Pension funds are becoming increasingly aware of the need to keep tabs on the performance and costs of their custodians as their role becomes ever more complex, writes Ian Morse
Quis custodiet ipsos custodies? Who guards the guardians? The answer, in the case of global custodians, is an increasing number of consultants. Some, like Mercer’s Sentinel Group, are themselves a part of global consulting firms. Others, like the London based Amaces, are specialist boutiques. All are united behind one principle. “Custodian performance needs to be measured,” says James Economides, chief executive of Amaces. “Pension funds need greater transparency on the costs and benefits of using one custodian against another.”
Trustees could be forgiven for being a mite sceptical about these claims. After all, most custodian relationships are medium to long term: if it isn’t broke, why fix it? “The answer lies in the growing complexity of these relationships,” argues Chris Angell, senior consultant at Mercer Investment Consulting. “These carry a range of visible but also submerged costs which added together have a measurable impact on net investment returns.” Examples here are diverse, ranging from the spread on foreign exchange transaction to the speed with which cash is credited to a fund’s account or the cost of overdrafts.
The role of third party consultants on monitoring all these aspects of the client-custodian relationship has created a lexicon of specialist terms that need to be learned by trustees and pension boards. All the global custodians offer a generic, global contract defining the overall relationship between themselves and clients. Beneath this will often sit a more client specific service level agreement (SLA), detailing aspects of this relationship. More and more often, this will comprise a list of key performance indicators (KPI). “These are best seen as setting tolerances for specific, measurable aspects of the relationship. These may or may not carry cash penalties, but they need to be monitored on a continuous, ongoing basis,” adds Angell.
There’s no ‘prix fixe’ menu of KPIs, but it is possible to identify a dozen or so which are on the lists typically drawn up by consultants. Most start with the time taken by a custodian to send a performance report to their client. For instance, monthly audited reports might be required on business day 10 - 10 working days after the end of the month they report. Penalties for late reporting could be a cash credit to the client per day against the overall custodian fee charge. As an alternative, each late day might carry a number of penalty points aggregated into a score at the end of each three and 12-month period. The SLA listing the KPIs may specify that after accruing a given number of penalty points the custodian has voided the contract or that there are no penalties in the event of the client changing custodian.
Another widely used KPI specifies the interest to be paid on any cash balances held by the custodian on behalf of the client. This cash may or not be swept into hypothecated accounts. A typical KPI for cash balances might be LIBOR-50 basis points (bps).
Another related KPI may specify the cost of any temporary overdraft offered by the custodian to the client. This would typically be framed as an upper tolerance; no overdraft will cost more than LIBOR+100bps and so on.
Account reconciliation is another topic very likely to be covered by a KPI. When pension funds invested most of their money in domestic, listed equities and investment grade bonds, reconciliation was rarely debated. But after regulatory requirements that assets be marked to market, and portfolio diversification into alternative investments, much attention is focused on reconciliation. “I would expect a KPI to detail tolerances for reconciliation,” observes Angell, “These might be as high as 30 basis points but on some asset classes could be squeezed down to as little as 10 or 15 basis points.”
The KPI covering reconciliation may stretch further, detailing the number of pricing sources used for an asset class and in some cases naming these sources. The key issue here is that the general definitions of pricing and reconciliation used in global custody agreements need to be expanded. Typically, these will only say that the global custodian will use best endeavours or follow best practice in pricing and reconciliation. “This is an area of constant challenge and change,” adds Angell. “Some pension funds have been badly caught out by custodians failing to price accurately as the credit crunch took effect.”
Measurement of a custodian’s processing capacity is another area that may be covered by a KPI. Global custodians like to advertise their use of straight through processing (STP); it has been a major source of cost saving over the past decade and STP capacity serves to differentiate global custodians from their less well capitalised competitors. KPIs can be used to test this capacity. Expect consultants to suggest a minimum percentage of trades settled without manual intervention. This limit will be set after taking account of a client’s portfolio; some equity and bond markets hardly permit STP, others are fully automated. Over-the-counter instruments will, by definition, not be included.
Income collection and other cash flows are also likely to be measured. Once again, expect a target to be set for processing these within a defined time scale. For example, 95% might have to be collected by a due date. Due date will be defined closely. Principal among income collections will be dividend streams and coupon payments on bonds.”The point of measuring the time taken for income collection is simply to optimise the cash held on interest-earning deposit with the custodian or elsewhere,” notes Angell. “In a big fund, one with income of millions a year, the amounts lost by collection delay can easily mount up.” Tax reclaims may be dealt with under the same principle but these vary on a country by country basis.
The spreads on any forex deals done by custodians on behalf of clients are now frequently covered by a separate KPI. Indeed, in recent years at least one major pension fund has sacked its custodian bank because it charged too much for forex transactions. Once again, the key issue in forming a KPI is to agree a definition of how to measure permitted spreads. General contracts will use a loose definition such as ‘best execution’. A typical definition in the UK might be the 16.00 fixed rate, or time-stamped transactions according to Reuters plus or minus 3-4 basis points.
Securities lending is another area likely to attract the attention of consultants. Key issues here are the setting of utilisation targets, and fee levels for lending transactions. Upper utilisation limits will be set by trustees and boards as a percentage of portfolio value; these limits have been widely reduced since the credit crunch. But a KPI may go beyond this, measuring the frequency of utilisation within this limit. Transaction fees vary but can be measured against an agreed average. Proxy voting might also be governed by a KPI. Some trustees and boards have a strong policy on socially responsible investing (SRI). They will want to know that custodians use the power to vote. Once again, activity levels will be measured.
Amaces has built up a universe of 74 clients that fully disclose their custodian relationships. This data pool is then applied to each individual client on a peer-group basis. Mercer says it does the same but on a more client-specific basis. In practice there might not be much difference, but one thing is sure, as Economides puts it: “More and more pension funds want to measure their custodians’ performance. Demand for this has increased during the credit crunch.”