Iain Morse reports from a cost-conscious UK custody market as trustees aim to comprehend, and lower, their risk exposure
Who would have expected the alleged conduct of an unnamed ‘high street’ UK custody bank would become the subject of a magazine article by Frank Field MP which could then prompt the Pensions Regulator to issue new guidance notes on stock lending? According to Field, the unnamed custodian, lent bonds and equities belonging to a UK defined benefit pension scheme without informing the trustees.
“This emphasises that trustees must better understand the risks involved in lending programmes,” notes Sonja Spinner, senior consultant and specialist on custodian services at Mercer in London. If proof were needed, the tale shows how sensitive all interested parties have become on the issue of risk. De-risking is now the dominant theme in UK pensions. Reasons include the direct funding consequences of the recession but also UK-specific long term trends. The latter arise from tax and regulatory changes made over the last decade.
According to the Pension Regulator only 27% of UK defined benefit schemes remain open to new members and accruals, down from 36% in 2007. While de-risking in the Netherlands means preserving open schemes while adjusting premiums and benefits, in the UK it usually means scheme closure concluding in a buy-out. This trend shows no signs of abating and is having an impact on the UK custody market. There is a general sense that UK defined benefit schemes are doomed to disappear; managing this process in a cost conscious manner is now an acceptable policy for sponsors and trustees.
“This environment is prompting trustees to look again at their cost base,” adds Spinner: all costs are under review. “The irony is that those associated with custodians tend to be much smaller than fees from other service providers such as asset managers. Typically they might amount to 1.5 or 2 basis points (bps) for assets worth £1bn (€1.15bn)”.
This looks cheap when active managers charge 20-100bps and hedge funds often even more. It is hard to see that these custody fee levels can be further compressed but the hunt for savings is on. “Public sector schemes offer custodians fixed term contracts, but in the private sector these are not normal and cost saving reviews are also becoming more common,” notes Spinner
At the same time, custodians are seeking to better cover their underlying fixed costs. Among the four providers that dominate the UK market - State Street, Northern Trust, JP Morgan and BNY Mellon - cash minimum charges of £30-50,000 against core fund accounting are now commonplace. These firms have competitors such as BNP Paribas, and RBC Dexia, but it is hard to see these gaining significant market share soon. A key indicator of the extent of competition among the ‘big four’ is their common interest in acquiring middle sized schemes as clients which a few years ago they might have passed over.
As in other mature markets, UK custodians are also facing ever closer scrutiny from trustees and their advisers. “Sponsors are driving this process,” judges Steve Smit, executive vice-president responsible for investor services for the UK and EMEA region at State Street. “They want to lift the lid on issues such as sub custodian default risk.” Meanwhile, sponsors are transitioning out of defined benefit into defined contribution pension schemes. “It is now quite common for an employer to run a closed but still accruing defined benefit scheme with a recently established defined contribution scheme for new joiners,” adds Penny Biggs, business development manager for the EMEA region at Northern Trust.
This is changing the business model used by global custodians. All speak of developing a multi-segment service component. Ten years ago, custodians might have boasted of being a pensions specialist, but no longer. Instead the emphasis is on multi-disciplinary expertise as the custodians track institutional assets from pension fund to fiduciary to insurer. “Whatever happens to the underlying assets they still need to be custodied,” adds Smit, “we will be competing for that business.”
In a market where all the economies of scale operate in favour of global providers, competition between them is clearly intense. A significant emerging theme is one-stop provision for both defined benefit and defined contribution schemes. The custodians make it clear that they will modify fee packages where they service both types of scheme for a single client. “For good reasons many employers would rather deal with one custodian for both scheme types,” adds Biggs, “We have tailored our service to meet this situation.’
Not surprisingly, there have been significant changes to the composition of private defined benefit asset portfolios, less to those of local authorities, both with consequences for the types of expertise required of custodians. According to the Pension Regulator’s ‘Purple Book’ of 2009, equities and gilts now comprise 83.5% of scheme assets, with over 50% of equities overseas. Alternatives or other investments now account for 6% of overall assets, a substantial increase from 2008, when they were only 3.8%. Overseas equities, bonds and alternatives are most strongly concentrated in large scheme portfolios.
Meanwhile, portfolio risk reduction is now accomplished in part by the growing use of derivatives. “Liability driven investment is now common practice,” says Benjie Fraser at JP Morgan Worldwide Securities Services. “This can be efficiently implemented using derivatives to hedge out risk and we as custodians provide vital expertise in this process.” The key types of contract employed to hedge these risks are interest and inflation swaps: “We have clients seeking to hedge out risk on liability matching out to years hence,” Fraser adds.
Needless to say, JP Morgan also manufactures derivatives in its investment bank. This is a common business model for custodians; the manufacture of OTC contracts also facilitates their capacity to price these for clients.
“Clients can buy any range of our services and we are able to manage their post-trade processing of OTCs, provide robust independent valuations and fund accounting for the lifecycle management of these contracts,” adds Julian Cork, head of global derivatives services at JP Morgan Worldwide Securities Services. This expertise covers over 40 OTC types. The bank has also developed its own in-house pricing platform which can be combined with third party price sources such as Mark-It. “Client demand is very robust for transparent pricing of OTCs and we devote much resource to this as the OTC market constantly evolves and innovates,” adds Cork.
There are alternatives to buying OTCs from an investment bank and trustees can always separate these functions. “We aim to offer clients simpler, easier to manage sets of relationships because multiple interfaces and relationships tend also to multiply cost,” adds Cork. This is the kind of thinking likely to appeal to cost-conscious sponsors.