The dark side of pension funds
Pension fund management has become a complex issue. It’s hardly surprising then to see that the cost of doing business has increased significantly. Most of Europe’s schemes are working hard to bring costs down in proportion to their extra expenditure, but observers argue that too much attention is paid to the obvious, while other costs are being ignored.
“People talk about investment management fees, but that is just one area out of many. What they seem to be doing less of is putting it all together and coming up with an overall figure,” explains consultant Georg Inderst. He believes that while the best funds have spent a lot of time controlling wider costs, others do not even know that they exist. More should be done to highlight them. “The OECD recommends that certain information should be given to members, and you would think that should include costs. A lot of it is being published in annual reports, but it wouldn’t necessarily be comprehensive, and would be piecemeal,” he says.
Even the larger Dutch funds, for example, which publish their annual expenditures, provide either a benchmark figure or a total figure of expenses. Costs are not broken down into fund management expenses or administrative expenses. Critics say that in general, pension funds have been sadly remiss. The measurement of costs comes down to good governance.
“Pension funds are governed by trustees who are responsible for bringing effective management to this business which happens to be a pension fund. They have to bring all the same disciplines, processes, oversight, and management effectiveness. They need to receive and pay money, invest money, administer records, and comply with legal aspects. I don’t think that trustees and sponsoring employers are managing the business that is represented by a pension scheme with the same diligence and effectiveness as they manage their other business,” argues Marc Hommel, pensions partners at PricewaterhouseCoopers (PWC).
Last month, PWC published a survey which revealed that 54% of UK pension trustee boards did not use a formal governance policy as a framework for decision making, despite the increased scrutiny they are under. Still, some improvements have been made. More than half of trustee boards now have business plans, although some chairmen expressed considerable doubt about the effectiveness of the plans. Perhaps, suggests PWC, it is because business planning is still comparatively new for many trustees, and so forms and content vary enormously. The survey was completed by 81 chairmen of large UK pension schemes.
Still, pension funds are under pressure. In the UK, for example, the Turner Report has brought a lot of these issues into the limelight. Speaking at an Investment Management Association dinner last year, Lord Turner pointed out that there is a striking difference in the administrative costs involved in different types of pension provision. State pay-as-you-go pension systems can have significant disadvantages, in particular rising fiscal costs in the face of demographic change. But, he argued, they are, at least in administrative terms, low cost operations, 10 basis points or less of the implicit capital value of the accrued pension rights. The large economy of scale funded schemes, such as Unilever, also have low costs, although they are slightly higher at 20 basis points or so. “And if you are a high income and high wealth individual you can cut a deal with your personnel pension provider and get costs well below 1%.”
But the person on middle or
low income, £10,000-£25,000 (e36,265), working for a small to medium size firm, can typically only buy a pension at a reduction in yield of at least 1% and often 1.5%. “Even at these rates the financial industry tells us, I think quite honestly and correctly, that this market segment is marginally profitable at best. But at these reductions-in-yield, applied over the life-time of a contract, 20%-30% of someone’s pension can have disappeared in costs by the time they come to draw it,” he said.
One of the problems is that it difficult to measure administrative costs. One pension fund, for example, considers the custodian to come under the heading of administration, while another argues that a custodian comes under investment costs.
What pension funds do agree on is that they are spending more on actuarial services. “We are spending more time doing valuations now, and we have to do them more frequently because of the way the market is going,” explains Peter Scales, chief executive of the London Pension Fund Authority. Still, actuarial costs remain low, percentage wise. The largest costs are mostly in personnel, and then IT. Roughly one sixth of the LPFA’s administrative expenses currently relate to technology costs. Last year, the £2.8bn fund changed its investment strategy to link itself more closely to its liabilities. “Our software has to be kept up to date. We invest quite a lot on our software vendors, and we have a bespoke system which manages the process in individual cases,” explains Scales.
Some schemes are run very economically, and others aren’t, explains Allan Course, head of administration consulting at Watson Wyatt. “It depends on the complexity of the scheme, and the extent to which the sponsoring company want to actively manage their pension fund,” he says. In the UK, administration costs, which are measured on an individual, rather than assets level, vary a great deal. For schemes of 500 – 1500 members, the median cost per member is about £70, with a first quartile cost of £50 and a third value of £130. Big schemes of between 10,000 to 20,000 members have median costs of £40 per member, so the expense drops considerably. £30 is the first quartile value and £55 is the third quartile value, meaning that it is a size game after all.
“If you look at the smaller schemes, then the providers that mostly suck up the costs are the administrator and the actuary and benefit consultant. When you get to the larger schemes, then it’s always the administrator, because proportionately, actuaries’ fees are spread over a greater size. Economies of scale do kick in with administration, but not very quickly,” explains Course.
The cost of administration led to flurry of outsourcing, but not everybody is convinced that this is a solution. “The trouble with administration is that some third party providers are cheap, but do the bare minimum. Unfortunately, you are dealing with people that need a huge amount of hand holding,” suggests one UK pension fund manager.
Last year, the Pensioensfonds Horeca & Catering (PH&C) scheme in the Netherlands celebrated its fortieth anniversary. At the same time, it decided to pull away administration from third party provider PVF Achmea and bring it back in-house. At the time, it estimated that it could save up to 35%, with the profit margin and the value added tax it was paying. Now, says Eric Uijen, head of the scheme, the difference between outsourcing and doing it in-house is about 10%. “We came to the conclusion that it was best to do it ourselves. PVF Achmea is quite a good administration organisation but they have hundreds of clients, so if you want to do things that aren’t standard, they have a problem,” says Uijen. He wants to both reduce the costs of the overall scheme, and increase the quality of services. “I know this is very tough to do, but we are quite sure we can do it, given our infrastructure, communications, and technology capabilities,” he argues.
