This is the second installment in a five-part series on fees and performance in defined contribution (DC) plans. In my first post back in June, I put fees under the microscope and looked at what CAP members are paying for. In this post, I look at some of the issues related to fees and fund manager performance.
First, a bit of international context: there is an overwhelming consensus that the costs in DC schemes in the UK should be clear, simple and comparable. In July, Global Pensions reported that emphasis is needed in the UK on the value service providers offer to sponsors and DC members. Fee transparency is also a major issue in the US: there have been a series of lawsuits related to plans that charged members excessive or undisclosed fees.
In Canada, Section 4.4 of the CAP Guidelines recommends that the component of the fees paid by the members be disclosed. Section 6 of the CAP Guidelines also recommends that the sponsor establish criteria for reviewing these service providers, however this requirement is often overlooked or forgotten once the manager is hired.
Plan sponsors, by choice, may pay certain administrative costs but have a fiduciary obligation to review the fees and costs paid by the member.
Members generally pay fees to the fund manager, record keeper and advisor. Record keeper and advisor fees (if applicable) are generally the same for each investment option while fund manager fees usually vary.
The fees are deducted from each investment option — and those fees reduce return performance. The amount a CAP member pays is based on the total fund manager, record keeper and advisor fee rates applied against the market value of each investment.
The amount of fees paid automatically increase as the amount of a member’s investments increase through contributions, earnings or increases in the market value.
Sponsors must monitor not just fee rates but also increases in the actual amount paid annually to the fund managers, record keeper and advisor to ensure any increase is justified by expected performance, improved service or new features.
Measuring fund manager return performance can be relatively straightforward. Performance is usually evaluated against specific return and risk benchmarks (market indices) after fees and outlined in the Statement of Investment Policies and (SIPP). The fund manager’s performance is expected to exceed the bench plus fees for specific time periods.
In assessing the fund manager’s performance the actual fee paid for each specific investment option should be used: it should not include any applicable record keeper or advisor fee. In other words the fund manager’s performance should be assessed on return performance and their portion of the total fee — not the portion of the total fees paid to the record keeper and advisor.
Equally important in assessing fund manager performance is monitoring risk (tracking error). Since the risk performance is likely looked at against the risk performance of the benchmark the tracking error before fees is a reasonable indicator of risk performance. Fund managers that achieve high returns but have tracking error exceeding the benchmark should be reviewed in relation other investment options available to members, the plan objectives, and the level of risk expected of the fund over specific time periods.
Assessing a fund manager’s performance therefore is a two step processing: return performance after fees and tracking error before fees.
If the CAP investment options include balanced funds or life cycle type funds (e.g. target date funds) other investment funds of the provider may be used that also charge fees. The CAP Guidelines recommend that all fees and operating expenses paid by the members should be disclosed. If the fees applicable to balanced or life cycle fund managers do not reflect the fees for funds used within the balanced or life cycle fund portfolios, then the sponsor should ensure they are disclosed as part of the investment option operating expenses.
The objective in monitoring fund manager performance is to ensure that each fund manager is performing as expected on an after fee basis and that the fees are reasonable.
Guaranteed Investment Investments
In offering guaranteed investment (GI) type options the record keepers do not levy fees based on the value of the members investment in the GIs as they do for other CAP investments: the members pay no manage, record keeper, or advisor fees. The provider does however earn income on GIs based on the spread between the guaranteed interest rate when the GIA is acquired by the member and prevailing future interest rates.
In other words, if a member invests in a five-year GI paying 2.5% and interest rates increase to 3.5% the provider benefits from paying the lower interest rate. Conversely if Interest rates decrease the provider may suffer a loss. Most record keepers also offer a premium of 0.3%-0.4% above the current market GIC rates offered by banks.
A sponsor can not monitor fees in the case of GIs but should monitor the current bi-weekly or monthly market interest rates paid to members to ensure they are competitive and, the CAP members are getting the GI rate premium promised by the provider. .
Fund manager fees are just one components of the fees paid by CAP members. The expectations regarding fund manager performance on an after fee basis should be outlined in the fund manager’s mandate in the plan as well as the risk performance expectations Fees are not applicable to guaranteed investment type investment s however the rates of interest and any premiums to be paid should be monitored .
The next blog will review the role of fees in monitoring record keeper and advisor performance as well as issues relating to treating the equal treatment of CAP members with respect to fees and costs.