How much does pension fund management have to cost? The mutual fund industry has been emphasising fees ranging from one to 1.5 percent of assets under management (AUM) per year. The insurance industry is used to even bigger numbers.

In 1999, the OASIS Committee set up by the Ministry of Social Justice and Empowerment had talked about numbers of 0.2 percent and below for the New Pension System (NPS), which could be obtained using an auction for procurement and using index funds. These numbers have been roundly criticised by mutual funds and insurance companies as being completely unrealistic and lacking in common sense.

A remarkable recent development shows the possibilities for low cost fund management under Indian conditions. The Coal Mines Provident Fund Organisation (CMPFO) recently conducted an auction to pick fund managers for assets of Rs 20,000 crore ($4.6 billion).

ICICI Securities and SBI quoted the lowest price of 0.01 per cent, in a competitive field containing HDFC Bank, UTI Bank, SBI Mutual Fund, IDBI Bank, IDBI Capital and Franklin Templeton. The CMPFO obtained a five-fold reduction in fees for fund management owing to this auction.

The result of this auction validates the approach of the NPS in targeting very low prices for fund management, through procurement by auction. Under Indian conditions, the cost of fund management -- which involves skilled labour -- is lower than the numbers found in the West. For a benchmark, the US civil servants pension, the Thrift Savings Plan (TSP), also uses an auction for recruitment of the fund manager for a fund of $186 billion.

The winning bids in the most recent selection were from Barclays Global, for fees ranging from 0.02 per cent to 0.08 per cent of AUM per year depending on the asset class. The experiences of the US civil servants pension are, thus, quite meaningful in thinking about the New Pension System in India, even though the size of NPS assets are tiny when compared to $186 billion.

CMPFO is a legislated fund under the Ministry of Coal. This highlights the fact that it is not just private sector treasuries which can drive such deals. The Employee Provident Fund Organisation (EPFO) which pays SBI less than 0.02 per cent is another example of competitive fees in a public sector setting.

Why are fees much lower with the US TSP, or the Indian CMPFO or EPFO, when compared with the gigantic charges of Indian mutual funds and insurance companies? The essential point is that bulk fund management is highly cost efficient. Mutual funds and life insurers pay large commissions to agents to get customers and then spend even larger amounts in trying to retain them through their marketing and advertisement budgets.

They also have to spend a significant amount in servicing retail customers. Fund managers' fees are drastically lower when the burden of an expensive distribution model and a large number of retail customers is taken out of the picture.

In the TSP, Barclays Global invests in debt and in equities (by passively tracking indices like S&P 500 or the MSCI EAFE). The subscribers in TSP are charged 0.05 per cent if they choose a stock fund or 0.04 per cent of they choose a debt fund. The subscribers in the TSP pay for the cost of the programme's administration and operations, including the expense of hiring Barclays as a manager. As with the NPS, the TSP achieves dramatically low costs through the centralisation of record keeping and the elimination of the conventional sales practices of fund managers.

Retail mutual funds in India, on the other hand, incur an annual expense ratio of 2-2.5 per cent. Then there is the entry and exit load over and above this. Recent offer documents filed by the mutual funds indicate that about half of the 2.5 per cent fee is for fund management.

The highest costs for fund management in India are found with insurance companies: they levy upto 50-60 per cent of the first year contribution in unit linked pension plan as charges. Only after the third year, do the charges recede below double digits. The high fee does not result in any special fund management services as it is largely paid out to the sales agents.

Such high prices are not in the interests of consumers. In policy discussions about pensions, it is emphasised that on a 30-year horizon, a 1 percentage point improvement in the rate of return generates a 30 per cent improvement in the terminal pension wealth. Equally, a 1 percentage point increase in the fees and expenses charged to the customer generates a 30 per cent reduction in the terminal pension wealth.

Good policy making in pensions is as much about the shift to equity and corporate bonds -- so as to increase the rate of return -- as about the organisational ideas of the NPS -- which would drive down the fees and expenses paid by the participants.

These expenditures reflect an inefficient organisation of the industry, and are eliminated by the NPS. The cost function for a fund manager under an NPS-like situation is very different. For example, the fund manager does not have to invest in fund collection infrastructure.

He would get the investment funds daily through a single cheque from an agency to be called the Central Record keeping Agency (CRA) and would be required to invest the funds as per the specified investment pattern under each of the available schemes. Further, there is no complicated stock picking to be done as the fund manager would largely track benchmark equity indices.

Further, the fund manager under the NPS would not be required to service the customers as that would be taken care of by the Point of Service (POS). In case of civil servants, the POS is the government itself. Once private sector POSs are envisaged, they would be working on behalf of the customers and not on behalf of the fund managers.

This could reduce the practice of distributors churning customers from one fund to another simply to get higher commissions. The fund manager would only be managing funds and even that would not require complex investment decisions as largely only passive investing in equity is contemplated.

Passive equity investment is the reason that even retail oriented Index or Exchange Traded Funds (ETFs) which track specific indices have a relatively low expense ratio compared to other equity mutual funds. For instance, UTI's Sundar ETF has an expense ratio of 0.5 per cent. Benchmark AMC charges an expense of about 0.41 per cent of the assets for its ETF -- Nifty BeES.

The charges could have been even lower if the fund AUM was larger than the Rs 140 crore ($35.25 million) that is managed under BeES.

The current commission costs for mutual funds agents are high because of structural problems in the distribution model of the mutual fund industry. In their case, the high commissions are paid not to grow the market and get new customers but to steal customers from other mutual funds or insurance companies. The NPS attempts to align the interests of the POPs to the customers'.

The NPS represents a fundamental 'business process reengineering' of the fund management industry, one that eliminates the huge payments being made to mutual fund agents and insurance agents. The CMPFO experience proves that an auction-based procurement for fund management for NPS will be able to deliver extremely low prices -- of 0.1 per cent or below -- in order to do bulk fund management.

The writer is Associate Director, Invest India Economic Foundation.