting a notional recovery of charges over the lifetime of the plan. This made it appear the costs were spread over the full term of the policy.

      A typical approach to back end loading would be to deduct, say, 5 per cent a year from the units notionally allocated from premiums that are paid in the first year or 18 months. These units are often called ‘initial’ or ‘capital’ units, as opposed to ‘accumulation’ units which would be secured from subsequent premiums. Thus the company could show units reflecting 100 per cent of the premium, and any net growth allowing for the extra charge. This process recoups expenses already incurred over the full term of the policy, without the difficulty of having ‘nil allocation’ periods. At maturity, the notional face value would match the ‘cash in’ value.

      Logically, if the policy is terminated prematurely then the surrender value (or more typically on pension arrangements the transfer value to another product) must reflect the costs actually incurred by applying a deduction to the current face value. The existence of this ‘early surrender penalty’ should always be recorded on the policy document and should also have been clear in the illustration that was given to the customer before buying the product.

      Investors should be aware that in reality there is no such thing as free money, anywhere David Trenner

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