Cost should be a consideration for trustees but not the only consideration
When you’re buying a washing machine, you don’t always buy the cheapest one, do you? You buy the one which, within your budget, is the most reliable, least likely to need fixing and that has a good reputation for getting your clothes clean. That tends to be true of most things in life. While cost is clearly a consideration when making purchasing decisions, what we really want is the best value for money.
Why then are pensions regulators so obsessed with cost? To the point of introducing a charge cap for defined contribution default funds, and consulting on a compulsory switch to passive management for the Local Government Pension Scheme (LGPS).
Active versus passive
Never is the cost debate more divided than in the area of active versus passive funds. Clearly passive strategies are cheaper than active ones. Where proponents of each side clash is over whether the extra cost of active management is justified.
Perhaps the loudest voice from the passive camp is Michael Johnson, research fellow at the Centre for Policy Studies. Johnson’s investigation into the LGPS was one of the key forces that led to a consultation on the wholesale switch to passive investments for the scheme.
How the hell do you choose which fund to invest in when there is no evidence of consistent performance”
Johnson argues that the cost benefits of passive investment taken alongside the poor performance of many active managers clearly shows why trustees should switch to passive investments.
He explains, “Over a seven year period and a 10 year period, not a single active fund manager is in the top half of performance [of results as demonstrated by Foreign and Colonial] full stop. Not a single one. And the point is really this; if you are a typical investor or an LGPS fund, how the hell do you choose which fund to invest in when there is no evidence of consistent performance over any specified time frame? It’s a blind lottery.”
Johnson has been banging the drum about passive management consistently for several years now.
However, Charlie Crole, who oversees Jupiter Asset Management’s institutional business, argues that to talk about the poor performance of managers is to misunderstand the nature of financial markets. “If everybody that chose active management was rewarded for it, then capitalism couldn’t work… Of course there will be managers who underperform, there are some good managers and some bad managers and it’s not inherently straightforward to identify good managers, but you can. “
However, this does not deal with Johnson’s criticism that for trustees trying to decide between the vast array of investment solutions out there, picking the right active strategy can be a lottery.
I don’t think anybody from on high should lay down edicts”
Crole thinks the solution is good advice: “The fact is: there is no substitute for judgement ultimately. But you can load the dice in your favour and of course that’s what the consultant industry has been built around.”
He continues “There are a panoply of service providers and advisers which have grown up to help people on some of the technical aspects of manager selection or fund selection or trusteeship that they could not do on their own.”
Alan Pickering, chairman of BESTrustees, agrees that advice helps: “if I was buying a washing machine I would go to wash adviser and see what’s on the market, as I’m a trustee buying investments I’ve got no hesitation in trying to choose a good investment consultant who will help me distinguish fad from fact and then put together a scheme specific portfolio. I don’t think anybody from on high should lay down edicts that we should follow when trying to produce scheme specific solutions to scheme specific challenges.”
So with good advice, can active management provide better value for money?
Johnson believes not. “In the few years I’ve been looking at the issue, I have yet to find anyone who can present me with some sensible data that supports the case for active fund management.”
Of course, Johnson’s focus is specifically on the management of listed equities, and there are many other investment areas where trustees can only turn to active management, such as real estate, hedge fund investments and private equity.
However Annabel Duncan, a defined contribution client adviser at J.P. Morgan Asset Management, argues that even within the world of equities there are some asset classes where it’s possible to allocate passively, but not advisable. “If you think about small cap equities, emerging market equities, high yield, emerging market debt, these are asset classes where you probably don’t want to be passively allocated.”
Why deny myself access to some tools in the toolkit that might be appropriate”
She contends that those investment classes that are characterised by high levels of volatility are probably not best suited to passive investment. Fixed income is one example. “In terms of all the turbulence we’ve seen, particularly around what’s going to happen with rate rises in the future, it’s an asset class where if you are just allocating to the index, you probably could be seeing a lot of volatility and not necessarily enough return potential for your members.”
