Pension fund managers say the level of commission brokers receive is too high. An official consultation in the UK into the services offered by brokers may say the same, but in the meantime, some funds are doing what they can to minimise the cost.
Among them is the pension fund of UK supermarket group J Sainsbury. For the past 10 years it has been reclaiming a portion of the commission it pays to brokers through a commission recapture programme.
Commission recapture is a simple idea. With the aim of winning larger volumes of business, some securities brokers are willing to hand back to clients a portion of the commission they earn on trades.
Though this can be done on an individual basis, the administrative hassle of it, say some, can make it counter-productive. Instead of fund managers negotiating individually on their clients’ behalf with brokers, international brokers or other intermediaries set up commission recapture programmes for large global investors. The largest providers of these recapture programmes are Frank Russell Securities and international broker Lynch, Jones & Ryan, although the major global custodians are beginning to offer the same service.
Providers have a list of brokers that are prepared to rebate commission, and this is put in the hands of the fund manager, who can direct trades where possible and desirable through the programme.
Geoff Pearson, manager of the Sainsbury fund, says that at one time the recapture programme was rebating £250,000 (e350,000) a year into the fund. The figure is lower than this now, partly because of changes to portfolios towards increased passive investment.
Pearson says the fund is happy to have the rebated cash, but feels the levels of commission demanded by brokers are too high in the first place. “We would much prefer a system whereby commission was minimised. But since it is collected, we feel it should be rebated back.”
Commission recapture is different from the practice of soft commission or soft dollars. It developed out of it, though soft commission has in the past been criticised for its lack of transparency. Legal changes paved the way.
In 1975, the New York Stock Exchange abolished fixed commission rates and, soon after, section 28 (e) was added to the Securities and Exchange Act of 1934. An effect of this was that investment managers became free to buy research independently of the executing broker. Traditionally, research had been bundled with the dealing service of brokers, but independent research firms later emerged.
With soft commission, a broker executing trades for a fund manager agrees to pay for its investment research services out of the commission it receives. But in the late 1990s, the US Securities & Exchange Commission published a report saying much more disclosure was needed about the details of the business. The lack of controls may have led to money managers using soft dollars to pay their own overheads.
The practice of commission recapture began in the US. In 1985, the first UK pension fund set up a commission recapture programme, but at that time, and for several years after that, the practice was limited to subsidiaries of US groups. “It was very much a case of our parent does it, so will we,” says Adrian Jackson of Frank Russell Securities.
It was not until the mid to late 1990s that commission recapture became popular in the UK and continental Europe. “More and more people started banging the same drum, which is a good thing for the end user… The client must have a choice,” Jackson says. Now there are eight firms offering commission recapture programmes in Europe.
But commission recapture is not nearly as big a product in Europe as it is in the US, says Michael Robarts, associate in the investment practice at Hewitt, Bacon & Woodrow. It is not a particularly economic product here, he says. This is mainly due to the use of pooled investment vehicles. Where commission is paid on behalf of pooled vehicles, it cannot be recaptured.
This means that any passive investment a pension fund has is not included in commission recapture; most bond portfolios are ruled out, as is anything held in investment funds, which accounts for a good part of pension funds’ foreign exposure. And it is on their foreign investment that UK pension funds pay the most commission because they don’t have the chance to pay net.
“So what you’re left with for a lot of schemes is UK equity,” he says. “The bottom line is it’s only the really big schemes in the UK where the amounts of commission make setting up and maintaining a commission recapture programme worthwhile.”
Why is it necessary to have a commission recapture programme in place at all? It is theoretically possible for a pension fund to cut its bills with brokers directly, says Jackson. “But the reality is that they’ve got enough to do already. What we bring to our client is buying power – there is an economy of scale here. But, secondly, we are providing an infrastructure for that to happen.”
When a fund implements a commission recapture programme, the first thing to address is – what is a comfortable proportion of trades to direct through the programme? Not all trades are suitable for the brokers on the list, and it is vital that the programme doesn’t interfere with best execution.
Pension funds need to talk to their managers about how much they might easily direct through the brokers on the list. Typically, the manager sets a target of 25%. But this all depends on the type of portfolio that the manager is running. Some are less suitable. For example, a manager of a small-cap portfolio would tend to use smaller regional brokers across Europe. In this case, a lower target would be approved.
“While we have a robust approach, it may not suit all people. What you don’t want is to have is a negative impact on your investment,” says Jackson.
Commission recapture programmes are mostly used by funds with between £50m and £100m. The annual commission rebated to the fund could be between £15,000 and £20,000, which, in absolute terms, says Jackson “is a fair bit of change”. Some clients, however, are rebated several hundred thousand pounds a year.
There are strict rules on how the rebated money can be used. Mostly funds use the credits to pay bills, though they can only used them for bills that would otherwise be paid by the pension fund itself. It cannot, for example, be used for costs that would be covered by the sponsoring company.
“If the fund is set up to pay for performance measurement services through its own assets, then it can use the credits for this, but if this would be paid for by the sponsoring company, then it is not appropriate,” says Jackson.
It is important that a firm providing a commission recapture programme makes it as simple as possible for the manager to use, he says, pointing out that the fund manager has nothing to gain from the programme, and is only implementing it for the benefit of the client.