This is a guide to the costs you incur when you purchase your units in a fund; at the end of this 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 suffecient 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 is Henry Tapper, Founding Editor of the Pension Play Pen and this forms part of a series of guides we are publishing, helping people understand how to purchase and manage a workplace pension.
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 pen-knife 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 short hand for “bid-offer spread” or “bid-ask spread”.
If we go to a car-boot, we incur two costs when we buy, the cost of getting into the market (a fiver at the gate) and the mark-up of the person we are buying from
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 fee, the stamp duty and the cost of conveyancing, there is a second part of the cost which is down to negotiation.
A story to make this easier to understand
I’ll give you an example. My Grandma bid for my parent’s house in 1960 and lost it at auction 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 wanted to go ahead because she wanted the house for my parents to live in. They still do 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 which was 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 , 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 governed my Grandma’s trade as 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 not to try too hard, you might get a kickback from those you pay fees to in all kinds of ways (Wimbledon tickets spring to mind). This I am afraid has 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 with Fund Managers. Maseratis are expensive to run.
Which is why we need three things
- We need fund managers to understand the cost of trading and only trade when the benefit outweighs the cost.
- We need the trading of the manager to be executed brilliantly, low fixed fees, minimal market impact.
- We need an independent watchdog, a governance committee, to make sure that trading is appropriate and that it is properly executed.
There are other things too – we need freely available information to 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 MI 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 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 which can and should be treated as a special case, the circumstance by which people use these funds being largely that they are being opted-in under auto-enrolment and are therefore deserving of particular attention.
The attention paid to the defaults of QWPS can and should be very high.
Firstly, there aren’t many QWPS 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 and the chances that they could spot the extra cost and therefore extra risk of a high trading, high cost fund are slim.
Rating 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 was to name managers who are in the latter camp, I would be in trouble.
However www.pensionplaypen.com provides ratings for the quality of investment management from each provider which includes an assessment of these things. 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 was, we wouldn’t need the OFT report and its recommendations and we wouldn’t need a charge cap.
So to sum up;-
This simple analogy between my Grandmother’s purchase of my parent’s 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 (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
- The annual management fee – paid to your manager to run the fund and keep costs 1-9 down
- Stamp duty – paid to HMRC on the buying and selling of UK shares and property
- Comissions – paid to brokers for buying and selling assets on your behalf
- Research paid to brokers as an extra on the commission and charged to your fund
- Stock lending fees – fees paid to third parties to lend your stock out for gain (reducing the value of the stock-lending)
- Hedging costs – fees paid to third parties – typically custodians but sometimes currency managers to manage currency risks
- Waiting costs – aka “out of market” , the cost of not being invested between trades
- With-holding taxes – typically on overseas assets (similar to stamp duty)
- Performance fees – paid to managers for exceeding targets
- “other” costs – everything from custody to the travel expenses of the fund managers
And in case you’re not aware, ten other costs that can be charged to your fund and reduce your pension.
- Advisory commissions – paid to advisers for advising you on your contributions and investments
- Record keeping costs – the cost of keeping records on the units you hold bought by your contributions
- Insurance costs – the extra costs imposed by insurers to “wrap” funds under an insurance or reinsurance treaty
- Wrap costs – the costs of running the insurance wrapper and creating liquidity within it
- Employer support costs – relationship management and provision of auto-enrolment support (HR and payroll)
- 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.
- Claims; the administration of transfers, payments on death or on retirement
- Communications; the costs of keeping you up to date with illustrations and statements
- Compliance; the cost of ensuring all the above is done properly
- General overhead what’s left over after all this has been paid for – including the provider’s margin.
Finally, here are the five ways in which money is taken from your pension fund
- 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.
- Through the Annual Management Charge AMC- that part of the Total Expense Ratio retained by the fund manager to cover its costs (paying staff, hiring premises, computers etc)
- Through Additional Expenses(AE); these are charged to NAV but may be linked to the AMC in which case AMC +AE =TER
- Through a charge on contributions; NEST make an explicit charge of 1.8% of the amount you contribute to repay a loan to the DWP taken out on policyholder’s behalves. As far as we know NEST are unique in this.
- Through a pounds shilling and pence periodic deduction of units from the fund ; NOW pensions do this.
These are the five charges (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 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.