Pensions have changed a lot in the past three decades. We no longer have virtually unregulated salesmen in shiny suits flogging expensive policies and taking a hefty commission from the provider. Charges have also (on average) plummeted, while regulatory and governance standards have ramped up as part of a wider effort to protect savers.

However, the legacy of this bygone era lives on through ‘exit penalties’. Such penalties were common in policies sold in the 1980s and 1990s, with providers arguing the fees were necessary to ensure the adviser was paid and, more importantly, the provider made a tidy profit.

These old-style plans often come with eye-wateringly high annual charges compared to modern pension contracts – charges that eat away at the value of your retirement pot.

Penalty problem

The introduction of the pension freedoms in April 2015 crystallised the problem of early exit penalties.

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 investigations revealed 670,000 people aged 55 or over faced an early exit charge. That’s a whopping £22.5bn of pension money.

Of these, 358,000 faced charges between 0-2%; 165,000 charges between 2-5%; 81,000 would pay between 5-10%; and 66,000 faced exit charges above 10%.

The severity of these charges meant many would not even countenance the prospect of switching to a modern, low-cost pension plan.

New system

As a result, the FCA has decided to impose a 1% charge cap on old-style early exit fees from March 31 2017, potentially fundamentally shifting the equation for savers considering whether or not to abandon these costly policies.

According to our calculations, if someone aged 55 had a pension with a 5% exit penalty and chose to transfer to a scheme with an annual charge that is 0.5 percentage points lower, it would take 11 years for them to recoup the negative impact of the exit fee.

However, once the cap bites and the 5% exit penalty charge falls to 1%, the maths changes dramatically.

Even with the hit of a 1% penalty on transferring, the lower annual charge means the saver is in ‘profit’ after just three years and would be £20,000 better off after 20 years.

This assumes a pot worth £100,000 at age 55 and annual investment returns before charges of 5%.

While this analysis is illustrative, the message to anyone with an exit fee is clear – review your policy, look at the annual charges and consider if it’s worth bearing the penalty in order to benefit from lower fees, and greater flexibility, in the long-term.

TOM SELBY

Senior analyst, AJ Bell

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