With regulators questioning the delegation and concentration of powers under fiduciary management and implemented consulting models, Iain Morse finds custodians sensing a
business opportunity

Has fiduciary management reached high tide – and can custodians benefit from that tide ebbing? Regulators, notably in the Netherlands, are reminding pension boards of the need to keep ultimate control of their pension investments. Their focus is on overall transparency, look-through portfolios, cost unbundling, enhanced cost control, reliable performance attribution and, above all else, robust risk control.

“This is about the improving quality of pension fund governance,” says Kerry White, managing director in strategic product delivery at BNY Mellon Securities Services.
“Change in this area has been accelerating over the past 4-5 years.” The trend has some way to run.

In the Netherlands, this regime first applied to core portfolio investments; the same regime has, since June 2012, been extended to alternative investments – to the extent that some pension boards are said to be withdrawing. Pensioenfonds van de Metalekto (PME) cashed out from 26 hedge funds late last year, citing lack of transparency and high costs and risks.

This is important because the Dutch pension regulation is increasingly taken as setting a benchmark for the EU. Trustees in the UK face very similar liabilities to their Dutch counterparts, although the Dutch regulator has led the way in requiring ever-greater transparency, performance attribution and risk control. The Dutch and UK markets have also experienced the biggest uptake of implemented consulting and latterly of fiduciary management – and there is now a shared sense that too much has been ceded to fiduciary managers by trustees and boards.

Custodians are not unhappy about this. They want to recover fee-rich value-added and ancillary services such as portfolio risk analysis, performance attribution and foreign exchange from the fiduciary managers.

“It is simply easier for custodians to wrap these extra services round their core custody, than for any other participants to have to extract the raw data from a custodian then process it,” White reasons. “After years of fee attrition, the custodians are looking for a permanent strategic gain at their rivals’ expense.”  

Talk of the so-called ‘solutions opportunity’ and ‘pure custody’ concepts abounds, building on the long-running rivalry between custody banks both with and without asset management and investment banking divisions under the same corporate roof.

KAS Bank sees a new paradigm emerging across Europe (see KAS Bank: ‘We call it custody 2.0’). In Germany it has just won the custody mandate for Südwestrundfunk via its German depotbank. The radio and TV station previously used six master-KAGS and three depotbanks.

“This structure is being radically simplified by our appointment,” says Sikko van Katwijk, chief commercial officer at KAS Bank. “We are a pure player in this market. There are no conflicts of interest in our position.”

KAS Bank is marketing itself as a ‘pure player’ because it expects this to be appealing in the context of the debate over conflict of interest where fiduciary managers or consultants supply clients with performance data as well as asset management and asset allocation services.

“Consultants that have a fiduciary management business to offer are conflicted by their advisory business,” warns Shamindra Perera, head of institutional business at Russell Investments. “This is an issue because consultants are the gatekeepers.”

At the core of the debate sits portfolio valuation, and consequently the role of the scheme custodian. After all, pension fund custodians must record and store the primary data for exchange-traded portfolio investments necessary to generate portfolio valuations and related metrics.

As a rule, fiduciary managers advocate the use of pooled funds. Whenever pooled funds are preferred over segregated accounts the fund management company will effectively select a custodian, thereby partly or wholly removing custodian choice from the pension fund trustee board.  Where investments are both direct and pooled, the pension fund’s main custodian will typically receive fund data from the fund manager’s custodian via the fund manager. Even if the fund manager’s custodian reports directly to the main custodian this is not a ‘sub-custodian’ relationship.

Just to complicate matters, existing practice on custodian use is quite diverse. Some pension funds have a single, directly employed custodian, which employs others on a sub-custodian basis. Other custodians emphasise their global character, all done in-house.
Some pension funds use more than one custodian in competitive parallel, others use a local custodian for domestic investments, and a global custodian for all else. This can result in a local custodian employing a global custodian as a sub-custodian.