Pickering believes that trustees need to keep their options open: “Why deny myself access to some tools in the toolkit that might be appropriate. Some employers are very keen on passive management. Some employers have the intellect or the stomach to tackle more complex investment opportunities that would be of an active nature.”
Both Duncan and Crole believe that it is time to move the debate on from active versus passive, and agree that trustees need to be looking at a holistic strategy that uses both approaches.
Crole explains: “All these different approaches, different fee scales, different asset classes, different philosophical approaches to investment management all have a part to play in fund structures.
“So, increasingly where liabilities can be matched very cheaply through bond matching that’s obviously going to be quasi-passive, with no active fees. Whereas the part of the portfolio perhaps where markets are less efficient, or where volatility or risk needs to be managed much more aggressively, then active management – and therefore higher fees – will need to be engaged.”
Crole is not just approaching this from an asset manager’s perspective. He is also the chairman of the Jupiter pension scheme, a DC scheme with £80-90bn assets under management. This scheme is mostly actively managed, however it also uses some elements of passive.
I get really, really angry when I see that costs are being used as a one-dimensional measure of the quality of a DC offering”
Duncan believes that it is crucial for trustees to focus not just on cost, but on the overall aims of their scheme. “If you imagine in the future, members saying: ‘Well, I haven’t got sufficient money to live on in retirement, these income replacement targets, we haven’t hit them’, to explain: ‘Well, we picked you the cheapest thing on offer’, doesn’t feel like you’re meeting your fiduciary responsibilities.”
She continues, “I think the conversation or decision-making should start with: ‘What are we trying to achieve for our members, what is the objective here and what is the best way to do that? What asset classes or kind of asset allocation is going to get us there?’”
Pickering agrees: “In the DC world I get really, really angry when I see that costs are being used as a one-dimensional measure of the quality of a DC offering. I think we really are storing up problems by blindly driving down costs…. the Plansponsor, the trustees and the members should expect an arrangement that is quality across the offering and not just cheap.”
The charge cap
A charge cap by definition falls foul of the cost versus value dichotomy. If I had a default fund with costs of 100bps prior to the cap, which yielded more net of costs than my sub-75bps default now does, then I am getting worse value for money.
What is more, Duncan argues that a charge cap was unnecessary and that market forces would have naturally have pushed investment fees for DC products down as schemes got bigger and more economies of scale could be achieved.
It’s a very real challenge”
She is also concerned that it has automatically pushed people towards passive management, despite the fact that it is possible to have a fully active default fund within the cap.
The biggest problem, however, is the shift towards prioritising cost over value. Duncan explains: “It’s a very real challenge and again it drives a behaviour which is just picking what I think I can fit in, in terms of cost, rather than thinking about what’s the most appropriate thing, and what will get most of my members to a safe level of income replacement.”
She points to the guidance from the Pensions Regulator on elements to consider when building a default fund: “Cost obviously does play a key part in how you feel about a default fund and extortionate fees will ravage members’ ability to be able to retire. That’s why TPR does include it in the six principles that you need to think about, but I think the thing that’s been forgotten about is that it was 1/6th, there were multiple other things that you need to think about when building a default fund.”
As a professional trustee, cheap is a one-dimensional yardstick that isn’t appropriate”
Pickering suggests that good governance is key. “A robust layer of governance is a much better way of trying to ensure that value for money leads to good outcomes, rather than applying a prescriptive charge cap which takes no account of the quality of the offering or the varying level of challenge that you face when meeting the needs of customers.”
Deciding between an active or passive strategy for your scheme depends on a variety of factors, whether it’s funding level for a DB scheme or ideal member outcomes for DC, but what is clear is that cost alone is not always a good indicator of value.
Or as Pickering puts it: “As a professional trustee, cheap is a one-dimensional yardstick that isn’t appropriate.”
After all, there’s no point in buying the cheapest washing machine only to have to replace it a week later if it’s not fit for purpose.