UK regulator homes in on costs
The issue of fees has been steadily moving to the forefront of regulators’ minds in the UK. Jonathan Williams examines the steps now being taken by the FCA
At a glance
• The Financial Conduct Authority has called for a single fee covering all costs.
• The Investment Association has created a board to look at improving cost disclosure.
• Local Government Pension Schemes are collaborating on a cost-disclosure framework which has interested the government.
The subject of management costs, and more recently fee transparency, has become one of the most controversial topics facing UK asset managers. In November last year, the Financial Conduct Authority (FCA) pledged firm action and called on the industry to introduce a single fee covering all costs incurred by investors.
Contained within its long-awaited interim report on the asset management industry, the FCA argued in favour of changes that put costs front and centre, including disclosing fees prominently when discussing an investment fund’s past performance, rather than discussing returns net of fees, and forcing the inclusion of transaction costs within the continuing charges figure used by UCITS and other funds.
The work builds on efforts by the FCA and Department for Work and Pensions (DWP) to improve transparency in the wake of auto-enrolment. In April 2015 a 75bps charge cap for default funds was introduced, together with an obligation for independent governance committees to reduce costs and examine decisions for value for money.
The battle over fees has long been expected by asset managers. Former head of the Investment Association, Daniel Godfrey, had sought to bind members to a code of conduct expressly placing the onus on the industry to invest in clients’ best interest, implicitly lowering fees. However, only 25 of the association’s 204 members – representing £1.8trn (€2.5trn) of its £5.5trn in assets – backed the principles published in 2015, and Godfrey departed from the Investment Association.
Following Godfrey’s departure, the Investment Association sought to be proactive, appointing an independent advisory board led by the National Employment Savings Trust’s CIO Mark Fawcett to develop a cost-disclosure framework.
Other parts of the pensions industry, notably UK local government pension schemes, were already hard at work on their own version of such a framework, which the DWP was said to be interested in applyng to private-sector funds. The question, therefore, is whether the work of the Investment Association’s board is too little, too late.
Andy Agathangelou, founding chairman of the campaigning Transparency Taskforce and a member of Fawcett’s board, told IPE he is prohibited from discussing the board’s work. “This is a matter with which I am incredibly uncomfortable,” he says. “I believe it to be an unhelpful position for Mark Fawcett to have decided that the [Investment Association] advisory board could not operate in a transparent and open manner.”
Fawcett declined to be interviewed in his role as board chairman, noting that he had not been mandated by the board to speak publicly on its work. To date, his only public intervention in the role was to criticise the Investment Association after it published a controversial report on asset management fees, which the board was “neither consulted on nor endorse[d]”.
Agathangelou argues that a number of Investment Association members are still attempting to maintain the status quo as far as fees are concerned, and this resistance is reflected in the lack of responses initially received by West Midlands Pension Fund (WMPF) when it began gathering more detailed asset management costs (see case study below).
David Kane, director of finance at WMPF, charged with developing the cost framework for local authority funds, argues that after initial resistance to the fund’s approaches in 2014 asset managers are now more willing to be transparent.
And even those less willing to be transparent will be facing an energised regulator with a sense of purpose. Andrew Bailey, the FCA’s chief executive, has linked the current low-return environment to the need for better scrutiny of fees.
Speaking when the interim report was released, Bailey said: “We want asset managers to ensure investors receive value for money through pursuing energetically their duty to act in their customers’ best interests.
“Low interest rates are necessary for the economy,” he added, “but we have to do everything else we can to ease the burden on savers. This is one thing we can do.”
“It is now perfectly clear in my mind that the brief the FCA was given was to take a look at what needs fixing and fix it”
Agathangelou says the interim report “blew away any doubt” that asset managers would be able to lobby effectively to avoid change he views as imperative. “It is now perfectly clear in my mind that the brief the FCA was given was to take a look at what needs fixing and fix it.”
He contrasts this with the previously perceived approach not to ruffle feathers among asset managers, and argues that if the FCA sticks to this mantra, then change on costs and fees has truly arrived.
Sweden AP7 focuses on costs in defined contribution funds
• Sjunde AP-fonden (AP7)
• State-run fund for PPM first-pillar DC pension component
• Location: Stockholm
• AUM: SEK314bn (€32bn)
• Asset classes: 291 equity/23 fixed income
• Fees: 0.11%/0.04%
Providers of defined contribution pensions have to walk a fine line between ensuring the products are low-cost but do not compromise quality. AP7 is no exception.
The fund complements Sweden’s pay-as-you-go (PAYG) system. In addition to the state PAYG-financed pension, Swedes must also contribute 2.5% of income into an individual investment account as part of the PPM system. AP7 provides a range funds within PPM and also the default fund.
PPM is only intended to generate 20-25% of retirement income. “As this is a minority of the overall retirement income, we can take greater risks with this fund,” says Richard Gröttheim, CEO of AP7.
The fund’s investment philosophy is to ensure scheme members have the right asset allocation according to their age. Gröttheim says: “This allocation can be implemented by using low-cost index products.” It is not necessary to use active strategies.
During the earlier part of working life, contributions are invested in an equity fund. As members approach retirement, this is transferred to a bond fund to protect the capital value of the pension pot.
The choice of assets available to AP7 is limited to equities and bonds. The limit on equities is not an issue for the fund, given the risk constraints, allowing it to take a robust attitude to equity risk. “Over the longer term the investor will benefit from volatility during a 30-40 year investment horizon,” says Gröttheim.
