Gail Moss gives practical advice to trustee boards looking to manage investment fees and other costs
Over the past few months, the Dutch pensions industry has been hotly debating the costs that pension funds pay their service providers.
It all kicked off in April, when the Dutch Financial Markets Authority published a report on the hidden costs of pension asset management. The report said that the true costs of asset management paid by Dutch pension funds are two to three times the figures they actually publish.
This sparked a controversy that has already prompted Dutch MPs to call for legislation forcing pension funds to publish all their investment costs.
But in a more general sense, the issue merely highlights a long-held suspicion that providers are creaming off extra revenue, hidden or otherwise.
Other countries too are tackling this problem.
The Danish pensions industry has been working for several years to create a system whereby pension fund members can see the costs of administration and investment deducted from their pension pots.
It is now possible for members to see what the costs are at a fund level and at an individual level, both in Danish kroner, and as a percentage of the fund value/individual pension savings. All pension funds can also see how their own costs compare with other funds because this information is shown on open websites.
There are plans for the pensions industry to set up a website - probably in 2012 - showing comparative data, including costs, from different funds. Furthermore, new legislation includes rules requiring the disclosure of advisers’ remuneration policies and the reasoning behind these policies, in order to ensure members have a chance to see possible remuneration incentives behind risk-taking. However, this kind of disclosure is not itself a solution; it can only be a tool to be used in conjunction with a hardheaded approach when it comes to service providers.
Hiring a new provider
Peter Damgaard Jensen, chief executive of PKA, the administration company for eight Danish labour market pension funds, says: “When hiring a new provider, there are two main questions board members should be asking themselves: what will be the total cost of a provider’s services, and does that cost structure really align with what the fund wants to achieve by using their services?”
In particular, boards should consider the relative merits of flat fees versus performance-related fees.
“You need to know how big a risk you want them to take,” says Jensen. “You might not want a fee structure that makes them take risks which are excessive.”
Furthermore, when paying performance-related fees, PKA uses a deferral arrangement, so that if the provider achieves an outstanding performance one year, not all of the related fees are paid out, in case this performance is reversed soon afterwards.
However, lower costs are not necessarily better per se.
Damgaard Jensen says: “You also have to take into consideration investment returns, because you may get a lower return from investments with lower charges. And for some services, charges may be higher because the pension fund is getting a more tailored service. That also goes for individual members’ costs, if they are getting a personalised service from the fund.”
“Managers are pushing asymmetric, disaligned types of structures to clients, without hurdle rates, caps or high water marks,” says Gerard Roelofs, head of investment, continental Europe, at Towers Watson. “We are against that. It is effectively a free call option for the manager and costs the client money. The best defence for clients is a high water mark, where they don’t pay performance fees until previous losses have been recouped.” In addition, he says, investment guidelines should be well defined, preventing the manager from being able to take too much risk.
Roelofs also dislikes the practice where outperformance fees are charged by managers before subtracting the fixed fee element of the realised performance.
“What we’re trying to encourage is symmetric performance-related fees, where the asset manager hands over part of the money when he underperforms,” he says. “Some Dutch fiduciary managers are now moving towards ‘bonus malus’ where they incur a fee the moment they underperform.”
Another area where clients may pay extra costs is setting up an LDI overlay to match part of the interest risk, using swaps, long-term bonds or a stakes in LDI funds.
“Funds are often opaque, so board members should be asking if fees are levied on the underlying notional swaps - which is costly - rather than assets, and the underlying costs of collateral management” says Roelofs. “And when rebalancing the overlay, the board should also be clear about who bears the cost.”
For instance, if LDI funds are used in the overlay, rebalancing will mean buying and selling new stakes in funds.
“If there are entry and exit fees, it’s a very costly affair, especially with management fees on top,” says Roelofs. “Overlays are necessary for balance sheet and risk management purposes, but not at any cost.”
Boards should also be aware of the possible cost of collateral management.
Collateral is often placed in risk-free money market funds, but while this involves fairly minimal investment activity, clients can still be charged a management fee.
A further issue for pension fund boards to scrutinise is double layers of costs, a standard feature of funds of funds structures, and particularly common for alternative investments such as private equity, infrastructure, hedge funds and real estate.
“If you’re paying a 1% management fee plus 10% of outperformance, and the underlying fund is also charging a fee, you can end up paying 3%-5% before the client receives any return,” says Roelofs.
But management fees are not the only hidden - or overpriced - costs. For instance, Dutch pension funds that have a segregated account with an asset manager must pay VAT on the assets under management, whereas other fund vehicles are not subject to the tax. This is often forgotten, but can amount to 80 or 90% of the total fee they pay.
Another cost that is often ignored is the transition cost for changing managers or mandates. “When making these changes, it’s vital for pension boards to find out what investments can be transferred in kind to the new manager, or netted internally, instead of selling them off and facing market risk, as well as extra transaction costs,” says Roelofs.
Custodian services can be a source of leaking costs and, as with any other service, it’s important to get the overall arrangements right.
Board members should always consider taking independent advice in hiring a custodian, says Mark Austin, manager, multinational relationship team, Northern Trust. “You should also check the company has expertise in the pensions area,” he adds. “If it has few pension fund clients, it may not, for instance, be aware of the need for the right collateral services - loaned and valued correctly - for LDI-driven investments.”
