Every pension fund uses the services of a custodian for safekeeping its assets and settling its trades. The custodian may be appointed indirectly – via the fund’s investment managers – or the fund may directly appoint its own custodian(s).
In some cases, when a fund chooses a particular investment manager, the manager will request the fund to appoint its own custodian. This is an increasing phenomenon in the UK. Another form of directly appointed custodian involves the pension fund choosing to appoint a ‘master’ custodian – a custodian that not only provides safekeeping and settlement functions but also provides consolidated reporting covering all the fund’s investments.
The one benefit that all pension funds get from appointing an independent custodian relates to risk control – if anything goes wrong, the fund has a direct contractual agreement with the custodian, and can use this to seek recompense. In contrast, where the fund uses the investment manager’s custodian, it needs to work through the investment manager to resolve any difficulties.
As a fund’s assets grow and it increases the number of its segregated investment portfolios, other benefits of an independent custodian, particularly a master custodian, can be realised. Firstly, the fund gains the benefit of receiving reports in a consistent format on each of its investment managers and portfolios. The second benefit is that the master custodian will consolidate reports to show positions for the fund as a whole.
The fund can access further efficiencies in reporting if it uses the custodian to prepare information that is otherwise compiled internally or by another third party. For example, custodians can provide reports complying with the fund’s accounting reporting requirements, thus saving significant time in the preparation of annual accounts. As a master custodian has all the data on the pension fund’s assets at hand, it can easily perform other calculations and prepare reports, such as performance measurement and analysis and the effect of any derivative holdings on exposure to each asset class and market.
Another major advantage of an independent custodian relates to the additional risk management tools it can provide – for example, the custodian can perform automated checks of one or all investment managers against their investment guidelines at a frequency specified by the fund. There are numerous other services custodians can perform for pension funds to improve the efficiency of investment operations, enhance risk controls or provide access to additional revenue. The value of these to each pension fund will depend on the size of the fund, the structure of its investments and its attitude to risk.
In the UK there are currently 10 custodians which service pension funds. The best custodian for each particular pension fund depends on the nature of the fund and the services it requires from the custodian. Large UK pension funds (those with in excess of £500m (e820m) do not find it difficult to locate a willing custodian. However ‘smaller’ funds often experience difficulty attracting custodians willing to offer satisfactory service at a decent price. This situation is changing with the entrance of two new players in the UK master custody market – Clydesdale Bank and Kas-Associatie.
The process of selecting a custodian is the first step in ensuring a successful, long term relationship, so it is important to get it right. There are various elements to a successful selection process.
The very first step in any third party selection process is to define the key objectives of appointing the third party and the criteria against which each candidate will be assessed. When selecting a custodian, objectives might include accessing best practice services, outsourcing non-core functions, improving reporting capabilities, reducing costs or achieving greater value for money. Evaluation criteria will obviously include service capabilities and proposed fees, but may also include factors such as commitment to the custody business, structure of the client relationship team and risk management processes.
The next step is to define service requirements. To do this properly, the fund should have some knowledge of market best practice (in order to gauge whether its expectations are realistic) and whether the service it is seeking is standard or top of the range (in which case it might expect to pay an above average fee).
A request for proposal (RFP) needs to be prepared to communicate the service requirements and investment structure to custodian. The RFP should also include a set of questions to enable the fund to assess responses against the key criteria.
The responses received from custodians are invariably voluminous and, with the exception of fee quotes, include written responses that often have a heavy tilt toward marketing hype. As a result, any evaluation tends to be subjective with a strong risk that focus will be on only a few aspects, often fees. Even fees though can be difficult to evaluate, as each custodian’s fee structure will differ from the others no matter how tightly you attempt to specify the assumptions and basis they should use. Introducing objectivity into the evaluation process is the key to overcoming the obstacles and incorporating all the evaluation criteria in the results.
A further complication in the evaluation process relates to verifying the claims made by the custodians – and in many cases, what the claims actually mean about the custodian’s processes. Claims can be checked by collecting references on shortlisted custodians and visiting each of the custodians with a set of supplementary questions which probe into the areas of concern. At this point, provided the above obstacles have been dealt with effectively, it should be relatively straightforward to summarise the results so that key findings can be easily compared and debated.
A thorough selection process will uncover the best custodian by ensuring no key aspect of the arrangement is overlooked, presenting findings in a way that is easy for trustees/decision makers to interpret and providing supporting data to demonstrate a thorough process to regulatory bodies or other concerned parties.
Once the preferred custodian has been identified and agreed, the new arrangement needs to be implemented, which will test a fund’s project management capabilities. Even smaller funds should allow two months for the transition to a new custodian, to ensure sufficient time to complete paperwork and conduct test data transfers before the actual transition of securities and records. A detailed transition plan should be developed for this process, and if the fund does not have the resources to be actively involved in the transition management, it should consider seeking outside assistance.
During transition the fund negotiates its contract with the custodian and documents its service requirements. If the custodian’s contractual stance was considered during the selection process, the fund may have been able to achieve significant improvements in the standard provisions - this is the time when its negotiating power is strongest. After the selection process, less important points and precise wording of amendments are agreed. Under no circumstances should the fund transfer assets to a new custodian before it has agreed and signed the contract.
Documentation of service requirements may be via schedules to the custody contract or a separate service level agreement. Initial documentation produced as part of the selection process can be refined after discussions with the custodian, identifying where its servicing and reporting capabilities match the fund’s needs and where modifications are required. Reviewing sample reports will assist the fund in this process.
If performed successfully, the selection and implementation processes will enable the fund to establish a strong relationship with a suitable custodian and will minimise the chance of disappointment with arrangements down the track.
Margaret Bishop and Suzanne Findley are London-based members of Deloitte & Touche’s global custody advisory services