Capping more than costs?

Why we believe a further reduction in the DC charge cap would be detrimental to members’ outcomes.

• The danger of adjusting the defined contribution (DC) charge cap further downwards is that innovation – which already struggles to thrive in DC – will be severely impeded.
• As an example, diversified growth funds can form a valuable building block of a default strategy, cushioning the effect of wild market gyrations. Such strategies would struggle to form part of a further cost-constrained default fund.
• A reduction in the charge cap may also limit DC schemes in their ability to focus on environmental, social and governance (ESG) considerations at precisely the point that the government is expecting more of them.

It is an uncontroversial statement that the aim of a defined contribution (DC) pension scheme is to build portfolios capable of delivering the best outcomes for their members. Investment returns, along with contributions and the sound management of risk, are ultimately what drive such outcomes.

The introduction of a regulatory charge cap in 2015 put the spotlight on the cost element of the equation, and has resulted in a market that has arguably become increasingly defined by basis points charged, rather than with a member outcome in mind.

A recent government consultation has led to a reassessment of the current charge-cap regime and whether its structure and level are appropriate five years on (it is currently set at 75 basis points). While it is healthy to ‘kick the tyres’ of any policy or arrangement, it does beg the question of whether a continuing focus on cost is appropriate, and if it conveys the right message to the market.

There is no market failure to correct here: typical scheme charges fall within the charge cap; indeed, in many cases they are significantly below. It could be argued that any imbalances exist more in the structure of the DC market itself, notably in relation to concentration risk, with schemes espousing similar strategies and the use of delivery mechanisms designed for a different era. Costs are, in fact, a less concerning piece of the DC picture.

Stifling innovation?

The danger of adjusting the DC charge cap further downwards is that innovation – which already struggles to thrive in DC – will be severely impeded, and the rich panoply of strategies which should and could feature in a default fund will be stifled.

As an example, diversified growth funds (DGFs) can form a valuable building block of a default strategy, cushioning the effect of wild market gyrations, such as the Covid-induced volatility seen in March this year. Moreover, in periods such as the global financial crisis, many scheme members suffered severe depletion of their savings pots as market volatility caused asset values to plummet precipitously. DGF strategies (our own Real Return being a good case study) which judiciously deploy the flexibility offered by an unconstrained approach, can seek to preserve capital, therefore avoiding the need for some tricky conversations with scheme members. Such strategies would struggle to form part of a further cost-constrained default fund.

The ESG angle

Similarly, the increasing appreciation of environmental, social and governance (ESG) considerations and the desire by schemes to reflect these in a default strategy are likely to be hindered. We know from a raft of surveys conducted by asset managers, platforms and other industry bodies that this is an area about which many scheme members and trustees feel passionately. A reduction in the charge cap may limit DC schemes in their ability to focus on these issues at precisely the point that the government is expecting more of them, as evidenced by the increased disclosure obligations related to ESG issues as part of a scheme’s Statement of Investment Principles.

Finally, it would be remiss not to mention the UK government’s own policy initiative to improve DC schemes’ ability to access to illiquid assets, including impact investing. The charge cap already creates something of an obstacle to investing in certain asset classes because of the limited investment budgets available and the challenges incorporating performance fees within a DC charge-cap framework. It would be ironic if these efforts were thwarted by the government’s very own legislation, which would at the very least convey mixed messages.

In summary, for DC to develop into a vibrant market, incorporating a diverse range of strategies, we believe we should not impose a cost straitjacket. The idea that the charge cap needs to be lowered to protect pension savers is not consistent with market dynamics, and could even drive some players out of the market altogether. DC members deserve better.

Authors

Catherine Doyle

Investment specialist