Are pension charges fair?

Chislehurst-Tony

I have a couple of private pensions with well-known providers (Standard Life and Aviva) and they use fairly usual charging structures based on the total value of my pension pot. When I analyse the growth in value of my funds the vast majority comes from the contributions I add myself rather than any investment growth resulting from anything the provider has done. On this basis why is it fair that they charge me a small percentage (typically 0.75%) of the total value.

Year on year the amount they take gets larger regardless of whether they perform well or disastrously and so there is no real incentive for them to manage my funds well.

Surely a better system would be for them to charge me a larger percentage (say 20%) of the investment growth in value of fund. So if they perform well they make more money but if the fund does poorly with losses then they get nothing at all.

I realise that the industry is hardly going to go for a model that actually penalises them if they do a bad job but why shouldn't we expect to pay in proportion to the quality of the service they provide?

Is there a market for an innovative and confident pension provider to offer a service of this kind? Does anyone know if such a fund actually exists now?

Thanks

dunstonh

Are pension charges fair?

If they didnt charge, how would they remain in business?

When I analyse the growth in value of my funds the vast majority comes from the contributions I add myself rather than any investment growth resulting from anything the provider has done.

Over what period?

On this basis why is it fair that they charge me a small percentage (typically 0.75%) of the total value.

How should they charge you then?
Surely you dont mean they should only charge you on growth periods? That would cost you far more (as growth periods outnumber negative and to cater for such a volatile income, the FCA would require greater capital adequacy which would push up costs even more)

Year on year the amount they take gets larger regardless of whether they perform well or disastrously and so there is no real incentive for them to manage my funds well.

If they performed disastrously, then your values would be going down and the charges you pay would go down.

Surely a better system would be for them to charge me a larger percentage (say 20%) of the investment growth in value of fund. So if they perform well they make more money but if the fund does poorly with losses then they get nothing at all.

In addition to the reasons already given as to why this is bad, another would be risk bias. You would be giving an incentive for them to take greater risks.

I realise that the industry is hardly going to go for a model that actually penalises them if they do a bad job but why shouldn't we expect to pay in proportion to the quality of the service they provide?

They provide a service irrespective of returns. In the great scheme of things, they have little impact on the returns as it is the asset class and period in the market in question that matters most.

Is there a market for an innovative and confident pension provider to offer a service of this kind? Does anyone know if such a fund actually exists now?

Only if they are foolish.

zagfles

There are funds with performance fees, but I don't really like them. Think about it - they create perverse incentives for the fund manager. If they get nothing if the fund goes down or stays static, then they don't really care which, do they?

Performance will need to be measured over a fixed period, eg a year. Say the fund went down 10% in the first half of the year. What does the manager do? They might think "may as well take a punt on something really risky" as they'll get nothing if it stays at -10%, nothing if it goes goes to -20%, but something if it recovers to +5%. So a no lose gamble for them, but a big possible lose gamble for the investor.

And what of a volatile fund? One that goes up and down all the time, say down 10% one year then up 20% the next. That would make them more than a fund that went up 5% both years.

The best way to incentive fund managers is to monitor their performance over the long term and switch away from poorly performing ones, taking into account relevant benchmarks and investment strategy & environment.

bigfreddiel

Once people realise the people who provide your pension are salesman trying to line their pockets from your own hard earned money. The hide behind a wall of jargon, hide exit fees in the small print and then 40 years later blame you for not taking notice of the huge lump you need to pay them to access your own, now depleted funds.

Luckily the gov is stepping in to try and stop this practice.

No doubt the usual culprits will be leaping on this thread to defend their professional practices.

We the public just need to educate ourselves a tiny bit to be able to understand how some key financial products work then we might be getting somewhere. Till then BAU.

Cheers fj

bowlhead99

zagfles wrote: »

There are funds with performance fees, but I don't really like them. Think about it - they create perverse incentives for the fund manager.

Others would argue that they create alignment of interest between the fund manager and the investor.

