The advice opportunity presented by FCA early exit fees cap
Pensions advice has changed beyond all recognition in the past three decades. Gone are the days of the waters being muddied by virtually unregulated salesmen flogging expensive policies and taking a hefty commission from the provider.
The Retail Distribution Review, for all its faults, has driven up standards in the sector, while the launch of the Financial Advice Market Review suggests policymakers are beginning to appreciate the value added by advisers in navigating the hideously complex retirement landscape successive governments have created.
Retirement products have evolved too. SIPPs and drawdown have shifted firmly into the mainstream, with competition in the platform market driving down prices for advisers and their clients. People can now choose from investments in every conceivable market, while opaque charging structures are slowly but surely being phased out in favour of transparent fees.
However, the long-term nature of pension saving means the legacy of the 1980s and 1990s lives on through exit penalties. Providers often argue these fees were necessary due to the front-loaded nature of the products – advice was given for ‘free’, but the adviser still needed to be paid through commission. As a result, the provider in turn needed to know the customer wouldn’t dump the policy before they made a profit – and so created a significant financial buffer to protect their bottom line.
These old-style plans also usually came with eye-wateringly high annual charges compared to modern pension contracts – charges that eat away at the value of clients’ retirement pots.
Exit penalties, which sometimes stretch beyond 10% of the value of a saver’s investments, were already a problem before the pension freedoms were introduced in April 2015. However, former Chancellor George Osborne’s radical overhaul brought the issue into sharp relief.
Savers were told they could spend and invest their retirement savings as they wanted and yet, for many, archaic charging structures blocked their path.
To give some context, FCA data suggests 670,000 people aged 55 or over face an exit charge. That’s a whopping £22.5bn of pension money.
Of these, 358,000 face charges between 0 and 2%; 165,000 charges between 2 and 5%; 81,000 would pay between 5 and 10%; and 66,000 face exit charges above 10%.
The severity of these penalties means many people would not even countenance the prospect of switching to a modern, low-cost pension plan. As a result, the FCA has decided to impose a 1% charge cap on old-style early exit fees from 31 March 2017, potentially fundamentally shifting the equation for clients considering whether or not to abandon these costly policies.
Let’s consider a simple ‘before and after’ example to illustrate the point. A 55 year old client bought a pension policy 20 years ago. The policy was right for her at the time, with charges of 1.5% a year– not ideal, but by no means the highest on the market.
She sits down with her adviser to consider transferring her £100,000 savings pot into a modern plan but because she has not yet reached her selected retirement date there is a 5% early exit penalty. On the other hand the new policy comes with total charges of 1%, a third lower than her existing policy. Her adviser runs the numbers and – after taking the initial £5,000 hit and assuming annual investment growth after charges of 4% - tells the client it could take 11 years for them to recoup the negative impact of the exit penalty through lower annual charges. On balance, they decide the severity of the exit fee means a transfer isn’t in her best interests.
However, that was all before the FCA’s 1% early exit penalty cap kicked in. She sits down again with her adviser on 1 April 2017 to see whether a transfer might now be a good idea.
The equation has changed dramatically. Even with the hit of a £1,000 penalty on quitting her contract – no small beer – the lower annual charges mean she is in ‘profit’ after just three years and could be £20,000 better off after 20 years. The choice is now a no-brainer, and her adviser moves the money across to the new scheme.
This admittedly rather simplified example illustrates the advice opportunity presented by the early exit fees charge cap. While many in the industry, including AJ Bell, would have preferred the regulator to go further and abolish old-style penalties altogether, for many savers this will still be a retirement planning game changer.
There will be tens of thousands of advised clients for whom the introduction of the early exit penalty ceiling provides an opportunity to review their retirement plans and potentially release the shackles of their out-of-date pension policy. In many cases, the short-term financial pain will be worth it for the long-term gain.