The industry is facing increasing pressure to lower the charge cap for DC schemes even further, but is this really in the best interests of savers? Emma Cusworth investigates.
“The charge cap is not beneficial for investors as the system is currently set up. It is not protecting the people that need protection.”
Maria Nazarova-Doyle
The charge cap applied to defined contribution (DC) pensions was sold by the regulator as providing better value for money to millions of workers. There is continued pressure on the regulator to lower the fee further, cutting it by a third, but serious questions must be asked about whether the charge cap really does offer members better value for money. If the answer is no, a move to lower the cap risks worsening the damage already done to DC and to savers’ ability to generate returns for retirement.
When it set the cap, which applies to default options used to meet the requirements of auto-enrolment, the Financial Conduct Authority (FCA) opted for the strictest of the three options it laid out in its consultation, landing at 0.75% of funds under management.
The impact of this cap is profound. The Pensions Policy Institute, in a March 2015 note, warned the importance of default funds should not be underestimated. It calculated that by the mid-2020s around 90% of members could be invested in a default fund and by 2030 up to 14 million active members could have invested around £480bn (in today’s terms) in DC schemes.
The Department for Work and Pensions (DWP) said last Autumn that savers could see a boost to their pension pots of “tens of thousands of pounds” as a result of the cap. And the FCA faces significant pressure to reduce the cap further to 0.5% in an effort to provide even better value for savers.
But does the charge cap really serve those it is designed to protect? Does it actually offer better value for money?
According to Maria Nazarova-Doyle, deputy head of DC investment consulting, JLT Employee Benefits: “The charge cap is not beneficial for investors as the system is currently set up. It is not protecting the people that need protection.”
LESSONS UNLEARNED
The major sticking point with the charge cap is the impact it has on the investment universe available to members. By restricting fees, the cap is effectively restricting members’ choice of managers and assets, and, by extension, their potential to generate returns for retirement income.
In the case of group personal pensions, which account for the majority of people saving for retirement, the 0.75% charge cap includes all the fees bundled into products, including those for the administrator. Importantly, administrators, lawyers, custodians and many of the providers whose fees must be accounted for in the charge cap are not responsible for growing the value of those assets.
“Administration costs are what they are,” Nazarova-Doyle says. “There is not much wiggle room in that part of the equation so the investment fees and the types of investments available get hit hard.”
In some cases the portion of fees allocated to investment management can be as little as 10 basis points, she says. Other experts suggest it is perhaps even as low as five basis points, or 6% of total cost budget.
At this low level, investors cannot expect much in the way of return generation to help grow their retirement income.
The result of the squeeze on investment management fees in DC, according to Zuhair Mohammed, partner, Global Investment Practice, Aon Hewitt, is that both diversification and higher-returning strategies are sacrificed in preference for passive management in large-cap equities.
The cap naturally favours managers who offer vanilla passive management where exposure can be obtained for a “handful of basis points”, says David Hutchins, head of AllianceBernstein (AB) Multi-Asset Pension Strategies in the UK. “You’re not going to get emerging markets or esoteric allocations within that fee,” he says. “You end up with a very restricted range of passive strategies that are not being dynamically managed over time.”
One institutional investor suggested the largest passive asset managers must have been instrumental in influencing the regulator in favour of the cap for anti- competitive reasons, calling it a “loss making activity unless you get enough scale”.
Nazarova-Doyle says a high number of clients have had to change the strategies offered in their default funds to become compliant with the charge cap. They have moved away from multi-asset funds, for example, which she says help manage downside risk and draw from different sources of return. “Most of these funds cost around 75 basis points or higher so are ruled out,” she says.
Yet, on the defined benefit (DB) side, one of the most important lessons learned from the financial crisis is the importance of diversification. DB schemes have used this argument to allocate to an ever-increasing range of private and public assets in order to access uncorrelated sources of investment risk and return.
Why then should DC not benefit from the same learning? The focus on fees in DC has created a dislocation of DC pensions from what is known to make good investment sense in today’s investment world.
There is a ‘learning gap’ growing between DB and DC where the latter knowingly fails to adapt to modern best practice in the same way as its less constrained cousin.
AB’s Hutchins says: “In DC we are seeing less diversification, less risk management and less opportunities for people to grow their money by looking at a broader opportunity set.”
MEMBERS DISADVANTAGED
Perhaps the most pertinent example of the learning and opportunity gap between DB and DC is the exclusion of higher-returning alternative asset classes, which also carry higher fees. Alternatives are not only excluded from DC by the charge-cap, but also by the unnecessarily tight liquidity restrictions placed on assets included in DC pension products.