Pension funds may also require very different levels of service from their custodians; domestic bonds held to maturity require little more than safekeeping, while actively traded foreign investments clearly require more than this. Where alternative investments such as private equity, derivatives or hedge funds are added to a portfolio, the options depend on which participant consolidates all the relevant data and reports it to the scheme’s board. In some cases custodians have side-stepped alternative investment valuation reporting in parallel with hedge fund administrators, passing it on to the pension fund board and their consultants.

The advent of the Alternative Investment Fund Managers Directive (AIFMD) is partly designed to squeeze the valuation of alternatives through a system of custodians that are legally liable for these valuations. The advent of a central clearing counterparty (CCP) will accelerate this process, while it is becoming more problematic for trustees and boards to invest into un-regulated offshore entities. Custodians are now offering an ever-wider scope for valuation and reporting, including asset classes that at one time they would not have included. This is one explanation for why they have been buying up hedge fund administrators.

This is against a background of real complexity on the supply side. Not long ago there were clear blue waters between asset managers, custodians, administrators, pension consultants and scheme actuaries. It is still possible for a pension fund to purchase each of these service components separately but this demands a lot of internal resources and cost on what many boards regard as ‘non-core’ activities – implemented consulting and fiduciary management are presented as partial solutions to this problem.

Under both models, trustees can fully delegate manager selection, monitoring and turnover. Perhaps the core difference lies in ownership of investment strategy. If this is delegated by the trustees, albeit within agreed limits, then ‘implemented’ becomes ‘fiduciary’.

Thus far, the asset and liability sides of the pension fund have been kept separate.
Traditionally, the liability side is the preserve of actuaries – but all the major firms of consultants, and many providers of implemented consulting and fiduciary management, also offer actuarial services. Delegation of all of these powers can create a situation where there is little practical oversight of the fiduciary manager beyond their reporting.

Regulators seem to be moving towards a system of delegation where the trustees regain control over the setting of strategy, strategic asset allocation and manager selection and de-selection – with tactical asset allocation delegated, depending on how it is interpreted.

Quality of data, analysis and reporting is the key to this. Some custodians are arguing that their franchise should be extended in this area. In the simplest version of this paradigm, custodians and implemented consulting providers or fiduciary managers operate in parallel in a vertical silo, at the top of which sits the trustees or the board. At each stage of operations, the fiduciary manager buys and sells via the custodian, which collects and analyses the resulting data, reporting directly to the trustees or board.

This paradigm recognises the key weaknesses both of fiduciary management and implemented consulting. The same conflicts of interest remain in the providers’ position but the cost of these should be transparent where custodian and manager are separate. Independent risk monitoring by the custodian can also supplement that done by the fiduciary manager – and pick up any risk arising from using a single fiduciary manager.

This is schematic and does not address the existing complexity of custody arrangements. The big question is over the degree of separation between custodian and fiduciary manager. In the bulge banks these are separated by Chinese walls – “a system than works well enough”, according to Stuart Catt, senior consultant at the Mercer Sentinel Group, although some have their doubts that this is sufficient.

Free-standing custody banks, those not part of wider groups which may include investment banks or asset management divisions, for instance, argue that only they offer robust pricing and analysis free of any conflict of interests. The proposal that only genuinely independent custodians should be used threatens the commercial interests of implemented consulting providers that currently reconcile asset and liability data for their pension fund clients. Needless to say, both the fiduciary managers and consultants are critical of this line of thinking.

It is also not clear how consistently this paradigm can be applied to a heterogeneous group of defined benefit pension schemes. In the UK, at least, some are open but most closed to new members, with wide variation by size, or portfolio constructions and maturity. It is difficult to argue that a scheme closed to members and contributions and looking to buy out member benefits needs the same arrangements as one which still has contributing members.

“The cost tolerances of schemes vary a good deal,” adds Catt. “Many will not pay the custodian for value-added services, some of which may be available for free from asset managers.”

The debate over fiduciary management and the role of custodians will be furious because it is really one about fee income in a tough commercial environment. What matters now is the attitude of regulators. If current trends continue they may converge on a requirement for pension funds to appoint an ‘independent’ custodian with more onerous liabilities on reporting than is even proposed under the AIFMD. A move of this kind could change the industry. Until then we can expect much more sound and fury from all parties.