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How to understand and minimise pension fees

POSTED: 18th September 2013
IN: Personal Guides
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Pension fees: If you manage to accrue a pension fund of £250,000 over 40 years, an annual management charge of 1.5 per cent with no other fees, would erode its value to just £175,000. If the charge was 2.5 per cent, then the pension value would fall to just £140,000.

undefinedThis shows the effect of compound interest and the huge difference even a small change in pension charges can make to your final retirement pot.

The problem is amplified because there are usually other charges within the underlying investment fund, such as share dealing costs.

A report published last year by the Royal Society for the Encouragement of Arts Manufactures and Commerce (RSA) found that the vast majority of employees and small businesses do not understand pension fees and their impact.

The report’s author, David Pitt Watson said: “For markets to work effectively, consumers need to know what they are buying.”

Types of pension

There are a number of different types of pension. Traditionally, final salary pension schemes provided employees with a defined benefit linked to the number of year’s service and salary.

However, for new employees this type of pension is now very rare. For those who are already members of such a scheme many employers have placed restrictions on the accrual of future benefits as the cost of such schemes has become prohibitive as average life expectancy has increased.

In the main, these have been replaced by defined contribution schemes, where employees take the investment risk.  This type of pension involves employees and employers building up a pension pot, which may be used to purchase an annuity to provide an income for life.

Self-invested personal pensions or SIPPs allow the investor to choose their own funds to invest in. In theory, this should mean that fees are lower because you manage your own pension. In practice, this can be the case, but it depends on what funds you invest in.

In the late 1990’s Stakeholder Pensions were introduced and fees capped at 0.50 per cent for the first 10 years and 1.0 per cent after.

This helped increase competition and brought down fees but transparency in pension charges did not improve which means, 15 years later, the battle to bring down pension fees is ongoing.

A recent report found that 21 of the 23 main pension providers did not tell members about charges. This has led to pressure for pension providers to introduce clearer statements, explicitly detailing fees and charges.

Which type typically charge highest fees?

Private pensions that are managed on your behalf tend to have the highest fees but consultancy charges vary.

If you look after the investment choices yourself, the management charges will be less. However, if you buy and sell shares and invest in lots of different funds you will have to pay transaction charges, so a SIPP may not always be the cheapest option.

Pension charges are taken as an annual management fee which refers to the percentage of the fund that is taken each year, rather than the percentage of the money invested.

This has a big impact if your pension fund is not growing over a long period of time. If you invest £1,000 a year, the charge of a 1.5 per cent annual fee would be just £15, but if the fund does not grow, the fees will continue to increase so that after 20 years you would be paying an annual charge of £250, a quarter of your annual contribution.

What do you pay fees for?

You pay fees for the management of the pension scheme and the expertise you receive from financial experts who invest the funds on your behalf.

Something the pensions industry is often criticised for is the opaque nature of its fee structure. As well as an annual management fee, transaction charges and share dealing, you can expect to pay for most other actions you take with your money.

You may need to transfer funds out, pay taxes such as stamp duty. Individual funds that you choose to invest in can also have a charge.

Additionally, if you stop investing in a pension fund you can be charged an exit fee.

Overall, there are many potential fees, depending on the type of pension you have and pension firms are not obliged to show these in a standardised way as is shown on a normal bank statement.

These can be shown on your annual pension statement as annual management charges, underlying fund costs, capital and accumulation unit prices, contribution fees and exit penalties and will be shown in a percentage form rather than as the actual cost in pounds.

Are fees coming down?

Overall, fees are falling. Typically annual management fees on an active private pension fund are now around 1.5 per cent or 0.50 per cent for a passive tracker fund but if you have an old pension you may find the fees higher than this.

The rise of online pension investing and share dealing has demystified what many financial advisors do and many more people are choosing to look after their own investments and this has helped to reduce pension fees.

Hidden fees

Taxes, management fees and broker commissions through compound interest can erode more than a third of the value of your pension.

This is calculated by taking a typical pension that is invested in for 25 years, with an annual charge of 1.5 per cent, which means your pension pot is cut by 37.5 per cent. However, this level of fees is reduced if you apply a “typical” level of growth to your pension savings of seven per cent.

Auto-enrolment

The new system of pension saving in the UK involves employers setting up pension schemes in which employees have to actively opt out of if they do not want to join.

The new scheme will be enhanced by the decision from the government Pensions Minister Steve Webb earlier this year that employees’ will not have to pay charges.

However, many small employers will now have to run the gauntlet of understanding pension fees and choosing the right funds to invest in on behalf of their employees, so small businesses also need to understand how pension fees and pension investments can work for the benefit of their employees.

10 top tips to minimise pension fees:

Manage your account online if you make regular share transactions
If you are investing into a  SIPP choose a provider with a low annual management fee
Limit the number of different funds that you invest in
Consider whether you will have to pay taxes on transactions you plan to make
Identify all charges and break them down into pounds so you can be clear on what you are paying for
Choose a pension provider with a good reputation
Consider managing your pension yourself to reduce fees
Assess your attitude towards risk and invest in appropriate funds
Choose a private pension with a low or no set up fee
Choose funds with low initial charges and upfront fees

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