General remarks about “tinkering” with the charge cap

A good place to start one’s thinking on charges caps is by asking “what is being capped and why?”. Not all costs and charges are capped by the 2015 cap.

Costs that are outside the cap include transaction costs, property holding and maintenance costs and their impact. These costs are not quoted in AMCs and impact performance. They are hidden but their impact can be detected in tracking error, the difference between market performance and the actual performance of a fund passively tracking the market.

The reason quoted by Government in 2015 for excluding these costs is that they are not part of the rents of the asset or fund manager but may also have been because there was (at that time) no standard way of measuring these costs. It was expected that in time, the cap might include transaction costs and even their impact, but the funds lobby has successfully argued that this might restrict managers from executing strategies and paralyse the market so that only passive funds are used in defaults. Ironically this is largely what has happened in the intervening five years.

The argument of the DWP’s consolidation consultation is that allowing performance fees to be excluded from the charge cap would increase the range of investments in defaults which would improve member outcomes. In practice it is simply accepting the funds lobby’s argument that some fund managers won’t bother marketing their services to the funders of workplace pensions because they can achieve better margins elsewhere.

This argument doesn’t compute if you follow the logic of the paragraphs above. There is no more reason to suppose funders will include hedge funds in defaults than they have been to include active management over the past five years. So long as the funders of workplace pensions are competing on price (which they still are), then the market will keep AMCs down, not the price cap. The price cap might be 2% pa and there would be little impact on prices paid by consumers.

So the arguments for including or excluding performance fees in the cap are largely academic, until buyers start buying on “value” rather than “money”, there is no reason to see funders including illiquids in their defaults. However we are seeing illiquids in defaults and the recent introduction of allocations into the Nest and Smart workplace defaults suggests that illiquids can be marketed at a price that leaves the funder sufficient margin. It could be argued that two swallows do not make a summer but the allocations are serious (around 8% of Smart’s assets), suggesting these are more than PR.

Why then are we needing to relax the charge cap to accommodate hedge fund managers’ , private equity funds and other illiquid investments? The answer is the same as for why transaction charges were left out of the 2015 cap – to appease the fund management industry. I suspect that very few default funds will breach the cap. This is mainly because allocations to illiquids will be unlikely to be more than 20% of the fund and also because it is neither in the funder or trustee’s interest to give the fund managers any rope.

Advised pensions aren’t fee sensitive.

In other parts of the DC pension market, prices of 2% pa are commonplace but this is discretionary spend. The wealth management industry loads consumers with fund fees, platform fees and advisory fees which can exceed 3% pa. Wealth managers have learned to sell on value not price and consumers show remarkable fee-tolerance when they consider value is being delivered (SJP have excellent customer ratings).

Non-advised pensions are fee sensitive.

But workplace pensions are not about discretionary spend, consumers are defaulted into them and rarely choose what fund to invest into.  They do not alone make choices on value for money. So trustees are mindful to protect members (and their own reputations) by erring on the side of caution. The bias towards putting money before value where advice is in short supply is very evident in MaPS investment pathway comparison service where the only variant advertised is price.

Relaxing the charge cap challenges the bias towards caution.

I have argued that the charge cap is unlikely to be breached by performance fees but that taking performance fees out of the cap will encourage illiquid funds to compete for allocations to defaults.

I have argued that lifting the cap in this way will encourage trustees and funders to include allocations to these assets.

The consolidation of assets into a few large schemes will mean that the allocations will be more meaningful (to hedge fund managers) and will make for better purchasing by funders and better oversite from trustees.

In the context of deep consolidation, the prospect of a serious and sustained shift into illiquids looks likely. There is an argument that in a consolidated market, there is no need for a charge cap at all.

The positioning of the relaxation is important if it is not to devalue the cap. For most DC schemes, the opportunity to incorporate illiquids is aspirational and the payment of such fees in excess of the cap is aspirational for all parties. In theory it would only happen if a serious amount of value had been created, but this brings us to the vexed question of valuations.

Performance fees must be paid against true value.

Valuations of illiquids are fraught and the payment of performance fees on uncertain valuations will be a source of concern to funders, trustees and even members (when things go wrong).

To quote John Kay in a recent article in Prospect Magazine, “At private equity’s too-frequent worst, existing businesses are acquired with the aid of mountains of too-cheap tax-favoured debt, assets are sold and short-term profits are enhanced at the expense of the long-term health of the business”

Kay compares such bad behaviour with the capacity of private equity to search out and provide stewardship to be the “right path to the broader future”.

Ludovic Phalippou’s recent criticisms of the private equity market moves from questions of value to details of valuations. The ad hominem attacks on him by firms such as Hamilton Lane suggests that there is more to Phalippou’s criticisms than private equity will admit.

For private equity and other forms of illiquid capital to justify the faith put in them through this intervention ,they must demonstrate greater transparency in their dealings than hereto now.

The role of trustees and funders in purchasing fund management of illiquids is critical and I agree with Hymans Robertson’s statement in their submission to the charge cap consultation.

In terms of the level of charges, this is heavily influenced by scale. With relatively small proportions of assets allocated to illiquid investments, it is mainly larger schemes that have sufficient scale to access illiquids.

Thankfully, this message is written like a watermark through the consolidation consultation.