The AE review is considering bringing transaction costs into the DC charge cap, but such a move could lead to perverse behaviour that is not in members' best interests. Stephanie Baxter explores the arguments
Action on transaction costs is gaining pace with the Financial Conduct Authority (FCA) set to respond in the coming months to its consultation on how they should be calculated and disclosed.
Yet will this be enough to gain transparency on these costs at a fast enough pace and should there be a more stringent approach?
While the 0.75% charge cap for defined contribution (DC) default funds has helped to drive down asset management fees since its launch in April 2015, transaction costs are excluded from the cap.
Separate to the FCA's work, the government's review of auto-enrolment (AE) is now looking at whether transaction costs, which can include security spreads, commissions and market taxes, should be included in the cap.
Could it work?
While there may be the political will to further drive down costs for savers, there are concerns it would lead to schemes and managers behaving in ways that would not be in members' best interests.
PTL client director Colin Richardson says it would be like "mixing up apples with pears" because the current charge cap is specifically for costs incurred by running the fund and administration. Transaction costs are not a fixed percentage of the net asset value and can be very volatile and vary considerably across different asset classes.
"A single cap across the board wouldn't work because you expect transaction costs to vary across different types of funds," he says. "A cap for index tracking funds would be different than a cap for an active fund where you expect higher transaction costs."
A single cap could result in some high returning asset classes that typically incur high transaction costs being excluded from default funds, such as property and emerging markets, and make it harder to include some diversified growth funds (DGFs). Meanwhile, it would likely lead to higher concentration in tracker funds over time.
The FCA has found transaction costs can add around 50 basis points (bps) on average to the cost of active management for equity investments. According to Aviva's pensions policy manager Dale Critchley, data shows transaction charges for passive strategies are less than 1bp, but charges for actively managed emerging market strategies can be as high as 140bps.
Schroders' head of UK institutional defined contribution Stephen Bowles explains how volatile these costs can be: "One month you could be over and the next under, especially where funds may already be near the cap. This could be amplified by funds that are small, growing in size, or subject to significant investor activity that requires transacting.
"In the same way, a fund invested in UK equities could incur 50bps in stamp duty if it was continually growing and trading for every flow it received. This is an unavoidable market tax where the scheme's asset allocation requires it to hold UK equities - purely hypothetical but possible."
A lack of regulatory consistency will also lead to variable outcomes as quantifying transaction costs for non-equity asset classes is still an area which needs further attention, adds Bowles.
"In this context, the inclusion of transaction costs could lead to issues with managing the DC charge cap and members having to be moved on a regular basis to and from funds, which would result in further administration and governance."
Another issue is that transaction costs incurred in switching asset allocation can be significant, with anti-dilution fees being charged on both the way out and into the new fund.
There are also concerns it would lead asset managers to make investment decisions on the basis of regulatory compliance rather than acting in members' best interests.
JP Morgan Asset Management head of UK DC Annabel Tonry is concerned that managers would make decisions on the basis of trying to keep transaction costs low.
"We wouldn't want to see behaviours where funds with higher transaction costs start being discounted or ignored, not on the basis of investment return or objective but on the perception that low levels of turnover equal better value for money."
The People's Pension director of policy and market engagement Darren Philp says while the first priority should be getting transparency around transaction costs with a common methodology and disclosure, he believes including them in the cap would force trustees and providers to take it more seriously.
He suggests a compromise to avoid some of the issues could be a 'soft cap' on transaction costs with a 'comply or explain' element, while other fees and costs would remain subject to a hard cap. This would help in cases where transaction costs would breach the cap level but be in the member's best interests, such as switching asset allocation.
Where a scheme breaches the charge cap because of transaction costs, it should be required to write to members and employers to say a breach has occurred and explain why, says Philp. "The chair of trustees or the independent governance committee (IGC) should also explain it in their annual governance statement, and could be communicated to the regulator."
However, others don't think a soft cap would work, with PTL's Richardson saying although the idea has merit, it is "better to have a clean charge cap" for everything apart from transaction costs. He believes it is better to have disclosure on transaction costs, which is starting to happen now with trustees and IGCs required to scrutinise and report on them in the annual statement.
Aviva's Critchley says a soft cap would be useful if trustee bodies can be seen to be governing in the best interests of members, but if not then it's simpler to stick with the regulatory 0.75% hard cap as it is.
Then, schemes could choose to include transaction charges within it if they wanted to. "If you didn't include transaction charges in the cap then in the chair's statement you would need a description on why you think they're appropriate," he adds.
But even so, he thinks including them in the cap in any form now would be a "presumptuous move" especially since both the current cap and the disclosure requirement on trustees and IGCs have only been in place less than two years.
While it's essential to get a better hold on transaction costs, capping them could be a premature move and be detrimental to members by excluding attractive asset classes and making diversification in DC even harder.
However, if it is going to be on the cards then a soft cap would be a compromise solution.
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