Pension Funds: The bigger cost picture
Asset management costs are only one part of the total equation, finds Gail Moss
At a glance
• Assessing the total cost picture means taking account of investment, transition, custody and administration costs.
• Funds should take value for money as well as cost into account.
• Some asset classes, such as private equity, need careful assessment to uncover hidden costs.
In an age of greater accountability, pension funds are under pressure to be more transparent on their costs. But while asset manager fees have long been a source of debate, the focus is shifting more towards other costs which can play an equally important part in the attrition of pension fund wealth.
The issue is particulalrly important for defined contribution (DC) schemes, says John Simmonds, principal, CEM Benchmarking. He says: “In the defined benefit (DB) world, corporate pension schemes are not so concerned with capital cost, more with managing liabilities off balance sheet.
“Operating costs are a very small percentage of the overall value of accrued liabilities, so for schemes with a big deficit, the operating costs are insignificant.” He adds: “But for DC schemes, costs are very important, as they directly affect members’ accounts. So minimising cost is very important, and that leads to a transparency problem. If we’re not understanding these costs, then we’re not going to be managing them either.”
Richard Birkin, head of DC at KPMG, says: “We’ve seen consolidation amongst some of the pension providers, which in some cases has included structural, systems and personnel changes. There is a heightened awareness of the issue of scheme costs and it has led to increased competition, as trustees and employers seek greater clarity on what they and their members are paying.”
Birkin continues: “For the most part, to date that has focused on the visible headline costs, for example, member total expense ratios, but over the last year we’ve seen greater scrutiny on underlying transaction processes and charges. This is clearly a developing area, but any structure that offers clearer comparable numbers would be welcomed.”
Cost covers a range of expenses. For instance, investment costs include not only transaction, trading and asset servicing/custody charges, but also administration, regulation, and reporting.
Simmonds sees two other main areas, the first being staff and general administration costs, including dealing with members’ phone calls (such as using call centres), mailing out documents and making payments to pensioners. The other area is governance, which covers the activities of the trustee board, and general oversight.
Rikhav Shah, senior manager for advisory services at Ernst & Young, says one of the problems is simply being able to know what the different costs are. “It is easy for pension funds to focus only on those costs that are invoiced, but unfortunately, many costs are not invoiced, and trustees are not aware of them. So, for example, with processes for investing and ongoing monitoring, trustees and their advisers should consider all costs, not just those expected to be incurred under normal circumstances during the life of the investment, but also on disinvestment.”
“It’s not easy to identify all costs – for example, most alternative asset classes, especially private equity, include multiple layers of fees for different participants,” says Simmonds. “It can be almost impossible to see through that structure to find out what they’re paying.”
So how do pension funds measure, benchmark and optimise these costs to ensure the best interests of members are served? Shah says: “Trustees should seek to understand the rationale of the different costs, why those costs are incurred and what benefit that activity has on the quality of the investment or service it results in.”
Birkin says one starting-point could be to carry out a ‘value-for-member’ assessment. “Conducting this process can identify areas that are unclear, poorly communicated or simply out of sync with the rapidly developing marketplace,” he says. “I think the real challenge is establishing an approach that is clear, consistent, and meaningful to members, trustees and employers.”
CEM Benchmarking asks its pension fund clients for information in a structured way, applying a default if the information is not available. Specific costs can then be compared with funds from CEM’s database of global pension funds, built up over 20 years, on a “sensible”, like-for-like basis.
Simmonds says: “One big driver of costs is asset mix – some asset classes are cheap, some expensive. So we normalise portfolios for asset mix differentials.”
Equally important is to make sure a pension fund is getting value for money. This means running a value metric alongside a cost metric to show whether higher costs result in better value for members. This analysis is important for larger schemes deciding whether or not to outsource their administration functions.
“As DB schemes mature and close to new members, the incidence of internally-administered schemes goes down,” says Simmonds. “The vast majority of pension schemes are going to outsource admin to a third party, to get economies of scale, as well as resources such as IT capability. Often this is because there are significant key-man risks, or they don’t want the responsibility.”
The UK government is committed to transparency of costs and charges in pension schemes. It is to introduce requirements for schemes to disclose information about transaction costs and administration charges in a standard, comparable format.
As part of this initiative, in March 2015 the Department for Work and Pensions and the Financial Conduct Authority asked for comments from the industry.
The call for evidence was intended to find out:
• What should be included in the transaction-cost reporting;
• How such costs should be captured and reported;
• Whether information about other factors that impact on investment return should also be provided;
• How independent governance committees and trustees will receive cost information and whether additional disclosure requirements on other parties are necessary to enable this.
The government is still analysing the feedback.
John Simmonds, principal at CEM Benchmarking, emphasises the importance for pension funds of context, saying that “talking about costs in isolation is not helpful”.
For instance, transaction costs will depend on the number of positions taken, and volume of trades: “Costs could be higher because there are more trades, or the costs of each transaction are higher.”
But the consultation appears to be timely. Richard Birkin, head of DC at KPMG, says: “The FCA’s call for evidence on improving transparency in workplace pensions was welcomed. There has been, and still is, a lot of confusion and frustration on this subject, so some form of clear standardised reporting would help to bring much needed clarity.”