This is particularly important when a manager is not in the position to create alignment of interest by investing a large proportion of his own net worth into the fund - for example, because he is not super rich and needs to invest in a diversified manner across multiple asset classes, sectors and geographies so can't put all his eggs in his own fund which is just one basket. So, a "salary and bonus" concept can be useful.

If it is fixed management fee (salary) only, and he just gets paid for showing up, it doesn't really matter as much if he does a good or bad job, so there is no incentive other than a loss of fees from management fees being charged on a slightly lower NAV next year, and hoping people don't leave and drive down the management fee even further. But that incentive isn't so good with a closed ended vehicle like an investment trust because investors can't just redeem and walk away. So plain vanilla management fees are not great for alignment of interest.

However the alternative of "bonus only" means he can't keep the rent paid and the lights on and the support staff employed in the inevitable down years, so that would be silly. Therefore, a mix of salary and bonus can be a good compromise.

Neil Woodford's Patient Capital IT is somewhat unique in being performance fee only (with performance fee being paid in shares to avoid loss of alignment of interest on payout) but this works for him as the "salary" comes from the management fee on his separate, and massive, equity income fund which is a good cash cow, keeping the lights on for the firm after all.

If they get nothing if the fund goes down or stays static, then they don't really care which, do they?

Yes they do care, because if they get far underwater it will be difficult for them to recover the losses back to above water *and* achieve the required performance criteria for the bonus the next year. The increased difficulty /reduced likelihood of making the future returns which qualify for incentive fees will make it difficult to recruit and retain talented staff who would otherwise be incentivised by such fees. So, it is clearly important to lose as little as possible in the down years, so you are not faced with a mission impossible for the up ones.

Performance will need to be measured over a fixed period, eg a year. Say the fund went down 10% in the first half of the year. What does the manager do? They might think "may as well take a punt on something really risky" as they'll get nothing if it stays at -10%, nothing if it goes goes to -20%, but something if it recovers to +5%. So a no lose gamble for them, but a big possible lose gamble for the investor.

This assumes performance fees are only evaluated for individual years in silos with no consideration for cumulative return over multi year periods over which the fund is expected to perform. Which is not really the case for any reasonably mainstream funds charging performance fees.

And what of a volatile fund? One that goes up and down all the time, say down 10% one year then up 20% the next. That would make them more than a fund that went up 5% both years.

No it wouldn't.

The way it would work in most funds you ever see in the retail market:

Fund A goes from 100 minus10% to 90 , and later plus 20% to 108.

In year one he gets zero as there is no performance to reward. In year two he makes a comeback with profit of 18 and the total return goes 8 above the previous "high watermark" (the line on the shore representing the highest point to which the "tide" of performance fees had previously been charged). He earns performance fees on that 8, not the 18

Fund B goes from 100 plus 5% to 105, and later plus 5% to 110.25.
In year one he gets his performance fee on the first 5 of return. In year two he gets his performance fee on the next 5.25 of return.

In that example, the Fund B manager was paid more performance fee because he delivered better cumulative performance. However probably when giving us the simple example you probably didn't really mean for us to bother with precise compounding and were just being simplistic with an assumption that both ended up at 110, getting there in different ways. Typically then, the performance fees would be the same, because the performance, which is what is being incentivised, is the same.

Some funds performance fee structures would not necessarily pay out at all in either situation, because their criteria to pay the performance bonus might be "high watermark or cumulative return of the Nasdaq biotech index, whichever greater". In such cases it is of course worth considering whether any benchmark is challenging or meaningful.

A number of funds don't have a benchmark to beat, just the performance fee and watermark, and I'm less of a fan of those but it depends how much the core "year in, year out" management fee is going to be and whether the investment opportunities are unique compared to what others might offer without performance fees.

Still, I think perhaps your dislike of performance fees comes from a flawed understanding of how they work in practice, especially if you think the manager will "double dip" and charge a fee for getting up to £100 NAV, lose £10 in a later year, and charge a fee on the £90 to £100 *again* before charging on the next £10 up to £110.

