Pension funds in Europe face increasingly unwieldy operations issues, while some have the additional strategic goal of growing a third-party business.
Multi-tiered structures, multiple managers and a demand for more frequent information are pressuring the operations of pension funds on both sides of the Atlantic. Bringing in more asset managers and using new asset classes require funds to devote more time to risk and compliance, which can actually increase risk for a fund and its participants. The safer all-around alternative is to find an outsourcing partner with the ability to consolidate data and the aptitude to continue rolling out compliance and risk tools.
“The bottom line is that custody is a technology business now,” one executive director of a US state investment board said recently.
Indeed, pension operations require robust and flexible systems that can link the rich supply of core custody data to market data. Wherever in the world we are talking with clients or prospects, we hear the common desire for market analytics, performance data and risk capabilities. They want on-screen, real-time portfolio valuations as well as corporate actions and market information related to those holdings. They want to be able to plug in analytical and risk tools to evaluate their various mandates and be able to do so on an intra-day basis.
Rather than trying to integrate information from the disparate systems of multiple custodians that an outside investment manager might employ, pension funds in the US are turning to a data consolidator—ultimately, a master record keeper— to provide those value-added services aimed at performance and risk analysis. Pension funds want to be able to “slice and dice” their data in ways that make sense for them, and they simply can’t afford to wait for monthly and quarterly reports.
Since choosing its service provider in 1983, the Minnesota State Board of Investment has expanded the service set for its $53bn (E00bn) portfolio to include performance measurement, commission recapture and foreign exchange trading along with global custody and securities lending. Howard Bicker, executive director of Minnesota’s board said recently, “We are in new asset classes and some of us are on investment boards that manage other state assets, so we’re required to do certain things that call for asset allocation and accounting services, and you need someone that offers not just custody, but technology services.”
Implementing software applications results in a fragmented model. The better path lies in linking the applications to core services. In other words, having one organisation provide data consolidation and higher-level data flows creates a streamlined solution.
In cases where a client is interested in outsourcing its pensions operations, there is no question that the road is neither clear nor smooth. Such partnerships might begin as discussions and evolve to strategic alliances after a client has painstakingly transitioned from a decades-old relationship with another trustee/custodian with whom it has other important business ties. Even with the strategic priority of growing a third-party pensions business, and even with pensions management advocating for a master record keeper, the selection process can take up to 18 months of extremely detailed case making and analysis.
In one US example, a prospective alliance partner visited clients of the service provider to look at various working operations models: plan sponsors managing their own assets, those managing their own assets as well as those of others, and investment managers that run pooled pension fund vehicles. They looked at all the creative ways that sponsors were managing assets for multiple clients using different custodians. They saw how the provider built interfaces, integrated information from disparate systems, formatted SWIFT messages and displayed the consolidated data.
Once the alliance partner went live with its new provider, the trust, accounting, trade support and support for pooled fund structures were implemented, and the reliability, accuracy and quality control of the partner’s funds increased significantly. The move to master record keeper is an ongoing decision that involves cost issues as well as internal change management. Significant obstacles to overcome include the fear of losing control over output. Strong leadership from the top down is critical to reassuring internal management that their gain is more control, not less, as well as the ability to pursue such things as the expansion of a third-party business.
On the one hand, Europe is a perfect candidate for outsourcing given its member states’ pensions restructuring. On the other hand, the lack of standardisation within its hugely diverse regulatory and fiscal framework makes it difficult to attain synergies when developing outsourcing solutions. The current EU directive should help. Aimed at promoting funded national systems based on state-supervised, privately managed schemes, the directive seeks to significantly liberalise restrictive investment policies for occupational pensions. It also begins the process of harmonising rules by setting common prudential standards.
Within five years we expect that increasing product and participant levels associated with defined contribution plans will fuel demand for participant record keeping in Europe, though certainly rules must evolve and stabilise before this very marketable benefit becomes an administration component of the service solution set. In the meantime, sponsors want partners that can consult for them, anticipate and pro-actively respond to developments at the multinational level, accommodate new products and structures, and consistently deliver what’s been promised.
For every function they outsource, managers expect higher quality results than they could achieve on their own, shorter lead times for implementation and cost effectiveness over the long term. Third-party systems that are flexible enough to accommodate the full service range from pre-trade to post- trade are their greatest advantage when coupled with depth of professional expertise on the business side.
Providers with a structural framework able to deliver consolidated reporting across the whole fund give sponsors the improved internal controls they seek. Traditionally, individual fund managers offered custody on the side and built its cost into fees. With increased scrutiny on the safeguarding of assets, global service providers that can also offer performance and analytics and securities lending have proved an efficient alternative. We expect these value-added services to increase in popularity as funds set their own benchmarks for managers. Multinational funds also want their custodial entity to offer an in-house consultant practice of regional accounting, tax and regulatory experts. Pro-active knowledge in these areas would be a high-value service, they say.
In Germany, where the desire for security is very strong, efficient asset management will be vital to instilling public confidence in the funded individual and company pension schemes that were launched this year. For asset managers, outsourcing represents the opportunity to turn the fixed cost of back office transaction processing into a variable cost. This will become increasingly significant as companies continue to introduce or switch to hybrid DC-DB plans.
Clearly some pension funds and custodians in Germany are outsourcing certain areas of their business to specialists. Pension fund operators will continue to face the question of whether to take risks in the areas of minimum guarantee and biometric risks or use an external provider as a more favourable cost alternative. Both economies of scale and segment specialisation can have a crucial influence on the revenues of the pension fund.
Outsourcing helped the Swedish government, in a very short period of time, revolutionise its first pillar system into a structure of four surplus funds of equal size, starting with identical asset allocations on 1 January 2001. The government also created a premium reserve system whereby less than 3% of payroll tax is invested in mutual funds chosen by participants and beneficiaries and managed mostly in the private sector. For those who don’t choose a vendor, the money goes into the government-sponsored default fund.
In Europe’s evolving pensions environment, companies with an institutional brand have the advantage of being able to create funds, administer and service them on an ever-widening scale. While we await tax harmonisation and the sorting out of language issues, our aim is to forge trust-infused partnerships that go beyond contractual service arrangements and that enable both outsourcer and provider to accommodate the changing environment.
Jeff Conway heads State Street Investor Services for the UK, northern Europe, South Africa and the Middle East