Schiehallion from Kinloch Rannoch

I’m a big fan of the British Business Bank (BBB) which helps start-ups like AgeWage organise the money to get them up and running and helps them grow.

I’m also a fan of their idea of making workplace pension work as hard as we do, by allowing them to invest in businesses like AgeWage.

The FT reports this morning that a cap on workplace pension charges should be adjusted to unlock the potential of “significantly” higher returns for younger savers from investing in riskier start ups.

Quietroom, Ignition House and Agewage research suggests that young people would be only too pleased to see their workplace savings invested for social purpose and they’re keen to know just how their money is working for them. Recent research in the UK by Investec and in Holland by ING  suggests that people would be prepared to accept lower returns to invest for good.

So I’m comfortable  with the report’s proposal to test the current 0.75% charge cap on workplace pension defaults  to account for carried interest, if this could accomodate investment in venture capital.

But I’m not so sure that this means scrapping the 0.75% cap and giving VC managers freedom to charge what they like. Savers can have their VC within a 0.75% framework and do not need to accept the pricing structures traditionally offered by venture capitalists.

The way venture capital (VC) managers want to take their fees is on a performance basis where they take a 2% charge on money invested and then 20% of any returns above an 8% hurdle rate.

The analysis in the BBB’s report which suggests a breach of the cap is possible assumes no fee reform whatsoever on the part of the VC manager.

It suggests they will continue charging a 2% base fee and 20% of all returns above a hurdle rate of 8%. It also assumes that a controversial structure known as “catch-up” will persist. This gives the VC manager 100% of all returns above the hurdle rate until the manager has gained 20% of all the returns.

This may sound a little confusing. So by way of example:

• Gross returns 6% – manager gets 2% scheme gets 4% [below the hurdle]
• Gross returns 8% – manager gets 2%, scheme gets 6% [right on the hurdle]
• Gross returns 10% – manager gets 4% scheme gets 6% [manager has taken additional 2% to ensure they get 20% of all gross returns]
• Gross returns 12% – managers gets 4.4%, scheme get 7.6%
• And so on.

So returns need to be 13-15% before scheme even gets something comparable to target returns for listed equities, and significantly higher to get something comparable to small cap equities (which deliver higher returns, but at higher risk).

If the venture capitalists think they can simply shoe-horn their products into workplace pensions at current margins, they should know they’ll face considerable opposition from consumerists.

A better way?

As an alternative,  the report quotes the Baillie Gifford Schiehallion fund, which charges 0.75-0.85% with no catch up and no performance fee.

If the cost of running a workplace pension platform is taken to be 0.15%, then accommodating this expensive product into workplace pension defaults at the BBB recommended allocation  of 5% over a savings lifetime could be easily accomodate within the 0.75% cap with no risk of breaching the cap through performance fees.

The problem for workplace pension managers is that their current budget for investment fees is so low that even a modest 5% allocation will eat into margins to a level that might upset shareholders and the financial projections given to the FCA/tPR within the fund’s business plan. I think it unlikely that most workplace pensions could absorb this extra investment cost without pushing up headline prices

Is there scope for a “pass on” in terms of increased fees? Almost certainly yes. The fund costs of both NEST and NOW are currently 0.3%, People’s Pension offers an all-in cost of 0.5% and many of the insurers offer group personal pensions competitive with these prices , there is certainly headroom to offer defaults within the cap by putting up prices.

Is it fair that people pay more for more- on any money-worth scale the answer is yes! The BBB (which is Government backed) say in their report that

“Given the historical outperformance of VC/GE [growth equity] investments, there is significant potential for defined contribution (pension) schemes to improve outcomes for their members by investing in the asset class”

and quantify the potential upside of the proposed 5% allocation as an improvement in member outcomes of 7-12%.

But of course those 7-12% savings could easily be eroded by fees which transfer the investment risk from the VC manager to the member.

If we are to have VC in our workplace pension funds, and – like Mick McAteer, I think we should, then it is going to have to be on terms that are fair to both investment manager and member. The traditional 2 and 20 structure modelled in the report is not a structure that should have any place in a workplace pension. The simple charging structure offered by Schiehallion is much more suitable to the simplified world of workplace pensions.

So reform not only can happen – reform is happening and it is now up to workplace pension providers to manage the fees they have to absorb down and to communicate with trustees , IGCs and ultimately employers and members, why headline prices have to go up to accomodate a true increase in value for money.

There is absolutely no need to change the charge cap to accomodate a 5% allocation to VC, there is an absolute need to change the way that VC managers think about risk and margin.

Thanks for help from my friends on the pricing research in the middle of this blog. Thanks to the Scottish Highlands and Schiehallion for a lifetime of holidays!