19 April 2022
Author: Matthew Roberts
So, how should we crack this particular nut? Let’s start with some context.
To those not local to the UK market, we apologise that the following is somewhat parochial given the existence of the charge cap and ongoing government consultations.
It is already possible for fund managers in the UK to charge performance fees in DC solutions, but this is constrained by the charge cap (currently set at 0.75% at the scheme level). Generally speaking, these structures have to be capped and/or negligible in size to pass muster. Consequently, fund structures with performance fees have regularly been considered more effort than they are worth and hence are rarely used. There is also the often-raised challenge surrounding inter-temporal fairness, which relates to how/whether these fees can be equitably charged to members given their specific cash flow profile.
Given all of this background, it is fair to say our poll question was over-simplifying the issue. In reality, the timely question (at least in the UK market) is whether performance fees should be included in the charge cap or not? This is the direction of travel for government and has been the subject of consultation. The consultation (results published at the end of March) received mixed responses. Perhaps this is further evidence of the aforementioned agency problem.
Next, we will address several key considerations in trying to answer this important question. We have included an assessment (pro/con) for each area from the perspective of DC savers.
The Link to Illiquids – Neutral
The debate over performance fees is inextricably linked to the broad-based desire to introduce more (innovative) illiquid investments in DC, which typically have performance fees. This leads on to a number of related questions including whether performance fees should only be permitted for illiquid investments and whether performance fees should only be permitted if they have a certain fee structure (i.e. hurdle rate, calculation point, crystallisation point, clawback, deferral etc.)?
Our view is that there should not be a special case made for a particular asset class or set of asset classes. We feel this would increase the chances of ‘gaming the system’. We would also caution against being too prescriptive over permissible fee structures since the right structure may well very much depend on the investment under consideration. It is a can of worms best avoided.
An Increase in Opportunity Set? Potential Pro
At the margin, the opportunity set must increase with a change of this nature. The improved choice could lead to improved diversification and thus, better outcomes.
However, in practice, moving performance fees to be outside the charge cap may not lead to a material improvement in the opportunity set for DC investors. There has already been some innovation with respect to developing flat fee solutions in alternatives for DC. Furthermore, fees (or rather, costs for the members) are incredibly important for DC schemes regardless of whether performance fees are charged/included in the charge cap or not. We would not expect, therefore, a wholesale shift to higher fee solutions if the regulation was loosened.
One potential consequence is that schemes could be drawn into certain performance fee structures to improve ‘fee optics’ for savers. This would be an unfortunate outcome. Another possible outcome is a ‘two-tier’ system, where a certain cohort of investors are willing to pay performance fees and others are not. Hopefully, innovation can help to solve this gradually over time.
Improved Alignment? Potential Pro
Overall, we would suggest there is potential for improvement in alignment although this is highly nuanced and certainly not always the case. For example, some performance fee structures can encourage excessive risk taking. There can also be a netting issue – when you combine several managers charging performance fees and some of them do well, some do poorly. The net result can be flat or negative performance at the portfolio level, yet performance fees will likely still have been charged on certain individual investments. In the world of private markets and other alternatives, we are also mindful of the potential for performance fees to be paid on market beta or as a result of financial engineering (i.e. leverage). It would be a shame if we transferred all of the issues that the institutional marketplace has, when it comes to these fees, into the DC market (particularly given we have a close-to-blank sheet of paper to start with).
Nevertheless, well structured performance fees can improve capacity management and do have the potential to lead to improved outcomes.
Loss of Bargaining Power? Potential Con
We do feel that the charge cap has, in some cases, been a useful negotiation tool for DC schemes when it comes to agreeing fees with fund managers. This would be weakened if performance fees were separated and more generally, could lead to unusual structures where there are particularly low management fees and particularly high performance fees (a further example of potential system ‘gaming’).
Inter-temporal fairness – Potential Con
The nature of DC creates a particular issue relating to inter-temporal fairness. In DB schemes, members have a benefit promise which is down to the sponsor to meet. In DC, the retirement outcome for a member depends directly on the performance of their assets. So, different members paying different fees for the same investment is a challenge. Perhaps this is a question of materiality.
We are big believers in DC being a crucial cog in the machine that ‘brings saving to the masses’. As such, the protection that the charge cap has brought for the previously over-charged members generally invested through some of the legacy contract-based arrangements, should be savoured in our view.
Transparency/Complexity – Potential Con
We have always felt that transparency is particularly important in DC. Imagine the scenario where a member asks to understand all the fees across their holdings. Performance fees can be much harder to calculate for an individual member and harder still to explain. As such, clear disclosure will be essential. There is also the issue as to whether private market firms are disclosing and calculating these fees correctly (see this SEC speech).
Operational issues – Neutral
These have been a huge challenge for many DC schemes more broadly; the pre-existing rules meant it was close-to-impossible to invest in, for example, monthly dealt funds. However, with the recent introduction of the Long Term Asset Fund (LTAF) structure and amendments to permitted links rules, they should now be solvable. The very existence of the new LTAF structure should go some way to alleviating some of the barriers to investment in alternative assets.
To Conclude – What is our view and what are we doing?
We manage a range of mandates for clients all with different objectives and fee preferences. Thus far, our solutions designed specifically for DC schemes have been structured without performance fees and this has been expressed as a clear preference amongst our DC clients.
As we contemplated the potential separation of performance fees from the charge cap, we felt that there were legitimate pros and cons, which are reflected in the result of our LinkedIn poll and the related agency problem.
In our view, the LTAF is a fantastic recent development and can act as an important stepping-stone for DC schemes wishing to explore alternative investments. Perhaps the take up of this new fund structure will help decipher whether performance fees should play a bigger role across the marketplace?
Once a decision has been made on the rules regarding fees, we feel the market would benefit from a period of extended stability. The uncertainty over regulation has made innovation challenging, which is perhaps ironic given innovation is a key objective.