Time to regulate disclosure requirements
August 17th, 2012 by 10X Investments
It is high time that Regulators mandate the minimum disclosure requirements. One of the reasons the retirement fund industry has been able to get away with high fees is its poor disclosure practices and the absence of regulations in this regard. Yet such disclosure is critical as total cost is the single most reliable predictor of a fund’s future performance.
There is of course a sound reason why the industry does not want to be transparent on pension fund costs. It wants to maintain the facade that it is competing on the basis of skill, even though the vast majority of general equity funds fail to beat the market over twenty years. The industry maintains this façade by marketing the gross returns of its best-performing funds and keeping costs out of sight (and hence out of mind). In this way an entire industry is able to overcharge and earn super profits (i.e. behave like a cartel).
But it is not simply a question of disclosing costs, or even reducing total costs down to one number, such as the reduction in yield. The following is required, to allow the investor to make informed decisions:
- Investors must know what fees they are paying. Investment returns should therefore have to be disclosed both before and after fees, and all deductions off contributions must be clearly visible.
- To this end, every investor should receive an annual invoice, detailing the rand amount of all costs deducted. This will give investors a true sense of how much money they are paying (nothing focuses the cost-conscious mind quite like a huge bill without discernible reward or performance!). The statement should show the balance carried forward from the previous year, to underline the accumulative impact of fees.
- At point of sale, total fees must be disclosed and placed in their proper context – namely the long-term real (after inflation) investment return the saver should expect from the investment. On a balanced portfolio, this may be 5% pa, on a money market investment only 1%. Investors must be informed how much of their real return will likely be eroded by fees, and what the likely impact is on the real (after-inflation) savings outcome. Only such disclosure will allow investors to make informed decisions, as required by the FAIS Act.
- Performance fees should be banned. These cannot be quantified, or factored in upfront. Investors pay active management fees for the possibility of outperformance, and should not have to pay even more fees if such outperformance is achieved. The argument that such fees align the interests of fund managers and investors is intellectually corrupt – given the skewed pay-off profile (fund managers do not compensate investors for underperforming), it merely encourages excessive risk-taking.
- A mandatory total expense or reduction-in-yield ratio would be helpful. It is however important that such a ratio is all-encompassing. Some fees are fixed, some are variable with the investment balance, some are one-off, some are quoted as a percentage of payroll or contribution. The UK has dedicated considerable time and effort to define this ratio. Importantly, it must also include distribution and investing costs (brokerage, taxes etc.) for local and international investments.
One of the objectives of the FAIS Act is to ensure that investors make informed decisions. It also requires that financial intermediaries disclose all conflicts of interest. Yet the very existence and tolerance of commission-based advice creates a conflict of interest, as the two parties compete in a zero-sum game for the same investment return. The mere disclosure of fees – if it happens – does not resolve this conflict. Commission-incentivise brokers will not voluntarily provide the context that would allows investors to really make an informed decision about costs and product choices. Only strict regulations will achieve that.