Complying with the DC charge cap has been tough, but schemes can put together high quality default funds within the 0.75% limit
In pensions circles, 6 April 2015 is best remembered as the day the at-retirement changes were implemented. Headlines shouted about freedom, choice and the wisdom of Lamborghini ownership. Much less was said about the new cap on default fund charges for auto-enrolled members, quietly brought in on the same day.
The cap on member-borne charges was intended to safeguard auto-enrolled pension savers from excessive fees and poor value for money. With a review due in 2017, has it had the desired effect – or, as some feared at the time, merely acted as a brake on investment innovation, potentially harming the members it seeks aims to protect?
Schemes can administer the member-borne cap in one of three ways: implementing a maximum 0.75% charge of funds under management (FUM); combining a charge on contributions with a percentage of FUM; or a mix of a flat annual fee and a percentage of FUM. Professional, investment, administration and communication charges must all be included within the cap.
Value, not cost
Good value charge cap-compliant default funds are about more than just cost. Andrew Dickson, investment director for Standard Life Investments (SLI) points to research that SLI carried out with the Pensions Policy Institute in March 2016, Value for money in DC workplace pensions. “We found that appraising investment design is not just about cost. Schemes also need other elements that deliver good outcomes in place - such as the right governance structure.”
The bigger your buying power, the better the price you will get
Scheme size is one of the key factors affecting how charges are structured. “If you have scale and volume of contributions you can really invest in governance, communications and investment. The bigger your buying power, the better the price you will get,” says Darren Philp, director of policy and market engagement at The People’s Pension.
Members in a very large scheme might pay 0.1% for admin
Andrew Brown, client director at Columbia Threadneedle Investments highlights the scale of that disparity: “Members in a very large scheme might expect to pay around 0.1% for administration – the company may even pay that for them. In a small scheme, the equivalent could be upwards of 0.4%, leaving very little for investment charges.”
Brown adds that low contribution rates in auto-enrolled schemes mean that investment strategies have to work harder than ever to deliver growth, make sure that members remain engaged, and ensure they are not put off by market fluctuations. That is a sizeable to-do list with potentially only a 0.35% charge to play with.
Inevitably, there have been compromises in investment strategies. “Generally we’ve seen a dumbing-down of asset managers’ best ideas,” says Mark Futcher, partner and head of DC at Barnett Waddingham. “All we are hearing at the moment is, ‘we know we need to control volatility – but we can’t control it as we want, so we’ve simply put caps and collars on it’.”
There have been constraints in some situations
Even though trustees and providers might be able to accommodate the majority of their investment requirements within the charge cap using low-cost tracker funds, there may still be specific instances where it poses a challenge. “, such as a scheme that wants to make a large allocation to a diversified growth fund (DGF) for mid-age members to control volatility,” says Alistair Byrne, senior DC strategist for State Street Global Advisors. “That is where it has started to bite.”
But, Byrne adds, there are options that can work within the charge cap, such as lower cost DGFs that use active asset allocation but not active underlying funds. He also points to increasing interest in smart beta as schemes look at ways to get the best from their investment charge budget.
Rising to the challenge
While the cap may have imposed limitations on some ambitions, a handful of schemes are spreading their investment net wider and investigating alternative assets, says Dickson of SLI. “Lots of DC schemes tick the alternatives box via a DGF, but some are going a step further and looking at genuine alternatives, such as direct investments in private markets.” The challenge is: can you do that within a charge cap environment?
It might be possible to include a 10% to 20% allocation to private market strategies
Byrne believes that, while difficult, a small allocation to alternatives is achievable. “You could have a core holding in low-cost passive equities, then consider where to go for additional value. It might be possible to include a 10% to 20% allocation to private market strategies within a default, but beyond that schemes would struggle.”
To date, the charge cap may have achieved its objective of protecting members from excessive, opaque costs. When it is reviewed next year, the question of value for money rather than simply low cost, may take centre stage and there is bound to be debate about whether the cap should be lowered further.
Perhaps a bigger issue, however, is the inequality between large schemes with strong governance arrangements that can negotiate the best deals and manage the cap most effectively - and those that do not have the scale or skills to get as good a deal for their members. Yet again, size matters.
The 2017 charge cap review
The charge cap will be reviewed by government next year. What should be included?
1. A change in the value of the cap?
“The dream scenario would be to leave the charge cap where it is,” cautions Andrew Brown of Columbia Threadneedle Investments. “A reduction would stifle innovation and it would become less attractive for asset managers to compete in the DC market with new solutions.”
“There is some recognition within government and policy makers that if you have any further impact on the charge cap, you really would be closing the door on DC savers being able to access the range of funds that could generate returns in the future,” adds Andrew Dickson of Standard Life Investments.
2. More transparency within the cap?
Darren Philp of The People’s Pension believes the review should concentrate on consistency and transparency rather than making changes to the level of the cap. “Last time around, the cap was a bit of a fudge. It’s hard for the consumer to make comparisons or even draw a baseline when you’ve got different schemes charging in different ways.”
Transparency around transaction costs is another issue that Philp says the review should address. “We need to get a move on and agree common standards.” But Alistair Byrne of State Street Global Advisers warns against expanding the scope of the costs: “It would be unhelpful to include transaction costs within the definition of the charges. The manager should disclose what the costs are and what’s been done to control them.”
3. More flexibility in implementation?
“We would like to see a ‘comply or explain’ approach,” says Mark Futcher of Barnett Waddingham. Futcher believes that setting a limit below which there is no need to justify how the charge is reached, “but if you do choose to go over it, you must justify that members are getting value from the higher charge” would be preferable to a set cap.
4. Extending the charge cap to post-retirement options?
Futcher adds: “We are storing up a problem in accruing pensions in a well governed institutional-rate environment, then moving members into higher charged retail contracts with no governance around them. We are not seeing anyone creating a to-and-through solution that looks at managing charges.”
Philp feels it is too early to decide whether the post-retirement market requires charge capping. “The market will develop as pot sizes grow and we need to give it a chance to evolve. But if that doesn’t happen, or customers are being ripped off, we would be at the front of the queue for a cap.”