Others are pooling resources in a bid to cut costs. Three Danish pension groups, PKA, which administers eight pension funds, PBU, and Laerernes Pension are to form a joint venture company to offer member services, actuarial services, financial services, and IT to other Danish labour market pension funds. Together they have more than 410,000 members, and the eight PKA funds will be the company’s first clients. Service to PBU will follow in mid-2007 (the company hopes to get off the ground in September this year) and to Laerernes Pension in early 2008.
Peter Damgaard Jensen, chief executive of PKA, breaks the funds’ costs down to service level costs, IT costs, and investment costs. “It’s always a good idea to identify business areas where co-operation or outsourcing facilitates not only quantity but also professional business handling.” But, he says: “It can be very costly to engage and build up skilled staff. It may be even more costly not to do so.” He also points out that though investments in IT are very expensive, “One push of the button may form and print 100,000 annual pension summaries. The same push could form and print 500,000”. The point being that once the money has been spent, there are savings to be made. Good IT investment could also help a fund use internet services, with IT mailboxes a direct way of savings costs, he points out. It also means that members can find a lot of what they need online, rather than contacting staff through telephone calls and letters. And when it comes to investment costs, PKA has managed to reduce direct investments by approximately 10% over the last few years, while assets under management have gone up 50%.
Damgaard Jensen suggests that pension funds need to identify and skip costs that do not directly add value. Some pension funds will find this harder than others, largely because many costs are not transparent. A UK pension fund manager at one of the biggest pension funds is quick to blame investment managers. “These people are greedy and very narcissistic. They are in love with themselves,” he says, arguing that fees are too high, and information is not forthcoming.
It may be an extreme view, but pension funds do want managers to be taken more into account. “What I’d like to find out is, if you give a manager a £100m mandate, how much does it really cost him to run that mandate?” asks Richard Stroud, chief executive of the London Pension Fund Authority. He argues that active managers can be charging between 30 and 40 basis points, while a passive manager only charges around 10. “You have to have significant outperformance to make up the difference.” One of the problems, he suggests, is that pension funds leave it too late to have a discussion about fees. “If you put an investment manager on your shortlist, you could tell them that you’re not so keen on their fees, as opposed to leaving it until you’ve chosen the manager that you want,” he argues.
But not everyone believes it is necessary for managers to breakdown costs. “You pay whatever the basis points management charge is, and in that sense, investments are probably the most transparent costs. When I buy my copy of the Times, I don’t know how they spend their money, but I know it will cost me sixty pence,” argues Watson Wyatt’s Course. Administrative costs, in contrast, can be variable depending on how much service is required.
Still, pension funds say that some diligence is required. “Pension funds should take enough time and effort to get the full transparency on the relevant cost structures. In a free market economy, everybody can ask for a fee quote from the competitors,” suggests Jan Willem Baan, newly appointed chief investment officer of the Dutch Doctors Pension Fund Services scheme. Still, he argues, “there is no need for the individual clients or the public to oversee the total costs of these companies.”
Many schemes, like the Netherland’s PGGM, and the LPFA, pay managers on a two tier structure, a flat fee and then a performance fee. Even then, suggests Henry Dikkema, group controller at PGGM, it is not always easy. “The costs of investment are less transparent than the costs of the pension fund, because we do a lot of business with external fund managers with all kinds of cost structures, like fund of fund costs, for example. Sometimes it’s difficult to oversee all the costs that you make,” he suggests.
Watson Wyatt points out that there are several problems with current fee structures. The ad valorem model, in which fees are paid to an investment manager based on the size of the assets managed, cause mis-alignment between the interests of all parties. “Managers have a big incentive to win new mandates and to ‘gather assets’. This is often in tension with good performance which benefits from the diseconomies of scale,” the firm suggests. Pension funds clearly agree: the last few years has seen boutique managers dominate. Watson Wyatt also points out that investors are increasingly frustrated with paying the same level of fees for below average or negative returns, and the Pension Trust’s Stroud points out that managers would rather sack an underperforming manager than try to reduce its fees.
Watson Wyatt suggests that more managers turn to a two-tier fee structure. In its model, a base fee would be charged, to cover overhead costs of the business, while a variable fee related to performance would be set up. The base fee would be a percentage of the value of the fund at the start date of the mandate, while the variable fee would be performance driven, but also include ‘soft’ factors such as the level of service provided by the manager.
The consultant also believes that part of the cost problem comes from too many providers on the food chain. “The major issue is that pension funds’ goals are tied to paying pensions, whereas agents may be more interested in managing their business in line with their own objectives,” the firm suggests. Plus, the agents may not work well as a cohesive team. Watson Wyatt suggests that the current time charge basis fees of consultants do not work well, as it does not provide good enough incentives to be efficient. It also leads to concerns about the development of a so-called ‘ambulance chasing’ mentality. Pension funds should be better at monitoring the activities of their consultants. Managers, meanwhile, should have the two fee structure. Brokers, who are also an expensive part of the food chain, are problematic in that they make money on asset turnover, and Watson Wyatt argues that increasing transparency is needed.
Still, observers warn that it’s important to put costs into perspective. “What you are doing when you make an investment is that you are making a dollar derivative. A dollar now for a dollar fifty tomorrow,” suggests Arun Muralidhar, chairman of Mcube Investment Technologies. “There is too much focus on cost, versus relative value,” he argues.
But pension funds argue that they have put costs in the context of overall value. “Cost is not the target for us, absolute return is our target. We are looking for stable, long term, high absolute return. To get that we have costs, which of course, we strive to keep as low as possible,” argues Henny Kapteijn, head of finance, control, and risk management at ABP. At the end of the day, she argues, quality should never be sacrificed for the sake of cost.