Eating only what you kill ... Performance-based fees in the pension fund industry

destroy value.

Put rather bluntly, but maybe a little bit of basic mathematics will help justify the tone. Did you know that for every half-a-percent charge in fees a member’s accumulated retirement savings drop by a fifth by the time they reach retirement age.

Put simply, if a member were to retire with US$1 million where the annual fees were say 1% of assets, this dramatically drops down to only US$800 000 if the fees had been 1,5% of assets instead. It is no surprise then that the regulator, Insurance and Pensions Commission (Ipec), has come out guns blazing on the industry demanding downwards fee reviews.

Just to be clear though, this is by no means an endorsement of the approach the regulator has taken in addressing the fees issue.

Suffice to say though that, as part of the key industry stakeholders, we shared our views on the regulator’s expenses draft guideline when it was out for public comment.

We would be more than happy to share with anyone what those views on the draft guideline were. That, of course, is a topic for another day.

For now, it is back to what is up for discussion today – performance-based fees. More specifically, investment management performance-based fees.

The ancient custom of “eating only what you kill”, inherited from our hunter-gatherer forefathers, is generally as applicable today as it was then.

Of course, this is more so in some aspects of life and less so in others. To what extent then is this noble custom applicable in the management of pension funds’ investments?

How are the asset managers charging fees currently, and how should fees?

What criteria should they be applying in coming up with, and justifying, their fee charging models? Are these fee models pro- or anti-members? How do the fee models, for instance, demonstrate a genuine pursuit of alignment of investment manager’s interests with those of the members? they be charging

Where are the yachts?

these

A story is told of a visitor in New York more than a century ago. After admiring yachts Wall Street bought with money earned providing investment management and advisory services, he wondered where the customers’ yachts were.

Of course, there were none. There was far more money to be made in providing investment management and advisory services than there was in receiving the investment advice.

The story is as relevant today as it was back then. Maybe in our case, we would recoin it to – where are the members’ SUVs? Even after more than a century of the story being told, the answer hasnot changed – there are none.

A critique’s perspective

Performance-based fee structures have been frowned upon in the recent past and reasons for that have ranged from their complexity and lack of transparency to that they are generally skewed in favour of the investment manager.

Issues of benchmark used, hurdle rate applied, participation level proposed, asymmetry, depth of application of the high water mark principle, and whether the end total fees are capped have dominated these conversations.

Clearly, critics of performancebased fee structures have brought to the fore shortcomings of the application of these fee structures in practice. That certainly is not in dispute. They, however, have not attacked the principle to the same degree ofadversariality as they have condemned the practice.

Let’s take a much deeper look.

Performance-based fees?

Performance-based fees can be defined as additional fees above a low base fee that reward an investment manager for outperforming a predefined benchmark. Like fixed fees, performance fees are paid as a percentage of the assets under management, with the percentage determined as a share of the outperformance generated. They are designed to reward an active manager’s skill in generating outperformance as well as to ensure alignment of interests of investment managers with those of their clients.

Performance fees motivate the manager to generate maximum returns. They can act as a key determinant of the difference between an asset manager striving for superior outperformance as opposed to being comfortable with benchmark-like average performance. With performance fee arrangements, the relationship between performance and a manager’s revenue is a lot more direct and immediate.

Performance fees discourage asset gathering, but instead motivate the manager to manage his investment capacity. Where a manager is charging fixed-rate fees for his skill, there is obvious incentive to increase assets under management to increase fee income.

But increased assets under management are not always in the investors’ best interests, especially when investment ideas are scarce, or market liquidity is constrained.

This is especially so with our local stock market that is neither that deep nor broad.

Furthermore, performance fees allow investors to pay for investment skills when they can most afford it. In tough times, when returns are low or even negative and charges matter most, it is unlikely that investors would incur significant performance-related fees and in fact may, in some cases, actually pay less in management fees for underperformance.

When times are good and returns are more substantial, however, investors are asked to pay what should be a relatively small slice of their total gains as a bonus to reward the skill of the investment management that has delivered those returns in the first place.

Performance fees allow investors to reward performing managers and “punish” under-performing managers.

They also reduce aggregate industry fees because only managers that outperform get paid the aggregate additional fee.

A manager’s willingness to accept performance fee arrangements is also a good measure of his confidence that he will out-perform the benchmark against which his performance is measured.

No above-reproach panacea

The ability of performance-based fees to align investor preferences for risk and return with managers’ incentives has been challenged quite a bit lately.

In the case where an investor is risk averse, a sudden switch to a standard performance-based fee does not, in and of itself, automatically and immediately, align the manager’s incentives with the members’ preferences since the standard fee rewards higher returns with no reference to volatility or risk.

There is also the issue of asymmetry — the fee is positive only and can create an option-like transfer of expected value from the investor to the manager.

For instance, the manager can invest in a promising, but risky, strategy. If the strategy works, both investor and manager benefit. If the strategy fails, however, the investor loses his capital while the manager loses only fees.

To A16