Stephanie Baxter looks at responses to the FCA's consultation on the murky area of transaction costs
At a glance
- Schemes will have to report on and analyse transaction costs when they assess value for money
- The FCA’s call for evidence asked the industry how these costs should be disclosed
- While transparency is welcomed, trade bodies warn it may cost schemes a lot of time and resources
Asset management fees have come down in defined contribution (DC) thanks to the 0.75% charge cap but costs that fall outside the cap are still a huge issue for schemes.
These hidden charges such as transaction costs can have a material impact on returns, particularly where a portfolio is actively managed. Disclosing these costs to trustees is paramount to enabling them to assess whether the scheme provides value for money to members.
The industry has applauded the Financial Conduct Authority (FCA) and Department for Work and Pensions (DWP) for taking the lead on this in their call for evidence on Transaction Costs Disclosure: Improving Transparency in Workplace Pensions, which ended on 5 May.
The True and Fair Campaign said in its response that shaking up the system will "significantly change behaviour" which is "clearly dysfunctional at present". "At the moment it is completely ignored by managers and various agents along the investment chain as the costs may be small individually but significant when added to other layers of costs," it added.
While everyone – even the asset management trade body the Investment Association – agrees there must be more transparency on these opaque costs, the big question is how to get there.
The first hurdle is gathering all the data, which the National Association of Pension Funds (NAPF) believes would be an arduous task.
Getting the data
Iain Cowell, a consultant at the trade body, says: "Schemes would have to go through an extensive exercise of gathering data, going to every manager and then filtering and cleaning up the data."
A number of schemes already collect this data via two or three people in their fund accounting teams. It is very challenging to get consistency across the data that is not calculated or reported in a standardised way. Cowell says it has taken schemes as much as five years to get to a point where they can understand their cost base.
"That's why we want the asset management industry to drive that process to be much cleaner and more consistent so the asset owners aren't struggling to receive the information," he adds.
The Investment Association chief executive Daniel Godfrey himself has admitted his industry misled the public during the last 20 years over charges, "with disclosure that nobody understands at best and which can be misleading at worst".
While schemes have much to gain from greater disclosure, they could face higher costs through rushing the use of an advanced template before inconsistencies in data are addressed.
The NAPF estimates that for a large scheme the cost of hiring a consultant to collate the data needed to complete the existing template could be around £20,000 a year.
There have been concerns in some quarters that it would be difficult and costly for asset managers to step up their game on transaction costs.
The Pensions Institute director David Blake is not convinced by these arguments, however. He says managers "should be doing this anyway" and does not believe it would require a lot of investment in IT resources.
The True and Fair Campaign rejects this claim, particularly the notion that it is difficult to identify bid/ask spreads: "It is actually surprisingly easy to capture the bid-ask spreads, particularly within the equities market."
It cites a "simple" tool on Bloomberg that captures the average bid/ask spread for most securities over customisable periods of time. While more challenging to do this for bonds, any major financial organisation with a dealing desk will have "intimate knowledge" of this, it added.
While transparency is welcome, it is crucial to avoid punitive costs for collecting data that is of limited value. "We shouldn't be looking at data that investors and asset managers have limited ability to change," says Cowell. "We should collect data that is meaningful, worth collecting, and that as informed buyers helps them do the job."
In February the pensions industry applauded the Investment Association's paper proposal of a methodology for consistently calculating portfolio turnover rate (PTR) and a framework for the disclosure of transaction costs. While Blake welcomes the trade body's endeavours, he says having these kinds of industry consultations that every couple of years throw up different approaches to the methodology "can be very complicated" and "takes time".
He says "let's not waste time" trying to agree suitable risk and return measures before starting to report transaction costs and "let's just get on with it".
"The DWP and FCA need to sit down with the relevant parties to understand these things better and have a plan for starting with something simple but then build this up over time into what we really want through planned timetables. I would just get it started with a timetable to trial things bearing in mind the costs."
What could go wrong?
Some respondents warned of the potential unintended consequences where increased transparency results in more rigid transaction cost budgets. The Society of Pension Professionals (SPP) said it was vital that attention to costs does not direct attention away from key concerns such as risk/return, contribution levels, and decumulation strategies, in securing good member outcomes.
"So the approach to transparency must avoid creating an environment in which there is implicit pressure to avoid investment strategies or transactions, due to concern that they might be perceived as too expensive," it cautioned.
One worry is that it could cause herding to passive investment strategies without any protective overlays such as currency hedging. Active strategies could be pressured to effectively become passive to produce lower costs.
Many schemes have already had to adopt passive strategies in the default fund to keep charges within the 75 basis points cap. Blake argues that the "average Joe" in an auto-enrolment default fund should not be engaged in active management anyway and should be in low-cost passive funds.
He believes turnover costs and other charges should be capped to discourage active trading. The existing charge cap could be extended to include some or all transaction costs or they could be put into a separate cap.
However, Blake acknowledges there are problems with having a DC cap that includes turnover costs because schemes don't know what they are until the end of the year.
"It's almost impossible to impose a strict year-by-year cap because you'd be in a position where in September you'd hit the cap and then you can't do any more active management until January."
This could unduly influence asset manager behaviour. The SPP said: "For example, if a manager was close to the limit of its transaction cost budget, it might feel under pressure not to sell an underperforming asset because to do so might breach its budget."
It would have to be done on a rolling basis such as over a three-year period to avoid this issue, says Blake. "You would put charges into components whereby certain charges would have to meet the cap every year but other charges wouldn't." For example, if one-year costs were 85bps then the next year they would need to be lowered to 65bps.
Other respondents were keen to avoid imposing a cap, notably the NAPF, which believes this is not the healthiest approach to drive future improvements.
Cowell says: "What we don't want is the creation of hard rules that allow people to game the system. This is why the whole thing has to be about openness and transparency where we all philosophically agree to do the same thing."
How should schemes measure costs?
There is much debate over how the impact of transaction costs on a portfolio should be measured.
The True and Fair Campaign said there must be a “simple, common analysis of transaction costs and other costs presented in a mandated uniformed format” so that scheme members are able to easily understand it.
It would put the key elements of transaction costs – broker commissions, taxes and spreads – into one comprehensive number and multiply it by the average portfolio turnover rate to give the actual impact of transaction costs as a percentage of the fund/portfolio each year.
What can we learn from the Dutch?
The Dutch pensions market is far ahead of UK in transparency and benchmarking of transaction costs, which it has been working on for the past five years. It was originally driven by the regulator, but to curtail that the industry decided to work together.
Yet five years on it is “still not at a perfect place”, says Cowell. While they have a much better grip on 75% of the tangible costs, they still don’t have a consistent picture on others such as market impact costs that are linked to the trading process.
“People aren’t hiding this information but it’s about developing consistent frameworks so people can engage on the topic in a meaningful way without spending excessive costs on consultants. It’s an incremental process because they are learning and understanding what costs they have.”
He says this is one of the key lessons the UK can learn from the Netherlands. “So there has to be incremental staged approach, which means getting meaningful information that we can do something with.”
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