HOW much of your pension pot is eaten up by charges every year? It’s a question that many people may have been asking after pension funds came under fire for levying excessive fees that wipe out savings.
But how important is it in the big scheme of saving for retirement?
Pension charges can wipe out up to 40 per cent of the value of our pensions, according to research by the Royal Society for the encouragement of Arts, Manufacturers and Commerce (RSA).
In fact, if a typical Dutch and typical British person saved the same amount for their retirement, the Dutch person could expect 50 per cent more income in retirement, the RSA claimed.
It also discovered that 21 of 23 pension funds in the UK failed to disclose their full charges. When quizzed, most funds claimed around £150 a year is taken on each £10,000 saved in a pension pot, yet experts believe annual charges could in reality be double that – around £310 once hidden fees are taken into account.
The furore prompted the Association of British Insurers to set out an action plan for clearer pension charges and costs in a letter to regulators. The move is designed to improve transparency across the whole of the pensions industry and raise consumer confidence ahead of the introduction of auto-enrolment into pensions this autumn.
But how much of an impact does all of this really have on your pension savings? Are pension charges really the biggest determinant of your ultimate retirement income or do contributions and investment performance remain the key factors? Let’s take a closer look.
Pensions are long-term investments, so the compound effect of higher charges can have a marked effect. For example, suppose you invest £200 per month towards your retirement fund over a period of 30 years, achieve a 6 per cent investment return and the charge on your pension is 1 per cent per year.
Based on current annuity rates for a 65-year-old man, this would produce a pension of around £9,000 a year. If charges are 2 per cent a year, the annual pension would be 16 per cent less. Quite a difference to the income you get in retirement.
When considering charges, it is important to consider not only the annual management charge (AMC), but also what is known as the total expense ratio (TER). The AMC is the headline cost of running the fund and the one that savers are most likely to be familiar with. However the TER also includes other, often hidden, costs such as those incurred when trading stocks within a fund.
If you invest in actively-managed funds, these can have a significant drag on investment performance. When you consider that it is almost impossible to predict with certainty which actively-managed funds will outperform their benchmark in the future (and the majority fail to do so), then there are strong arguments for avoiding such funds altogether. By investing in passively-managed or index-tracking funds not only will you reduce the risk of underperformance, but you also pay less in charges.
Another way of reducing costs is to consider what you are paying for any old and possibly forgotten pensions you may still have from previous employment. One particular trap to avoid is continuing to pay contributions into a plan where there is a “bid/offer spread”.
This was once an almost universal practice whereby the investor would buy units for typically 5 per cent more than they would be able to sell them for. In other words, if you were investing £100, effectively only £95 would be invested and there would be other management charges on top. Thankfully, this practice has died out on plans that have been established in recent years.
So, charges are important and there are simple steps which can be taken to reduce costs. But are charges the most important factor in determining your retirement income? Not really.
In order to be in a position to retire on the income you need, it is essential to have a plan which determines the level of contributions needed to fund that retirement, stick to the plan and never miss a beat.
More than anything else, in other words, it is the contributions you pay into your pension (or other savings earmarked for the long-term), that will determine the outcome.
So how do you determine your “magic number” – the amount you need to save each month to provide your desired income in retirement?
The factors that need to be taken into account include your age now, when you want the financial option of stopping work, the value of existing funds, investment growth, inflation and what you are trying to achieve. With agreed and measurable objectives, it is possible to work backwards to arrive at how much you need to invest to achieve your goals.
Equally, simply throwing money at a pension or other long-term investments without regularly reassessing your situation is likely to end in failure. Investment returns and inflation can vary widely year-on-year and changes to personal circumstances can knock any well-laid plan off course.
The answer is to review your position annually, and gradually replace the assumptions with what has actually happened. That way, plans can be adjusted and kept on track as retirement gradually approaches.
So what about the actual investments in which your save in the hope of capital growth? As mentioned above, many experts believe that investing passively into a diversified portfolio to achieve asset class returns will produce superior returns in the long run. There are others who will argue the case for active fund management.
Whichever camp you are in, most would agree that regularly rebalancing your pension is an important way to boost your eventual returns.
In a nutshell, in a portfolio comprising diverse assets, the various elements will grow (or fall) at different rates. For example, following a year of strong stock market growth, a fund originally made up of 70 per cent equities may now account for 75 per cent or more.
By reducing the equity content back to the original 70 per cent, the fund is being brought back to the agreed objective, but in addition you are crystallising profit, which is then reinvested in assets that have underperformed in relative terms.
This is called rebalancing and a disciplined approach to this can be shown to increase returns without a corresponding rise in investment risk.
• Bill Saunders is a certified financial planner and head of financial planning at Acumen Financial Planning