Pension funds being burdened by excessive asset management fees

Pension funds are on the hunt for alpha,
the added dash of performance over and above the returns generated
by a benchmark index. A resultant scramble for services of
alternative asset managers has been a primary driver of a
substantial increase in investment management fees paid by pension
funds, an increase that is not always justified, cautions
consultancy Watson Wyatt in a research note entitled “A fairer deal
on fees”.

According to Watson Wyatt, the average investment management fee
paid by pension funds and superannuation funds worldwide has jumped
by almost 70 percent, from 65 basis points of fund asset value in
2002 to 110 basis points at present.

Providing background, Paul Trickett, European head of investment
consulting at Watson Wyatt, said: “One of the main reasons for this
upward cost spiral is investors’ focus on alpha, which has
increased their appetite for alternative assets. Investors have
naturally assumed that they are paying these fees to reward manager
skill, but in many cases they are wrong.”

Putting it succinctly, in the note the consultancy explained that
many pension funds have been paying “alpha fees for beta
performance” because the main driver of returns in recent years has
been the strength of the markets. Quite simply, beta performance,
in essence the returns generated by the market, have merely been
enhanced (leveraged) by adding an element of debt to
portfolios.

“This is obviously a good deal for investment managers, but not
necessarily for their investors,” said Trickett. However, he
stressed: “While we strongly believe managers should be fairly
compensated, fees are currently too high for the value they
deliver, particularly as we enter a lower-return environment.” He
added that in the recent past, many trustees have unwittingly paid
away the vast majority of their alpha in fees.

In addition to its reservations on the plausibility of returns
delivered by alpha-focused alternative asset managers, Watson Wyatt
identified what it views as other flaws in investment manager fees.
These include:

• base fees are generally calculated on an ad valorem basis
that encourages asset gathering and can harm performance;

• annual performance fees can amount to a free option for the
manager, as the upside is uncapped but the downside is limited to
the base fee;

• fees can also be paid on money waiting in cash to be drawn
down for investment;

• many leveraged real estate managers charge fees on the gross
exposure rather than committed capital; and

• fees charged by funds-of-funds can use a combination of
these flawed approaches and in many instances lack
transparency.

Trickett concluded: “This [asset management fees] is a complex
area, which doesn’t mean it should be glossed over as too much
value has already been allowed to leak away. There are signs of
change as we move into a different market environment where many
managers will no longer be able to justify their charges without
beta to bail them out. Active managers that wish to win pension
fund money will need to offer them a fairer deal.”

Watson Wyatt believes an ideal fee structure should have a low base
fee to cover costs and a performance fee that should be calculated
over longer periods, typically three to five years, and have
hurdles and high-water marks. In addition, total fees should never
be more than 50 percent of alpha.