New Developments in Long-Term Asset Management

Supported by the Norwegian Finance Initiative
Monika Piazzesi and Luis Viceira, Organizers
First Annual Conference
Cambridge, Massachusetts

May 19-20, 2016

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Incentive Fees and Competition in Pension Funds:

Evidence from a Regulatory Experiment

Private retirement savings funds play an increasingly important role around the world. By the end of 2013, retirement funds in the OECD countries had about $25 trillion of assets under management (AUM). Moreover, countries increasingly rely on private pension schemes using the defined-contribution model, where investment risks are borne by savers. The well-being of future retirees around the world thus depends on the quality of investment decisions made by fund managers and on the extent to which these managers' incentives are aligned with the long-term interests of their investor-savers.

In this study, Assaf Hamdani, Eugene Kandel, Yevgeny Mugerman and Yishay Yafeh examine two policy instruments which regulators can use to align the interests of savers and pension fund managers — restrictions on the fee structure and the extent to which pension funds are exposed to competition. The researchers take advantage of a unique regulatory experiment in Israel that enables them to study the effect of performance-based fees and competition on fund performance and costs.

How does the structure of fees paid to private pension funds affect managerial behavior? A vast principal-agent literature prescribes performance-based pay for an agent whose performance depends on her unobserved actions. Yet, regulators around the world normally prohibit such incentive-fee arrangements in retirement savings schemes and other retail-oriented investment products, such as mutual funds. Instead, the predominant fee structure for retirement saving programs and mutual funds around the world is a fixed percentage of AUM. The rationale underlying the prohibition on incentive fees is the concern that performance-based fees might lead to excessive risk-taking.

Competition among funds may motive funds to serve savers' long-term interests even in an environment with AUM-based fee structures. The premise underlying this argument is that funds with better investment returns will attract more investors (inflows), thereby increasing assets under management and fees.

A unique historical regulatory setting in Israel provides a rare opportunity to estimate the effect of incentives and competition on fund performance. A decade-long process of reform has created exogenous differences among retirement-savings schemes in both their management fee structure and the intensity of the competition they face, based on the year in which they were established. Moreover, in many cases the same management companies run different types of savings schemes contemporaneously. This unique environment makes it possible to study how the fee structure and the intensity of competition affect the quality of management and risk taking in long-term savings schemes.

The researchers use monthly data on asset allocations and returns for 72 long-term savings funds for the 11-year period between January 2005 and February 2016. There are three types of funds in the sample: funds with performance-based fees, facing no competition; funds with AUM-based fees, facing low competitive pressure; and funds with AUM-based fees, operating in a highly competitive environment. The sample period includes the financial crisis of 2008, when funds taking higher risks would have been penalized.

The researchers find that funds with performance-based fees exhibit higher returns than funds with AUM-based fees. Whether or not they also exhibit higher risk depends on the measures used. Perhaps more importantly, funds with performance-based fees consistently exhibit higher risk-adjusted returns. Finally, they find that funds with AUM-based fees facing intense competition tend to underperform funds operating with minimal competitive pressure. However, competition does appear to be associated with reduced fees.

These findings have several implications for the regulation of private pension funds.

First, in the retirement savings industry incentives and competition do not appear to be perfect substitutes. On average, the performance of the portfolio of a saver who allocated her retirement savings to funds with performance-based fees would be superior to that experienced by a saver whose retirement savings are managed in AUM-based retirement savings schemes. By contrast, the performance of the portfolio of a saver who allocated her retirement savings to funds with AUM-based fees operating in a competitive environment would tend to be inferior, on average, to the performance of the portfolio of a saver whose retirement savings' managers are shielded from competitive pressures.

Second, the findings cast doubt on the efficacy of the prohibition on performance-based fees in retirement savings funds. Specifically, the research shows that this prohibition may undermine the quality of fund management. Even though, in line with the regulatory rationale underlying the prohibition of performance-based fees, funds with such fees may be perceived according to some measures as riskier than other funds (even though according to most measures they are not), performance-based fees seem to raise the quality of fund management to an extent that savers in such funds consistently realize higher risk-adjusted returns than investors in funds with AUM-based fees. Stated differently, it is possible that the natural tendency of regulators to try to avoid a near-term pension savings crisis through restrictions on the use of high-powered incentives may come at a significant long-term cost for the retirees.

Finally, the analysis suggests that it may be valuable to explore new directions for regulating pension funds' fee structure and competition. Regulators have at their disposal a variety of measures that can contain excessive risk-taking even under a regime of performance-based fees, such as quantitative limits on investments in certain asset classes and fiduciary duties.

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