Saturday, 27 January 2018

Pensions, Tax Subsidies Charges and Incentives to Save

We recently enjoyed a lively exchange on this topic here.  And I said I’d write up something from experience on the coal face as it were.

First a little history.  Pensions originated much earlier than you might think. Quite a few centuries ago some notable taking on a Kings Patent was often obliged as the price to pay the outgoing tenant an income for life. Pensions are therefore strictly a regular payment to someone from someone else.  Annuities were sold by the government to raise money for wars. These annuities morphed into Gilts, which is largely why today annuities sold by insurance companies are mostly backed by Gilts, Gilt cashflows being relatively certain of being sustainable as they are funded out of taxation. By coercion if you prefer.  Private individuals could buy deferred annuities which came into payment at a set date or age in the future, the forerunner of today’s personal pensions.  In time large employers started to offer company pensions to their workforces.  These were offered not generally out of altruism but as an employee retention incentive. From memory at this time it was agreed between employers and the state that as company contributions were an expense they should be treated as pay, and as this pay would not be drawn until retirement age all income and capital taxes should equitably be deferred until those benefits were drawn, with the quid pro quo that the pension benefits – the ‘annuity’ – would be taxed as pay on the whole amount not just on the interest element.  Clearly these tax breaks were an incentive to join the company scheme or if you were a professional or self employed take out a Retirement Annuity Policy. So far so all well and good. 

Over the years as the size of the pensions fund grew it was obvious that the tax breaks were ‘costing’ the state revenue.  (In fact to align with the deferred pay philosophy) these taxes were not lost, merely deferred until the pension came into payment.

Also over time many insurers got in on the act, notably outfits like Hambro Life, Abbey Life and so on  - early examples of sales led unit linked insurers.  Some of the antics of their reps and the inveterate tendency for the state to prodnose into stuff led from the 1970’s to a series of official investigations and reports into pension and private savings, and various ‘reforms’ were mandated leading to the Financial Services Acts of 1986 which made some very fundamental changes.

In my view these Acts were very flawed, not because they ‘deregulated’ (which they did not – they introduced regulation) but because they made a fundamentally flawed intervention into the sanctity of private contract by forcing employer final salary schemes to make cash equivalent transfers of benefits to any member who requested one. This inevitably led to the pensions transfers scandal.  The problems with pensions do start there but the final nails in the coffin came under the New Labour government between 1997 and 2010. The worst financial services act ever, the Financial Services and Markets Act 2000 imposed an entirely flawed regime on the FS industry and effectively crippled company pension schemes.

In the above I have ignored the history of State Pensions, SERPs, S2P, Stakeholder, Auto Enrolment, etc. etc. all of which in one way or another have been largely flawed initiatives.  I have also ignored the failure of Equitable Life which gave me a great feeling of schadenfreude.

In any event pensions regulations themselves are now immensely complicated.  The Common Man has no hope of understanding them, at all.  And in my humble opinion there is no one man in the UK that understands them.  I have an employee who is nominated as our pensions guru and he is backed up subscription access to a specialist technical service who have specialists in separate bits of the legislation and rules.  That is a bill to my business of possibly £20,000 per annum – and we are a very small business.

Pensions Tax

As stated above pensions are deferred pay. The deal is that you pay no tax on the contributions you make, but you’ll be taxed on the whole annuity payment when you take your benefits.  I think that that is easy to understand, simple, and fair.

The question is what proportion of these tax breaks end up in the hands of the scheme providers?
Well, for defined benefits schemes of a reasonable size which are well funded and well run, the answer is not much.  The Trustees can access institutionally priced investment funds which have very low charges. Nil initial and as low as 0.1% TER (See below for TER explanation).  Where these schemes tend to lose out is when they employ ‘consultants’.  These are the usual rent seeking culprits like Capita or Aon (the latter has atrocious administration). I have seen the most stupid recommendations for investment from these outfits.  I also know that they routinely churned Group Personal Pension schemes for the initial commission.

For company money purchase schemes/GPP’s the same factors apply.  They can be run very efficiently, and we have done so.

Total Expense Ratios

These are now called OCR’s.  Ongoing Charges Ratio.

I started in FS in the late 1980’s.  By the early 90’s we were asking fund companies what their total charges were and the good ones would tell you.  In 1996 two blokes Paul Moulton and Hughes Gilibert set up Fitzrovia Fund Research to research and analyse funds costs.  That business developed the Total Expense Ratio methodology and was latterly sold to Lipper.  Gilibert and another ex-Fitzrovia alumnus now run

The Fitzrovia data was used by many pensions (and fund consultants) to drill down into the full costs of fund management.  Good managers published their Fitzrovia TER’s on their own fund fact sheets.
If you want to you can Google these outfits and check their methodologies and see just how thorough they were in getting this data right.

Today, with their usual johnny come lately skill the regulators mandate the publication of TERs (now OCR’s) as if they’d just thought of it.

