When the DC charge cap was introduced last year it was meant to safeguard value for money. However, Charlotte Moore finds this isn't necessarily the case.
- The charge cap was introduced to ensure auto-enrolled members’ returns were not eroded by high manager fees.
- Difficult markets have proved challenging for cheaper solutions.
- To date there has been much focus on investment charges but more focus should be put on administration charges.
The UK government introduced the 0.75% charge cap in April 2015 to ensure auto-enrolled members' returns were not eroded by high manager fees. But the structure of the defined contribution (DC) market has created an uneven playing field, with many schemes seeing their investment budgets severely constrained.
Rather than ensuring the charge cap only applied to investment charges, the government said it should apply to those costs borne by the members. In the UK market there is considerable variation in which charges are borne by the members and which the employer will pay.
Aon Hewitt investment principal Jo Sharples, says: "Investment manager fees are usually paid by the members although there are a few schemes where the costs are paid by the employer." While most members are paying investment manager fees, there is far more variation, however, in the payment of administration costs.
If an employer has contracted out DC scheme provision either to a group pension provider or a master trust, then the members are likely to bear not only the investment management charges but also the administration fees. Sharples says: "While the employer could still choose to foot this expense themselves, in most cases the costs are paid by the member."
Not only will the members need to pay the costs of investment and administration fees but they will also be footing the bill for communications and governance of the scheme. "These extra costs are typically included in the overall price because the scheme is provided as a product," says Sharples.
In contrast, trustee-based schemes that use an investment consultant, vary in their approach. Some choose to outsource the administration of the scheme to a third-party provider, while others opt to bundle the investment and administration. Sharples says: "Where the administration is done by a third-party specialist provider, this cost is usually billed and paid by the employer rather than the members."
This results in a significant difference in the costs being borne by the members. In the case of a few schemes, the employer is bearing all of the costs, including the administration and management charges, but many millions of scheme members are paying for all of the costs associated with running a DC scheme.
Sharples says: "While a few scheme members will be able to allocate the full 75 basis points to investment charges, there will be considerable variation for other members depending on the size of the scheme."
Larger schemes with a significant number of members and a growing and sizeable pot of assets will be able to negotiate better fees for both investment and administration costs. Sharples says: "Larger schemes will be able to negotiate administration rates as low as 15 basis points but 20bps is more common." That still leaves a decent margin for investment management fees, she adds.
Smaller schemes, however, could be paying twice that amount for administration. "It could be as much as 65 basis points, which leaves next to nothing for investment management fees," adds Sharples. For these very small schemes, large master trusts like NEST are attractive because they can use their scale to negotiate a much better deal for scheme members, she adds.
Variation in cost structure
This variation in cost structure is applicable both to trust and contract-based scheme – larger schemes will be able to negotiate better administration and investment management fees and so provide better value to their members, says Sharples.
The constraint the charge cap places on investment management fees is particularly important in auto-enrolled pensions because most members are in a default fund. Limited budget to spend on investment options makes it harder to implement more sophisticated solutions, which could help to manage the inherent volatility of the equity markets.
P-Solve director of solutions Philip Jones says: "When the government announced the fee cap, it marked five years of equity markets making annual returns of more than 15%." In these market conditions, cheap passive equity trackers will produce excellent returns.
But equity markets are cyclic and bull markets do not persist. Jones says: "Over the last year there has been a market correction and considerable variation in the performance of different investment products." Tracking products have mirrored underlying market conditions while higher cost diversified growth funds have produced returns despite the market correction, he adds.
Cheaper investment strategies will fail when equity markets either move sideways or fall. "As these solutions do not have access to alternative sources of return, in sideways markets they fail to make additional returns, and lose value in falling equity markets," says Jones.
The structure of the charge cap rules also makes it much harder to include alternative investments, such as property and infrastructure, in default funds.
Scottish Widows head of industry development Peter Glancy, says: "Property holding costs have been included in the charge cap." That means renovation, maintenance and insurance costs are included in the charge cap. "Those costs have nothing do with running a property fund," he adds. The charge cap also prevents the use of infrastructure in default funds.
For scheme members at the early stage of their career, an investment strategy that is highly reliant on passive equity might not pose that significant a problem. These members have not yet accumulated sufficient wealth in their pension pot for a market correction to make a serious dent in their wealth. They also have plenty of time for performance to improve and their capital value to recover.
However, if a member is only a decade away from retirement, an over-exposure to equities could have a material impact on the quality of their retirement. Their pension pots are now close to its maximum value so any market corrections will make a much bigger impact. Nor can they afford to wait around for several years for their fund to recover its value. Jones says: "This is when not spending enough on an investment strategy that protects against such market volatility could make a lasting impact on retirement income."
The abolition of the purchase of an annuity on retirement has made it even more important to preserve the value of the pension pot. State Street Global Advisors head of European DC Nigel Aston says: "If the value of the pot falls significantly in retirement it will have a very real impact on the member's quality of life." It's vital to manage the volatility of the pension pot. "That requires a more sophisticated approach than simply investing in a static allocation of passive equities" he adds.
Not only has the introduction of the charge cap created this uneven playing field, it has made many companies focus on almost entirely the cost of DC scheme provision. Mercer DC Consulting principal Steve Budge says: "Some companies are simply opting for the lowest cost option; they are not even making use of the budget they have to spend."
Aston adds: "The size of the investment budget is not the key concern when companies are weighing their DC pension options."
Companies are doing this because they believe that's what members want, he adds. "Too many companies are not sitting back and considering what would provide the best value to the members over the longer term," says Budge.
One way to make the playing field both more level and to get companies to think more rationally about longer-term value would be to focus separately on administration and investment management fees.
Newton Investment Management head of DC Catherine Doyle says: "There has been little attempt to disaggregate administrative charges from investment charges." That's despite the level of administrative charges varying wildly between large and small schemes.
A more holistic and transparent view on costs would enable both pension schemes and their advisers to review whether the split between these two important costs was correct, adds Doyle.
Consolidation of the market will help not only to reduce investment management fees but also administration charges. Aston says: "Scale is required to make administration low cost and efficient."
There should be a much greater focus on administration fees. Aston says: "To date, all the focus has been on investment management charges. Now record keeping needs to be both lower cost and much more effective." Administration should be brought up to date by make it digital and more flexible, he adds.
A more radical approach would be an abolition of the charge cap altogether. Rather than ensuring scheme members are not overcharged for their pension, the introduction of the charge cap has shifted the focus away from the investment strategy in DC schemes.
Doyle says: "Until the government introduced the charge cap, the industry was endeavouring to design the best strategies to give the best outcome for the most members. Now everyone is just obsessed with cost not long-term value."
Newton’s Curt Custard considers the investment outlook for 2021 and the implications for DC schemes
Master trusts’ investment strategies have grown and become more sophisticated over the last three years, but “growing pains” are hindering progress, according to the Defined Contribution Investment Forum (DCIF).
More than half of BlackRock’s flagship UK defined contribution (DC) default fund’s assets will be invested in ESG strategies by June 2021.
Graeme Bold says the right communications can improve both the level of savings and the outcomes for savers.