This is a long and involved blog but it deals with an important subject in a timely way.
One of the perceived unfairness’s of DC rather than DB pensions is that DB pensioners have all costs paid by the scheme while DC savers bear their own charges.
This leads to people moaning that the people in front of them are getting too big a slice of the cake.
It’s not quite as simple as that, but that’s how it seems and perhaps in guilty recognition that this is unfair, employers do their best to redress members focusing on reducing member born DC charges.
The employer’s narrative is a lot easier if it has cut the member’s annual management charge in half. I have been to job interviews where the employer explained the pension by the charge I would pay. Most workplace pensions offer a single-charge AMC which makes comparisons easy and intuitive. Employers benchmark charges because they can be easily compared, they don’t benchmark value because they don’t know how to compare it.
I suspect this is why we have created the unofficial VFM measure out of costs and charges.
This explains why complexities such as trading and transaction costs (which aren’t included in the AMC) have become such a feature of IGC and Trustee chair reports. We are obsessed by costs and charges not by member outcomes nor by the quality of services they pay for.
The DWP, FCA and TPR has woken up to what really matters. It’s not bosses willy-waggling about how low their pension’s charges are. What matters is how big member’s pots are, compared with the amounts paid into those pots. Of course, charges are an important limiter on the size of people’s pots but where member returns are high, the cost of achieving them should not diminish the fact that the scheme has done well. It could be argued that provides that do not spend heavily on investment management are creating a false economy or even ripping their savers off.
Put another way, you can have high charges and high value for money, though it is a lot harder to do than most people think. You need real expertise and a lot of money to get value from private markets, which is why most workplace pensions still invest for the most part in funds that track the major quoted markets.
One of the objectives of this phase of the value for money assessment is to improve the diversification of investments in accumulation, that means allocating resource to investment (not a race to the bottom on charges).
All this should be motherhood and apple pie, but it still needs to be said.
Knowing what you pay for = transparency
If you run a pension fund, you have three buckets of cost.
- Money you pay to manage savers’ money – the investment bucket
- Money you pay to provide savers with services – from record keeping to claims
- Money you keep back to pay for the overhead of the organization (and perhaps profits)
There is currently too little transparency. This information isn’t properly published. Where providers split the services and investment elements of an AMC (as L&G do) we can’t tell if what we pay as an investment charge is what L&G pays its managers under its investment management agreements (including to its in-house manager – LGIM) . Disclosures are usually muddied by apportionment of overhead and profit (3) to investment (1) and services buckets. (2)
The problem starts with the investment bucket. The Investment Management Agreement (IMA) between the pension provider and the fund manager is often a secret protected by a non-disclosure agreement typically ensuring the “favored nation status” offered by the terms (keep quiet or we’ll have to give your terms to everyone). Hilariously, everyone seems to get favored nation status no matter how much they pay!
Even if there isn’t an NDA, providers don’t like to admit to how small a slice of the pie goes on investment.
Because savers, employers and sometimes even trustees don’t know what the provider is paying for investment management, they can’t work out what they are paying to provide services and to meet the overhead. To understand VFM we need more transparency about who pays what.
Most employers would be surprised and a little worried by how little of the AMC is paid to investment managers under the IMA. Experts too are worried because they are suspicious of unfair practices, that go on behind closed doors.
Because of the secrecy, there are suspicions that providers are getting kickbacks from savers funds which subsidize these costs, these kickbacks can involve “stock-lending” where the AMC is reduced in exchange for the agreement allowing member’s stock to be lent to others – a kind of secondary banking.
Another technique of manipulating the cost directly charged to the provider is to charge expenses incurred by fund managers to the fund and not to the AMC. I have seen instances of the travel expenses paid by fund managers charged to the fund -and the IMA allowing this. Of course this means the saver is paying twice, through the AMC and through lower fund performance.
The FCA is wise to this stuff and through its work on transparency , led by Chris Sier, has found ways to disclose all costs so that trustees can see what the scheme is really paying. In DC – where savers typically bear all costs, the regulator is keen they don’t pay twice.
It’s the job of trustees and IGCs to protect savers against being ripped off by poorly drafted IMAs or agreements that put the consumer second. The Consumer Duty has a part to play here.
Transparency is the best disinfectant and things are improving, but there are still many investment costs not in the AMC – especially the costs created by investment administration. Thankfully, we are about to have a value for money framework that can nail this so the DC saver is treated more fairly.
Should costs be included as a test for the Value for Money assessment?
