Sizing up the cost of pensions

If all the sectors in the financial services industry, pensions has never been known for its extravagance. But changing demographics and calls for greater accountability have really put the squeeze on costs in the sector. Across Europe, public sector and corporate pension schemes alike are under pressure to run more efficiently.

Ironically, though, this drive for greater efficiency is costing pension schemes a lot of money.

"If anything, the cost pressures are going up," says Joanne Livingstone, principal at consultancy Punter Southall in London. "For pension fund clients going through the new funding regulations - having to monitor the employer covenant, for example - the costs are rising,"
she says.

On top of this, she points out, the number of scheme members is falling, so the cost per head is on its way up. While one can say that most of the measures aim to boost efficiency, they do cost money.

"Looking at controls is a very good thing, but it is an exercise in itself; there's an initial investment involved in looking at it," says Livingstone. "Pension funds are having to spend a lot on making change at the moment, and it's probably going to be a while before this pays off," she adds.

Though it has become vital for all pension providers to make sure they are running as well and cost-effectively as possible, it is particularly important in the UK public sector where the local tax payer is the backstop of the scheme, says Nicola Mark, head of the Norfolk county council pension fund in the UK.

Though the UK Local Government Pension Scheme is the only part of the British public sector pension system that is fully funded, benefits are guaranteed by statute. In the unlikely event that the scheme failed, the government would have to foot the pensions bill, Mark points out.

"I do feel a responsibility to make it as efficient as it can be, not just in terms of cost, but in terms of outcome as well," she says.

But in order run more efficiently, what are the main areas pension funds should focus on?

As Jacob Bikker and Jan de Dreu pointed out in their August 2006 paper on pension fund efficiency for the Dutch central bank, the two major components that determine the cost of pension provision are the quality of the scheme and the net return on investments. "However, administrative and investment costs can also increase the cost of retirement security substantially," they add.

If annual operating costs rise by 1% of pension fund assets, then eventual benefits will be reduced cumulatively by 27%, the paper's authors point out.

Unsurprisingly, Bikker and De Dreu say administrative costs depend heavily on the size of the pension fund, and to a lesser extent, on the type of governance structure, pension plan design and management choices.

When it comes to keeping both administration and investment costs down, the larger funds certainly seem to have the edge.

In the UK, an Audit Commission report into the cost of administering local government pension funds in London weighed up the efficiency of pension provision there compared with metropolitan areas elsewhere in the UK. The London funds were much more expensive, the report found.

The total administration cost per scheme member at a London borough pension fund was an average £126 (€186) - £82 higher than the average for a metropolitan fund outside London, which was just £44. "This cost difference is due to diseconomies of scale and the London effect," they said. The ‘London effect' is shorthand for the higher cost of salaries and office accommodation in the south of England.

The paper came up with a number of suggestions for ways the London funds could take advantage of the economies of scale that non-London funds had.

Though each came with their own set of pros and cons, the options included creating one London-wide pension fund, merging funds to create a smaller number of London pension funds or creating a pension authority - or authorities - for core pensions administration, leaving the responsibility for funding with the individual boroughs.

So, smaller funds can merge with others in order to win economies of scale. But the process of merging is expensive in itself, and can be impractical for many reasons. However, outsourcing is an effective way of gaining the same benefits.

In investment, multi management claims to offer smaller pension funds the buying power of their larger counterparts. But does the extra layer of fees that multi-management involves negate the benefits?

"Obviously, if you don't possess the scalability, then that might be the case," says Johan Cras, managing director of institutional business in the EMEA region at the multi manager Russell Investment Group. "We have good buying power because we are a sizeable client.

"The other perspective is that we are able to build a highly efficient operational structure," he says. "It's from an administration perspective that we are so good; we can bring down the costs." Russell can put securities lending in place for clients that would otherwise be too small, he adds.

