Corporate Adviser/Standard Life round table - Is there such a thing as the perfect default?
The charges issue looks set to dominate the shaping of auto-enrolment default funds in ways that will not necessarily always work in the member’s favour. Gregor Watt reports
The issue of charges is never far from the surface in financial services and pension scheme default funds are no exception. The last 12 months have seen politicians, trade bodies, investment managers, academics and consumer groups take it in turns to put their tuppence worth into the debate about what level of charges is acceptable for pension savers.
With the Government’s auto-enrolment programme nudging millions of members of the public into pensions without a wet signature, the impact of charges on default funds is taking on an added urgency.
If the typical experience of defined contribution schemes holds true for auto-enrolment then at least eight out of 10 pension scheme members will end up in their scheme’s default investment option – this could mean around 7 million people will end up in an investment fund they have not specifically chosen.
To address concerns over the issue, in January the Government commissioned a review by the Office of Fair Trading into the value for money offered by defined contribution pension schemes, including reviewing whether a charge cap needs to be introduced.
The effect such a charge cap would have on default funds was one of the key issues tackled in a roundtable discussion Is there such a thing as the perfect default fund? hosted by Corporate Adviser last month.
The OFT is due to complete its investigation by the end of the summer but it may take several months before it publishes its final report. Its initial progress report published in early July suggested that transparency of charging and well as the levels of scheme charges are very much on the agenda.
Standard Life head of workplace strategy Jamie Jenkins said: “The real question that the people charged with the decision will wrestle with is ‘what is the charge cap trying to achieve?’”
Jenkins suggested there are two main arguments in favour of a charge cap. First is that a cap is needed to prevent people being auto-enrolled into schemes with outdated and excessively high charging structures. The second argument is that the industry is fundamentally not competitive and that a charge cap is needed to force the industry to act in pension savers’ interests.
“Those are the two camps; do you try to catch the outliers with the cap or do you try and fundamentally change the way that pricing works in the industry?”
Jenkins argued that competition has meant that charges have come down significantly so large scale interference in the market is widely thought to be unnecessary.
“Charges have demonstrably come down a lot in the last 10 to 15 years and continue to do so through the function of competition,” said Jenkins.
In addition to the level of charges, the OFT is also looking at the complexity and transparency of charges and Mazars chief investment officer David Baker said the industry hasn’t always helped itself when it comes to the way charges are levied.
“Competition should be sufficient to drive down prices but only if you have transparency and very clearly comparable charges so you can make an informed decision. The industry has been very guilty over many years of useless innovation which is there to try and demonstrate difference in a product which is in fact hiding away a high level of charge, so more transparency and a very clear AMC which can be displayed would be sufficient to drive down costs.”
Baker said if the authorities do decide to introduce a charge cap it could have an impact on the choice of provider currently available to smaller schemes and he suggests the regulators may have to introduce an obligation on providers to continue to service these schemes.
“If you do have a charge cap one of the consequences is smaller schemes will probably suffer in terms of who they go to. We are seeing it at the moment that insurers are cherry-picking which schemes they want to take. It is a commercial decision, it is entirely sensible given what is happening with auto-enrolment timescales. Obviously there is Nest to pick up those small employers but in order to give smaller schemes a choice then there should be some sort of obligation.”
The introduction of a charge cap could also have an impact on the level of service offered to pension schemes.
Standard Life head of investment solutions Jenny Holt said providers currently offer a range of services to employers, including administration and governance in addition to investment management, and reducing the maximum permitted charge could see this restricted.
“You have to bear in mind what you are paying for and who is doing what.
“For a cheaper option, you may find that cost is only covering the investment management charge but there is still the responsibility to carry out that investment governance function and that has then got to fall back on somebody. If the provider is not doing it, it falls back on the employer and their adviser to have to do it.”
Barclays Corporate and Employer Solutions investment consultant Lydia Fearn said she has also experienced difficulties getting providers to quote for business and said it often proves hard to come up with a workable comparison.
“Comparing like for like isn’t always that easy. You try to get providers to give the same transparency but you slice it through and you have to ask ‘what am I paying for here and how can I compare and how can I see how competitive it is?’” said Fearn.
Another issue with a potential charge cap is the potential to limit investment choices.
Fearn said a drive to keep overall charges low was driving a trend for greater adoption of passive funds as employers are scared to choosing active investment management for fear of driving up costs.
Buck Consultants senior investment consultant Simon Hill said the increase in the use of passive investments, partly driven by companies seeking to keep down costs, could be contributing to some of the problems in capital markets raised by professor John Kay in his recent analysis of the UK equity markets carried out for the Government. Without active fund managers seeking alpha, share valuations could become less accurate, meaning the market does not necessarily supply capital to the most efficient and profitable companies.
“I have real concern that capital markets have not been functioning well for some time and I think that is one of the reasons our economy is finding it so difficult to recover from recession. Whether this is a consequence of the huge push into passive management, particularly over the last 5 years as DC funds have been growing, I don’t know yet and neither does any other economist, but it is possible.
“Kay wrote about this and I think we will see more discussion around this in the next few years, about whether things we are doing to help save us, we think, may end up causing a bigger problem. Because at the end of the day if the economy isn’t functioning well because of those things you changed, then it is in nobody’s interest.”
Any focus on scheme costs also raises the question of whether master trusts will gain traction because of the potential cost savings they can offer smaller employers.
Hill said: “Some consolidation and some sharing of costs burdens clearly makes sense.”
But he warned that an emphasis on size for the sake of it is not healthy and said it is perfectly possible for smaller schemes to offer low charges by offering lower levels of service.
“I’ve never been a great fan of academic linear projections of cost against scale. It doesn’t always work in practice. As long as we have plural solutions, so lots of options, then that is a good thing.”
But even before the OFT has released its report, there is a consensus that Nest’s adoption of something broadly equivalent to a 0.5 per cent AMC – even though the 1.8 per cent contribution charge means older workers will pay more – is leading to this level of charge being seen as the industry standard.
Jenkins said: “Benchmarks tend to drive industries in terms of what people think is reasonable.
“If you go back to stakeholder, people say stakeholder was a failure. As a product or as a policy, perhaps, but as a benchmark for what charges should be it was very successful.
It was not as if everyone went into stakeholders under 1 per cent but they generally went into schemes under 1 per cent, as that was perceived to be the new norm. If we say that Nest is tending towards 0.5 per cent or indeed other providers are now tending towards 0.5 per cent, as the benchmark, the kind of Mars bar price, then the market will adjust for that, as people will not buy it for 4 per cent or £4 for a Mars bar.”
The charges on pensions story still has a long way to run, not least because of the lack of clarity on charges in the investments underlying the funds themselves. But the high profile the charges issue has achieved in the media means more expensive solutions will only be put in place where a clear value proposition has been put forward. n