It may be the only way you are funding your retirement but its ability to keep you financially stable may be affected by the flotilla of fees and charges levied.

Yes, with interest rates on the floor, more and more people are considering the option of investing their pension fund in an approved retirement fund (ARF), rather than opting for the certainty of an annuity.

However, a new report from the Pensions Council into ARFs sold through intermediaries by insurance companies shows that the level of charges imposed on such funds may be negating any return the fund offers, given the low return environment we are in.

And the fault lies not just with charges from insurance companies – it is also with brokers offering financial advice on the products.

Unfortunately, as the report highlights, it is particularly difficult to seek out the better options.

"We know it's not a competitive market on one level because consumers are not fully aware or informed of all the complexities," says Pensions Council chairman Jim Murray.

Indeed one reader recently received a refund of €26,000 when he started to investigate the structure of his ARF and discovered that a request to set up an ARF on a fee basis was actually done on the basis of an upfront commission of 5 per cent.

So, if you are in the market for an ARF, or may be in the near future, what can the report (http://iti.ms/295mMU9) teach you about keeping charges as low as possible?

How ARF providers earn their fees

We are all probably familiar with annual fund charges, which impose a fee based on a percentage of the value of the ARF. Charges typically range around the 1 per cent mark. But be aware that this is not the only fee you might be paying.

Another popular charge is an “allocation rate”, expressed as a percentage of the ARF investment amount. It either reduces or increases the total investment amount. An initial allocation rate of 99 per cent for example, will see just €990 of a €1,000 ARF invested.

Where it gets tricky is when an allocation rate is higher than 100 per cent – for example an allocation rate of 101 per cent will see €1,010 invested instead of 1,000. But this doesn’t mean that the life company is investing money on your behalf: a higher allocation rate is typically used in conjunction with commission paid to a broker, and the net effect is to reduce the amount of funds that are actually invested.

The complex mechanisms make it much more difficult for consumers to shop around – and life companies know this. Murray says “an enormous amount of charges” are levied on ARF customers.

Other charges include an annual plan charge, which is expressed as a percentage of the ongoing value of the ARF and is typically deducted by annual encashment of units by the insurer; and a monetary policy fee, deducted regularly from the consumer’s ARF account.

Finally, you may find yourself subject to an early encashment charge if the ARF is terminated during an initial period after its establishment, typically within the first five years, either through full encashment or transfer to another fund manager.

Key tip: Ask your provider for the ‘reduction in yield’

According to Murray, consumers should ask their ARF provider for the precise “reduction in yield”, which should encompass all the above charges and indicates by how much these charges reduce the value of your investment.

Financial adviser Liam Ferguson goes one step further and suggests you ask for the reduction in yield including commission (see below). This should help you compare charging structures on a like-for-like basis.

How financial advisers earn fees

The next charge a pensioner may face on their ARF is the fee earned by their financial adviser for offering advice on the product in the first place.

The broker is paid in one of two ways:

1) The consumer pays a fee directly to the adviser (not all intermediaries will offer this option, so beware).

2)The insurance company pays commission to the adviser.

Consumers are typically advised – where possible – to pay the fee upfront, as opting for commission can turn out to be a lot more expensive in the long run and the method by which it is earned – and taken from your investment fund – can be opaque.

For example, insurance companies can pay a broker an initial commission, ranging from 0-5 per cent of the initial amount invested. On top of this, an adviser can earn recurring or so-called “trail” commission.

Ostensibly, this is to pay the adviser for giving a yearly review of the ARF, but it can be a hefty fee for the service, running at between 0-1 per cent of the annual ARF value. The commission will vary from insurer to insurer but of course it doesn’t really come out of their pocket.

As the report succinctly states “every euro of remuneration payable to the intermediary [broker] reduces the ARF value accordingly”.