In practice, all mainstream funds, investment companies and investment trusts will have a high watermark concept or investors would laugh them out of town. The fact that the funds continue to exist, but you didn't realise this, and just skipped straight to laughing them out of town, means perhaps you have missed some opportunities. If you think there are a bunch operating without high watermarks, please list a few.

(the above 'education' is not meant to sounds patronising so apologies if it does- and is more directed at zagfles rather than bigfreddiel, as I appreciate freddie despises paying for active management or advice in any form):)

The best way to incentive fund managers is to monitor their performance over the long term and switch away from poorly performing ones, taking into account relevant benchmarks and investment strategy & environment.

No denying that is one way of doing it but quite slow to implement.

Chislehurst-Tony

How should they charge you then?


Surely you dont mean they should only charge you on growth periods? That
would cost you far more (as growth periods outnumber negative and to cater for
such a volatile income, the FCA would require greater capital adequacy which
would push up costs even more)

If you want to protect fund managers from global market trends over which they have no control (which seems like a fair position) then a fee structure based on their fund performance relative to an agreed average of stock market indices would work. If they outperform the average world markets then they get some large percentage of the growth they have contributed to and vice-versa. I don't mind paying more if the fund outperforms the market. [As an aside I once persuaded an estate agent to sell my house on a variable percentage commission which I based on a formula that increased his share as the sale price increased. Below a certain value he knew he would get nothing at all but he was hugely incentivised to get the best possible price because his fee share grew. In most flat fee environments it is never worth the while of the agent to maximise the price because the marginal fee gained is not worth considering compared to closing the sale at any price. He got a great price for the house!]

In addition to the reasons already given as to why this is bad, another would be
risk bias. You would be giving an incentive for them to take greater risks.

Fair point. Measuring performance against global indices would reduce this risk a little because they wouldn't be panned for weak performance in a poor financial conditions.

Only if they are foolish

.

True enough. While there are people willing to pay you regardless of how badly you perform then why change.

Malthusian

Performance fees are usually a rip off. You're not going to find a fund manager that will pay money into your fund when he underperforms, so it incentivises them to take as many risky bets, or "beta", as possible. If they don't come off they lose relatively little and if they do they rake in the performance fees.

This acts as a significant drag on performance. Stock market investments grow over the long term because the good years outweigh the bad ones. But performance fees take a big chunk of the upside while leaving the investor fully exposed to the downside.

As others have said, with a percentage fee their take increases as my fund goes up, and it goes down by the same amount as my fund goes down (unlike with a performance fee). That's enough incentive and alignment of interests for me.

Unlike some people I expect any business I employ to make a profit out of me. If it's not a mutually beneficial transaction, then one of us is being screwed, and if I'm not certain it's them it's almost certainly me.

dunstonh

Ok, another scenario....

What if the portfolio is built to be lower risk than the benchmark?

That means it will likely underperform the benchmark but it will be less volatile. Why should they be penalised for doing exactly as intended?

If you take a typical 1-10 risk scale and look at the mixed investment 20-60% share sector. 16% of the funds fall under risk 4, 18% under risk 5, 33% under risk 6 and 18% under risk 7. They are in the same sector and measured against the same sector average. However, there is no way a risk 4 and a risk 7 fund should be compared for performance. In the long term, risk 7 funds should outperform risk 4 funds. However, a cautious investor shouldnt be anywhere near risk 7 and the risk 4 fund is better for them. So, why should the unsuitable risk 7 fund receive more of a fee than the suitable risk 4 fund that may not actually get any fee whatsoever under your suggestion?

While there are people willing to pay you regardless of how badly you perform then why change.

You are paying them to do a job. They do that job irrespective of returns. Most of the return does not come from the fund manager. It comes from the investment sector. however, if you feel the fund is not good then you move out of it. Then the fund house gets nothing. If you are not an active investor (in doing reviews etc) or do not use a servicing IFA then really you shouldnt be using funds that require reviews. Instead you should stick with multi-asset funds using passives as the underlying investments.