There is more pressure than ever on pension funds to keep a lid on their costs. “That’s because of the current environment,” says Ron Hitchens, financial controller of the Xerox pension fund in the UK. “Falling markets and therefore falling values of pension funds are happening at a time when you still have to meet your liabilities.”
But is there really much that pension funds can do to trim their cost bases? Apart from taxes, the main costs of running portfolios are for fees for the actively managed part of a portfolio and on the custody side, says Daniel Gloor, head of asset management at the Canton of Zurich pension fund.
“We do keep an eye on these costs, but mainly you have to accept them – especially taxes which you can’t change.” And anyway, he says, in relative terms, costs are a small issue as they represent only 0.2% of the fund’s total assets.
The majority of the Canton of Zurich fund’s investments are indexed, and therefore carry low costs, says Gloor. Using passive rather than active management can be a way of keeping costs down.
“Only 15% of our funds are in actively managed funds.” Cost is one of the factors when assessing a fund manager, he says, but in practice dissatisfaction is more likely to be with performance than costs.
Management fees are one of the largest costs of running portfolios. And as Hitchens points out, since they are linked to market values, these fees have come down in the last three years without any action from investors at all.
But even in relative terms, asset management fees are expected to shrink significantly over the next four years. Consultant Oliver, Wyman & Co and UBS Warburg said last autumn that they expect average gross fees across all asset classes in Europe to decline at a rate of 2% a year over the next four years. Countries charging higher fees will be forced to bring them down in line with their European counterparts, they said. Hitchens says the level of fees paid to asset managers is negotiated initially, and then it is maintained. But it is important not to put too high a priority on keeping management costs as close as possible to the ground. The ability of a manager to manage investments well is far more important than the level of fee it charges. “We tend to look for value from managers rather than minimal costs at all cost,” says Hitchens.
Daniel Wiener, managing director at State Street says pension funds should be aware of the fees they are paying. “The key issue for a fund is to understand all their costs both in terms of visible costs such as fees and also invisible costs such as those incurred through trading. When the fund pays fees it clearly needs to ensure that the benefits it is receiving outweigh the cost,” he says.
One way of reining in the expense of running portfolios is to do it yourself. Pension funds that manage their assets in-house often report slimmer cost margins than those using external fund managers.
Roy Peters is chief executive of Aerion – the in-house asset manager of the Lattice Group pension scheme in the UK. Citing figures from performance measurement firm the WM Company, he says the costs for internally managed funds are 0.1% cheaper than those for externally managed funds.
Why is this? For a start, asset management companies have big overheads to pay for that an internal management team does not. “We don’t have big marketing budgets,” says Peters. “This takes up 30% of external managers’ costs.”
And while salaries are roughly the same for investment professionals, whether they work inhouse for a pension fund, or for a stand-alone asset management firm, the overall staff costs are lower for inhouse management. “With external managers, the bonus is very much geared to the profitability of the business and how the business is growing,” says Peters. “The bonus levels are considerably less (at pension funds) and this is another reason why internal costs tend to be lower.”
Offices at pension fund premises do not have to be as grand as those for asset management firms. Since pension funds do not have to impress potential clients, they can spare themselves the expense of having a marble foyer.
Doing it yourself may be cheaper, but for many pension funds, taking asset management inhouse is not a viable option. Larger pension funds such as Shell and BP are able to do it, but others are too small to make the exercise worthwhile. For others, the administrative expense and work involved in making the change would negate any benefit.
“If you are externally managed, then to go to an internally managed situation involves a lot of issues,” says Peters. “This is not just cost – also, how do you recruit staff?”
Xerox’s Hitchens says his team is not set up to manage internally. “We would have to become authorised decision makers,” he says. “We’re not authorised to take day-to-day investment decisions.”
In the UK, the Myners report focussed attention on the cost of running portfolios. Pension funds in the UK have been asked by the UK government to become better educated about their costs, says Dick McSherry of Elkins/McSherry – which provides analyses of costs for large investors.
In equity management, says McSherry, the controllable costs, globally, average 84 basis points. This figure includes global custody, at an average of three basis points, asset management fees at 30 bp and administration at three bp.
“Of that, 48 basis points are in the trading area,” he says. “That is not an area that is always under heavy scrutiny by pension funds.” Trading costs can be difficult to spot. Broker commission may be fairly clear, but not the market impact. Elkins/ McSherry measures the market impact by comparing the executed price of a transaction to the average price for that stock on the day.
The firm provides quarterly cost analysis for 125 pension funds in 12 countries. This analysis lets the funds compare their costs with those of their peers. Aerion is one of the pension funds that keeps tabs on its costs by subscribing to the Elkins/McSherry analysis. But how does this help actually cut costs?
“If you use services like ours, firstly, you become aware of the cost,” he says. “And when people know you’re looking at costs, they have a tendency to come down.” The information gained can be used as a weighty negotiating tool, he says.
Portfolio costs can mount up for pension funds at times of transition. This may be when money is changing from one fund manager to another, but also when major changes to the asset mix are introduced.
It is important to engage a good transition manager for major switches, says Wiener. “The risk is that when a transition manager is not used to manage the transition, the trading costs can be huge,” he says. The WM Company showed that the cost, for a UK local authority, of changing a portfolio from balanced to core satellite could be 270 bp when a transition manager is not used, says Wiener. As a transition manager, State Street frequently saves clients in excess of 200bp, he says.
Peters says Aerion keeps its costs down during asset allocation switches by using derivatives in the initial stages. “We almost always do the initial asset allocation move through the futures market so we can do it quickly and cheaply,” he says. This is more important for equity market switches than for bonds, which can be sold more quickly, he adds.
“Then we’ve got the economic exposure. We have a short futures position and are long in the stocks,” says Peters. After this, the stocks are sold through a basket trade.