Cap fund fees to pay for social care

Imagine you are in charge of a broke government. Perhaps you have a national debt edging towards 90% of gross domestic product and are still spending more than you get in tax revenues every month. Perhaps you have spent weeks playing with spreadsheets, but found that, whatever you put in, you can't get the date at which that deficit disappears to arrive any sooner than 2025. This is tricky because you have a pile of new financial obligations on your hands.

Your population is ageing. You need to find a way to finance their social care, their all-too-long retirements and the rickety health service you have keeping them alive. It is also tricky, because you can't see many places to raise the money you need: you have, for example, nailed your colours to the mast of cutting corporation tax. So while you know that there is no shortage of cash knocking around in some sectors late last year Britain's Financial Conduct Authority established that the average profit margin of UK-based asset management companies is 36% against an All-Share average of a mere 16% you have no taxation-related way to get at it.

This is exactly the situation that the UK finds itself in but it is also one that can be extrapolated to pretty much every Western government. Ageing populations. Not enough pension provision. And no obvious way to sort that out. The good news is that there is a way to significantly change part of the game. The bad news is that it is not very free market. The solution lies in fund management price caps.

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Let's say you save £300 a month for 40 years into investment funds of one kind or another inside a tax wrapper. Pay average annual costs of 1.5% (the average cost of an actively managed fund in the European Union ranges from 1.44% to 1.96% depending on the country), make an average return of 7% a year and you will end up with around £495,000. Apply the 4% rule (that it is safe-ish to spend 4% of your pension savings every year in retirement) and you will have an income of just under £20,000.

Now imagine the costs are 0.75%. Those numbers become £605,000 accumulated and £24,200 as income. Over £100,000 of wealth has been directly transferred from the financial services industry to the individual with no need for any tax and spend intermediary (more commonly known as the government). And that £100,000 does not just benefit one taxpayer it benefits all of us. The extra £4,000 income changes the beneficiary's entitlement to means-tested benefits and it also makes them more likely to be paying for their own social care. How's that for efficient wealth redistribution from an oligopolistic, competition-resistant super sector to the individual?

You might think this is very unlikely. I think you might be wrong. The UK at least has form on fees. The price of unit trusts was capped until 1980 in the mid-1960s the norm was to charge a 5% upfront fee and 0.25% a year thereafter. It capped so-called stakeholder pension charges at (a high) 1.5% for their first ten years and 1% thereafter. Last year regulators put in place a 0.75% cap for default auto-enrolment pension funds. There is also a 1% cap on exit charges from private pensions.

And politicians are having a go in other areas too: Theresa May is planning to cap utility bills. In this context, it is worth remembering her oft-repeated pledge to step in where the market isn't working and noting that in the fund management business regulators are pretty convinced it is not. You might also think that fees are coming under such pressure from passive funds that they will soon come down with no need for the regulator to say another word: as passive fees head to zero, surely active fees will head to 0.5%? You might be partly right: some of the better firms have set themselves on that path, but not enough of them.

The truth is that price competition won't work properly as long as fees across the industry are not directly comparable (which they are not); as long as the consumer finds the charging structure too complicated to engage with (look at the utilities market); as long as firms are allowed to keep trying to persuade investors to focus more on the hype about future returns than on price; and as long as the big managers have billions sitting in legacy funds that the consumer doesn't understand.

This situation gives the industry a choice. The first option is to work with regulators to start charging a clear all-in-one fee to include all administration and transaction costs and to print that number in the biggest, boldest type on every fact sheet. There is a remarkably high level of resistance to this. How, the managers say, can they know how much they will trade during a year and what it will cost? The answer is they can't, but, like all other sellers of services, they will just have to bear the risk of managing their businesses as best they can. Excellent price transparency is the first and best step to a properly competitive market.

The second choice for the fund managers is to keep foot-dragging on pricing. The former might ward off intervention for a while. I suspect the latter will not.

This article was first published in the Financial Times.