The reactions I’ve read to Ed Milliband‘s “all-out attack on pension charges” have been universally negative. They  range from Robert Burgon’s “open letter to Ed Milliband” condemning the lumping of good and bad together to the broadside from Otto Thorenson of the ABI (linked).

All week I have promoted alternatives to the current system of DC pensions we run in the UK. I argue our system of DC workplace pensions  is under delivering and without a good kicking will continue to produce less pension per pound contributed than it could.

By about 50%!

I have pointed to alternatives.

The scheme that Robert Burgon manages on behalf of 38,000 plumbers is a model of good governance. It shows that the high-cost low-value approach to pensions can and has been avoided and that a meaningful accrual under a career average defined benefit scheme can be achieved without breaking the bank or the balance sheet.

I’ve written about the new breed of mastertrusts including the insured mastertrusts of Legal & General and Standard Life, NOW, NEST and the People’s Pensions.

I’ve held up the Dutch collective DC plans and particularly the not-for-profit governance structures that manage them as examples we could adopt. These plans and their governance can bring probity back to pensions.

But these are isolated islands of good practice in a sea of sludge created by years of questionable and sometimes “mal”practice.

To use a plumbing conceit (Robert), our system has leaky pipes and the money that should be coming out of the pipe and into people’s bank accounts in retirement is being siphoned into the pools of the wealthy. David Pitt-Watson’s recent comments about the Dutch pension system are irrefutable. We are leaking up to 50% of the pension the Dutch are getting and much of the leakage is due to unnecessary pension charges.

Most of our workplace DC pensions (unlike well run DB plan’s like Robert’s) are not providing value for money and aren’t just unclear about charges , they are downright misleading.

By attacking the wasteful charges of UK pensions, Milliband , McClymont and the Labour party research team are reinforcing not obstructing the key messages of Webb and the coalition.

I’ve had some correspondence with the research team and would draw to the attention of Gregg McClymont , the shadow pensions minister and his team of advisers (who inform Milliband) fall into three “abuses” that can and should be stamped on

Active management costs;

recent research supplied by Norma Cohen of the FT suggests that the average transactional costs incurred by an actively managed pension fund are 1.07%. These costs do not appear on any documents you receive and their impact is not declared retrospectively.

The 1.07% pa covers the costs of buying and selling assets and include the various taxes involved  (principally stamp duty). You may be happy to pay these costs if you think that you will get more than 1.07% return on your investments.

However you do not have to pay this extra charge, you can avoid doing so by using passive funds. The abuse is that these costs are not displayed and largely ignored , even by those who govern the management of workplace savings plans. Pitt-Watson’s research attributes more than 50% of the cost savings achieved by the Dutch to efficiencies in asset accumulation.The costs we pay for active management would not be countenanced within their well managed plans.

Switching costs;

Most  DC providers  talks about “free switching” but switching between funds is not free to the person switching. People incur  transactional costs in moving from one fund to another.

Though some managers (typically passive managers) can reduce these charges through skilful management, all too often switches involve the use of “dilution levies”- “fund manager speak” for buried costs that get lost in transition and mean part of the money switched leaks into the “pools” of city firms- typically custodial banks.

The “free” bit refers to the fact that the insurance company is not taking a cut for itself but that does not mean the switch is free. As with the question of active management charges, “charge-free” does not mean “cost free“.

In case you think that you are not going to be switching funds- think again. If you see the word “lifestyle” in the description of the fund you are in, you can be  sure that a regular switching process is built-in to your pension strategy. This will typically involve 120 automated fund switches in the five to ten years before you retire about which you have no control, the costs of which you will never know.

And of course, if you have a small pot, the cost of moving that small pot will include a switch charge. Steve Webb’s “operation small pot” depends on trust that neither ceding nor receiving scheme will provide anything less than “fair value” on transfer. In my book “fair value” includes transparency and value for money on switching costs.

Distribution costs;

To win new business, pension providers pay commissions to advisers to promote their products to employers and to people.

These commissions are paid for from the funds you are building up via the annual management charge you are paying.

I have nothing against sales commissions, but where the commissions are paid for by people when the distribution of the pensions is organised by the company, it is wrong for those commissions to be taken.

I know of cases where advisers continue to be paid commissions without so much as turning up at the employer’s offices from year to year.

