A cap or a con?

A 1 % cap on charges is a cornerstone of government policy. It applies to stakeholder pensions, the proposed "stakeholder products" and CAT standards for ISAs.

A problem with such caps is that investors tend to be told in years to come: "Sorry, oh dear some charges were accidentally left out of the cap." This is already happening with the stakeholder cap. Fund managers sometimes pay for various services such as Reuters by "soft commissions", which it is now proposed should be abolished. This will bring payment for these services within the cap.

Soft commissions are estimated to be up to 40 % of total commissions paid to UK stockbrokers by UK fund managers, which amounted to £ 2.3 bn in 2000. Including investment abroad all commissions paid by UK fund managers were perhaps £ 4 bn. But this is only a fraction of the cost of trading - probably less than one fifth.

These costs are outside the stakeholder cap. They result from buying and selling the underlying investments. A recent report from Fitzrovia (1) shows that turnover varies widely between different unit trusts and OEICS, from 0.6 to 685.5 %, where 100 % turnover means that the total amount of buying and selling for a year is equal to the total assets (taking an average over the year). The average portfolio turnover for the actively managed equity funds in the Fitzrovia report was 67 %, implying that investments are held on average for only 18 months. Sometimes a fund manager buys shares in a company, sells them and buys them back again all in the same year.

The FSA estimates that the cost to investors of 100 % turnover is 1.5 to 1.8 % of capital per annum. Stockbroker's commission is estimated to be 0.3 %, which is up to one fifth of this cost. Stamp duty is 0.5 %. Multiplying the Fitzrovia 67 % average turnover by 1.5, it follows that dealing costs result in a deterioration in investment performance for investors of at least 1 % per annum.

Nevertheless the FSA does not want investors to know about portfolio turnover: "We have decided that we will not bring forward proposals to require the disclosure of portfolio turnover." (2). It is given as a percentage in the accounts on mutual funds in the US, but not unit trusts in the UK.

The government wants to encourage people to save. But saying "charges are capped at 1 %" without also saying that there are additional charges is a hard sell. A factsheet of the FSA (3) states:

"Providers of the stakeholder pensions usually charge for managing your money. There is an upper limit to this charge. The limit is 1 % of the value of your fund each year."

A booklet of the Department for Work and Pensions (4) mentions additional charges starting:

"As well as the one per cent, the law allows pension provider to recover costs and charges they have to pay for certain other things."

FSA factsheets are probably more widely read than DWP booklets. It seems that the proposed stakeholder products will not come with a warning about charges outside the cap - judging from the list of warnings for these products in the Sandler Review. There are numerous warnings already on the web about portfolio turnover and the associated dealing costs. A search on "portfolio turnover" produces a list of over a quarter of a million websites.

1. Portfolio Turnover of UK Funds, Fitzrovia, December 2002.

2. Informing consumers: product disclosure at the point of sale, consultation paper, FSA, February 2003.

3. Stakeholder pensions and decision trees, factsheet, FSA, April 2003.

4. Stakeholder pensions Your guide, DWP, May 2002.

19th April 2003.