Custodians provide a range of other services other than custody, such as collateral management, performance measurement and risk and compliance monitoring, and pension boards need to decide which specific services they want.
“They should ask whether they can get better scale benefits in a bundled service from one institution, which might be preferable for small and medium-sized funds,” says Austin. “A bigger scheme however might be able to buy services from several institutions, cherry-picking the best for each service. And don’t overlook the cultural aspect - you have to hire a firm you get on with.” And he warns against buying cheap for cheap’s sake: “The cheapest car insurance doesn’t always provide much if you crash your car.”
Pension boards also need to ensure they are comfortable with the legal arrangements used by custodians in providing services. “Custodians play a very important role and you need to know they have the right controls in place,” says Austin. “They should also have a strong balance sheet, because the pension fund’s cash appears there.”
At first glance, there might not seem as much scope for cost reduction in services from custodians as there is with asset managers. But appearances are deceptive, and pension board members should review custodians’ performance on a quarterly basis, using key performance indicators which can be provided by the custodians themselves.
According to Stuart Catt, consultant with Mercer Sentinel, these indicators include:
• Number of settlements per month, and the number of failures (that is, the transactions settled outside the market period). Settlement rates should be checked with a universe supplied by the consultant, who should be asked to investigate any underperformance. “This is important, because the pension fund could get ‘bought in’ [forced to buy shares elsewhere because the seller did not deliver their securities] or may be subject to pay interest costs to the counterparty for deals not settled on time,” says Catt.
• Tax reclaims on dividends and capital gains in a non-domiciled market where there is a double tax treaty. If the custodian is the tax reclaim agent, board members should check that these are obtained in a timely manner.
• Corporate actions such as rights issues. Boards should check how the investment managers and custodians make their elections (eg, to accept or sell rights to new shares) and that this is done in a timely manner. This also applies to more routine instructions to investment managers such as whether to accept dividend payments in shares or cash.
• Cash balances. These should be monitored quarterly, noting how much cash is on the custodian’s balance sheet, and how much is being swept off periodically to a cash reinvestment vehicle. Board members should also be able to compare rates of return for cash and non-cash vehicles such as money market funds against the market. These are all useful short-term checks which can save, or make, money for the pension fund.
But there are also long-term tools that boards should be using.
“All pension funds should be reviewing the effects of foreign exchange transactions which the custodian carries out on their behalf,” says Catt. “The custodian will certainly be looking to make revenue from forex deals, and board members should check this does not become excessive.”
There are two main areas to be checked. The first is where an investment manager is running a global portfolio and runs out of foreign currency - say US dollars - for a specific transaction. The manager can either place the trade themselves by selling euros, or instruct the custodian to do so. The other area is income repatriation, where coupon payments or dividends, paid in forex, need to be repatriated into the fund’s currency (say from US dollars into euros).
“That is a significant opportunity for slippage and excess earnings by the custodian,” says Catt. “The trades they are put on may have wider spreads than for other players in the forex market. Board members should be comparing spreads with market rates. They can ask a third party provider such as Mercer, Amaces or Thomas Murray to look at this, using raw forex data from their custodian.”
Catt also recommends carrying out longer-term monitoring - say on a three-year basis - of the standard fees charged by custodians for services such as holding assets, settling funds, and producing performance measurement. These should be compared against a benchmark of competitive rates supplied by a consultant.
Besides benchmarking costs, pension funds can use other measures to help offset admin costs, for instance, by offering services such as securities lending. This is the practice of lending equities, bonds or other assets in return for a fee to a third party which might need an equity position from another investor for a specific period to cover a short position.
The borrower has to provide collateral, in the form of cash or securities, to at least cover the value of the securities being borrowed. And while securities lending is sometimes seen as a low-risk way of providing extra revenue, Catt warns that there are dangers. “There is more risk than trustees have historically appreciated, especially if funds accept cash collateral within their lending programme,” he says. “The cash needs to be reinvested to get a return from borrowers, which means trustees are taking an investment risk on the portfolio. That risk should be monitored on a quarterly basis.”
Catt says that cash collateral portfolios are invested in securities - typically commercial paper and some short-term debt - with longer durations than for a standard short-term money market fund, so they have a higher risk profile.
“It is important for the amortised cost of those securities to closely track the market value, because that is a key indicator of stress in the cash collateral portfolio,” he says. “As stress goes up, the market value of these securities will fall more than the amortised value. And if the gap becomes too wide, you are effectively locked in until values recover.”
A further consideration is counterparty risk. Boards should monitor borrowers and look for a well-diversified book of loans so that no counterparty represents over 20% of the total value (this is the limit recommended by UCITS guidelines).
More generally, board members should be looking at how the revenue generated from securities lending compares with the wider market. One way to do this is to use the service from Data Explorers (www.dataexplorers.com), which provides data allowing pension funds to see how they have performed against Data Explorers’ own universe.
Board members should also make themselves aware whether the pooled funds they invest in are engaged in securities lending.
This should be disclosed in a fund’s prospectus, but what is not necessarily published is what collateral is provided, and how the lending is split between the pooled fund sponsor and lending agent. “What is shown is not always enough for board members to make an informed decision,” says Catt. “However, the necessary information may be published by other organisations.”