New FCA proposals to improve the disclosure of transaction costs in workplace pensions

Whose disclosure obligations?

The FCA acknowledges that there are usually several different parties involved in managing the assets of a workplace pension, and not all the information required for disclosing transaction costs will necessarily be available to a firm directly providing services to a scheme.

For example, a scheme investing through a fund of funds will incur transaction costs when the underlying funds invest in securities, and also when the fund of funds buys and sells underlying funds. An investment manager with a bespoke mandate will incur costs on behalf of a scheme when investing directly in securities and in the funds of other investment managers. An insurer providing a life/ trustee investment policy wrapper may use a third party manager which invests in range of further third party funds. In each case, input will be required from other parties in the investment “chain” to allow the lead firm dealing directly with the scheme governance body to compile the transaction cost disclosure.

The FCA considers that the ultimate responsibility to the scheme governance body rests with the lead firm providing it services, but other firms will be obliged in the new rules to provide the necessary information to facilitate this.

However, if an investment manager is not FCA-regulated, these rules will not create a direct obligation on that manager. This will impact on investment “chains” involving overseas managers. The new rules will apply to “firms”, meaning that incoming EEA and Treaty firms are caught in addition to UK authorised firms, but other overseas managers will not be subject to the rules. It will be important in this situation, where the scheme has a direct relationship with a non-FCA-regulated investment manager, to contractually require the manager to provide the necessary disclosure through the investment management agreement. Scheme governance bodies may also wish to revisit the documentation appointing their lead provider to ensure that the lead provider is obliged to request similar contractual protection when appointing a non-FCA-regulated manager behind the scenes or when investing in a third party fund that is not subject to UK rules. This may be difficult in practice in certain investment “chains”, particularly where a non-UK sub-investment manager is used or there is investment in offshore hedge and private equity funds.

Where a lead provider is not able to provide transaction cost disclosure for all the assets in a scheme, it will have to disclose this clearly to the scheme governance body with an explanation of why this has not been possible. The scheme governance body will then have to explain in its annual report why it has not been able to obtain the information and how it will take steps to be granted access to that information in future.

The obligation to provide information will be in response to a request from the scheme governance body, or another firm in the chain in response to such a request, rather than a minimum frequency imposed by the FCA (although the FCA notes that scheme governance bodies have annual obligations to report so in practice the information will be requested annually).

Categories of transaction costs

Transaction costs should be presented as a total cost with a breakdown into categories of identifiable cost. These categories should at least include:

• Taxes. Although taxes are not within the control of the manager and do not benefit the manager or any other party in the transaction, the FCA still considers them to be a disclosable transaction charge as they impact on the “value” of the transaction to the investor.
• Explicit fees and charges. The FCA notes that these should be straightforward to calculate and in some asset classes such as real estate could be a significant amount.
• Securities lending costs. The FCA expects fees payable to lending agents in securities financing transactions to be fully disclosed. Any reduction in the full revenue attributable to the loan (and thus to the portfolio) should therefore be reported as a cost.

Transaction costs must be amalgamated at the level of the “arrangement” (i.e. the individual arrangements available to members). Where an arrangement does not hold the investment for the whole reporting period, the transaction costs for the period actually held can be pro-rated, on the assumption that the costs were spread evenly through the accounting period.

An asset manager or other firm using an anti-dilution mechanism may factor the mechanism into the aggregate transaction costs calculation but it must also provide the sum of transaction costs for buy and sell transactions excluding adjustments for anti-dilution mechanisms, for clarity. The FCA considers costs attributable to managing flows into and out of the portfolio to be relevant for disclosure (as they impact on the value for money received by members) but these should be presented separately from costs arising from decisions taken by the asset manager as part of the strategy.

Other relevant information should also be presented where available and the FCA sets out non-exhaustive guidance on what this might include, such as: investment return, measures of risk, portfolio turnover rate, proportion of securities loaned or borrowed, costs other than transaction costs, and typical and maximum levels of entry, exit and switching costs.

As the Pensions Act 2014 will require the FCA and DWP to make rules for disclosing and publishing administration charges alongside transaction costs in due course, the FCA also includes, for completeness, rules to require disclosure of these administration costs to scheme governance bodies.

The FCA’s proposed calculation methodology for implicit costs

The FCA notes that explicit charges (separate from the product price) are straightforward to calculate. The challenge is how to calculate implicit costs which affect the price at which a transaction takes place, and how to ensure that firms apply this consistently.

