David Hutchins: Why pension and investment costs should be separated

These are tough times. Even before the UK’s decision to leave the EU, the slow-growth environment had led to substantial downgrades of future investment return expectations; and Brexit will only exacerbate this trend. This new world has made it even harder to convince people to put aside enough for their retirement.

The knee-jerk reaction is simply to say either ‘Save more, retire later’, ‘Retire poorer’ or even ‘Take more risk’. Given this state of affairs, there is a strong case to say that, alongside savers, the onus should be on DC schemes to look at their systems and processes and do everything possible to secure the best outcomes, net of costs, for
savers’ investments and ensure nothing is lost via cost-of-investment inefficiencies.

An area to focus on here should be how providers deliver value for members and employ thoughtful cost-management practices to ensure that greater process efficiencies are balanced with sufficient investment allocations in pursuit of the best risk-adjusted returns.

First, we must break down overall pension costs into universally accepted administrative charges and investment elements. A single bundled charge, with little transparency on how it is spent, hardly encourages good behaviour from pension providers or buyers. By contrast, separating investment and admin costs would enable regulators, independent advisers and employer pension committees to hold providers to account and ensure a fair balance between what is spent on admin and what is spent on investment, which ultimately determines retirement outcomes for most scheme members who contribute and invest in line with the plan’s default strategy.

But we are yet to see this. As an increasing number of providers sell to plan sponsors on headline price alone, investment budgets have fallen more quickly than any other item in overall cost budgets. This effectively ensures a focus on those services most valued by the plan sponsor, to the detriment of typical plan members. Indeed, some providers are spending as little as 10 per cent of the costs they incur on investment as they rush towards the cheapest investment strategies, rather than those that will deliver the best net outcomes at a very challenging time for markets.

Some asset classes can be slightly more costly to access but, if used appropriately, can secure better diversification and, therefore, better member outcomes. Liquid alternatives are good examples. At the same time, certain pension strategies can benefit from exposure to more sophisticated risk-control mechanisms, such as currency-hedging overseas investments. These things seem obvious in the context of pension savers’ final outcomes but are ultimately impossible if the bulk of costs are spent on admin.

In the US, admin fees can be as low as single-digit basis points. There are structural differences between the UK and US markets but the US experience shows what can be achieved when admin cost efficiency, and transparency about how costs are incurred, are the key focus – instead of just overall costs.

In the UK there is a lot of divergence in how pension scheme charges break down. Instead of focusing on ‘all-in’ costs, schemes should be clear about how much is allocated to generating investment returns and how much is spent elsewhere.

Spending around 40 per cent of the pension charge on the investment-related budget is sensible and would deliver a better product mix and greater diversification, thereby allowing for better risk-adjusted returns. This could significantly improve many people’s pension outcomes.

But the focus on transparency should not stop at charges; schemes must be held accountable for their performance. A requirement to publish historical returns achieved by the default strategy, net of all costs incurred by members, is sensible and would be welcomed by members.

Annual reviews of pension schemes’ default investment strategy and the value provided for members are, therefore, a must. It is incumbent on trustees and IGCs to consider carefully if the same investment strategy could be achieved at a lower cost to members – or if better net outcomes could genuinely be achieved if members spent more.