Actively seeking alpha

Active management is under pressure in the price-capped world. But with institutional scale it can be brought into defaults, finds Emma Wall

The pensions industry has less than a year to get its act together and limbo dance under the 0.75 per cent charge cap. After much to-ing and fro-ing the charge cap is now non-negotiable, sewn into a steadfast future timeline by political affiliations and market expectation.

The April 2015 deadline places the introduction of the pensions cap at a month before the general election. Much like the annuity-scrapping pensions reforms announced by George Osborne in March’s Budget, the political cost of having to push back the cap again, is just not an option.

And so now comes the crunch – DC pension providers fed by auto-enrolment now have to overhaul their offering to comply with the target set by Liberal Democrat pensions minister Steve Webb and his Department of Work & Pensions colleagues.

When the charge cap was first announced last autumn many said that it would mean the death knell for active management within pension portfolios. Without the cash to pay for alpha, retirement savers could kiss goodbye to the likes of funds from Neil Woodford and Richard Buxton in their pension portfolios. Smart beta may prove an increasingly popular to strategic capture some active-management-like returns on a budget, but it’s hard to mimic the real deal.

Aon Hewitt consultant John Foster says fund selection will be highly dependent on the headroom available within the 0.75 per cent for additional charges for active management.

“For example in a bundled arrangement where the member borne charges include the cost of providing the administration and customer services there will be less scope for this than within an arrangement that only passes on the investment management and fund platform charges to  members,” he explains.

As well as the ‘what’ of measuring charges, the ‘when’ will make a difference to investment flexibility too.

“At what level the charge cap bites, and over what time period it is measured, is going to be a big determinant in answering this question, as is the fund management industry’s response if they want to retain and grow their share of the market for DC default fund assets that are set to grow significantly over the next few years,” Foster adds.

Standard Life head of workplace strategy Jamie Jenkins highlights that economies of scale will play a role in the accessibility of low-cost active management.

He said that the ability to access such solutions may become more restricted for the smallest firms in future, especially in the event that there is further legislative pressure on charges from Government. This in turn may well be to the detriment of members within those schemes.

Mark Poulson, of consultancy The Lang Cat, blames the active management industry for pricing smaller firms out, and it was within their power to facilitate them.

“Pension funds have long been able to buy active management at 0.15 per cent or less on an institutional basis. It is purely a commercial decision for active managers about whether they would like a huge chunk of asset at a lower margin, or not,” he said.

“They could charge 0.3 per cent and still leave 0.45 per cent for admin, which across a book should be plenty. Costs in active fund management need driven down, and this might be a way to do this.”

A number of schemes already comply with the charge cap, and manage to incorporate actively managed funds into the mix.

A number of elements within Nest’s default investment portfolios are actively managed, including UK corporate bonds, money market investments and of course direct real estate investments. Standard Life is quick to point out their default solutions are actively managed and under the threshold too.

There is speculation that the 0.75 per cent cap is just the first stage in a line of staggered reductions.

“As DC assets grow, there will be a drive to reduce costs further, but I believe that will be seen through the market driving costs down rather than as a result of further regulation,” says Barclays Corporate & Employer Solutions head of investment consulting Lydia Fearn.

Foster says that future-proofing pension funds is a higher priority to trustees than charges, as the increased choice for individuals at retirement now that annuities are no longer compulsory purchases require greater investment flexibility.

He continues: “The question then becomes what is the best price at which this is available through appropriate passively or actively managed options. The impact and consideration of charging levels and the value for money these represent, are intrinsic to this approach rather than being the driver of change.”

Mercer’s Gail Philippart agrees that although the cap might restrict access to more sophisticated funds being developed now and in the future, the recent scrapping of annuities places extra pressure outcomes, which is supportive of active management and diversification within pension funds.

Of course the perverse fact of the charge cap is that the restrictions do not apply to all schemes – not to defined benefit schemes, not to legacy schemes, not even to new non-default portfolios.

