FOOL'S EYE VIEW
Charges Are Crucial

By Christopher Spink
June 1, 2001

If you want to manage your finances effectively you must focus on how much you pay for essential financial products. These include your pension or other retirement plan, such as an ISA; your mortgage; and any brokerage account where you keep your shares, funds or other savings. If you have debts you should assess how much you pay your lenders as well.

You won't be surprised to hear that these charges and fees should be as low as possible. But how low is reasonable? What should you expect to pay for such services? This is vital. Indeed it can't be exaggerated how important keeping a check on fees is. It's perhaps the most fundamental way of working out whether you're getting good value for money.

The long-standing grudge many people, including most contributors to the Fool and its discussion boards, have with financial providers is precisely that they don't offer decent value. People have long got used to paying through the nose for quite simple financial products. This is how many providers prospered. Luckily these greedy profit margins are now coming under pressure from consumers wanting a better deal.

Inflation issues

One reason why people are becoming more aware of charges is because the rate of inflation is now much lower than it has been for decades. In the early 1980s and 1990s prices rose on average by a staggering 10% each year. In this environment you could expect building society savings accounts to pay interest of 12% or so. In some years the stock market rose as much as 20%.

When that happened you didn't mind paying initial fees of as much as 5% and an annual charge of 2% or more. This only reduced your returns slightly; by a few percentage points or so. Now those days are long gone, though. Inflation has fallen dramatically to just 2%. That's a fifth of the level it was at a decade ago! However, some stock market funds still charge annual fees of 2%. Many haven't changed their pricing at all.

That seems slightly unfair when actuaries at the financial services regulator, the FSA, have revised their forecasts of future investment growth down to 4% at the most pessimistic, 6% on average and 8% at the most optimistic. All these guidelines give growth forecasts in real terms, after accounting for inflation. Add back today's inflation rate and investment returns are 6%, 8% and 10%.

This means that a fund charging 2% a year will swallow either a third, a quarter or a fifth of total returns in charges in an average year. That's hugely expensive. In the early 90s it would only have cost a tenth of returns, if a fund grew at 20%. No wonder that consumers are noticing the impact of charges much more than they did when inflation was higher.

CAT standards

The Government has tried to impose standards on the financial industry to protect consumers from outrageous charges and terms on products. These are the CAT standards, which stand for charges, access and terms. Mortgages and ISAs are covered by this scheme and credit cards may be shortly. In addition the Government's Stakeholder Pension scheme states that no provider can charge more than 1% in annual fees.

CAT ISAs can't charge any initial fees at all and again only a maximum of 1% a year. With inflation now much lower, dragging down investment expectations to 6%, 8% and 10% depending on how optimistic you are, a 1% annual charge is now quite a lot: either a sixth, eighth, or tenth of total returns. Perhaps instead a different charging structure should be imposed now that investment forecasts are lower?

For instance if a fund is only growing at 8% each year and annual charges are 1%, then an eighth of your returns will be taken away each year. That could be a quite substantial reduction as your fund grows and builds. Some brokers have started to charge a flat fee of, say, £20 a year on their clients' accounts rather than a percentage fee. That makes sense if you plan to build up savings or fund over the long run.

You should avoid initial charges. These are taken off any money placed within a scheme. Say 5% is charged; that means you only have 95% of your money growing for you, rather than 100%. Over the lifetime of a scheme, which now may only grow 6% in real terms, that initial charge can have a chronic effect on your overall returns.

For example...

So, when taking out a financial product you intend to hold for the long run the first thing you should look at is how much it will cost you in fees. Remember that inflation is currently 2% and average expected returns are 8% at best. Thus if you are charged 1% a year in fees your returns will be a sixth less than expected in real terms. Let's look at an example:

If you invest £1,000 a year in a fund that grows at 6% a year with no fees charged whatsoever then that will become £84,802 after 30 years.

If you invested the same £1,000 a year in the same fund growing at 6% a year but had to pay 1% a year in fees then after 30 years the fund will be worth £70,761, about a sixth less.

If you were charged an initial fee of 5% on the money you put in this fund as well as a 1% annual charge, your £1,000 a year would only become £67,223, over a fifth less than the fund without any charges.

Unfortunately most personal pensions, which were sold in the early 1990s, charge fees rather like the last fund. That's why charges are crucial.

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