GLOBAL - Pension funds should reduce their external investment management costs by 10 basis points and use this saving to increase their internal resources, consulting firm Watson Wyatt has suggested.

Tim Hodgson, senior investment consultant at Watson Wyatt, said pension funds should consider reallocating assets from funds of hedge funds, for example, and reduce costs by around 10 basis points, and use this 10bp reduction to hire an in-house investment professional.

This, according to Hodgson, would create a reinforcing virtuous cycle whereby a fund would increase its bargaining power and thereby its efficiency through enhanced internal governance.

The consultancy is about to publish a major study on pension fund investment, which also reveals pension funds' cost base has roughly doubled in the last five years, from 65 basis points to 110 basis points for a large fund.

Watson Wyatt has calculated a typical large pension fund now pays annual transaction costs of around 45 basis points on assets, investment management costs of 55bp and internal costs of just 5-10bp.

Hodgson also said there was considerable misalignment and "mis-specification" in asset management fees, which often saw investors paying hedge fund-type fees for leveraged beta returns.

"Fees and costs are too high in the majority of cases for their underlying value proposition," said Hodgson.

"The underlying case is that we have a flawed incentive structure. There are many reasons, but there is asymmetric information and agents who should be acting for capital owners know more than owners but are incentivised to keep the situation that way. The one big issue is whether you can change that structure," he added.

The study, entitled Defining Moments and scheduled for publication next month, will argue four "defining moments" in recent years have reshaped institutional investment:

The arrival of absolute return strategies following the 2000-2003 bear market; The arrival of the Dutch fiduciary management model; Development of better risk management following the sub-prime crisis, and Assumed forthcoming financial services regulation following the credit crunch.

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