26 November 2015
Is your pension manager leaving you underfunded?
by Frank O’Nomics
UK pension schemes face significant shortfalls. As of the end of April, the aggregate deficit of 6000 defined benefit pension schemes in the UK was calculated (by the Pension Protection Fund) at £243bn, up from £215bn 3 years earlier, and this despite £44bn of extra contributions. This growing shortfall is generally deemed to be the result of a double-whammy of moderate asset price growth and low interest rates inhibiting the asset side, with increasing longevity pushing up scheme liabilities. But what if there are other aspects which are causing the shortfall? And what if these aspects could be addressed to correct the asset-liability imbalance?
Consider the costs of running your fund: if the industry’s stated norm of 0.75% (the level set in recent legislation on auto-enrolment) is really as much as 3%, compounding effects would mean that the impact over the life of a 35 year pension fund could account for most of the shortfall. There is no evidence to prove that Einstein really did describe compound interest as the most powerful force in human history but , when you consider that a 1% additional cost over the life of a fund is estimated to reduce its final value by 24%, you can see why he might have. Most of us, when confronted by pension documents, skip over the bit about the impact of charges as the percentage always seems quite small, even though the cumulative effects over the life of an investment can be quite large. There is a serious debate as to whether we are being given the true extent of the costs involved in managing our pensions; the 0.75% cap does not include the transaction costs of managing the fund, and efforts to find answers seem to be confronted by a wall of silence from the fund management industry.
Only last month, Daniel Godfrey was ousted from his role as the head of the Investment Association after his calls for greater clarity on fees and costs (among other reforms) led to two major asset managers threatening to leave the association. So just how much does it cost to run our pension funds and what impact is this having on the prospective returns?
Getting to the bottom of the numbers is not easy but, via the use of the Freedom of Information Act, some details have been obtained regarding Local Authority Funds. At the outset there is a cost issue here given that the 89 UK Local Authorities themselves duplicate internal costs by having 89 different boards looking after funds which are generally managed by around just 10 large investment managers. Just think how much the pooling of funds could save, given that the objectives are generally the same.
But a greater costs burden becomes apparent when one investigates the degree to which the investment managers turn over these pension portfolios. For funds which are supposed to generate long-term stable returns one would expect investments to also be for the long-term. However, when the funds were asked for details as to fund turnover, researchers found that most traded the full size of their assets more than once a year, and some disclosed that they traded a staggering 38 times the size of the portfolio per year. Why does this matter? Well, over and above the costs of administering the funds, trading costs (custody and FX charges, stamp duty etc) will be significant. It seems that the time horizons used by the fund managers, trying to generate strong short-term returns, are totally out of line with the long-term objectives of pension fund managers.
Further, some of these costs are seen as producing dubious benefit; for example, funds turning over equities to generate soft commission so that they can receive more research from banks, or plan sponsors paying money to consultants to assess the best fund manager to select. On this latter point, a group at the Said Business School in Oxford examined what drove the recommendations of consultants and how much value their process added to plan sponsors, with the finding showing that their recommendations relied on ‘soft’ factors, with no evidence that they added value to fund performance. Taking all of this together, it is not hard to see why some estimate that true fund management costs are some 4 times the figure which has been suggested by the industry itself.
Help may be at hand in the form of a new Transparency Task Force, headed by Andy Agathangelou. He has identified 18 areas of concern surrounding workplace pensions, one of which is transaction costs and charges. He said at a recent meeting of the organization: “Transparency will happen because consumer groups and the regulator want it to.” He may be correct, but how quickly this happens will be very important.
The Dutch have set a good example of how to address the issue, by threatening high penalties for those schemes which fail to disclose the full extent of management costs. They start with a much more appropriate balance of cost allocation, with around one third for management and two thirds for performance, whereas the UK operates on the opposite balance. Investors will be happy to pay more if their funds perform better, and this is the case in Holland. Dutch pension schemes are around 112% funded as opposed to a figure of 80% in the UK.
One would hope that threats from the authorities will not be necessary in the UK, but the elements that pushed out Daniel Godfrey may take some shifting. Once we know the full extent of the costs we can properly engage in a debate as to how they can be contained. Indeed, the very process of analysis and disclosure should encourage asset managers to put their houses in order. We must hope that Mr Agathangelou has some early success, or maybe we should all just move to Holland…
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