Premium pitfalls for the pensioner: Andrew Warwick-Thompson illustrates how commission charges arise, and how then can eat into your savings

FEW PEOPLE outside firms of actuaries actually understand how commission on pension plans works. And despite numerous appeals, the regulators have failed to improve matters.

If the Government really wants people to provide for their long-term futures through private pension plans, it really needs to protect the public with legislation to limit regular premium commission payments and enforce the full disclosure of payments in advance.

Commission is a complex area, but understanding the mechanism is a necessary to deciding whether a plan represents value for money. Rates vary from provider to provider, markedly so between single and regular premium plans, and because providers hide commission charges in different ways.

There follows an outline of the basic principles with reference to unit-linked policies. The structure of with-profits policies achieves the same end by a different means.

How much commission is paid?

Single premium commission is paid at a basic rate of 4 per cent of each premium.

Regular premium commission loads payments to the salesman up front. For an annual premium of pounds 5,000 payable for 20 years, an insurer might pay 3 per cent of the annual premium multiplied by 20, - ( pounds 5,000 x 0.03) x 20 = pounds 3,000.

In this example, the initial commission is equal to 60 per cent of the first year's premium.

Renewal commission, typically between 1 and 3 per cent per annum, is payable on the anniversary of the plan, so long as premiums are maintained.

Who pays the commission?

The plan-holder.

Single premium commission is generally payable from the initial charge. Most unit-linked funds have a 5 to 6 per cent spread between the offer price, at which the units are bought, and the bid price, at which they are sold, so a 4 per cent commission can easily be absorbed in the front-end charge.

Annual premium commission is paid by the provider at the start of a plan and is recouped via its charging structure. For example, special 'capital' units are allocated in respect of the premiums for the first year or two and a high management charge is levied on them. Typical annual management charges on capital units will be between 3 and 7 per cent a year.

The use of capital units disguises what has actually happened, ie, that a large percentage of the initial premium has been paid away in commission. Some providers invest no premiums at all until the front-end charges have been met, although this is rare.

Do mutual providers have the same commission structure?

Yes.

What about providers which don't pay commission?

Some pension providers, such as Equitable Life, do not pay commission to independent pension advisers. This results in a plan charging structure which is generally lower than the norm. However, such providers may pay their own representatives on a performance-related basis, similar to a commission structure, from policy-holders' funds.

What is the impact of commission?

The best example is that of two identical plans, one on nil-commission terms and the other on standard terms. The difference in the proceeds at maturity is the true cost to the plan-holder of the commission payments.

Suppose that Mr A and Mr B start 20-year pension plans on the same date for an annual premium of pounds 20,000. Mr A uses his insurance broker on normal commission terms. Mr B has the same plan, via a fee-based adviser, on nil-commission terms.

If each plan achieves a rate of return before charges of 13 per cent per annum, Mr A's policy will be worth pounds 1,456,000 after 20 years and Mr B's pounds l,612,000. The difference is pounds 156,000, nearly 10 per cent, which is the cost of commission.

What happens on early retirement or transfer?

To gain approval from the Inland Revenue, personal pensions must permit retirement at any age between 50 and 75 and and allow transfers to other providers.

In the case of unit-linked policies set up with a single premium no penalty will normally apply. But a penalty will arise with annual premium policies set up on normal commission terms as the result of a 'claw- back' of part of the capital unit value. This means that using the early retirement and transfer rights is unattractive in many cases.

In this case, the remuneration structure of the policy defeats the policy-holder's right to transfer or retire early.

The price of setting up a pension on nil-commission terms is the payment of a fee to the adviser. Fees are generally costed by time but can be estimated in advance and do not reduce the prospective pension fund at retirement. Furthermore, nil-commission policies do not penalise the plan-holder on either early retirement or transfer.

Unfortunately, there is no shift to fee-based advice. Nevertheless, the public still has a right to know the amount of commission paid to advisers before they take out a personal pension plans.

The author is head of the partnership pensions section of Bacon & Woodrow, actuaries and consultants

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