Since 2010, the fund has focused on lowering the costs of its equity portfolio from 0.15% to 0.11%. The fund has achieved this cost reduction by having its core equity investment in global indices and taking a tough negotiating stance with its investment managers.
In addition to its core investment in global indices, the fund will ratchet up and down the risk of the equity portfolio – by changing the amount of leverage in the fund. There is also a 10% allocation to equity long-short funds, as well as an allocation to a private equity fund of funds.
AP7 does not reveal the fees its pays to its investment funds as this would be counter-productive for both the managers and the fund, says Grotthiem. But it uses a different fee structure for different managers. The fund uses its scale to negotiate the best possible fixed fee with passive managers.
For its active managers, however, the fund favours a base fee and a performance fee structure. “We like to have as low a base fee as possible and a higher performance fee. It was more difficult, however, to get managers to accept that we want to pay as low a base fee as possible,” says Gröttheim.
“It is better for our members and the managers to share in the performance of the fund and to only pay a small amount if they do not perform.”
Similar negotiation tactics have enabled the fund to build a straightforward yet low-cost bond fund. It is principally invested in Swedish government and mortgage bonds and has a management fee of 0.04%.
While AP7 has worked hard to keep its costs low over the past six years, its focus will now shift to improving fund diversification – even though the investment strategies it plans to target will be more expensive.
Gröttheim says: “We are going to increase our allocation to emerging-market equities and private equity as well as adding an allocation to small caps.” Once these changes have been made, AP7 will allocate some of the portfolio to factor investing, such as value, growth and momentum strategies, he adds.
Now the fund has greater scale it is able to pursue a more sophisticated strategy, and it will be able to negotiate a better price for these more expensive investment strategies, Gröttheim concludes.
UK: West Midlands develops cost-disclosure template
• West Midlands Pension Fund
• UK LGPS fund
• Location: Wolverhampton
• Assets: £11.7bn (€13.8bn) (31 March 2016)
• Members: 287,874
• Employers: 536
• Total investment management costs for 2015-16: £69.8m (0.6% of AUM)
If investment management costs rose nearly sevenfold over the course of two years, most pension funds would launch an investigation, not celebrate. But it is with some pride that the UK’s West Midlands Pension Fund (WMPF) reports costs of £69.8m (€88.3m) for 2015-16, because it is the culmination of two years of work for its director of finance, David Kane.
Kane’s local authority, Wolverhampton Borough Council, has monitored fees at the £11.6bn WMPF for a long time, the result of concerns that invoices received from external managers were not fully capturing management costs – particularly regarding more expensive alternative investments. “We knew we weren’t seeing up front the cost of those investments,” Kane says. “So we were keeping some information internally, just some management information, to try and estimate what we thought the true gross cost was.”
However, Kane’s approach changed in 2014 when the Chartered Institute of Public Finance and Accountancy (CIPFA) published guidance on how local government pension schemes (LGPS) should capture management expenses. He says the guidance offered a “solid framework” that WMPF and other LGPSs used to draft a new disclosure template that fully captured performance fees and other previously less easily identified costs. The template asked all of WMPF’s managers to detail base management fees, transaction costs, and any other costs being charged against the portfolios.
While the response from WMPF’s external managers was not comprehensive, Kane describes it as respectable. The information provided allowed him to complete “fairly accurate” estimates of the costs incurred by the fund each quarter, although he admits the task required “quite a substantial process” of data cleansing to improve consistency.
“Different managers had filled in their returns in a different way – which was an exercise in itself – but at the end of the day we had a set of figures that we felt we could place reasonable reliance on and include in our accounts.”
As a result, overall management costs appeared to increase from £11.2m in 2013-14 – of which £8.5m was attributed to external managers – to £81.2m the following year. “It was a very dramatic switch in our accounts,” Kane recalls. “It was potentially a concern we were holding ourselves up for some criticism. We were the ones sticking our heads above the parapet.”
“There’s more that we can do to develop the reporting of transaction costs – it’s a hideously complex area, and I’m not under the illusion that we’ve got to the bottom of that”
To that end, it was explained to the fund’s pensions committee – which is equivalent to the trustee board of an LGPS – that despite the apparent increase, the new disclosure was simply disclosing unrecorded costs.
In fact, when the revised template was applied retroactively, management costs for 2013-14 stood at over £87m, decreasing to £81m the following year, and falling to £69.8m by 2015-16. Expressed as a percentage of assets costs dropped by 11bps over 2014-15 to 6bps this year.
Kane says due to improved disclosure the fund can show savings of £35m since the 2013-14 financial year, partly down to tougher negotiations, but also attributable to a change in asset allocation and divestment from hedge funds and commodities. Additionally, some of the fund’s externally managed global equity portfolio is now overseen by WMPF’s in-house management team.
“We set up around £500m in-house, which is vastly cheaper – so that’s also saved quite a bit of money,” Kane says.
Looking ahead, Kane has not finished pushing for better comparability by ensuring that all LGPS report their pooled investments in a similar fashion – a crucial matter as schemes in England and Wales begin pooling assets as part of a government-mandated reform.
But Kane says there are further opportunities for transparency on costs. “There’s more that we can do to develop the reporting of transaction costs – it’s a hideously complex area, and I’m not under the illusion that we’ve got to the bottom of that.”