Edition: March / May 2017
FUND COSTS 2
When government steps in
Resonating in the current SA debate is Britain’s experience of a cap on fees.
Dean Wetton* evaluates the pros and cons.
In the UK some years back, the Pensions Commission delivered the Turner report which recommended automatic enrolment (AE) of individuals into pension funds. With cross-party parliamentary support the 2008 Pensions Act legislated for all employers to automatically enrol qualifying workers into a pension scheme. Phased implementation began with the largest employers in 2012 and completion is expected by 2018.
The Office of Fair Trading conducted a market study in 2013 into workplace defined-contribution (DC) pensions. It concluded that the buy side of the market was weak and required support. Costs and charges to savers were particularly examined as the OFT had found them ranging from 0,1% to above 2% of funds’ assets.
It was concluded that, if people were compelled into saving for retirement, they should not be charged too much for the privilege. In April 2015 a charge cap was imposed on default arrangements of AE pension schemes whereby the total amount charged to a saver could not exceed 75bps (0,75%).
With the continuing decline in availability of DB pension schemes, this was a necessary measure to help control the burden placed on savers who might risk seeing their pension pots eroded by high management fees. Further, trustees of all defined-contribution (DC) pension funds and the ‘independent governance committees’ of insurers are now required to report on their evaluation of value for money for all scheme members under their control.
Immediately this raises the debate on cost versus value. Can a pension scheme remain effective with these restrictions? As with many things, those who thrive are those that can afford scale. Many of the larger master trusts (vehicles for the pooling of funds to obtain wholesale prices, similar to SA umbrellas) and insurers are offering strong products at below 75bps, so it can be done.
What then of those who can’t work at these levels? Is a government-imposed barrier to entry a bad thing? The Pensions Regulator lists 13 schemes which have currently obtained master-trust assurance, and the full number in development could be closer to 70. They cannot all hope to be effective. The market may already be oversaturated. While market forces would usually correct this, when dealing with the public’s pension savings an extra level of prudence is required.
Unintended consequences and unforeseen benefits
There is an advantage to savers if competition is limited. Fewer master trusts will allow greater development of scale, in turn allowing further cost reductions. This barrier permits fewer initial competitors and speeds up the process of market rationalisation.
There is, however, an unintended consequence. As smaller employers are brought into AE, an increasing number will be regarded as “uneconomic” and unwanted by many potential providers, leaving these schemes with little choice other than NEST (the workplace pension, established under Department of Works & Pensions sponsorship, which has its initial cost base underwritten by government).
|Wetton . . . a good thing
There is also a risk that a charge cap limits options available to providers. One must expect default funds in the AE universe to be essentially passive, as little will be affordable in the way of active management. Solutions can be found.
For example, 25-year-old individual just beginning to save is unlikely to need a product-charging structure anywhere near 75bps for largely passive investments, but older savers willing to pay more to protect a larger pot may avoid the default-only cap by self-selecting a product that better suits them.
What we see in response to the charge cap is the emergence of a class of “semi-passive” funds. Though the cap makes full active management unaffordable to most, it would not take much to develop an active fund which invests in the same funds as a passive benchmark – save for a few, minor removals of investments deemed unjustifiably risky. Once set up, such funds require little management and so are offered at a much lower price than a traditionally active fund and yet would likely outperform a fully passive fund in the long term.
A more intractable problem area may prove to be what costs are to be included within the charge cap. Currently fund transaction costs are not included but this may change. However, not only is it difficult to pin down the amounts of these costs but their inclusion could further limit managers’ ability to perform if, by acting, they are put at risk of “using up” their transaction budget.
Best bangs for bucks
Ultimately the introduction of the charge cap seems to be a good thing. It is a distortion of the free market, but it is necessary. By imposing a set of rigid guidelines, providers have been forced to become more creative. That some products are priced well below the charge cap proves that the restrictions are sufficiently loose.
Certainly, members who were paying egregious fees have benefited and it is difficult to point to many who have lost out. Those providers unable to adapt would be unlikely to offer a strong product long term, and so perhaps should not be trusted with the pension pots of uninterested and financially unsophisticated savers.
Initially it was feared the charge cap might be too restrictive. Now it has come to be widely accepted and even welcomed. It means a closer focus on the fees budget to determine “most bang for buck”. This is found in asset allocation and governance, not in stock selection.
* Wetton is a partner in Dean Wetton Advisory, a London-based boutique pensions and investment advisory firm. Founded in 2009, it now has a global client base with some £16bn under advice