Rumours abound that the charge cap could be reduced to 50bps or extended to decumulation products. What would this mean for trustees? Sara Benwell explores
Everyone who has ever bought a car knows that cost and value are not always equivalent. Often the cheapest model will be slower, less fuel efficient or even unsafe. This is true of most things in life, and pensions in particular.
Or it could look like this one…
That doesn’t mean that costs aren’t important. While value can be subjective, most people agree that there are two main things to consider – how much you have to pay for something and what you get out of it.
The problem with measuring value in a pension scheme is measuring the second part of the equation – how do you account for outputs such as communications?
So the only thing that trustees can completely control is what they pay for the products they use, which may go some way to explaining why the government chose to impose a charge cap on default funds.
I’m quite uncomfortable philosophically with charge caps”
Nigel Aston, head of European defined contribution at State Street Global Advisors, says: “I’m quite uncomfortable philosophically with charge caps generally. However, what is clear is that many members were being overcharged for relatively ineffective DC investment products.
“The cap means that we, as asset managers, need to be more innovative rather than seeing the constraint as an excuse to be less so.”
Ever since the 75 basis point cap was introduced in 2015, there have been rumours that it might be dropped to 50bps.
Learning from the past
To understand what the impact of a lower charge cap might be, it is useful to look at what effects the current one has had.
Mark Futcher, head of defined contribution at Barnett Waddingham, argues that the current cap has stifled innovation, so lowering it would make the situation worse.
He says: “Fund managers are trying to bring more diversified, more sophisticated growth vehicles into the DC space but in order to comply with the charge cap they are having to dumb down their best thinking, so you get a diluted version. For those who want the best thinking, why can’t they have it?”
Aston is fairly sanguine about the effect on innovation – arguing that the industry wasn’t really doing much before the cap anyway, so it hasn’t really been curbed – but he does warn that a lower cap could start making things very difficult for trustees.
Alan Pickering, chairman, BESTrustees, agrees. He says: “Yes, the 0.75% charge cap has awakened people to the fact that returns may or may not happen but charges will be with us forever. It’s been a useful wake-up call, but if you drive it any lower than 0.75% there is a danger that cheap will drive out good.”
For those who want the best thinking, why can’t they have it?”
Most can agree that asset managers bore the brunt of the existing charge cap, with the focus falling firmly on the fees they charge for their services.
This was the intention behind the policy – and members will be reassured that trustees are scrutinising their asset management costs – but it is important that trustees keep sight of the other charges and fees associated with investments.
Aston points to administration as a potential area of focus. He says: “It’s been odd that most of the focus as to where these cuts need to come from has been directed towards asset managers rather than administrators. There’s administration that costs 30 or 40 basis points equivalent.
“Aggregation and scale and a move to more efficient technology should enable administrators to become better and cheaper.”
Pickering agrees. “Investment charges aren’t the only costs. We’ve administration and communication costs as well and just to focus on one of those elements could be counter-productive. When you go shopping you will always have a budget in mind but you are also looking for the right product that meets your particular needs.
“If an employer or a group of trustees just look at the investment costs of a particular opportunity they may well be selling their members short in the long run.”
Transaction costs are not included in the cap. These charges are notoriously hard to understand and even trickier to explain to members, but like any other costs can be detrimental to the investment returns.
If more is to be done with charge caps, it would be prudent for regulators and government to shine a spotlight on other fees within default funds.
Who is it hitting?
Aston worries that, because the cap is limited to the default, it is not protecting those who are paying the highest charges, such as those in legacy schemes. He says: “A lot of the large plans were well under the cap already – 75bps is probably double what these plans were paying anyway.”
He suggests two areas where the charge cap may not be having its intended effect.
75bps is probably double what these plans were paying anyway”
The first of these is plans where smaller firms are likely to auto-enrol. The cap was needed to protect the workforces of smaller employers that do not have economies of scale. However, while most of these employers use the larger mastertrusts, Aston fears that SMEs going into smaller plans could still end up paying too much.
The second target is very old legacy plans, many of which have higher charges, particularly in those funds that are not defaults and don’t sit within the charge cap.
One suggestion is that before considering a lower charge cap, regulators should first consider expanding the cap to those areas where charges are high and protection is desperately needed.
What about decumulation?
Rumours suggest the government is considering extending the charge cap, although it is the decumulation world that sits in their sights, rather than legacy schemes.
Aston does not see how this could work. He argues that, as staying in the drawdown plan is not compulsory, people have to make a choice at retirement.
We need a market with a number of participants”
Clearly, many of the options, including taking cash or investing in buy-to-let, would have to sit outside that cap. So there are questions about whether a cap can or should be applied to a voluntary product and how wide its scope might be.
Even if one could be applied, there are worries about the relatively immature DC drawdown market. Pickering says: “We need a market with a number of participants where there will be innovation and competition and you’re going to staunch that with a rigid upfront cap.
“Particularly where it’s a new market… At this stage the few investing their capital in producing these sorts of products need to know that there will be a reasonable return on their capital investment.”
It is clear that more efficiencies can be achieved. But questions remain about how this would be best achieved. Experts seem to think that a 50bps cap on defaults would be damaging, although there is an argument for extending the cap at its current rate to other parts of the market.
And there are philosophical questions about caps in general. Futcher says: “In a world where you’re trying to justify that everything is good value for money, why do we need one? It doesn’t make sense.”
Or as Pickering puts it: “I’d much rather place my faith in transparency and good governance than the sledgehammer of a charge cap.”
I’d much rather place my faith in transparency and good governance”
If the government wants to lower the cap, Futcher calls for a ‘comply or explain’ approach, where trustees who want to use more expensive products can do so (as long as they are within 75bps) but have to explain how their approach will yield value for money.
However, he believes the government would do better to focus on creating a more tangible measurement of value.
He concludes: “The car market is competitive. There are cheap cars that get you from A to B, but some people prefer more luxury. We decide what value is for us: whether cost, comfort, brand or looks. Equally, in pensions we need something tangible.”
Otherwise a focus on cost rather than value could lead to cheap pension schemes breaking down en route to retirement.