But apart from the bare costs, Russell's size means its clients can invest in some funds that would otherwise be closed to them, says Cras. "The added-value multi management offers is access to an unlimited array of managers globally. Without it, some investors would struggle to get access, or they might be limited in the amount they could allocate to individual funds," he says. Some promising investment funds might be soft-closed - closed to new investors - but open to the clients of a multi-manager with a foot already in the door.

Adding alternative asset classes to their portfolios is an increasingly popular way for European pension funds to spread their risk. But specialists do charge far higher fees than traditional managers. At a time when schemes need to pare down the costs, can they really afford this luxury?

"Specialist investments are often made with the intention of reducing risk, so it is akin to an insurance policy," says Livingstone. Spending money on investment vehicles that will reduce risk probably is an appropriate thing for pension funds to do, she says.

And managing risk in some parts of the portfolio enables more risks to be taken in other parts, potentially generating higher returns, she points out.

Zuhair Mohammed of Psolve Asset Solutions, the specialist investment consultancy arm of Punter Southall, says these new vehicles can allow pension schemes to access a better balance between risk and reward, even after allowing for the higher fees, he says.

"Trustees need to resist placing too much emphasis on the question of tangible fees, and consider whether there's an opportunity to get a higher return, net of fees, for a commensurate level of risk," he says.

But in their paper for the Dutch central bank, Bikker and de Dreu conclude that higher investment costs are not generally justified in performance terms.

Using research into the costs incurred by mutual funds to shed light on the efficiency of investment operations at pension funds, the pair found that a few studies did suggest mutual funds can offset higher expenses by achieving higher returns.

However, many other studies had found that higher costs were not related to better performance, relative to the risk-adjusted rate of return, they said.

"The evidence suggests that in general higher costs incurred by mutual funds do not lead to higher returns," they said, concluding that stakeholders were likely to be best served by pension funds with low investment costs.

But leaving aside the level of fee an investment manager charges for their services, picking the managers that can deliver the best investment performance - and being willing to ditch the services of those that cannot - is essential for pension fund efficiency.

So much for the general picture. But how can a pension fund tell if the high cost of one particular high-flying manager is worth it? Many pension funds are paying for independent in-depth analysis to help them judge. Rick Di Mascio is CEO of Inalytics, which analyses manager skill for its pension fund and fund manager clients. "Managers are essentially appointed for their skills, and yet there's been no objective measure of their strength," he says. "We identify what their strengths are, getting behind the performance figures and putting them under the microscope."

Inalytics' clients include some of the bigger pensions players in Europe, such as Unilever, USS and Blue Sky.

Investing in new IT systems is an expensive exercise, but one that can lead to far greater efficiency which translates as savings. Pension fund managers have to weigh the future benefits against the initial outlay.

But in many cases, pension funds have no choice but to update their IT systems anyway. "Tax simplification has led to people having to review their systems," says Livingstone. Every pension scheme has to do its own cost-benefit analysis to find out whether the outlay on IT for a
particular purpose is worth it or not, she says.

Larger pension funds can often trim costs by stock lending and commission recapture, but it is harder for smaller funds to use these options.

Mohammed says very few UK pension schemes undertake stock lending, and those that do tend to be the larger ones because of the cost of setting up the legal agreements. The share of lending revenue that the manager retains can be high, and the actual saving made by the pension scheme often falls well below that suggested at the outset, he adds.

And while commission recapture - a means of clawing back commission paid to brokers - can in theory save money for large investors, UK schemes tend to shy away from it, according to Mohammed.

Commission rates have generally reduced, he explains, as fund managers drive a harder bargain for their investors. "This practice also appears to sit uncomfortably with the concept of treating your clients fairly," he adds.

Norfolk county council pension fund

ast year, the £1.9bn (€2.8bn) Norfolk county council pension fund, which runs the local government pension scheme on behalf of 90 employers in Norfolk, formally reported on the overall efficiency of its pension fund for the first time.

The review pinpointed some areas for possible improvement, but the exercise was also about defining exactly what efficiency means for a pension fund.

