The cost of investing has long been a concern of the Pensions Spotlight column. This is because annual percentage costs have a disproportionate effect on long-term pension investors. So it should not be a surprise that recent government initiatives to tackle the cost of investing have been warmly received on these pages.
The government department responsible for local authorities is encouraging councils – by hook or by crook – to reduce the costs in their staff pension funds in order to save the taxpayer hundreds of millions of pounds a year in fees.
In November, more details were scheduled to be published as to how this will work. And when it comes to personal pension planning, pensions minister Steve Webb has gone to great pains to keep the charges involved in auto-enrolment down to a minimum. Earlier this year he announced a 0.75 per cent cap on the total cost (excluding transaction costs) for default funds from April 2015 onwards. This cap will be reviewed in 2017 with a view to reducing it and, potentially, including transaction costs within the calculation.
An enemy within
Costs are without doubt the enemy of the long-term investor. Administration charges, platform fees, spreads on funds and direct investments, commissions on transactions, initial charges, dilution levies, annual management fees and other ongoing fund costs: this is by no means an exhaustive list of the costs that investors suffer. And this applies no matter how large or small a pension investor you are – the same is true of a £2bn local authority as it is of a humble £100,000 Sipp investor.
What is true, however, is that smaller investors are often disproportionately hurt by costs. Steve Webb is right, therefore, to focus on cost, but is his charge cap effective and what will be the impact of lowering it or restructuring the calculation in three years’ time?
Placing a 0.75 per cent fee cap on default funds seems fair at face value; after all, the majority of investors in this vehicle will barely be aware they are in it at all, let alone the details of how it works. More savvy or motivated investors can then make an active choice to switch into more expensive funds later on. But, as any Sipp administrator will tell you, getting the total cost, including pension administration costs, below this mark without using very basic funds under the bonnet is not easy.
The solution widely adopted is to use static multi-asset funds of passive funds, or to blend higher cost dynamic asset allocation funds with lower cost passive equities. That should keep the fund costs low enough to allow room for administration fees to be added on top. By using these methods, some auto-enrolment default funds have even kept the overall total cost down to 0.5 per cent, others have just squeezed under the 0.75 per cent barrier. But it has not been easy to stick to Mr Webb’s ultimatum.
Lowering the cap in a few years’ time could have dramatic consequences.
Even a small shift in the hurdle could mean that administrators are forced to change investment funds, shifting members en masse into plain vanilla equity funds (and incurring ’hidden’ transaction costs in the process.) Some providers have already responded. They have assumed that the cap will eventually fall to 0.5 per cent and have made sure their offering qualifies already.
This in itself has drawbacks. By setting the bar this low, it is almost impossible to afford any reasonable professional investment management. The customer gets a basket of passive funds that occasionally get rebalanced – and that’s about it. For instance, it is very difficult indeed to price target date funds, which incorporate sophisticated discretionary asset allocation and risk management over the life of the investment, so that it fits under a 0.5 per cent cap. Auto-enrolment schemes using target date funds as the default will struggle to adjust to future reviews of the cap – and any significant changes required could hurt underlying investors.
Yet more costs
But if the price cap as currently defined is a challenge, that is nothing compared to what might happen should transaction costs also be taken into account. The Cass Business School has conducted research into transaction costs, which has suggested that only 15 per cent of these costs are being disclosed. The published total expense ratio (TER) or ongoing fund charge (OFC) – which is the measure used in the default fund cap – captures trading fees, taxes, management fees, custody and administration costs.
These are some of the costs that are not captured; ‘bid-ask’ spreads, transaction costs in funds and securities lending. Some of the terminology is defined in Box 1.
Unfortunately, these undisclosed costs could be adding 0.6 per cent to the price of any form of professionally managed fund – completely blowing the budget. Even the lowest cost passive funds incur transaction costs that are currently hidden from view. These costs are incurred any time a fund buys or sells a security, which is why active funds with a higher turnover are hurt hardest.
This is one of the main reasons why active stockpicking funds so often underperform equivalent passive funds, and is without doubt a major problem. But how can transaction costs be incorporated in Mr Webb’s default fund cap without scaring investors away or devastating the market?
There is no doubt that having a standard, transparent measure of all the costs incurred by investment funds would be a good thing. The trouble is that there is no existing standard and the necessary data is often not reliably collected. Insisting that it is collected will inevitably increase costs – which would be passed on to the investor.
The Cass Business School has launched a project to collect this data from fund managers, but it will not be an easy process. And because these transaction costs can be high, there is a real concern among fund managers that if they make themselves more transparent than their rivals they also make themselves look considerably more expensive, even though this may not be the case.
Any standard projection will show that a pension scheme with 1 per cent higher costs will significantly reduce retirement income – by as much as 50 per cent over 20 years for a fund growing at 6 per cent a year.
Not cheap
The fact is that investing is not a cheap business. Unless market prices rise consistently – which is rare – making money is a challenge. For pension savers who need growth, there is no alternative and no cost-free option. Mr Webb is a treading a difficult path. On the one hand his drive for greater transparency must be in the consumers’ interests. On the other, consumers are naïve when it comes to investing and must not be put off the process, or be driven to poor options, because the full costs of investing look so daunting.
They are daunting, but the potential rewards are high. Face-to-face with a client, an adviser has a chance of explaining this balance without sugar coating it. But the bare truth remains, no matter how you go about it, a good chunk of any long-term investor’s money will end up in the pockets of a wide variety of financial services companies fulfilling different functions. If markets grow, it makes the outcome worthwhile.
So the question, ultimately, falls on the lap of the adviser. Just how much do you explain to a client without scaring them off from investing altogether?
Bob Campion is head of institutional business at Charles Stanley Pan Asset Capital Management