Fund Charges

Take two sample funds. One a global all cap equity fund the other a global bond fund.  A typical asset split in a pension would be 60% / 40% equity to Bond

Fund                                                                                                      OCR

Vanguard Global All Cap Equity Fund                  0.24% (Institutional class would be less)
Vanguard Global Bond Index Fund (hedged)       0.15%  (for the institutional class it would be 0.1%)

Total weighted OCR                                             0.20%

Pensions admin (Aviva Platform)                           0.25%  (This varies between 0.10% and o.40%)

Total charge                                                            0.45% per annum.

If you want / need to use the services of someone like us then that would be in addition to that figure and again would vary with both quantum and the extent of the services you wanted / needed.

Final Comment

There are lots and lots of investment managers and thousands and thousands of funds out there who charge a whole lot more and definitely soak up the tax subsidies.  This is especially true of things like VCT’s and EIS’s and Cash ISA’s.  And there are certain outfits who are notorious (IMHO) for overcharging, St James Place for example.

But without a shadow of a doubt you are perfectly able to operate a personal pension for less than 0.5% per annum all in.  The real problem with pensions costs is not the investment management – it is the stupid complexity of the rules and regulations arising from a history of utterly flawed interventions by governments and their bureaucratic Satraps.

(Apologies for the length of this. Also I completed it in haste whilst motivated)


Rich Tee said...

I haven't really grasped the complexity of it. What I do know is that a few years ago I ended up working for a company without a pension scheme. So I started a SIPP and managed it myself online. I was very happy.

Then auto-enrolment came along so my employer was forced by law to start a pension scheme. I asked them to pay their employer's contribution into my SIPP and they refused. So I either had to let them enrol me into another pension scheme, or I lose the employer contribution. I can't tell you how much I resent being treated like this.

Rich Tee said...

I would also like to add that I think it may be a good idea to delay paying into a pension until you own a property. This is because if you don't own a property when you retire you will have to pay rent out of your pension, which cancels out much of the benefit of paying into a scheme in the first place.

Auto-enrolment doesn't take this into account of course. It reduces the amount of take home pay so making it even harder for a person to save up for a deposit, and so less likely to own a home at retirement.

Lola said...

RT. All modern personal pensions are de facto SIPPs in the sense that you are not bound to use the pension wrapper manager's own funds, as in the Avia example above. A true SIPP will enable investment in all things permitted by the HMRC rules, including commercial property. At which point they become costly. There is a halfway house SIPP which permits all investments allowed except property, i.e. direct equities, bonds, hedge funds etc as well as mutual funds. These latter SIPPs excellent value when the fund is large enough. The best (IMHO) is run by a specialist admin outfit called Transact, which we use a lot. (NB Transact are pure admin. They do not run money at all.

Mark Wadsworth said...

L, like you say, while the underlying historic principle makes sense, the whole overlapping sets of regulations are largely collapsing under their own weight.

Q - why 'should' the government incentivise 'pensions saving'?

A - to minimise poverty in old age.

As RT point out, it's best to pay off your mortgage first before you worry about pensions. If you pay more into a pension plan and as a result can't scrape a deposit together and are stuck renting, you are clearly worse off. If you pay your mortgage off more slowly while chipping into a pension fund, you are merely running to stand still.

Further, people's inclination to save is barely affected by pensions tax gimmicks. Most would have saved anyway, and only a minority would not have. So the entire cost of pensions tax breaks is 'spent' on tipping that tiny minority into saving - and in turn a lot of these people would have been better off saving up for a deposit or paying off the mortgage quicker.

If answer "to minimise pensioner poverty" is correct, this is most easily achieved with a non-means tested Citizen's Pension. The whole means-testing crapola is a disincentive to save for people on low incomes, and those are exactly the people worth helping.

And get rid of the stupid tax breaks, better to reduce the deficit or if you wish, bump up the old age/Citizen's Pension by £10 or £20, at which stage we can say "Right, there is no more pensioner poverty) as defined, job done".

Mike W said...

Thanks Lola, good discussion.

'I would also like to add that I think it may be a good idea to delay paying into a pension until you own a property'

As Rich Tee outlines above, a few years ago I decided to bite the bullet and put most of our savings into the property, so we were mortgage free ASAP. I jumped more for 'existential reasons' in truth: how old were we, were we fit or in decay, did we wish to work full time or part time in future, would we move again on retirement?

So when I read that Simon Marly 52, a charted accountant, had effectively sold up to do the opposite, I got a little nervous. Have been meaning to post this before.

Lola said...

MikeW. INH experience a lot of Chartered Accountants don't have a bloody clue about 'investing', pensions or whatever.

Dinero said...

Cheers Lola , interesting post.

Lola said...

D. And all at no charge...

formertory said...

a lot of Chartered Accountants don't have a bloody clue about 'investing', pensions or whatever.

How true. Taking advice from my dear old late father (FCA, finance director of major plc) cost me a great deal of (lost growth) money; took me 10 years to find out how wrong he was and why. Still, it spurred me on to find out more about pension and investment - a positive thing. And I learned that accountants don't, after all, know everything about money.

Lola said...

FT. I saw a newspaper article some years ago about an accountant who'd sold his house put the lot into gilts and was renting until house prices crashed. Haven't seen the follow up story.