Just as the dust is starting to settle over 401(k) fee scrutiny, new research shows performance fees paid by pension funds worldwide are up 50% compared to five years ago, reports Watson Wyatt.

"This is obviously a good deal for investment managers, but not necessarily for their investors," says Paul Trickett, European head of investment consulting at Watson Wyatt. "While we strongly believe managers should be fairly compensated, fees are currently too high for the value they deliver, particularly as we enter a lower-return environment," he adds.

For instance, fees now average around 110 basis points (1.10%) compared with around 65 basis points (.65%) in 2002. The reason cited for the spike in fees stems from investors' focus on "alpha" generators- hedge funds, private equity and real estate- intended to outperform the market. Beta investments, by comparison, yield an average market return.

In the report brief, analysts contend that fee structures in the asset management industry are too high for the value they offer.

Craig Baker, global head of manager research at Watson Wyatt, explains that hedge funds generally charge an annual base fee of 1% to 2% on the value of committed capital, with a 20% performance fee. Private equity fees are similar. Yet, he points out that this is far more than the typical annual fees charged by traditional long-only managers, which would often be below 50 basis points (.5%).

Pension fund analysts agree that performance fees provide managers with an incentive to perform well and ensure that their interests reflect the clients'. The alignment of interest, however, is seriously lacking in the current fee model, Baker asserts.

With the present system, "annual performance fees amount to a free option for the manager," because the upside is uncapped while the downside is limited to the base fee," he notes.

Pension funds generally assume they are paying high fees to reward a manager's skills, or alpha.

But in reality, investors are paying alpha fees for beta performance, given that the main driver of returns in recent years has been the strength of the markets, Baker observes.

The current market encourages investment managers to leverage their portfolios to boost returns, thus investors are often paying for leveraged beta.

Yet he warns managers that "flaws in fee structures tend to become exposed when markets falter."

Trickett admits this is "a complex area, which doesn't mean it should be glossed over, as too much value has already been allowed to leak away."

He believes the industry is headed into a different market environment where many managers will no longer be able to justify their charges without beta to bail them out.

Investment managers that "wish to win pension fund money will need to offer them a fairer deal," Trickett contends.

To get the performance-fee system back into line, Watson Wyatt recommends the following:

• Investors need to understand what proportion of alpha their managers are taking in fees, even if they are doing a good job.

• Managers should always set hurdles, such as T-bills or a realistic fixed percentage, reflecting the expected long-term beta exposure, which may even be leveraged beta. They would then collect fees only on performance above this benchmark rate.

• Instead of calculating performance fees based on annual results, charge the fees on a rolling three-year basis, or longer.

• This reduces the option value and makes performance fees a fairer deal for investors.

• Base fees should reflect actual costs. Calculating base fees on the value of assets under management encourages asset gathering, which can harm performance.

• Fee structures should not be standardized across the industry, given that investment strategies are so different. A low-capacity strategy, or one that requires a costly global infrastructure, is justified in charging higher-than-average base fees.