The system of commissions is to be fixed going forward (by the RDR)but the ongoing payment of sales commissions on increments to the premiums paid by members (as a result of pay rises for instance) will continue.

There is a real risk of recidivism here and we will watch with interest any attempts by insurers to continue to pay advisers to distribute new product through “advisory fees” which are charged to members funds and are no more than distribution credits.

What are the answers?

There is an alternative to the costs incurred by active managers – passive management.

There is an alternative to the costs incurred in lifestyle switching programs;- target – dated funds

There is an alternative to sales commissions – commission free direct offer charging which cuts out the middleman and ensures that members get what they pay for.

Lets’s look at each solution in more detail;- firstly let’s be clear, it is possible for companies to engage directly not just with NEST and the mastertrusts but also with the insurers – even when they are offering contract-based plans (GPPs and stakeholder plans). By requesting comission-free direct offer terms, a company are ensuring that no adviser will be paid by the member and the only fees paid to advisers will be paid directly against work done.

We are about to embark on a program of auto-enrolment that will see up to 11m people joining DC plans for the first time. As they join automatically , there is no need for insurers to pay anyone to distribute product. This is a B2B sale and it is businesses who should pick up the tab through fees. Passing the costs on to members through commissions is bad practice and should stop.

As for alternatives to the problems with lifestyling, an alternative exists. Target-Dated Funds are available on most platforms  and if your existing provider does not offer them, then consider looking around.

We have recently seen the introduction of target dated funds as the default investment object of NEST. Other mastertrusts including Blue Sky Pensions, SHPS DC and the Pension Trust’s Flexible Retirement Plan are following suit. In ten years, let’s hope that the more transparent , less risky and cheaper target dated funds have generally taken over from Lifestyle programs.

Finally, let’s be clear about active management and its true costs. There is no problem an individual paying up to 3% pa in fund management charges as long as they understand the impact of those charges and the challenge they pose to the fund manager to get the extra-performance to make them worth paying. We cannot offer these expensive actively managed funds on a non-advised basis and they certainly should not (as they sometimes do) form part of a workplace savings default investment option.

Reducing switching costs, sales commissions and active management fees will together take real costs out of the accumulation of pension funds. That is of course only part of the story, there are high costs attaching to the purchase of a pension annuity which itself will likely produce considerably less than other forms of pension payment systems.

But that is another story.

It is absolutely vital that the pensions industry reforms itself and its product. Robert Burgon is right to point out that there are areas of excellence but I’m afraid that even Defined Benefit plans can sometimes fall victim to unwanted and unknown charges of the type I’ve described.

There is such ignorance about these charges. Anything that can be done to bring them to the attention of the public, of those who buy workplace pension plans for their staff and the trustees and pension committees governing these scheme’s progress is good.

Milliband’s initiative is good.

The pensions industry, quite understandably does not want to air its dirty linen in public and would much rather not air it all. The current system keeps a lot of people in jobs but it does not keep customers in good pensions.

If the price of cleaning up our act is the loss of jobs (and mine would  be at risk with everyone else’s) so be it.

The general complaint that Milliband is issuing his broadside at the very outset of auto-enrolment is a nonsense. Auto-enrolment may start on October 1st 2012 but it is an ongoing process. The 11m new pension savers are going to need cheaper more understandable and better pension savings plans and for that to happen, there will needs be a lot of cleaning up of the mess that we’ve seen build up over the years.

The damage of not getting to grips with these problems cannot be undone. Water that has leaked is lost. The sooner that we get to grips with these abuses and put an end to them the better.

I welcome Milliband’s attack on pension charges.

Bring it on.

Related articles

• Too important to hide;- why the Government has to investigate pension default charges (henrytapper.com)
• Miliband promises ‘all-out attack’ on rip-off pension charges (guardian.co.uk)
• Getting CEO’s and Chairmen “comfortably” relaxed about pensions. (henrytapper.com)
• Maybe consumer cynicism about pensions is right.. (henrytapper.com)
• Miliband’s attack on ‘rip-off’ pension funds: We will cap excessive charges, say Labour leader (thisismoney.co.uk)
• So you want better pensions? (henrytapper.com)
• Does your pension scheme need advice? (henrytapper.com)
• Can we get our business leaders to bother with pensions? (henrytapper.com)
• Plumber’s Pensions are safe with Penny Plumb (henrytapper.com)
• Fat pension fees flatten savers’ hopes (telegraph.co.uk)