About fund management and pension costs

This is a guide to the costs you incur when you purchase your units in a fund. At the end of the guide I explain what other costs go into the purchase of units in a workplace pension fund, and how the fund management charges are likely to be capped, in time, to reduce the risk of the workplace pension not delivering a sufficient pot of money to buy a pension.

This guide does not cover what goes on at or after retirement, nor does it cover the costs of moving your pension pot from one place to another; those are related stories which we deal with elsewhere.

The “I” in this guide is me, Henry Tapper, Founding Editor of Pension PlayPen. The guide forms part of a series we are publishing, helping people understand how to purchase and manage a workplace pension.

Introduction

When you buy and sell things, there is a generally a difference between what you get in your pocket after a sale and what you have to pay for the same thing. It doesn’t matter if it is a house from an estate agent, a stock or a share, or a penknife at a car boot sale.

We can call this difference a “spread”, a word that relates to the size of the gap between two things and, in financial terms, is shorthand for “bid-offer spread” or “bid-ask spread”.

If we go to a car boot sale, we incur two costs when we buy something: the cost of getting into the market (eg a fiver at the gate) and the mark-up the seller has put on the item. It’s the same when we’re buying and selling a house; while the fixed part of the spread ( what you are bound to lose) is the estate agent’s fee, the stamp duty and the cost of conveyancing, there is a second part of the cost which is down to negotiation.

Take the example of my grandma

My grandma bid at auction for my parents’ house in 1960, but lost to a speculator. She wanted the house so much that she contacted the speculator who agreed to sell it to her for the cost of the auction fees and £200 (then 10% of the sale price).

This totally transparent arrangement irked my grandma, but she still went ahead because she wanted the house for my parents to live in. They still live there, and now the cost of the deal seems small (it can be sensible to hold an asset for 53 years!). If we were to look at this transaction in terms of today’s financial markets, we would say that my grandma paid a 13% spread which comprised £60 in costs charged, and £200 – the market impact of the speculator’s negotiation.

I remember my grandma telling me that she negotiated her conveyancing costs to the ground, but some, like tax and auction fees, were non-negotiable. She stressed that the £200 she paid to the speculator had originally been £300, and she’d recovered well (she never forgave herself for stopping bidding).

My grandma stands in relation to the trade she made exactly as a fund manager stands in relation to the buying and selling of an asset (a share, a property, a debt or even a derivative). She was my parent’s fiduciary, meaning they entrusted her to do the deal and she used her best endeavours to do it well. That’s how it should be.

How this relates to your pension

The same factors that governed my grandma’s trade govern the success or failure of any financial trade. There are fixed costs, which are non-negotiable (essentially tax), and the rest is up for grabs.

If the manager of the trade is your mother, and she is negotiating on your behalf, you’d expect her to care a lot not to waste your money. But if the trade is on behalf of thousands of unit-holders, and there’s nobody watching or marking your perfor­mance, the incentive to get the best deal is a lot less.

In an extreme case, you might even be rewarded by the person you are trading with for not trying too hard; you might get a kickback from those you pay fees to in all kinds of ways (Wimbledon tickets spring to mind). This sort of thing has, I am afraid, gone on too long – and still goes on.

So there’s a lot of trust at stake, and this business of poor or even dodgy trading is the crack in the pipe through which much of our money (and our confidence in fund management) leaks out.

How we can manage these costs

We should know better not to rely on trust, certainly with City traders and Fund Managers. Maseratis are expensive to run.

This is why we need three things.

1. We need fund managers to understand the cost of trading, and only trade when the benefit outweighs the cost.
2. We need the trading of the manager to be executed brilliantly, with low fixed fees and minimal market impact.
3. We need an independent watchdog — a governance committee — to make sure that the trading is appropriate and that it is properly executed.

There are other things too. We need freely available information for those overseeing the trading decisions and the quality of the execution.

We need independent watchdogs — both within the fund managers and without (trustees and IGCs) — interested and informed enough to analyse the trade, and assess whether the cost of trading is justified by the value the trading brings, and whether value for money is being achieved in execution.

Controlling costs without tying the fund manager’s hands

This is not the same as saying there should be no trading. From time to time, assets have to be sold, if only to create the cash to pay people when they encash units.

Indeed a cap on transaction costs is effectively a prohibition on management styles (high-frequency trading for one) which require high levels of portfolio turnover. I personally believe that high portfolio turnover is rarely a sensible strategy for long-term investors such as pension funds, but I am not ruling them out of court either for myself or for others.

Why these costs need to be measured and when they need to be capped

However, I believe that the overall cost of trading — the fixed fees, not the market impact — is within the control of fund managers, can be measured and (in certain circumstances) should be limited. Which is why we, Pension PlayPen, have argued that these costs be controlled, measured and limited by the wider scope of a charges cap.

