Cost disclosure framework must help schemes judge value

The European Packaged Retail and Insurance-based Investment Products regulations and revised Markets in Financial Instruments Directive, which come into effect in January 2018, demand increased disclosure and transparency of investment costs.

To date, investors have not known the true cost of investing due to under-reported costs and revenue leakage

In the UK, asset managers will have a duty to respond to requests for transaction cost data relating to workplace pensions from January 3 2018.

Building on LGPS success

The Financial Conduct Authority’s asset management market study concluded in June 2017 that institutional investors, such as pension schemes, often find it difficult to obtain pertinent information in a form that enables them to understand costs and assess value for money.

Against this backdrop, the Institutional Disclosure Working Group, established by the FCA in September 2017, is expected to release its first cost disclosure framework in the coming weeks or months.

Its work will build upon cost disclosure frameworks used by the Local Government Pension Scheme and the Dutch regulator, and we can expect similarities and improvements to that work.

We hope the working group will take a broader view, and provide a framework that will help trustees understand the full range of investment costs they are incurring.

Include value for money info

The LGPS Code of Transparency – which is already in place for local government schemes and reflects best practice in the Netherlands – has many positives, but also presents some challenges to trustees.

Most importantly, the cost assessment template focuses on the numbers, but says nothing about whether those costs represent good value for investors.

The context is missing; its inclusion is crucial to avoid a race to the bottom, where literal costs dominate over value for members and investment outcomes.

Industry has been poor on implicit costs

The fact that few advisers or trustees really understand investment costs makes this assessment process doubly hard.

This is particularly true for transaction costs. While explicit costs – such as manager fees, broker commission, taxes and custody charges – are easy to identify and understand, this is generally not the case for implicit costs, such as trading costs, which have historically been ignored by pension schemes.

Furthermore, under the FCA’s recommended slippage-cost calculation methodology, these trading costs can potentially outweigh transaction charges and even total investment costs. We would expect the IDWG framework to help highlight these issues.

Detail is crucial

We also expect the IDWG framework to add more asset classes and go into much greater levels of detail.

Breaking down investment costs into their component parts will reveal many of the variable practices employed across the asset management industry.

These practices vary on issues such as who pays for broker research, policies around stock lending, box profits and the capping of charges, as well as the impact on investment costs of including more expensive asset classes in popular multi-asset structures.

To date, investors have not known the true cost of investing, due to under-reported costs and revenue leakage.

But even when all these costs are clearly identified, pension schemes will still need help making sense of them. This will require an understanding of how costs arise and what can be done to optimise them.

Transparency is what the industry needs

Asset managers, whether active or passive, will need to fight their corner to demonstrate that those costs represent good value.

Pension schemes will undoubtedly benefit from this unbundling. Clearer disclosure of costs will empower pension scheme trustees to grill their asset managers on all charges and ensure trading is optimal and in the best interest of their members.

Fund costs will fall as managers absorb more costs, such as broker research, and there is likely to be an increased use of performance fees as active managers seek to recover these costs.

Donny Hay is a client director at professional trustee company PTL