Few pension providers have reduced charges in line with stakeholder on all their pre-existing pension contracts, but although this would appear to unfairly impact on the financial health of policyholders, the issue is not that clear cut
Overpriced and still here, pre-stakeholder personal pension plans that retain a two-tier annual charging structure and early termination penalties may damage a policyholders financial health. However, when providers introduced their stakeholder schemes in April 2001, only a minority eliminated these and other anachronistic charging features on all pre-existing pension contracts.
This issue needs to be handled carefully by the industry. It would be all too easy for the consumer press to identify which companies appear to be on the side of the angels and hang the rest by their thumbs. But, as always, the issue is far from clear cut.
In some cases, the retention of old charging structures is not just a question of profits and greed. Clients may have worked through the higher-charging years and reached a point where the effective annual management charge is lower than the stakeholder 1% cap. Even here, though, increments may attract the old punitive initial charges.
For some of these life offices, it is virtually impossible to convert older contracts to a modern, explicit charging structure. Providers such as Scottish Equitable that included particularly high allocation rates in the early years on certain contracts or incorporated loyalty bonuses may need to maintain higher charges to meet their guarantees. The alternative would be to cut fund values ' a move that would be seen as grossly unfair by consumers, who probably never quite understood the charges in the first place. An alternative is for the proprietary companies to go to their shareholders to recoup their losses. Hardly a win-win PR opportunity.
Of course, mutuals do not even have this option and would have to deplete reserves ' controversial at the best of times but particularly so post-Equitable Life ' or reduce returns to non-pension policyholders.
The context for this debate is important. Clients have always been prepared to pay an explicit higher annual charge for specialist asset management. What we are talking about here is the obscure, implicit charges that used to be standard within the industry to cover sales commission, administration and marketing, among other aspects.
So just how many people may be paying too much for their future pension contributions? Between 1987 and 1989, more than 25 million personal pension plans were sold. Clearly, this figure does not take account of multiple policies and terminations. Nevertheless, we are talking big numbers. On top of which, there are the pre-1987 retirement annuity contracts.
The cut-off date of 1999 was selected because it was when providers saw the writing on the wall and started to revise and simplify their charges. In March that year, the Financial Services Authority's predecessor, the Personal Investment Authority (PIA), issued Regulatory Update 64, warning providers to get their charges in line with the new stakeholder regime.
It is after this date that we finally saw the demise of the capital (initial) units, policy fees and high early allocation rates that made pension plan charges such a mystery to everyone except the actuaries.
Few providers have reduced charges in line with the stakeholder cap across the board on all pre-existing pension contracts. Among the life offices to have done so are Standard Life, Norwich Union and Clerical Medical. Royal Liver has reduced charges on most of its pension book.
The bancassurers are also in the vanguard. HSBC and Barclays, for example, have reduced charges on their entire individual pension books. Harpal Karlcut, head of life and pensions at HSBC Bank, says: 'If you have got a personal pension, you should not have to transfer to a stakeholder to enjoy lower charges.'
Following the alliance with Legal & General in January 2001, Barclays' pre-stakeholder business continues to be managed by Barclays Life as a closed book. New clients are offered an L&G stakeholder. Abbey National has reduced charges but only for personal pensions sold after 1999. The majority of providers still operate some anachronistic contracts that could run for another 25 years.
For advisers unfamiliar with the good old/bad old days, it is worth taking a look at the oddities found in pre-1999 contracts. Bid/offer spreads of 5% and the separate monthly policy fee were common features but have largely disappeared.
More insidious for those who increase premiums on an older contract is the two-tier annual charge. This works by allocating premiums in the first couple of years to capital or initial units (the precise initial period depending on the term to retirement). These units bear a high annual charge of anything up to 6% and continue to do so throughout the entire term. Arguably, the effect of this initial period is eroded over time as the fund builds up but unless the feature is abolished, any increments to the regular premium will also attract these heavy charges.
After the initial period is up, further premiums are allocated to accumulation units that attract a much lower charge, often at 0.5%-0.75%, well below the stakeholder 1%.
The allocation system is also idiosyncratic. The aim is to attract the customer with a high allocation rate ' a something-for-nothing marketing bribe if you like. For example, for every £100 invested, the client might secure units worth £110 or even £120. This up-front subsidy from the life office is generally clawed back over the term of the policy. The charges also cover the upfront (indemnity) commission to the adviser, based on the entire term.
Where does this leave advisers who recognise that a new client has a pension plan with punitive charges and penalties? Robert Hall, partner with consultants Watson Wyatt, believes the adviser needs to consider several different issues.
'The most important point is to look at the current effective annual charge,' he says. 'For clients with older pension contracts who have worked off the effects of the bid-offer spread and capital units, the effective annual management charge could be 0.5%-0.75%. In this case, it would not necessarily make sense to switch the existing fund.'
However, there are other issues to consider, Hall says. For example, how should you deal with top-ups? Some policies have an RPI-linked premium increment built in, which could attract the higher capital unit charges. A client in this position might be able to continue the premiums at a flat rate and direct top-up premiums to a new policy. 'In these cases there should not be any penalty,' Hall says.
The next question is whether the policy should be paid up ' that is, closed to new premiums. This might be an acceptable approach as, after about five years, the marginal rate of charges could be lower than 1%. The client would then start a new policy for all future contributions rather than just top-ups.
The biggest decision, Hall suggests, is whether or not to transfer the whole fund to a new provider. While this might be tempting, careful analysis is required. The decision will depend on the effective annual management charge and the penalties that might be imposed. Other issues can also influence the decision, such as lack of fund choice or inflexible policy terms.
One way to assess the client's position purely on cost grounds is to compare the projected full policy value at retirement, using real charges, with the same analysis using the (usually much lower) transfer value and a new provider's charges.
This is what the adviser Bestinvest's pension charging analysis system is designed to do. Using a 5% growth rate and real charges, the adviser can calculate the reduction in yield for comparison purposes.
The service, at www.bestinvest.co.uk, costs 0.5% of the fund value, subject to a minimum of £250.
Simon Leach, pension supervisor at chartered accountants Blick Rothenberg, stresses the charges are just one issue a professional adviser will examine. He says: 'We would also consider the investment options under the existing contract and its flexibility ' to check if there are any penalties for early retirement, for example. High earners should think very carefully before abandoning a retirement annuity contract because the earnings cap does not apply to this older-style contract. A switch to a personal pension will trigger the cap for future contributions.'
While the price cuts across the board are welcome, they do raise important questions of solvency. Ned Cazalet, head of Cazalet Consulting, is not a man to mince his words. 'In the case of Standard Life, for example, we wouldn't say the reduction in charges was a consumer triumph,' he says. 'Someone has to pay and, in the case of a mutual where the charges have been cut on the entire pension book, the other policyholders will suffer.
'Standard Life has not put forward a figure for the cost of cutting these charges but we estimate it will cost the provider about £1bn, which will have to be funded out of reserves and via other policyholders.'
Cazalet, a leading analyst of the financial strength of life offices, predicts that in a few years time, when the loss-leading stakeholder providers have gathered in a substantial portion of the market, we are likely to see predatory foreign insurance companies, particularly from the US, undercutting UK life offices in a bid for their funds.
'Stakeholder providers are taking a massive business risk,' warns Cazalet. 'They are cutting charges to the bone and paying lunatic rates of commission at a time when excess with-profits capital has fallen by £100bn ' from £130bn in 2000 to £30bn today. In most cases, they do not expect to make a profit for 12 to 15 years.'
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