GLOBAL - Pension funds are paying 50% more in fees compared with five years ago, following an increased appetite for 'alpha' in the form of hedge funds and private equity, Watson Wyatt has revealed.

Research by the consulting firm reveals pension funds around the world are now paying a global average fee of approximately 110 basis points compared to around 65 basis points in 2002.

The research note, entitled 'A fairer deal on fees', claimed the key reason for the rise is an increased investor focus on 'alpha' returns and subsequently increased investment in hedge funds, private equity and real estate.

For example, Watson Wyatt said hedge funds typically charge an annual base fee of 1-2% on the value of committed capital, plus a 20% performance fee, while private equity fees are similar.

This contrasts sharply with the typical annual fees of 50 basis points, or lower, charged by traditional long-only managers, and although pension funds normally access hedge fund exposure through funds of funds, the consultancy warned this could add an extra 1% annual base fee and 10% of net returns as a performance fee, which could lead to 95% of the alpha returns being paid away in fees.

The report warned many pension funds have been paying managers 'alpha' fees for 'beta' performance as a result, as the main driver for returns in the last few years has been the strong equity market.

This market environment has encouraged managers to leverage portfolios in an attempt to boost returns, which means investors are often paying high fees for leveraged beta - market returns multiplied by gearing - rather than true alpha.

Paul Trickett, European head of investment consulting at Watson Wyatt, said: "This is obviously a good deal for investment managers, but not necessarily for their investors. While we strongly believe managers should be fairly compensated, fees are currently too high for the value they deliver particularly as we enter a lower-return environment."

The report criticised existing fee structures, such as base fees calculated on an ad valoreum basis and annual performance fees where the "upside is uncapped and the downside is limited to the base fee", and instead suggested the "ideal" fee structure should have a low base fee to cover costs and a performance fee calculated over longer periods of three to five years.

Trickett pointed out although the issue of fees and alpha is a "complex area", it should not be "glossed over" as too much value has already been allowed to leak away.

However, he claimed: "There are signs of change as we move into a different market environment where many managers will no longer be able to justify their charges without beta to bail them out. In future, active managers that wish to win pension fund money will need to offer them a fairer deal."

This is not the first time Watson Wyatt has raised the issue of higher fees for pension funds, as Roger Urwin, head of investment consulting at the firm, recently argued pensions funds need to do more to reduce the fees they pay. (See earlier IPE story: Absolute returns need lower fees - Watson Wyatt)

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