Securities Services: Defining custody’s contribution
As DC builds assets, trust-based structures come into their own and cost-saving aggregation opportunities abound. Iain Morse finds custodians well-positioned to put them into action
The consensus is that the future of private sector pension provision in much of Europe and the UK will be based on defined contributions (DC). That will have varied consequences for custodians. Contract DC plans have been seen as the means by which sponsors minimise their involvement while making some pension provision for employees.
Contract provision removes the need for trustees or active participation by main board directors. In a true open architecture plan, different asset management companies will have their own custodians reporting to the scheme administrator.
This prevalence of contract provision, and the aspiration to offer very wide fund choice via open architecture, now look a little out-of-date. There is strong evidence that most scheme members prefer using default funds, and open architecture can also be expensive in terms of administration and record keeping.
Employers, particularly those with existing, trustee-governed defined benefit (DB)
schemes, are seeing the virtue of extending that trustee governance to newly-established DC provision.
“DC is in a process of change, and there is a skill transfer from DB to DC,” says Crispin Lace, a senior consultant at Russell Investments.
In the UK, the National Association of Pension Fund’s (NAPF) 2012 Survey makes this point: of 695,000 DC schemes in the survey, half are trust-based, accounting for 65% of all active DC members, a ratio predicted to increase. DC schemes, particularly the trust-based ones, are building up substantial assets – 40% of all DC schemes now have more than £50m.
“As this happens the argument for a trust structure becomes stronger and its benefits become more evident,” judges Benjie Fraser, a senior vice-president at JP Morgan Securities Services.
Where the sponsor chooses a DC scheme with trustees, a separate administrator and custodian must be appointed. In the language of EU directives, the administrator is an ‘operator’, the custodian a ‘depository’. If a DB scheme already exists, the same trustees may serve both schemes. In some cases the employer will pay the costs of running the scheme, in others the members will be expected to meet at least a proportion of these costs.
By every measure, trust-based DC tends to have lower annual management costs than contract-based schemes. The emerging paradigm for trust-based DC schemes offers a limited suite of default funds, typically ‘growth’, ‘income’ and ‘cash’, allocating and transferring member contributions and accrued benefits from one fund to another by each members’ age or time to planned retirement. According to the 2012 NAPF Survey, 91% of DC schemes offer default funds, of which 42% use passive funds as default. The remainder use actively managed funds including multi-asset funds.
Transfers from one default fund to another are set by a formula determined by the trustees. Members may be allowed discretion in fund transfers and in some schemes there may also be access to a non-default range of funds. The system can also be adjusted to take account of member-specific risk preference. For instance, they may choose to stay in one default fund rather than another, and so on.
While the default system works automatically, member fund choice requires intervention by both the administrator and custodian, increasing overall costs. The default funds have a number of cost benefits for members: they may be managed by one or more of the managers already running DB portfolios, and the DB and DC assets can be pooled and managed together, while separately hypothecated in a manner that satisfies the relevant regulations.
This can significantly reduce the management costs of still relatively small DC funds. It can also permit a wider blend of asset classes in DC funds than previously has been common – such as private equity and infrastructure.
“The motive is to build efficient portfolios which meet the target-age formula in terms both of their risk and return characteristics,” says Phillip Caldwell, product manager for asset pooling at Northern Trust. “Custodians will be expected to report performance on a bespoke basis as per trustees’ requirements.”
In this new paradigm, the scheme administrator keeps records of members and their contributions. The custodian can be seen as sitting below the administrator, automatically allocating contributions and transferring funds according to the target-age formula set by the trustees. The custodian will service the main default funds and any sub-funds, reporting on NAVs, and using whatever risk metrics have been selected by the trustees.
These will include fund performance measured against return and volatility benchmarks. Custodians also provide data on performance attribution, mandate compliance, and cost analysis. The custodian interface with the administrator permits the latter to prepare reports or ‘interest statements’ of benefits accrued by individual scheme members. These activities are, needless to say, fee-rich. Custodians are also first choice for foreign exchange (FX) services and, although rare at present, for securities lending on DC asset pools.
They are also naturally positioned to provide overlays and other derivative products. As DC funds invest in a wider range of asset types, not only listed stocks and liquid bonds, but also private markets, property and commodities, robust valuations will be required.
“Custodians are being asked to provide DC scheme administrators and trustees with consolidated reports which include these asset classes,” says Caldwell. “This data still has to be sent to the administrator in a form which permits individual members to receive accurate benefit statements.”
Asset aggregation, variously-defined and implemented, is the key theme running though this refashioned DC world. As we have seen, the benefit of asset aggregation is supported through wider use of default funds within DC schemes. EU cross-border schemes, permitted under the IORP Directive, remain rare, but could also benefit from aggregation. In both cases, custodians are seeing new, lucrative sources of income from growing pools of DC assets. Current EU policy in the strict separation of custodians and administrators, and need for robust and more microscopic reporting by custodians, will only amplify this theme.
“This part of the market could be well served by a UK version of the Australian master trust concept, rolling up small accounts into a single cost effective structure,” adds Lace.
The NAPF has published research estimating that 35% of DC pension funds, amounting to 3.9m DC pension pots held by 3.5m individuals, hold aggregate assets worth approximately £7.9bn. On the same data, there are 1.8m DC pots each containing assets worth less than £2,000, with an aggregate value of £1.3bn. DC account aggregation leading to asset aggregation – a certain theme for the near future – will play strongly in the interests of the custodians, and those numbers indicate the potential size of the opportunity.