The answer is yes, but to inform the tests that matter to savers, the value they get from their pot and the value they get from the quality of services provided them. The cost test is not a test of VFM , it is the test that allows value for money to be established and understood.
Let me explain.
Let’s say that a workplace pension charges an AMC of 0.5% (50 bps).
By looking hard at the IMA (s) for the default fund , the trustees or IGCs have verified that 0.1% (10bps) is being spent on investments. That means the saver is spending 40 bps each year on services and to cover the provider’s overhead (and profit).
Another workplace pension is also charging 50 bps but here there is 20 bps going on investments and 30 bps is being kept for services and overhead.
The lower the investment cost , the more should be expected from services. The DWP is working on a way to measure the quality of services in an objective way. If it can do so, it can compare this measure with the cost of delivering it and give a “value for money services test” which says that savers are or aren’t getting value from the balance of the charge via a traffic light system with red saying no, green saying yes and amber saying maybe.
IMAs which are subsidized by costs being charged to the funds will see the returns on those funds lowered . This might lead to a provider failing the performance test of the VFM framework. It might also lead to employers losing confidence in a provider and seeking alternatives. Greater accountability will drive competition.
Subsidies – where the AMC is subsidized by combination charge (to the saver)
AMCs which are reduced by providers levying combination charges (a monthly fund deduction for administration or a deduction from the contributions – which Nest does to pay a DWP loan) can account for the revenues from these charges as additional AMC and this can be compared with the value of services offered to test quality of service.
For instance a monthly management charge can be ignored as a unit deduction as it will impact return on the eventual outcome* . Deductions from contributions can be added back into the contribution and used to calculate true member returns (which are the lower as a result)
* Internal rates of return treat all unit deductions as claims (partial transfers) which impact the outcome (net asset value). They are accounted for but ignored.
Subsidies – where the AMC is subsidized by the employer picking up costs.
Where the AMC is subsidized by an employer picking up the cost of the IMA and/or the services offered to savers then this should be declared as an “employee benefit”.
It is effectively an additional contribution to the scheme but will be accounted for as an improvement of the scheme’s Value for Money. Other enhancements include the payment for a trustee board, of a scheme executive and the employer paying the trustee’s legal and accounting bills. All of these subsidies are to the value of saver’s money but it is a business decision whether or not to continue that subsidy.
Making the subsidy overt is in the employer’s interests and it is in the saver’s interests to know these subsidies exist, especially if the saver is considering transferring away from a scheme where they are still receiving these subsidies.
These employer subsidies can improve the VFM of services and the VFM of investments but they don’t mean that a subsidized scheme is giving VFM. Where a scheme is subsidized and does not pass the VFM tests, then employers should think seriously about the viability of running their own scheme.
Should costs and charges publicize a RAG rating?
I think the answer is that the test for costs and charges should be carried out and should be publicized but not as a RAG rating. A RAG (red amber green) rating here implies that a scheme could be “failed” for having the wrong level of costs and charges. Other than not complying with a charge cap, there should be no right or wrong charge, right or wrong appears in the VFM of saver outcomes (performances) and the quality of services received.
But we can see from the above, that provided transparency is offered on the costs and charges in the default (the only fund tested by the VFM assessment) then employers can see how much resource is being devoted to investments (informing on its perception of the performance score) and how much is being allocated to the quality of services.
Provided the quality of services threshold is properly calibrated, it should measure not just the amount spent by the provider on services (including admin, governance , communications and day to day member support) but suggest how much is being retained by the provider. Mutuals, which do not distribute profits , should distribute a higher percentage of costs and charges to investments and services. But sloppy mutuals who have high overheads , poor controls and who overpay , may still be found wanting on overall VFM.
Both the performance and quality of services tests in a VFM assessments should be RAGs but the cost test shouldn’t be. Cost is not a VFM measure although you need to understand the apportionment of costs to understand overall value for money.
Many people have argued that we don’t need a cost test, I would argue that we do. It is a test of the transparency of the provider of the scheme and a test of the governance of its fiduciaries. If the information in the cost test is found to be false, the scheme is failing a key disclosure and should be publicly censured or even closed. But savers, employers and even trustees should not high or low costs themselves as a measure of VFM. Cost disclosure is a measure of scheme transparency and scheme transparency should be a hygiene factor for a regulated workplace pension.
Working out value?
I’ll end with a picture that talks to our behavior. Most of us value the pension promise highly but when we’re in a well run workplace pension, we take it for granted.
It is only when we lose value from our pension that we start to value what we’ve lost.
The value for money work being done by the DWP helps us understand the value we are getting as we go along, so we don’t have to worry about that right hand box.
