The West Midlands Pension Fund is well on the way to full transparency, and has already used it to challenge managers on fees and exit high cost funds, CIO Jason Fletcher tells Stephanie Baxter.
All pension funds are under immense pressure to demonstrate they are delivering value for money, particularly the 89 local government pension funds which must prove to taxpayers they are cost efficient.
One major challenge has been getting a true and complete picture of the costs incurred through investment.
The Local Government Pension Scheme (LGPS) has now taken a big step towards transparency, with the launch of a voluntary code which its asset managers are expected to sign up to.
Leading the pack is the £11.6bn West Midlands Pension Fund (WMPF), which played an important role in developing the code's cost collection template.
After asking its external managers to hand over more detailed cost data, and developing its own internal cost templates, the fund is now well on the way to having full transparency, particularly in liquid assets. The fund believes it is a better investor for knowing the true costs of investing, and that it has led to better alignment of interests.
The scheme's journey began around four years ago when its investment costs shot up after adopting the Chartered Institute of Public Finance and Accountancy's (CIPFA's) updated accounting standard. It requires funds to report many more costs than under the old standard, which only required LGPS funds to report on invoiced fees - which are just a fraction of total costs.
Under the old standard, WMPF reported £11.3m of costs in the 2012/13 year, and £11.2m in 2013/14. However, its costs for 2013/14 ballooned to £87.3m after applying the new standard.
This was a challenging time for WMPF but it immediately took action and each year since has reduced its costs, to £81.2m in 2014/15 and £69.8m in 2015/16. Figures for 2016/17 which are not yet fully audited are also expected to be down.
Chief investment officer Jason Fletcher, who joined the fund last September from the Universities Superannuation Scheme, says: "By fully understanding our costs, we are now able to go through them and challenge costs. For example, we negotiated down fees, which was only possible because we knew what the costs are. It's surprising how many investors don't ask managers for cost cuts; it's hard to ask for it if you don't actually know what you're paying."
A big factor was reducing the total return fund (hedge fund) exposure, which is one way to reduce costs. Transparency also allowed it to move from high cost to low cost external funds, because when "you have a picture of the full costs you can actually make those comparisons," he adds.
Another factor was increasing the amount of money managed in-house to 44% (£6.6bn) of total assets, rising by 12% (£800m) in the past 12 months. As internal management costs are on a fixed basis - rather than ad valorem basis of external managers - they have not risen in line with asset markets over the last year.
Fletcher says it is important to build cost transparency into the investment process. "Given that around 25% of investment return is taken away by costs (assuming a 1% full investment cost and many commentators expecting a 4% return), maybe when selecting asset managers we should spend 25% of your time looking at costs as part of due diligence and the selection process."
It has taken up a lot of time and effort for WMPF, which already had an in-house finance team of seven people. However, he says it becomes easier once a framework is in place.
"The biggest problem is comparing apples with oranges (investment managers with different ways of calculating costs). It's very costly to do the work in the first place, but the millions of pounds you can save will make it worth the investment in time. "
Therefore the code, which will require managers to send a full breakdown of implicit and explicit costs in a standardised format, should go a long way to help funds achieve transparency. Two asset managers have already signed up to the code, with more expected to do so in the coming months.
However, there is still some way to go in alternatives, which the code's template doesn't yet cater for. "We believe more can be done in alternatives where it gets more challenging due to the complexity of their cost structures and where we are still trying to get the full picture on costs," says Fletcher.
Change in mind-set
Fletcher believes the mind-set of investors and managers has definitely moved on.
"Fund managers are understandably sensitive to reducing costs because it comes out of their profit and loss, but they are moving to a more investor-friendly approach. As investors we're trying to reduce our investment costs, and asset managers are trying to protect their profits.
When the fund asked its external managers in March how they would deliver on the Markets in Financial Instruments Directive II (MiFID II) rules which come out later this year, some understood it as a move to being fully transparent, but not all.
"Now we're at that stage where full cost transparency is vital for WMPF to deliver value for money to their investors," he says. "Full cost transparency is going to come anyway, so it's really a case of delivering it now rather than finding ways to avoid it."
There is an argument that the voluntary code doesn't go far enough, and that the regulator should enforce it. However, Fletcher disagrees, saying that "neither side wants the whole thing regulated".
"Some managers may not want to fully disclose, but there are ways asset owners can enforce it, such as asking existing managers to sign up to the code, which hopefully most will do. Cost transparency will be one of the things people ask for when doing a beauty parade."
Misalignment of interests
Cost transparency should help to build more trusting relationships between funds and asset managers.
Fletcher thinks there's a big misalignment of interests, which works along two lines, the first being ad valorem fees: "Why should you pay the manager twice as much just because the market's doubled and they're not doing anything different?"
The second is performance fees: "The investor wants outperformance over the benchmark but performance fees only seem to work in one direction: if they outperform they get a carry or performance fees, if they underperform they don't share in the downside."
The fund holds the view that carry arrangements and performance fees in many cases are too high and the outperformance/hurdle levels too low.
Fletcher thinks the model going forward should be on a more fixed cost basis. "Although many investors seem to be moving away from performance fees, we could find common ground by having a performance fee at a reasonable level combined with a fixed fee. Some managers are starting to work on that model.
"Nailing down a fixed fee or even fixed fee plus inflation model going forward is probably the starting point. We've started to make some progress on that, and will be discussing this with investment managers over time."
Whether it's getting cost transparency or questioning fee structures, these are all important steps towards tackling the historic problem of misalignment of interests between pension funds and their managers.
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