The circumstance I have in mind is the default fund of a Qualifying Workplace Pen­sion Scheme (QWPS), which can and should be treated as a special case, since people are using these funds largely as a result of being opted-in under auto-enrolment and therefore these funds are deserving of particular attention.

The attention paid to the default funds of QWPSs can and should be very high. Firstly, there aren’t many QWPSs to be managed and, by definition, they only have one default investment option.

Secondly, these funds are used by 80% of investors and are likely to become very large very quickly (see the numbers enrolling).

Thirdly, while those auto-enrolled are likely to be sensible folk, they will generally not be financially sophisticated. The chances that they could spot the extra cost and, therefore, the extra risk of a high-trading, high-cost fund, are slim.

Rating a fund manager’s cost controls

Unfortunately, the attention paid to these costs varies. I know fund managers that are scrupulous, and I know others who are taking the piss. If I were to name managers who are in the latter camp, I would be in trouble.

However http://www.pensionplaypen.com provides ratings for the quality of investment management from each provider, which includes an assessment of these considerations. It cannot be definitive, as we currently do not have the quality of management information available to properly assess what is going on within each fund manager. That is why we need better governance, better disclosure to fiduciaries (and consultants) and better fiduciaries (and consultants).

The system isn’t working very well at the moment; if it were, we wouldn’t need the OFT report and its recommendations, and we wouldn’t need a charge cap.

So, to sum up:

The simple analogy between my grandmother’s purchase of my parents’ house, and the fiduciary obligation of a fund manager to trade selectively and well, guides my thinking on charges. My grandma made a mistake, but she mitigated the cost of the mistake by restitution. Fund managers make mistakes; unless they are incompetent or insouciant, they do not need to be fired.

However, unless there is scrutiny of their activities by trustees who know what to look for, how to measure (ie they know what good looks like) and have a means of forcing things to be put right, there really is no way we can tell what is going on.

We know from decades, (if not centuries) of experience that, left to their own devices, the City boys will take us to the cleaners. We know that of estate agents and property speculators; we even know this to happen at car boot sales.

Top ten expenses members pay on their funds

1. The annual management fee - paid to your manager to run the fund and keep costs 1-9 down
2. Stamp duty – paid to HMRC on the buying and selling of UK shares and property
3. Commissions – paid to brokers for buying and selling assets on your behalf
4. Research paid to brokers as an extra on the commission, and charged to your fund
5. Stock lending fees – fees paid to third parties to lend your stock out for gain (reducing the value of the stock-lending)
6. Hedging costs – fees paid to third parties, typically to custodians, but sometimes to currency managers to manage currency risks
7. Waiting costs – aka “out of market”, the cost of not being invested between trades
8. With-holding taxes – typically on overseas assets (similar to stamp duty)
9. Performance fees – paid to managers for exceeding targets
10. “Other” costs – everything from the cost of custody to the travel expenses of the fund

Ten other costs that can be charged to your fund and reduce your pension.

1. Advisory commissions – paid to advisers for advising you on your contributions and investments
2. Record-keeping costs – the cost of keeping records on the units you hold, bought by your contributions
3. Insurance costs – the extra costs imposed by insurers to “wrap” funds under an insurance or reinsurance treaty
4. Wrap costs – the costs of running the insurance wrapper and creating liquidity within it
5. Employer support costs – relationship management and the provision of auto-enrolment support (HR and payroll)
6. Unit sales and purchases – normally providers hope to cross off sales with purchase of units but sometimes they have to physically buy and sell units.
7. Claims – the administration of transfers, payments on death or on retirement
8. Communications – the costs of keeping you up to date with illustrations and statements
9. Compliance – the cost of ensuring all the above is done properly
10. General overheads – what’s left over after all this has been paid for, including the provider’s margin.

Five ways in which money is taken from your pension fund

1. From the net asset value of your fund (NAV) – this is known as an implicit charge, as you don’t see it explicitly but it reduces performance and thus your pension.
2. Through the Annual Management Charge (AMC) – that part of the Total Expense Ratio (TER) retained by the fund manager to cover its costs (paying staff, hiring premises. 
3. Through Additional Expenses(AE) – these are charged to NAV but may be linked to the AMC in which case AMC +AE =TER
4. Through a charge on contributions – NEST makes an explicit charge of 1.8% of the amount you contribute to repay a loan to the DWP taken out on behalf of the policy­holders. As far as we know, NEST are unique in this.
5. Through a pounds shilling and pence periodic deduction of units from the fund – NOW: Pensions do this.

These are the five charges that we know about, that directly impact on the amount a member gets in retirement.

There are other costs that impact on members indirectly: typically the costs to em­ployers in creating and maintaining systems to manage auto-enrolment and comply with regulations, the cost of selecting a provider, and the ongoing monitoring of the provider’s performance.

These costs can best be thought of as limiting the employer’s capacity to pay higher contributions into the workplace pension.

On some occasions, these costs are born within the AMC, though this practice is frowned upon.