Pension funds – should performance fees be retired?

While some pundits have argued recently that performance fees have had their day, this is an oversimplification, particularly in the retirement fund industry.

In the retail space, investors are essentially price-takers, as they have no negotiation power over the fees and the fee structures that they pay to asset managers. If they are unhappy, their only option is to vote with their feet.  With retirement funds, the situation is different as trustees and their advisors can influence the way performance fees are structured. 

Performance fees have historically favoured asset managers, were often highly complex and their calculation was not readily replicable or sufficiently transparent to investors. Regulatory instruments like the Default Regulations and Treating Customers Fairly are promoting simplification and transparency of fees. Active asset managers are facing increased competition, including in the form of passive or index investments. Consequently, asset managers are recognising the need for compromise in fee structures.

Though increasingly viewed with skepticism, performance fees can, in fact, be beneficial to retirement fund members if they are structured in a way that appropriately incentivises fund managers. Equally, flat fees can sometimes act as more of a drag on returns than performance fees.  

When it comes to structuring a performance fee, there is a breakeven point or ‘sweet spot’ that trustees or their advisors can calculate to determine the point at which a flat fee or a performance-based fee provides longer term better value.  Further, the appropriateness of the benchmark on which performance is measured, should be interrogated. 

Over and above that, we believe that in today’s environment performance fees need to meet certain minimum criteria, namely:

• They should be transparent. Gone are the days when a ‘black box’ approach is acceptable.  How fees are calculated, what the threshold is before they kick in, and every other aspect of a performance fee should be disclosed by the asset manager.
• They should be simple and replicable. An overly complex fee structure makes it difficult for trustees and members to understand and can often leave trustees feeling that a manager is simply pulling the wool over their eyes.
• It should be representative of the investment opportunity and the investment mandate being implemented.
• It must be fair to both the members and the managers when underperformance occurs. This means there should be a structure in place whereby managers give back some of performance fee charged to the fund if they subsequently underperform.

When structured appropriately, performance fees can align the interest asset managers and retirement fund members, to the ultimate benefit of both.

– Prasheen Singh,
Senior Consultant, Investment Advisory, RisCura

* This article was originally published online by Money Marketing on 26 June 2019.