The pension industry is facing calls to cut “enormous” fees just as an estimated eight million individuals are about to join the retirement savings market for the first time.

Just months before auto-enrolment legislation, which obliges all UK employers to offer a workplace pension scheme, comes into force for the largest employers, a report from think-tank the Royal Society for the Encouragement of Arts, Manufactures and Commerce (RSA) says inappropriate pension charges are swallowing as much as 40 percent of final retirement pots.

The RSA’s report Seeing Through the British Pension System says customers are “being badly misled about the true nature of costs and charges” and that “markets will fail; customers will buy bad products and good pension suppliers are likely to be replaced by bad ones”.

The auto-enrolment market is already heavily cost-conscious, with providers keen to keep charges sub 50 basis points (bps), and this has thus far proved a boon for passive managers.

The government-backed default scheme, the National Employment Savings Trust (Nest), charges a 30bps annual management charge (AMC) and has made clear its commitment to passive management as a means of achieving its low cost status.

As a key tenet of its investment beliefs Nest states: “Passive management, where available, generally delivers better value for money than active security selection.”

Such an endorsement of passive management could not come at a better time for the sector, with millions of fledgling savers on the cusp of joining the market, but how are passive managers responding?

Nick Blake, head of retail at Vanguard, says new pension money is flowing towards passive investment but the type of savings vehicle employers choose for their staff is dependent on the problem they are trying to solve.

He says if the goal is to keep costs as low as possible, then 100 percent index trackers seem the most likely solution. “Our experience is there has been a good movement to passively managed products. That is normally on the basis that employers say what they have already got looks damned expensive and they know there is better value to be had out there,” Blake says.

Along with low fees, employers also expect simplicity from their pension products.

The National Association of Pension Funds says 80 percent of defined contribution (DC) pension scheme members are in the default fund, which means they leave asset allocation and investment management selection decisions to their employer.

Consequently, employers need to be able to communicate the investment decisions made on their members’ behalves both simply and effectively, which also plays to the passive manager’s strengths.

Richard Hannam, European head of passive equity State Street Global Advisors (SSgA), says: “There is a simplicity [to passive management] as well as lower governance and lower costs and that is important in terms of the final return you achieve.”

The low cost, straightforward nature of the index tracker offering has enabled passive managers to gain significant DC market share, a trend which is likely to continue.

According to the Defined Contribution Investment Forum, which is made up of DC asset managers, passive assets accounted for 35 percent of all UK DC pension scheme assets in 2010. By 2020 the organisation predicts this figure will reach 46 percent.

To maintain this momentum, however, passive managers may find it is not as simple as offering the 100 percent index tracker funds that typified the default options of old.

Since 2008 market volatility has given DC investors such a bumpy ride that there is a demand for products that offer a much smoother investment experience.

In response, diversified growth funds (DGFs) have become more popular, offering investors exposure to a variety of asset classes and promising more of an absolute return.

The best DGFs were able to hold their value in both 2008 and 2011 at a time when 100 percent equity savers saw their pots diminish.

Brian Henderson, European head of DC pensions at investment consultant Mercer, says: “Traditionally we have seen DC schemes 100 percent invested in equities, often in tracker funds, but over the last three or four years people have been trying to get out of those investments. There is a greater appreciation of member outcomes; employers and trustees recognise they can get one-third or half the volatility from a DGF than a 100 percent passive equity fund.”

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