By Dale Critchley, Policy Manager, Aviva
The power of compounding means that a small % increase in returns transforms into a larger % increase in fund size at retirement.
It’s easy to show this in an illustration: decrease the charges and investment returns will rise, and if all other factors stay the same, the customer is richer in retirement. It’s also easy for people to understand. If I reduce the charges I can see that people are going to be better off than if charges (for exactly the same thing) were higher. We know that human beings aren’t good at processing huge amounts of data, we tend to shun complexity and look for simpler solutions to complex problems. This simple sum and the assumption that a workplace pension is a homogenous product works well.
The problem with the illustration and the thought process behind it, is that it’s not often in life that you can get the exact same thing for less. Anyone who’s been tempted to buy the cheapest bucket and spade for their summer staycation this year may well have discovered the folly of their decision as the spade snapped and the handle came off the bucket mid sandcastle.
If we were to consider the impact of a lower charge in depth, we’d need to examine a range of impacts, not just do the simple mental arithmetic.
A lower limit on charges for investment solutions may well limit the range of investments a scheme can use, the sophistication of any volatility management and the ability of the trustees to manage risks. At Aviva we’re focused on managing environmental, social and governance (ESG) risks within the funds we manage as well as through the default solutions we make available to workplace pensions. This helps trustees meet their legislative responsibilities as well as helping deliver sustainable long-term growth for members. But this additional work can result in additional costs.
Transaction charges are another type of cost that are currently under the microscope. These are the charges incurred by the fund manager when trading the investments that make up the fund. If we assume these are to be reduced, we have to think how that would be achieved. If it’s through fewer trades, what is the potential impact on returns if there’s more focus on buying and holding than trading?
Charges in bundled DC pensions don’t only cover investment costs, generally they’ll cover the cost of running the pension scheme, the administration and all member communications too. So, we’d also need to look at the impact of cost cutting in these areas and how they might affect member behaviour.
What impact would lower quality communications or administration have on member confidence in the scheme, and their ability to make good decisions when contributing, and importantly, when taking their benefits?
An employee who takes all of their DC benefits as a lump sum (potentially becoming an additional rate tax-payer in the process) can undo years of good governance and management of returns.
It’s clear that contrary to how we naturally think about charges, the impact of reducing them is not a simple and direct relationship with returns.
There are a host of intangibles that come into play. The more difficult decisions, about potential investment returns and human behaviour, demand more analysis by governance bodies.
While it’s important that we put charges under the microscope, its equally important that we look up from the microscope and take the bigger picture into account, to make those value judgements that can have such a significant impact on member outcomes.
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