Personal Finance: How the monster eats your savings

Let's hope that the Government's proposals for pensions remove some of the charging scandals.

If there is one unifying theme in all the Treasury's proposals on pensions - from stakeholder schemes to the new unit and investment trust-backed vehicle discussed last week - it is an emphasis on the need for low-charging funds.

The Treasury's insistence on low-cost products has informed its plans on "CATmarking", or setting benchmarks for investments. It is also reflected in an unrelenting hostility to the way life insurance companies are perceived to be levying heavy fees on the pensions they sell to the public.

There is no question that many companies impose heavy charges. These can take several forms.

Most plans have so-called "bid/offer spreads" of 5 per cent. This means that if you place pounds 100 in a pension today, it will only be worth pounds 95 tomorrow. Then there are fund charges of around 1 per cent a year, falling to 0.5 per cent after some 10 years.

Unit trust PEPs have similar charges, of course. However, pension companies then slip in plan fees of around pounds 3 per month, which rise with inflation. Even then, with most companies, such charges fall well short of covering their costs, which are dominated by the heavy commissions they pay those people and firms who sell their products. Big-hitting charges now come into play.

The most common way this is done involves sharp reductions in the allocation of early premiums into investment units. In other words, in the first year or two that you pay premiums into a pension, a large slice of your money disappears in charges.

The lowest allocations include 35 per cent of premiums paid for 30 months with Allied Dunbar, 30 per cent for 27 months with Eagle Star, and 35 per cent for 24 months with Sun Life of Canada. This means that if you pay premiums of pounds 200 a month for 2 years, a total of pounds 4,800, you can say goodbye to pounds 3,120 or pounds 3,360 if the fund grows by 9 per cent a year.

The most misleading way in which policy holders are charged is through the use of "capital units". Premiums for year one, or years one and two, will often go into these units. Charges on capital units affect you in two ways. First, if you stop paying premiums, you will lose a substantial chunk of them. For example, if you stop paying pounds 200 monthly premiums at the end of year two with plans from Canada Life or J Rothschild, you would lose around pounds 2,500 or pounds 3,000.

Second, even if you keep paying premiums into the pension, your capital units are subject to levies as high as 6 per cent a year - for the duration of the pension. This means that if investment growth is 9 per cent a year your capital units would grow at only 3 per cent a year. There will always be a chunk of your pension affected in this way, no matter how long you continue paying premiums.

Of course, companies argue that over the years, the effect of capital units is gradually diluted. However, the reverse applies if a policyholder halts contributions into the pension, as more of the overall fund will always be hit at the higher level.

A charitable interpretation of these charges is that only a few people stop paying premiums, or that companies do not expect lapses to happen. The truth is different. Recent figures from the Personal Investment Authority, the financial watchdog, indicate that, depending on the sales outlet, some 30 to 40 per cent of planholders stop paying premiums by the end of the fourth year. With many companies, over half the planholders stop by the end of the fifth year. Companies not only know about lapses - they plan their charges to take account of them.

The effects of individual charges can be compared through "reductions in yield", or RIY. But this can be confusing to many. For example, assuming investment growth at 9 per cent a year, a 1 per cent annual charge would reduce growth to 8 per cent, an RIY of 1 per cent.

However, with other charges, the RIY may not be constant. Thus, a plan fee of pounds 3 a month, rising in line with inflation, would reduce 9 per cent annual growth to 7.4 per cent after 2 years, and to 8.7 per cent after 10 years. The plan fee has an RIY of 1.6 per cent at 2 years and only 0.3 per cent after 10 years.

If only 50 per cent of premiums for years 1 and 2 are allocated to a plan, the effective investment growth of all the premiums would be minus 47.5 per cent a year by year two.

This would change to minus 1.2 per cent a year by year five, and to plus 6.2 per cent a year by year 10. The RIYs of such a reduction in early allocations would then be 56.5 per cent at year 2, 10.2 per cent at year 5 and 2.8 per cent at year 10.

Confused? You should be.

The RIY make-ups of big-hitting mixes of charges are illustrated in the first part of our table. The effects of charges like bid/offer spreads, annual fund charges and plan fees, are dwarfed by the big-hitting charges. Some 27 well-known companies are listed as using such heavy charges, but many others do. Taking account of lapses, towards half or more of the plan-holders of these companies stand to make losses or very poor returns.

But not all pension companies have such big-hitting charges, as shown in the second part of the table. Some companies, six of which sell through independent financial advisers, such as Standard Life and Scottish Widows, recoup costs through small but constant cuts in allocations of money invested by policy holders. There is also a growing band of very low charge companies, as Equitable Life is joined by direct sellers like Virgin, Direct Line and several others.

Ignorance of the situation is the basic reason why people still buy plans with hard-hitting charges. But that ignorance has been backed by the inaction of governments and regulators. Up to now, they have appeared stupefied by an industrial monster which consumes rather than multiplies the savings of up to half the people it is meant to serve.

It is to be hoped that the Government's new initiatives will help to bring this all to an end.