Q&A: Should you be worried about defined contribution pensions?

pension protestor
Image caption Millions of savers may not be getting value for money from their pension schemes

The Office of Fair Trading has concluded that many "defined contribution" pension schemes offer poor value for money. It is calling on the Pensions Regulator and the Association of British Insurers(ABI), the industry body, to help weed out the schemes that offer poor value.

But it has stopped short of recommending a cap on management charges, for the moment at least.

About 5 million people currently pay into such schemes, with a further 9 million expected to join over the next five years.

What is a defined contribution (DC) scheme?

This is a scheme where both the employee and the employer pay contributions each month. Those contributions are usually invested into shares or bonds.

The ultimate size of the pension pot depends on how well those shares and bonds perform, and on the amount of charges that are deducted for management fees every year. When they retire, savers use that pension pot to buy an annuity, which will pay them an income for the rest of their lives.

Under DC schemes, workers carry the investment risk, and there is no certainty about what they will receive in retirement.

How much difference can a management charge make to the value of a DC scheme?

Most DC schemes now charge around 0.5% a year, but older schemes can charge up to 2.3%. Such charges can cut the value of a pension pot by as much as a third.

On a pension pot of £440,000, a 0.5% charge would reduce the total by 11%, to £390,000. A 1% annual charge would reduce the pot by 21%, to £346,000.

The OFT says management charges on some older pension schemes can be as much as 26% higher than on newer schemes.

Why has this issue arisen now?

Millions of people have already signed up to pensions for the first time, under the government's auto-enrolment programme.

It began with large companies in October 2013, but smaller and medium-sized companies are now in the process of joining too. About 9 million extra people are expected to join DC schemes within the next five years.

For the first time workers are automatically signed up for the company pension plan, unless they decide to opt out. If more people are to be encouraged to join, it is important that they can see value for money in the schemes being offered.

Will there be a cap on management charges?

For the moment, the OFT has decided against a ban on higher charges. However, if enquiries by the ABI and the Pensions Regulator fail to weed out the poor value schemes, it may reconsider.

The government, too, has decided to go ahead with a consultation on capping, after the pensions minister, Steve Webb, spoke about the possibility of a 1% cap.

What charges will be banned?

At the moment people who move jobs often have to leave the pension scheme they belong to. They then become so-called deferred members of their scheme. Some pension providers make large charges on deferred members, or offer discounts for those still paying into the scheme. The OFT has recommended that these Active Member Discounts (AMDs) should be banned.

The Department for Work and Pensions will now consult on whether such providers should be banned from taking part in auto-enrolment schemes. Schemes that carry large commissions for advisers could also be banned.

What should I do if I am in a poor value scheme?

People are being advised not to do anything hasty.

Tom McPhail, of the financial advice firm Hargreaves Lansdown, said: "If you are in a company pension scheme, you should probably stay there. Don't panic and jump out. But if you have moved jobs, go back and see if you can get better value for money in your old pensions."

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