Currently more than 90 per cent of those auto-enrolled are sitting in the default fund. But if the charge cap does have a detrimental effect on performance, because trustees are forced to prioritise price, the industry could see a backlash of savvy scheme members switching out of the default funds.

Nest chief investment officer Mark Fawcett is less sceptical. He believes default funds are, and will remain, by far and away the most important part of any qualifying automatic enrolment scheme’s design.

“We would not anticipate that the charge cap should see any significant migration of savers from default funds primarily because we do not believe that the charge cap should materially hinder a default fund’s capacity to deliver good outcomes – be it through pure index investing or blending active and passive such as is done in the Nest Retirement Date Funds,” he says.

Others disagree. Jenkins says that he expects there will be some migration, but this will simply be a symptom of the industry maturing and members becoming more engaged with their financial future.

“We anticipate members will start to make more active decisions of their own – over time – as they become more engaged with their savings. The popularity of the recent Budget announcements and the growing level of pension funds are both good reasons for this increased interest,” he says.

Philippart adds investors will choose how they save in retirement based on when they want to spend those savings and how they wish to access it.

“The critical importance of trying to get members to select a path so that the investment strategy will match that destination will likely result in fewer members investing in the default,” she says.

Fearn thinks it wouldn’t hurt to use the charge cap as a catalyst to streamline the choices available to members.

“I think that clearer designed strategies will need to be made available and communicated to members so that they can make informed choices,” she says.

“These strategies will need to be governed and communicated to the members to choose as they wish. It will become more important for members to engage and select the right investment strategy for them given the flexibility around taking their pension savings at retirement age.”

There is Another Way

Lest we forget the latest twist in the tale now the pensions industry and retirement savers are being told, like those NatWest ads of old; there is another way.

Collective Defined Contribution schemes – or CDC – were deemed important enough for the monarch to drop into her recent Queen’s Speech, but remain intangible enough that no one outside of the pensions industry knows what they are. And they may not have to comply with the charge cap.

The purpose of the CDC is to provide greater certainty of the members’ outcomes, and therefore Fearn says that even if they do not fall under the charge cap, management fees will need to be reviewed and monitored as these have a direct impact on future outcomes.

If the schemes become large enough however, the pooling inherent in CDC will mean they can purchase on a segregated mandate basis, just like big DB schemes.

Poulson highlights that this will drive better deals, and mean that active management may become more affordable.  Although there’s no charge cap for now, common sense would suggest CDC schemes should try to operate at or below the cap.

“CDC needs careful managing in terms of investment strategy on an ongoing basis; this may enhance a scheme’s ability to actually spend the time required in picking active managers on either return-seeking assets or matching assets,” says Poulson.

Active management in the dock 

Retail investors who opt for active management are getting a poor deal, according to new research from the Pensions Institute, which found almost all active fund managers fail to outperform the market once fees are extracted from returns.

Ninety-nine per cent of all equity mutual fund managers are unable to deliver outperformance from stock selection or market timing, according to a 10-year study by the Pensions Institute at Cass Business School.

The study, which examined the monthly returns of 516 UK domestic unit trusts and OIECS between 1998 and 2008, revealed an average annual post-fee alpha return of minus 1.44 per cent. The report argues that just 1 per cent of fund managers are ‘stars’ who are able to generate superior performance in excess of their operating and trading costs.

The Pensions Institute also found fund size has a strong negative effect on the average fund manager’s benchmark-adjusted performance. Academics found that a 1 per cent increase in funds under management led to a nine basis point drop in alpha per year. 

The paper argues large funds tend to underperform small funds because funds which attract inflows scale up their existing investment, driving up asset prices and pushing down yields. 

Pensions Institute director Professor David Blake says “This suggests that a typical investor would be almost 1.44 per cent a year better off by switching to a low-cost passive UK equity tracker.”