Something funny happened to the custody business on the way to the 21st century: ‘custodians’ effectively became ‘financial services providers’. The term ‘custodian’ is still widely used, of course, but custody provision itself is no longer a real differentiator in the market.
All of the established providers do custody well, within reasonable margins of error and subject to varying levels of client service – the added value proposition comes from products and services beyond basic custody. But many pension fund trustees have been slow to grasp how much more than custody their ‘custodians’ can offer, and while trustee knowledge and understanding of the financial services industry is steadily increasing, a large gap still exists between the resources which are available to pension funds and those which are actually being taken on board.
A bit of a history lesson may be in order. In the earliest days of custody provision, custodians were little more than huge safe deposit boxes for certificates of ownership of shares, bonds, warrants and derivatives. As the custody process increasingly became dematerialised and automated, the industry became much more efficient – the myth of custodians as gray-haired, heavily whiskered gentlemen sitting in front of vaults and twiddling their thumbs was debunked. With increased efficiency came the realisation that custodians could expand their core offering into competencies such as income collection, tax reclamation, corporate actions and proxy voting, and then to diversify still further into areas which are complementary to custody but not directly related to it. Some institutional investors drove this expansion as their global businesses expanded, but many others remained conservative and avoided the uncertainty of an industry still perceived to be evolving.
The expansion of ‘custody’ services was paralleled by a consolidation in the number and range of providers. As industry boomed in the 1990s, spurred on by ever-increasing cross-border institutional investment, asset managers increasingly outsourced their custody-related capabilities to specialist custodians and vacated the field.
This consolidation encouraged the rise of ‘global custodians’ with an expanded – and increasingly integrated – product offering. At the same time, these providers were given an indirect but valuable boost in the UK by the publication of the Myners Report in 2001, which criticised pension funds for not actively seeking to add value in the investment process and for not looking beyond a limited range of investment consultants supplying bundled actuarial and investment advice.
Providers capable of adding value beyond custody suddenly had an audience being directed to listen to them.
Four years on from Myners, investor knowledge has increased by leaps and bounds. Investment consultants dedicated to niche pensions topics are increasing in number and being increasingly used to provide sound advice. Forums such as the NAPF are now hugely prominent. Media attention given to pensions issues is at an all-time high, and shows no signs of waning.
But for all of this, a central question remains: are pension funds putting their increased investment knowledge to good use, or does the heart remain stronger than the head? Are trustees appointing ‘custodians’ for the old, historic reasons, or have they advanced to the extent that they can focus upon elements of the financial services equation which can really add value to their scheme members? The short answer is that more pension fund clients are indeed getting more out of their service providers, but this trend is progressing much more slowly that perhaps it should.
Particularly in the post-Myners world of funding shortfalls and regulatory responsibilities, pension funds should be challenging their financial service providers to answer tough questions about where they can add real value. The rise of the global provider has effectively eliminated the distinction between ‘core custody’ and ‘value-added’ services. Today, pension funds should view any service which can help them become more efficient and/or eliminate costs as fundamentally important. Here are some key questions fund trustees should ask themselves:
n Can our provider offer a wide array of additional products and services to reduce risk or enhance return? Are we missing out on opportunities to use services like securities lending and commission recapture to minimise costs? Do we have access to state-of-the-art currency overlay products and services which can help us maximise cashflow?
n Are we getting the amount and quality of reporting we need from our provider to feel confident about where we stand, both at the macro and micro levels? When multi-jurisdictional reporting becomes an issue, are we getting the reporting support we need to tie many disparate strands of data into one comprehensive picture?
n Do we have performance measurement consultants who can review and present an expert opinion on the performance of the fund? Do we trust the expertise behind those numbers? And is that performance data presented for us clearly, in a way which directly helps us make better investment decisions?
n Does our provider have a consulting services group which can look at our internal processes with a view to re-engineering them to increase efficiency? We may have a financial services consultant, but are there ways we can use our provider’s expertise in a quasi-consultancy role to help align its services with our needs?
n Do we have a transition management team in place to mitigate the risk and cost of changes to our investment management structure, or to facilitate a shift to a liability-based benchmark? If not, have we done our homework on what transition management might have to offer us in the future?
The point about ‘quasi-consultancy’ is perhaps the most critical of all. A good financial services provider should know the needs of its established clients better than anyone – including any independent consultant(s) – and will be in a position to offer solutions in areas where they identify a gap in the fund’s current provision levels. Trustees who err on the side of conservatism and view such approaches by their service provider as invasive attempts to cross-sell can miss out on very useful benefits. These are not the go-go 1990s anymore – every little bit of added value can ultimately make the difference between shortfall and surplus.
If a pension fund cannot trust its provider to provide useful advice with the fund’s best interest at heart, a vital element of partnership is missing and must be quickly rectified lest the relationship dissolve.
The one caveat to the value-added equation is that transparency issues must not be overlooked. This is particularly true on the supply side – the discovery of hidden costs can be the death knell of a productive partnership – but it also pertains to the fund itself. Myners urged that pension schemes do everything they can to add value, and indeed to measure their own performance as well as that of their advisors and managers, but also that every decision is taken openly, guided by a strong ‘Statement of Investment Principles’ which accounts for the current market landscape and provides clear direction about the fund’s intended course of action. By all means, funds should add more products and services when appropriate, but only within an environment which is open and transparent to everyone: consultant, provider, trustee and scheme member alike.
Of course, ‘transparency’ must not be used as a crutch any more than regulatory pressures or market conditions should be used as excuses for defensive thinking about custody-related issues. Financial service providers are now able to offer more products of greater usefulness to their customers than ever before. In turn, pension funds must embrace their responsibility to deliver maximum value to their scheme members and begin to ask tougher questions of themselves, their providers and their consultants. The sooner that ‘custody-only’ is seen as a potential problem, not an all-encompassing solution, the sooner such funds will be able to embrace all of the added value their financial services providers have to offer.