These charges can further eat away at your investments. For example, if the adviser earns an initial commission of 3 per cent, and trail commission of 0.5 per cent per year, the total charges payable by the consumer (insurer charges + intermediary remuneration), based on typical insurer charges would see the value of the ARF fall by 6 per cent if the ARF is terminated after a year, or 3.36 per cent in the second year.

Most notable perhaps, is that with such a commission structure, the broker or financial adviser will get to keep between 52 per cent and 66 per cent of the total charges, depending on how long the ARF is held. Yes the broker, who offers advice on the product but has no role in actually running the investment, gets to keep as much as two thirds of the fees.

As Ferguson notes, it is mandatory that, before someone signs on a dotted line, commission payments must be disclosed – but payments such as trail commission are given as percentages. A 0.25 per cent annual fee may not sound like much – but a €750 annual payment (on a €300,000 ARF) to your broker may stop you in your tracks.

In this respect, if you have a larger fund, “a fee based approach may be more economical” notes Ferguson. And don’t be shy in asking exactly how much the broker is earning for advising you on a particular product.

“If an intermediary starts talking about charges in jargon terms, then it’s a very fair question to ask, ‘I’m not in your business. Will you please explain these charges in words I can understand and in euro and cent. If they can’t or won’t, then it’s time to go find another,” suggests Ferguson.

Key tip: Financial advice costs

Broker charges may have as much or “even more impact” on the total charges borne by the consumer as the choice of insurer or product, the report reveals. So choose your adviser wisely. As Ferguson notes, “the message in the report could probably be extended to not only should you shop around between insurers, but possibly of more relevance is to shop around between intermediaries”.

Why these charges matter

As the report points out, how much income you will be able to draw down from your ARF in retirement depends on two factors:

1) The investment return your funds can generate.

2) The charges imposed on it.

While it can be difficult to guarantee the former, a pensioner can exert control over the latter.

Take an ARF investment of €75,000. Depending on the ARF provider the consumer chooses, they could stand to save up to €5,440 in insurer charges over 10 years by choosing the provider with the lowest charges.

To put it another way, if the individual was drawing down income of 4 per cent a year on the ARF, opting for the cheapest provider would deliver benefits to the tune of almost two extra years of income.

If the ARF was worth double that, at €150,000, the savings would jump to €11,720. And this does not even include the impact commission can have on your funds, which will act as a further drain. Worryingly, the report notes that in a low interest rate environment, pensioners are at risk of not seeing any gains in their funds due to the impact of charges.

“In a low inflation/interest rate/investment return climate, total charges can significantly reduce, or in some cases completely eliminate, the investment return earned by the ARF,” the report says.

For example, if your ARF is invested in a low-risk cash fund earning 1 per cent a year, but the total charges on your ARF come to 1.46 per cent, the actual return on your ARF will be negative. Even if it is invested in a managed fund with a greater predicted return, you may find that ARF charges will absorb nearly 40 per cent of any returns.

“Any charges these days in a time of low interest rates have a disproportionate effect on final outcomes,” Murray says.

Key tip: wise up on charges

If you’d rather spend your retirement funds yourself, and not gift them to your insurance company, wise up on charges.

Shopping around is not easy

As the report notes, consumers can make significant savings if they “shop around”. However, it also points out that complex charging structures make it “extremely difficult” to do so – not just for the average consumer to compare products, but for the brokers selling them also.

This is because life companies apply different annual charges and allocation rates depending on how the product is purchased.

Consider New Ireland’s products for example. If you opt for your broker to be paid by an upfront commission, New Ireland will set a higher gross allocation rate (103.5-105 per cent) and a corresponding annual management charge (1 per cent) under its Structure A. On the other hand, where a client agrees a fee, the client will have a lower gross allocation rate (100-101.5 per cent) and a corresponding, lower annual management charge (0.5 per cent). But which is the better deal for the consumer? And why isn’t it easier to work out?

Key tip: do homework yourself

Make sure your adviser is aware of all the charges on the available products – and is informed enough to find you the best deal. Or do your homework yourself.