Should we measure pension fees as “risk”?


We use a very simple modeller at First Actuarial which shows the corrosion of your pension by fees over time. One axis of the graph shows the fees you pay expressed as a percentage of the fund, the other shows the time you pay them for. Plot one against another , you get a number, that’s the amount the fees you pay have eaten into the pension you get. (we use standards SMPI assumptions).

We’re not that interested who benefits from the fees , we are interested in what web people call the UX – user experience. The user in this case being a member of a workplace savings scheme (formerly known as beneficiary or member).

UX-good …Big pension

UX-bad ….Small pension

And as every fool knoweth, the total cost of the user’s experience of a  pension plan includes the operating costs of the platform manager (AMC), the additional fund expenses of the fund manager (AFE) ,the portfolio management costs of running the fund (PMC) and the cost of advice – the consultancy charge (CC). If the cost of advice is picked up by the employer, we can consider this to be in lieu of contributions and convert it to a Consultancy Charge.

So the formula to calculate the annual cost of the UX is

AMC+ AFE + PMC +CC =”what the member pays” or Total Charge.

Now as Professor David Blake of Cass tells us, the impact of this Total Charge is normally larger than the positive impact of skilled asset management (the value add or alpha). To test this, he has built a model which is the pensions equivalent of the Hadron Collider. (I am promised a visit to Cass Towers where no doubt I will be led into a germ free room in a white suit).

If charges present such a great risk to your eventual pension, I am surprised that an industry obsessed by risk management has not come up with a measure to assess this risk. I won’t bitch about conflicts of interest – only to say there’s an element of “turkeys not voting for Christmas” here.  The issue is that to measure risk against return on the entire User Experience, you need to be clear about definitions.

Some will argue that the value of a smoothed investment strategy is not just in its absolute return but in the peace of mind it gives to the member during the accumulation phase.

I say that’s bunkum. Our model defines return as the money that is given to the member at the end of accumulation to buy a pension (one day we’ll do it on the amount of pension but we aren’t there yet),

So a proper risk measure for fees might be the total cost of the UX (fees) set against the total value of the UX (money to purchase pension)

The total cost has to be measure against a risk-free cost, which I reckon to be 0%. How can you manage the UX for nothing? Well because of a positive thing you can sometimes do with funds of sufficient size and stability – stock lending. Stock lending might reduce the total cost of the UX to nothing through an offset of revenues generated v costs incurred. I suspect that some members of DC plans whose total charge is around 0.1% AMC (BT and Logica GPP members) might be close to such a “risk free fee”, especially if their passive manager is fully rebating stock-lending revenues.

Any fees incurred above the risk free level represent additional risk and need to be justified. To  use the jargon of the age “they need to be wanted risk”. An example of wanted risk might be the cost of buying more stock for the fund. An example of unwanted risk would be higher than normal commission paid to brokers to pay for access to CEOs or Twickenham tickets.

The parable of the talents applies here, burying your money under ground (or under the mattress) is risk-free but valueless. The measure compares the risk taken against the reward earned. The servant who invested actively (rather than burying his talent) was able to please his master through the growth of the money he had been given, the servant who buried the money under ground got a good kicking.

Paradoxically, there are people who claim to make their money from doing very little, the most obvious are the passive managers who just watch the computers whirr and make sure the execution of what they do is as low-cost as it can be. A step up from them are the fundamental managers- most famously Warren Buffet.

Buffet spends his time being sage and only acts when he have a deep conviction hs idea is good.

Another example is Terry Smith of Fundsmith, the sage of Cavendish Square. Terry’s proudest boast is that he has nothing to report, this means his strategy is working and he has not had to tinker. Terry has had great success doing very little (but considering an awful lot) and despite not selling a single stock in 2012, he became the world’s top performing global equity manager.

And  the sage of the  Pension Play PenDavid Hargreaves– is of this camp. He advocates a random approach to investment which dispenses with funds and allocates cash to equities without any form of intermediation (I take issue with the efficiency of the approach as it can never capture economies of scale but I get his direction of travel)

So at one end of the spectrum of fee-risk, we have the passive managers who do very little and charge next to nothing, at the other end you have managers who buy and sell like there’s no tomorrow (which for them there usually isn’t). In our view, the high turnover approach is doubly expensive as high turnover managers pay less attention to best execution so in terms of fees they take on huge amounts of unwanted risk and would have a very poor fee to return ratio. In fact their fees could be higher than their returns making them a very risky prospect for investors!

Take the argument a stage on and start looking at the other costs- the AMC which pays for the expenses of the platform manager (the insurer usually though you have to look at other platform providers like NEST and NOW and Hargreaves Lansdowne. Do the additional costs they incur and pass on to members, generate extra return?

It’s harder to measure the value of the platform though there must be value to the UX or people wouldn’t use the platforms – go on Hargreaves Lansdowne or NEST’s or NOW’s websites to work out what the value is to you.

I would say it’s marketing value and not properly part of my return formulation but I’m prepared to be swayed by an argument that the accessibility of the platform makes savings more comfortable and encourages good behaviours that result in higher contributions and higher pensions…though this is tenuous.

There are many risk adjusted returns we can use to better measure the performance of managers, but none that focusses on the measure of risk as “fees incurred”. If, as I suspect and David Blake suspects, it is the managers who are delivering the most for the least who are providing the best pension outcomes, then we should be adopting such a risk measure.

This is simple measure which makes such fundamental sense that any fool can grasp it. It is so obvious that I wonder why we haven’t thought of it before and no doubt many who have read this far, will be questioning whether I am a total buffoon.

I’d hope that I can point to the Warren Buffets and Terry Smiths and the David Hargreaves as my teachers!

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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3 Responses to Should we measure pension fees as “risk”?

  1. The answer to your headline is “Certainly!”.

    The biggest likely risk in DC is shortfall risk – that we just don’t put enough money into the plan to start with, and the projections that we are provided aren’t particularly transparent. Take a 5% return, for instance (that used to be the FSA’s low-end number and will now be the mid-range number for projections). How credible is that as a figure for long-term fund returns on a gross basis? Now knock off 1% per year in fees – how credible now?

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