"This is the first time we have formally reviewed efficiency over both scheme administration and investment," says Nicola Mark, head of the pension fund. Though pensions staff and the trustees at the Norfolk fund had often discussed and considered the smooth and cost-effective running of the fund, the results had
not been put together officially before.

And it was important to look at efficiency holistically, she says, taking in both sides of pension scheme activities. The report was not purely concerned with keeping costs low, but also about scrutinising the level of service given to members, she says.

"We wanted to be able to understand what we mean by efficiency, and for trustees to be able to understand it too," Mark says. "Efficiency is about maximising all the resources around you to ensure the best outcome, whether it's in administration or investment."

In its introduction, the report stresses the importance of regular monitoring, and is aimed at identifying areas in both administration and investment management to ensure continuing best value for the fund's stakeholders.

Starting with investment management, the report assesses the fund's investment performance, both against its benchmark, and against the funds of other local authorities.

It covers the choice of strategic benchmark, noting that the trigger point of 2% from target allocation avoids "incurring unnecessary transaction and opportunity costs from frequent small adjustments".

Under the section on investment management fees, the review has a table of fees the Norfolk fund pays for each asset class, alongside a comparison figure for the average fee paid by another local government pension scheme.

Although it concludes that the fees it pays seem reasonable, it says the fund will continue to investigate this area and compare it with the private sector.

On the administration side, the report covers collection of contributions and benchmarking the cost of administration. Apart from taking part in the SF3 cost benchmarking run by the UK's department for communities and local government, the Norfolk fund has also joined the CIPFA benchmarking club for pensions administration.

That exercise showed Norfolk's administration cost per member was £21.61 in 2005-06, against the club average of £21.45, the report says. Though the cost was slightly higher, Norfolk says it administers its scheme for a third more than the average number of employers, and has significantly higher membership turnover (22%).

Mark points out that the scheme has a higher level of service than some schemes, and this inevitably contributes to a marginally higher cost.

The CIPFA club survey also showed how well Norfolk was doing against its peers in terms of providing timely service to its members, such as sending out official letters, pension statements and answering queries.

The report can be downloaded from http://www.norfolk.gov.uk/consumption/groups/public/documents/committee_report/pensions190906item7pdf.pdf

PensionDanmark

ast year, Denmark's €8.3bn labour market pension fund PensionDanmark managed to cut its administrative costs for the fourth year in a row. It now spends just DKR318 (€43) per member, which equates to 2% of premiums.

Being a huge pension scheme with more than half a million members certainly gives PensionDanmark access to rare economies of scale. But other pension funds can use some of its cost-cutting methods too, says CEO Torben Möger Pedersen.

"Many pension funds can outsource some of their administrative tasks and thereby buy their way
to economies of scale by teaming up with professional outsourcing partners that can deliver this,"
he says.

"This is of course much more difficult if the pension fund has very complex products that are difficult for the customer to understand and manoeuvre in when they want to adjust them to their particular situation," he says.

If customer service is heavily reliant on many face-to-face consultations - perhaps because of complicated products - this does make it hard to curb costs, Möger Pedersen points out.

Focusing on three key measures has enabled PensionDanmark to maintain its position as the most cost effective pension fund in the country, he says.

These three measures are a high degree of outsourcing in both administration and portfolio management, the digitalisation of all work flows, and making use of economies of scale, he says.

Regarding outsourcing, Möger Pedersen says it is crucial for a pension fund to keep a constant watch over precisely what top management spends its time on.

"It is, from a long-term perspective, more important to spend time on the ‘important' instead of the ‘urgent'," he says. "Outsourcing helps that process."

Digitalising work flows streamlines processes for the fund. "Matching data from PensionDanmark with already existing data from government bodies dramatically reduced process costs," he says.

But perhaps the key to the scheme's success in driving down costs is its commitment to the task. Möger Pedersen says the organisation feels very strongly about getting low administrative costs for the scheme's members.

"First of all, a mandatory pension scheme…has an ethical obligation to deliver competitive products at a low price," he says. (See also interview on page 22)