Hard going for smaller funds
Size is not everything but for small European pension funds their investment options can be constrained by whether they can find a custodian prepared to take on their business.
Consolidation in the custody business is also potentially leading to pooling of pension funds to gain economies of scale, although offering other services as part of the deal and attracting new entrants to the market might be easier options, according to experts.
Custody is the safekeeping of a traded security, once it has been cleared and settled. The custodian also collects the dividends, watches out for corporate actions, such as mergers and acquisitions that would affect the client’s holding, reclaims taxes and deals with proxy voting.
Most small pension funds, however, do not use a separate custodian. This is because they use balanced, or pooled, rather than specialist accounts. By using a pooled vehicle, the fund manager takes care of the custody of the securities.
Mark Walker, head of the European custody group at Mercer Investment consulting, says if a pension fund had reached a reasonable size and was looking to move from a pooled vehicle to a segregated account then the issue of custody costs needed to be kept in mind with the types of fund managers wanted, in discussions with the investment consultants.
He says: “About £200m (e325m) to £250m is a reasonable size to have segregated assets rather than balanced or pooled but pension fund trustees should think of whether they want to be finding custodian at the same time of making a decision rather than letting the pooled or unit trust fund managers take care of custody.”
The custodian holding the segregated portfolio’s securities might also report on the pooled vehicle’s securities as well, to simplify the information received by trustees. But he warns: “Size does matter to custodians.
“For the smaller pension funds with specialist fund managers running segregated accounts of between £15m and £50m, where the managers do not have tied relationships with custodians, means the trustees need to find a separate custodian. But there is a struggle in finding choice between providers.”
He says there were only one or two custodians targeting the smaller pension funds, such as KAS Bank. John Gout, head of Dutch sales at Northern Trust, agrees. He says: “Small pension funds have difficulty in getting serviced by custodians and they might have to pay more. And some of the major global custodians, such as Citibank, JP Morgan or State Street, have high minimum fees for global custody and so the pension funds needs major performance to overcome this.”
Christian Schlenger, managing director at Alpha Portfolio Advisors, says that in Germany every institution needs a custodian for their Spezialfonds. These funds have to use a KAG, a bank specialising in investment funds, that includes depository or custody services platform, which can be run by the asset manager. In a master KAG structure, a global custodian is used. He says: “There is no legal minimum size for the Spezialfonds to need a custodian but the typical size is about e50m.”
Schlenger agrees, “size matters as custodians prefer scale”. He says the fees charged by the custodians were quite low, at between 1 and 9 basis points. “For a Spezialfonds of less than e50m a bank will take on the custody if it is profitable, perhaps by tying it in with asset management.”
Gout says from his experience between 1 and 5 basis points in fees was more common but by broadening the services required by the custodian then it could be undertaken. He says: “We look, for example, at multi-national companies, to offer them a global concept of service so that if one of their local pension funds, such as in the Netherlands, is small it might be offset by a big and profitable fund in the US.”
Gout adds that as the pension funds have to have a custody or agent bank, such as ABN Amro, ING or Fortis, then small pension funds with mainly local assets will tend to go to the agent banks that can combine custody with foreign exchange dealing or investment management.
Custodians are broadening their service offering to encompass anything required after the front office has traded.
Walker says: “Core custody is not quite a commodity but it is relatively low margin business. In the future, small pension fund custodians will probably want to broaden service offered to them as well as bigger players and so do performance measurement, accounting or commission recapture business.”
Another way of broadening the service offered by custodians and paying their fees is for pension funds to lend out their securities, for a fee, to hedge funds or others.
Walker says : “The minimum discretionary fees for custody and safekeeping is usually between £30,000 to £40,000, but this can be offset by securities lending. However, this depends on the pension fund having the volume of securities required by the other party and what type of portfolio it has.
“There are not too many pension funds with less than £50m in assets offsetting custody fees by securities lending but there are some with more than £200m. It tends to be UK funds lending out gilts but there is more money to be made from European equities.”
Schlenger says: “Security lending is an option for all its_German clients but less than 50% use this to offset custodian fees as it depends on the asset class held in their portfolio – with specialist areas, such as emerging markets or Japanese equities or euro small and mid caps or corporate bonds being of most interest.”
Gout agrees. He says: “Small firms have difficulty in getting custodians to perform securities lending. So they may combine a number of pension funds to construct a pension pool to gain the scale to lend out a sufficient pot of interest to investment bank clients or just as a way to make it more economic to pay the custodians fees directly.”
He added that consolidation of custodians and banks “will lead to small pension funds combining, as the custody costs are high and to make sure they are serviced.”
Walker agrees that consolidation was happening. But he says as markets developed across Europe new players were entering some of the smaller markets as they became more developed. Ireland, for example, had seen the primary duopoly of the Bank of Ireland and AIB, which had usually tied custody to the provision of investment management, broken by foreign providers, such as ABN Amro and Northern Trust.
Walker says the Dutch market was similar to the UK and Ireland, as the most sophisticated funded pension scheme market, in having foreign provision of custody and global players. “In other markets, it is mainly domestic players that provide custody to the smaller pension funds, such as BNP Paribas in France, Pictet in Switzerland, Nordea in Scandinavia and Fortis in Benelux.”
For pension funds looking to keep custody fees to a minimum, therefore, there appears to be a difficult line to draw whether it is feasible or desirable to take on a global custodian.