Many of the asset classes where DB schemes are looking to increase their exposure, such as real estate, private equity or infrastructure, in an effort to increase their yield potential while also deriving strong net-of-fee returns, are inaccessible to default DC schemes.
In 2013 the the Defined Contribution Investment Forum (DCIF) produced a paper suggesting 80% of UK DC assets were invested in equities, but allowing access to assets such as hedge funds, property, infrastructure and reinsurance, which are both higher-fee and less liquid investments, would not only increase diversification, it would improve the value of retirement pots by as much as 5%.
The same year, Towers Watson in a document entitled DC Investments, A Path to Improve Long-Term Outcomes, found that adding illiquid strategies into target-date funds “improves their risk-adjusted expected returns”. “That is because these strategies generally improve diversification, lower volatility and create the potential for higher long-term return premiums from the use of less liquid investments,” according to the paper.
In September 2015 a study in the US by the Defined Contribution Institutional Investment Association (DCIIA) found a clear performance difference between DB and DC schemes had resulted from the inability of DC schemes to invest in illiquid assets.
Their study found over the last 18 years, DB plans had at least a 1.1% advantage in annualised investment performance. Although some liquid and lower cost versions of alternative assets exist – such as REITs in the case of real estate – the economic exposure is significantly different in many listed instruments even though they might offer a more DC-friendly level of liquidity and cost.
Aon Hewitt’s Mohammed calculated the performance differential over the lifetime of a pension pot invested in liquid versus illiquid investments to be around 5%, putting DC investors at a disadvantage in a yield-hungry world.
The Universities Superannuation Scheme will be tackling this problem next year as it sets up a DC section. Head of strategy coordination, Kathryn Graham, describes the charge cap as “a complicated issue”. “Our aspiration is to be able to offer the full suite of investments to DC members as we do to DB members,” she says, “but it seems like there are complications. Cost is one and valuation is another. Some things that purport to be infrastructure, such as infrastructure equity, are in fact very different. We have yet to solve this problem.”
Jill Barber, head of institutional, UK and Ireland, for Franklin Templeton, who is in the process of developing the firm’s DC offering, says: “DC members should have access to the same opportunities as DB members. They have the same goal of providing income in retirement for members. We mustn’t lose sight of that.”
TRANSPARENCY NEEDED
In the hope of changing the ratio of capped charges that are spent on investment, or of balancing the direction of pressure on the regulator in favour of better investment outcomes, it is beholden on the industry to educate the regulator and members better about what it means to save for the long term and to look at value in terms of returns net of fees.
“The initial impact of the cap has been to reduce investment spending and the quality of those investments,” AB’s Hutchins says. “Typically, around 10-25% of the budget goes on investment. That is not the perception of market commentators, however. They think a lot more is spent on investment, probably because the investment products’ fees also account for fees on other services underlying the funds, such as administrators.”
Greater transparency around exactly how the charge cap breaks down for schemes is a critical part of this, which would draw attention to the relatively little sum paid to generate growth through investment performance. A breakdown of fees should be a required disclosure, according to Hutchins, to explain exactly where members’ money is being spent. Although end-users are unlikely to make use of those figures, “governance improves as people take the fee breakdown more seriously”, he argues.
“A trustee trying to deliver value for money has got to ask if spending five basis points on investment and 70 basis points on administration represents good value for money,” Hutchins says. “If they had five more to spend on investment, would that result in better outcomes?”
Although a removal of the charge cap is highly unlikely, even if transparency improves, greater visibility of fee breakdowns could help to sway the regulator to review the structure of the cap, making it apply to investment only, or to dissuade them from any further reductions. This will be critical in creating a level playing field between DC and DB and to allow DC investors to benefit from the same best practice their DB cousins have leveraged since the financial crisis to improve risk-adjusted returns and outcomes for members.
Given DC members are so reliant on the growth of their deferred wages to generate income for their retirement, can it really be in their interests to spend so little on investment to generate that growth? If the result of regulation is to disadvantage investors in schemes where they are assuming all the investment risk, it would seem to be a failing of the regulations. Education and transparency are essential ingredients in changing perceptions about the cap.
As Hutchins says: “Disclosure of fee breakdowns is the way we have to go, rather than blindly reducing the charge cap further without understanding the implications of imposing it in the first place.”
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