The following guest post is by Mark Meldon, an independent financial advisor who has come on-board to explain some of the more obscure or technical corners of personal finance.
I began my career in financial services back in 1988, working at the head office of a long-gone life insurer in Surrey. I then joined an independent financial advisory practice in 1990 with a specific remit to advise members of occupational schemes about things like insurance policies and additional pension contributions.
Mainly, though, I was involved in arranging the new kid on the block – personal pension plans.
Private Pension Plans
In a certain guise, personal, or private, pension plans have been available in the UK continuously since the Finance Act of 19561 when what are known as ‘retirement annuity policies’ or ‘Section 226 policies’ were introduced under legislation. They were often marketed specifically at the self-employed.
Then, in 1988, personal pensions were launched to great fanfare. These remain available today, but much has changed over the last 30 years as far as charges, retirement options, and who offers them are concerned.
It isn’t my purpose to deal with too much history here (fascinating as it might be to me), but there are a few things that need to be understood regarding old policies that are gathering dust in the traditional box under the bed.
Sometimes – quite often in fact – gems can be found among those dusty piles of paperwork accumulated after years of neglect.
In order to keep things reasonably clear, let’s just call these ‘private pension plans’. Although there were distinctions between ‘S226’ and ‘PPP’ policies (the latter, for example allowed millions to ‘contract-out’ of the then state pension top-up scheme, SERPS), most of these have now vanished as legislation has changed over the decades.
What has not changed, with one very important exception, are the contract terms and conditions applicable to whatever plan(s) you might have2. This is the potentially very interesting bit!
Insured or SIPP?
Up until very recently, the vast majority of private pension plans were sold by life insurance companies. SIPPs (Self-Invested Personal Pensions), incidentally, are subject to exactly the same rules as those ‘insured’ schemes – they just have more investment choices and have become increasingly popular as administration and investment charges have been driven down by technological advances.
There are, however, millions of insured arrangements in the UK and, anecdotally, the majority of these are not currently receiving contributions. I think that there has never been a better time to look at these ancient policies to see how well they meet your needs.
Crucially, some might have very favourable guarantees that give certainty of payment throughout retirement, at a level that current investment conditions are unlikely to match.
That said some consideration should perhaps be given to rounding them up into a shiny new arrangement that can offer all of the flexibility permitted under the pension freedoms introduced in 2015.
If you think about it, a personal pension requires two basic things to make it work: administration and investment management. An insured plan bundles these two things together and can offer additional features such as life insurance and disability benefits (this is called a ‘waiver of contribution benefit’). Whereas, briefly, a SIPP separates these basic elements. You pay an administrator and you choose the investments.
I think the general perception that all insured private pensions are markedly inferior to a SIPP simply isn’t true, and I’ll try to explain why in a moment.
But first we need to look at who sold them.
Disruptive technology and administration costs
Looking at administration first, I remember filling in huge data input sheets in the new business department of that long-gone life office. These sheets were then sent off to a computer department that occupied a whole floor of a large building for an overnight run.
Whilst that makes me sounds ancient, those computers were state of the art then, albeit vastly inferior to today’s smart phones that we all take so much for granted. Such disruptive technology quickly overtook many life offices and made many of their products uncompetitive as far as administration costs were concerned. (Who would have thought of the impact of the likes of Hargreaves Lansdown and others back then, with the operating efficiencies their business model later introduced?)
Most private pensions were not sold through IFAs. Rather, in those days many life offices had huge direct sales forces. Indeed the number of such advisers has shrunk by as much as eighty percent.3
Back in the early 1990s there were over 100 hundred companies selling private pensions. Today there are just a half-dozen serious players left in the market! Running from Abbey Life, Allied Dunbar, London & Manchester, NPI, Royal Life, Sun Life to Zurich Life, these so-called ‘zombie’ life offices have often been bought up by consolidators such as Phoenix Life and ReAssure. The consolidators now run hundreds of legacy books of business – and pretty well in my opinion, in the main.
These consolidators are subject to strict rules and conduct of business but are, of course, commercial organisations and need to make a profit. They do this from the multitude of plan charges and investment charges that came with these old policies.
Up until the abolition of commission at the end of 2012, the typical private pension might have the following charging structure:
- A 5% bid/offer spread as an initial charge on every contribution paid.
- A policy fee of £3 per month.
- Contributions paid within an initial period defined in the policy conditions were often allocated to ‘capital’ or ‘initial’ units, which suffered an annual management charge of, typically, between 3% and 9%. Regular contributions paid after the initial period and single contributions were usually allocated to ‘ordinary’ or ‘accumulation’ units, which suffer an annual management charge of, typically, between 0.5% and 1.5%.
- Providers used initial/capital units to recoup their expenses associated with setting up regular contribution pension policies and the cost of commission payments, which were substantially higher for regular premiums than for single premiums.
- Alternatively, rather less than you paid was actually invested into ordinary units for a period of time – known as front-end loading – with the quid pro quo being that there were few, if any, early termination charges.
As far as the commission paid in those far-off days is concerned, let us consider someone deciding to pay a not unreasonable £250 per month into a private insured pension for 30 years. Based on the commission scales from the mid-1990s, the direct salesman would expect to be paid something like £2,900 in up-front commission, whereas an IFA rather less at something like £1,900 – the differential being explained by the fact that the direct salesman gives 100% of his business to the life office.
Now you can see why the charges were so high!
Had our investor paid a £3,000 single contribution, by the way, the commission would have been £240 for the direct salesman and £150 for the IFA. Hmm!
Investment management for insured pensions
The choices here fell broadly into two basic options: ‘with-profits’ and ‘unit-linked’, with the latter far more prevalent than the former thanks to the likes of disruptive innovators such as Abbey Life and Hambro Life (later called Allied Dunbar, now Zurich Assurance).