The FCA’s proposed approach to implicit costs is to require the disclosure of transaction costs based on a comparison of actual execution price with the value of the asset immediately before the order to transact entered the market.

This methodology requires the actual price at which the order was executed (a matter of record in a firm’s accounting system) and the time an order enters the market (which should be captured by an order management system and is required to be recorded under MiFID in any case). This “arrival time” is then used to identify the appropriate valuation (whether the mid-market price or otherwise – see further below) of the asset at that time, which can then be compared to the execution price.

This approach is referred to as the “slippage cost”, the general principle being that the transaction cost is the difference between the price at which the asset is valued immediately before the order is placed in the market AND the price at which it is actually traded. This “loss” of value is the implicit cost of the transaction.

The FCA considers that this methodology relies on data that are widely available for most assets, avoiding the need for complicated calculations or estimates. It believes it has created a regime which is resilient to future changes in practice and allows for reporting of transaction costs without creating incentives for asset managers to undertake transactions in a particular way.

The FCA notes that it rejected the main alternative methodology (the volume-weighted average price or VWAP) because it can only be applied more liquid markets and is perceived as being more open to gaming or manipulation.

Calculating the arrival price and factors that may be taken into account

Where intraday prices are readily available, the appropriate arrival price is the last price immediately before the order entered the market. Where intraday prices are not available, it is the last available mid-price (which may be the opening price, or the previous closing price where no subsequent price is available).

For equity trades agreed by auction, the appropriate arrival price will be the mid-price immediately prior to the auction. Where an instruction is given to place an order into the market at a specific time, the price at the time the order is transmitted to the executing broker should be used to calculate the arrival price. Where an order is transmitted to a broker outside trading hours the subsequent opening price should be used.

For bonds that do not trade on a daily basis, the FCA considers the valuations maintained by market data providers to be a fair assessment for an arrival price (while noting that MiFID II may lead to a greater availability of intraday prices for bonds).

For foreign exchange, a consolidated foreign exchange rate should be used to calculate the arrival price, rather than a rate taken from a single counterparty (even where there is an agreement in place with a single counterparty to undertake all foreign exchange transactions).

For derivatives that are publicly traded on transparent markets, the arrival price will be the price of the derivative at the time the order is transmitted to the broker and the transaction cost will be the value of the exposure to the underlying asset that the transaction has obtained at the actual transaction price, compared to the value of the exposure that would have been obtained at the arrival price.

Linear over-the-counter derivatives (i.e. whose prices move up and down directly in line with movements in the underlying asset) should have transaction costs calculated using the costs of transacting in the underlying asset. This would mean using the price of the underlying asset itself as the arrival price (appropriately weighted if the derivative relates to more than one underlying asset).

Non-linear over the counter derivatives such as options may have materially different trading costs from trading in the underlying asset. Instead of a market price, a fair value price for the option should be used as the arrival price. The FCA expects firms to calculate this fair value in accordance with normal market conventions but does not provide any further guidance.

Illiquid assets such as residential property should also have their fair value used as the arrival price, whether from a prior valuation adjusted for known market movements, or an independent valuation prior to transacting, or where no valuation is available, an assessment of fair value based on reasonable comparable information. The FCA notes that explicit costs tend to be significant for illiquid assets and these should be presented clearly.

The FCA notes particular difficulties around situations where “spread” is used to determine costs (the difference between reported buy and sell prices). There is a risk of a high degree of inconsistency in this approach, and detailed regulatory guidelines or standard spreads would be likely to be too inflexible. The FCA considers that the best approach in this situation is to determine “effective spread” (i.e. between the actual transaction price and the previous mid-price), which the FCA believes is consistent its proposed methodology.

The FCA does not propose a definition of “market impact” in the rules. It considers that when analysing a large number of orders, the market impact that relates to market fluctuations should tend towards zero. Where it does not, this represents a cost that is the consequence of the investment or trading strategy. The proposed methodology will therefore capture the cost of market impact but will not separate out market impact from other factors.

The FCA methodology excludes the impact of “delay costs” (not executing an order on the day it is raised) by effectively resetting the arrival price to the opening price on the day of the transaction (or the previous close if the opening price is not available). The FCA notes that factors that affect day to day performance should be counted as investment performance (reported separately to investors, but not a transaction cost) whereas costs that arise on the day that a transaction takes place should be reported as transaction costs.

The FCA notes that a number of commercial providers are able to carry out the type of analysis required to implement its proposed methodology but equally firms should be able to build their own systems to calculate transaction costs using this methodology if they wish to do this in-house.