23rd July 2012
The report's publication today coincides with pensions minister Steve Webb telling the Daily Telegraph that the coalition wants a clampdown on "excessive" pension fund charges. He warned "the Government will act within months to cap excessive fees if it has to."
London School of Economics academic Kay wants UK equity markets to support as a core purpose enhancing UK company performance and financing and providing returns to savers. He condemns the "short-termism", principally caused by "a misalignment of incentives within the investment chain and the displacement of trust relationships by a culture based on transactions and trading."
Long term trust
The report does suffer from a case of "motherhood and apple-pie"; among the headline recommendations in the 100 pages plus report are:
· moving away from a focus on short-term transactions and trading to an environment based on long-term trust relationships.
· better aligning asset managers' remuneration to the interests of their clients
· the need to ensure that the regulation of market structures and incentives work properly for the real end users.
Who could possibly disagree with any of those?
Business secretary Vince Cable, whose department commissioned the report, said: "This is an insightful and powerful review which describes vividly the flaws of the UK's financial markets and their relationships with investors and businesses."
Putting Kay into action
The question now for investors is how will these changes – in particular those that affect the City culture that has grown over the past twenty five years – be put into action.
Cable says: "Professor Kay has set out his clear vision for a way forward, with recommendations for government and others, and I will consider these in depth and look forward to responding in detail later this year." This is government speak for "don't hold your breath".
Will there be attempts at top-down moves which could take years of debate, possibly leading to little other than cosmetic alterations, and scant underlying cultural change, or will savers act in a bottom-up fashion, looking for changes to the present model which, the report states, is often more aligned to the needs of the investment industry than to investors?
Layers upon layers of fees
The Kay report criticises the layers of charges including platform fees, custodian fees, fund manager fees, fund of fund manager fees and financial adviser fees. This could suggest a return to a simpler situation where investors are either self-directed or deal directly with a fund manager – as they do with many investment trusts – or a stockbroker with a one-off fee for buying and selling.
Kay admits: "There is no ‘magic bullet' that will deliver these outcomes, but the range of recommendations set out in this review will provide a clear vision and roadmap to help us achieve a financial world very different from our recent experience."
Short-termism eroding trust
The report deals firstly with "the erosion of trust and the misalignment of incentives". These include:
· Short-termism – a tendency to under-invest in assets, research, staff or reputation balanced by hyperactivity in restructuring, financial engineering and mergers work. The conflict between "the imperatives of asset managers" and the interests of those who invest in it is at the heart of the Kay analysis of short-termism.
· Quality not quantity – it's not the amount of shareholder engagement that counts but its quality. Many companies would rather dissident shareholders sold rather than engaged – they prefer the anonymous trader to the concerned investor. The decrease in the role of insurance and pension companies and the increase in the short term trader holdings has reduced the incentives for engagement
· Equity markets no longer raise significant new money – their principal role has become the oversight of capital in a company rather than between companies.
· The growth of intermediation – layers of management and advice – has led to increased costs for investors but increased potential for "misaligned incentives" and "a tendency to view market effectiveness through the eyes of intermediaries rather than companies or end investors."
· A regulatory approach which has led to "large quantities of data, much of little use to users." This could "drive damaging short term decisions by investors."
· An asset manager focus on the "behaviour of other market participants rather than on understanding the underlying value of the business."
· Monitoring of asset managers is "too often based on short term relative performance".
Solutions will take time
But while most market participants will understand the analysis, the Kay-proposed solutions a mix of the positive and the vague.
The easy to understand include:
· Consultations with major long term shareholders over boardroom appointments
· An end to managing short term earnings expectations (including the current quarterly reporting)
· Full disclosure of fund manager costs including transaction charges and performance fees.
· Income from stock lending to be disclosed and rebated to investors.
· Finding cost effective ways for private investors to hold assets on an electronic register.
Many other recommendations, however, sound more like a wish list than ideas that could be put into force. These include:
· High quality reporting should be "strongly encouraged"
· Merger and acquisition activity should be kept under "careful review" by the government and by investors
· Regulators should shy away from prescriptive models in valuation and risk and instead encourage "informed judgement"
· New standards of fiduciary duty which are not capable of being contractually overridden.
· A more expansive form of "stewardship", focusing on strategic issues.
Will John Kay's labours on his report make any difference? Only time will tell. The substantive question is whether the asset industry can make changes to practice and culture based on Kay's undoubted good ideas before investors vote with their feet and find other ways of engaging their funds.
Pension fund anger is limited
Meanwhile, pensions minister Steve Webb's look at pension charges seems limited to old style products with high charges.
He said: "I would like to see the leading companies look again at their ‘back book' of old pension policies. They should ask themselves if the battered reputation of their
industry would not be greatly enhanced if they were to revisit these schemes and offer scheme members fairer terms."
With auto-enrolment just months away, the government is conscious of the need to avoid adverse pensions publicity. And it must be aware that the last government's "big pensions idea" – Stakeholder plans – produced little new savings while the initial low cost structure was combated by the pensions investment industry which eventually succeeded in forcing costs higher.
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