Superannuation and pension funds around the world are paying on-average 50% more in fees than they were five years ago, according to research by consulting firm Watson Wyatt. The research shows that fees now average around 1.1% compared with around 0.65% in 2002, with the vast majority of these costs being paid in fees to external investment managers and brokers.

Graeme Miller, head of investment consulting at Watson Wyatt Australia, says one of the main reasons for the rise in fees is the focus on alpha -- or the returns investors generate regardless of the general direction of asset classes or markets -- which has increased the appetite for alternative assets. ôInvestors have naturally assumed that they are paying these fees to reward manager skill, but in many cases they are wrong,ö Miller says.

Watson Wyatt notes that many pension funds have been paying alpha fees for beta performance, because the main driver of returns in recent years has been the strength of the markets. This has encouraged investment managers to leverage their portfolios to boost returns, which means that investors are often paying for leveraged beta or market returns multiplied by gearing, the firm says.

ôThis is obviously a good deal for investment managers, but not necessarily for their investors,ö Miller says. ôWhile we strongly believe managers should be fairly compensated, fees are currently too high for the value they deliver, particularly as we enter a lower-return environment. Also, performance fees introduced to align interests have been less than effective because they are generally poorly designed and tipped in the manager's favour.ö

The Watson Wyatt research identifies several flaws in investment manager fees: base fees are calculated as a percentage of funds under management, which encourages asset gathering and can harm performance; annual performance fees can amount to a free option for the manager, as the upside is uncapped but the downside is limited to the base fee; fees can also be paid on money waiting in cash to be drawn down for investment; many leveraged real estate managers charge fees on the gross exposure rather than committed capital; and fees charged by funds of funds can use a combination of these flawed approaches and in many instances lack transparency.

ôIn the recent past, many trustees have unwittingly paid away the vast majority of their alpha in fees, surprisingly even when their fund managers have performed particularly well,ö Miller says.

According to Watson Wyatt, an ideal fee structure should have a low base fee to cover costs and a performance fee which should be calculated over longer periods of typically three to five years, and include hurdles and high-water marks. In addition, total fees should never be more than 50% of alpha and costs should formally be included in fundsÆ risk budgets, the firm says. It also says that fee structures should not be standardised across the industry in view of the increasing diversity of investment strategies and mandates.

ôThere are signs of change as we move into a different market environment where many managers will no longer be able to justify their charges without beta to bail them out,ö Miller says. ôIn future, active managers that wish to win mandates from superannuation funds must offer them a fairer deal.ö