Beware provider's charges that could kill growth in your portfolio

Julian Knight advises how to avoid falling prey to high fees levied by pension and investment firms

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In the world of pensions and investment, the devil can so often be in the detail. From restrictive terms to ongoing charges, ignorance can cost. "The level of charges and any penalties imposed for transferring your funds out of a pension scheme can have a huge effect on your wealth in retirement," warns Tom McPhail, a pensions expert at independent financial advisers Hargreaves Lansdown.

"Take, for example, a 40-year-old looking to retire on a specific target income at age 65. If the effect of charges is to reduce the annual growth of the pension fund from 7 to 5 per cent it will mean a delay of five years in the saver actually getting to their target pension."

Pension providers charge an ongoing management fee. These have dropped in recent years ever since the Government introduced stakeholder pension schemes – basic funds with easy access, fewer restrictions and capped charges. However, stakeholder pension schemes are allowed to charge up to 1.5 per cent per year for the first decade of investment, then 1 per cent. Often, according to Mr McPhail, this is still too much.

"Many of these stakeholder pensions basically track the stock market index, which doesn't require sophisticated fund management, just a computer tracking the market. However, some providers still charge 1.5 per cent a year. If it was non-pensionable fund, investors would be paying just 0.5 per cent; frankly they are a rip-off. When it comes to charges, it's not just a case of going for the lowest – it's about ensuring that you get value for money."

Some of the bigger pension managers such as Aviva and Legal & General offer stakeholder pensions with charges below 1 per cent a year, and they don't limit fund choice to trackers.

Many people who bought pensions in the 1980s and 1990s already know the damaging effect of charges. Back then, not only were annual charges in excess of 2 per cent a year commonplace, but those looking to stop contributions or move their money to another pension provider faced severe penalties. Penalties of 10 per cent for moving funds are not unknown. "Before moving a pension you have to think long and hard. You may lose thousands in the transfer," said Mr McPhail.

Those looking to move out of a with-profits pension may also be hit with a market value adjustment (MVA) or market value Reduction (MVR). In effect, this is an exit penalty and can cost thousands. Meanwhile, people looking for pensions advice may also be in for a shock: financial advisers often charge fees of £120-£200 an hour for giving advice and can earn commission from the pension provider too. Sometimes the commission can be as high as 5 per cent on the total invested during the first two years of the life of the pension. Although, last week, the Financial Services Authority said it would like to see an end to commission by 2012. In addition, advisers can earn a smaller "trail commission" often for the life of the product.

The key, according to David Elms of Independent Financial Advice Promotion, is to establish advice fees and charges up front and don't be afraid too bargain.

"The most transparent way to pay is to agree an hourly rate with your adviser. Any commission that the adviser receives should be used to offset against these fees. You could even find that the commission outweighs the advice fee; if this is the case ask for anything left over to be handed back to you or reinvested in the product you've just bought," Mr Elms said.

Advisers can also earn hefty commission for recommending investment funds, but of much greater concern are the myriad charges that come with unit and, to a lesser extent, investment trusts.

Put simply, unit and investment trusts are collective investment vehicles where fund management groups pool investor cash to buy a basket of shares. Returns reflect the increase – or otherwise – in the value of the basket of shares. Although exit penalties aren't an issue, unit and investment trusts come with their own charges.

First up is the initial charge, which as the name suggests is levied when the investor buys into the fund. Initial charges can range from 0 to 5 per cent but can be avoided. "There are still fund management groups which, if you approach directly, will levy an initial charge, but if you buy the investment through a fund supermarket, most of these funds come without an initial charge because the supermarket has mass buying power," said Darius McDermott from independent financial advisers Chelsea Financial Services, which offers a fund supermarket service, as do Hargreaves Lansdown and Fundsnetwork run by Fidelity.

However, when it comes to annual management charges, fund supermarkets offer less of a get-out-of-jail-free card, with some fund managers imposing fees of 1 or 1.5 per cent per year. According to David Kuo from financial advice website fool.co.uk, the performance of the fund management groups don't justify the hefty annual charge. "The big charging funds are usually actively managed which means that there is a fund manager making buying and selling decisions, and this human element to the funds is how the annual fee is justified. That seems all good until you realise that three-quarters of these managers actually underperform the stock market, sometimes by a long way, and for that they want to take more of your money."

Instead of going for an actively managed fund which charges a 1-1.5 per cent annual management fee, Mr Kuo recommends investing in funds which simply track the stock market indices. "A ballpark annual management charge is 0.5 per cent and the recently launched Vanguard funds is cheaper still, charging just 0.15 per cent. Say you invest £100 a month for 25 years and your investment returns 9 per cent a year on average. A fund with a total charge of 0.5 per cent would give you a final sum of £98,200. But a fund that charges just 0.15 per cent will give you £103,590 – that's an additional £5,390. Even a relatively small difference in levels of charges can have a big effect on your returns."

Some fund managers of late have even started levying what's called an outperformance fee. The idea is if the fund beats the benchmark it sets for performance, it will levy an additional fee. The one proviso is that many funds have what's called a high-water mark, which means that the outperformance fee comes into play only once the unit price of the fund has reached a new high. Nevertheless, Mr McDermott is not impressed with the fee. "This is an unwelcome additional charge which has recently crossed over from the hedge-fund universe. Basically, what's happened is that a host of new absolute return funds have been launched which use hedge-fund techniques and the charging structure has been ported over as well."

However, Mr McDermott doesn't buy the argument that actively managed funds should be shunned altogether. "The best performing tracker is currently lying 81st on the list of UK all companies funds. That means that there are 80 funds out there which have beaten all the trackers going in the past three years and that's taking management charges into account.

"The fact is that over the past 10 years, if you'd been invested with the best fund managers you'd have seen returns of 50, 100 or in one instance 150 per cent. The key is to correctly identify the manager which brings with them a track record of outperformance, and I don't think investors worry too much about the charges if they back a winner."