With-profits funds were, and are, substantial pools of money managed internally by the life office. Unit-linked funds came in various flavours such as a Managed Fund, UK Equity Fund, Property Fund and others.
The most commonly perceived difference between with-profits and unit-linked investment is that the value of unit-linked policies is more volatile. This is because the policy value is obtained by multiplying the number of units held by the prevailing published bid price, which fluctuates directly in line with the market value of the assets held in the fund.
The return achieved, therefore, directly follows market conditions and volatility can clearly be seen though variations in the bid price of units. I have always found this a rather more transparent approach to investment.
By contrast, the value of a with-profits policy is largely determined by the insurance company and is not directly related to the value of the underlying assets of the with-profits fund. Instead, insurers allocate a return through the mechanism of bonus declarations, which aims to smooth out the volatility in the value of the underlying assets. This conservative approach was favoured by many IFAs back in the 1980s and 1990s but is rarely available today.
Traps for the unwary
You might think that all old insured private pension plans are terrible, but that isn’t always so. For example, many policies have valuable features that are just not available today.
Indeed, some are extraordinarily attractive.
For instance, up until the mid-1990s, many life offices offered a ‘guaranteed annuity rate’ on their policies. Simply put, you can take a fixed secure income for life from the policy when you reach retirement age. Sometimes this so-called GAR isn’t actually much use in the real world, as it might only be available as a pension paid annually in arrears with no options like a spouse’s pension. However, many do offer flexible options – you really need to check.
A couple of years or so ago, I advised a client to exercise a GAR which gave him a return of 16% on his fund! From an after tax-free cash fund of £85,000 or so, he has already been paid gross income of £27,200, and he is only 67 – amazingly, that is around 3.5x what he could buy today from a pension annuity on the open market today. Bearing in mind that he only paid in around £12,000 in net contributions to the plan back in the 1980s, I can only say “kerching!”
Many old policies I look at also offer insurance benefits like life cover and ‘waiver of contribution benefit’ – the former is often rather expensive but the latter means that the insurance company will effectively pay your pension contributions on your behalf if you suffer from long-term ill-health. I had experience of a lady who became ill and her pension payments continued for 12 years under this provision.
Marketing gimmicks were common, too – loyalty bonuses, charge rebates and the like. I have a handful of clients who set up private pensions with what was the Sun Life in 1992 and these policies were all set up to finish at age 55. Two of these clients have long gone past that age but have kept the policies up and they now benefit from ‘Extra Fund Injection’ (remember all those ‘EFI’ badges on the back of cars in the early 90s?) which effectively wipes most of the policy charges and makes their contracts very attractive even in comparison with today’s low-cost options.
However, I have looked at hundreds of old private pensions over the last 15 odd years and most, unfortunately, are pretty poor value, exhibiting high cost, mediocre investment returns and no special features.
I’d say that my advice has been to ‘hold’ about a quarter of the plans I have investigated in detail and to ‘fold’ three-quarters into a better value contract offering access to all currently permitted options on retirement. About half of these funds are now in a SIPP wrapper and the other half (generally the smaller funds) in insured policies.
Good news and what to do
The good news is that it is now much easier to fold an old pension into a new arrangement as the FCA (Financial Conduct Authority) introduced a 1% maximum exit charge rule in April. That is now the most a life office can charge on exit. (That said, at least half of the plans I have looked at didn’t have exit charges anyway.)
To undertake what I call an audit of old pension policies is rather complex and time-consuming. But you could do it yourself and here is what you need to do.
1. Obtain a projection of benefits from your existing private pension plan provider. This will effectively confirm the charges on your contract, the current fund, and transfer values, but you will need the life office to firm up details (see below).
2. Undertake an initial assessment of the charges, paying particular attention to the ‘reduction in yield’ (RIY) and transfer value figures. Also refer to fund charge information and with-profits guides.
3. Alternative illustrations should then be sourced from potential alternative providers using today’s different charging regimes. It’s certainly worth asking the current provider for a so-called ‘existing business illustration’ if the firm is still accepting additional contributions – many will not take increases where high guarantees feature in the policy.
4. You then need to do a detailed product charge analysis. Most IFAs will have some groovy (and quite expensive) software to do this, but you might need to set up spreadsheets.
5. For with-profit investments you need to:
- Analyse independent fund ratings, and financial strength of the provider;
- Consider the provider’s bonus track record;
- Analyse the asset mix of the fund. Does it still meet you requirements, does the annual management charge represent good value for that asset mix?
6. Then you need to factor in any special features mentioned above as objectively as you can in the light of your circumstances now.
7. Eventually, you can make some kind of reasoned decision about what to do.
Alternatively, you could hire an IFA to do all of this heavy work for you. They are likely to have access to industry tools that you can’t get hold of and will have plenty of subjective experience on which to draw.
Whether to Hold or Fold an old pension plan is ultimately your choice, but I do think the decision needs to be carefully thought through. There are a multiplicity of factors you need to take into account, as I hope I have demonstrated.
Please note: The article above ONLY concerns ‘defined contribution’ or ‘money purchase’ pension plans. These can be personal pensions, company-sponsored schemes, AVC’s, FSAVC’s, Executive Pensions, and stakeholder plans. It does NOT concern defined benefit or final salary pensions – that’s a much more complicated area.
- Source: Personal Pensions Handbook & Unit-Linked Survey 1994/95. [↩]
- The exception is it is now much less onerous to fold an old pension into a new arrangement, thanks to a 1% maximum exit charge rule that was brought in by the Financial Conduct Authority in April. Previously charges could be 20% or more! [↩]
- Source: Personal Finance Society 2016. [↩]