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Impact Investing

IPE special report May 2018

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UK: Flawed model

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Iain Morse reviews the market for custody services for UK pension funds

"The UK custody market is very concentrated, with business margins currently compressed to tissue-paper thinness," warns Stuart Catt, associate at Mercer's Sentinel Group.

A glance at the state of the pension industry reveals why this might be the case. While aggregate defined benefit pension scheme assets are worth £1.04trn (€1.3trn) according to the Pension Protection Scheme as at 30 June 2012, liabilities were £1.3trn. Out of 6,432 schemes, only 1,044 are in surplus.

The rate of closure and wind-up is rising; there were 7,800 in April 2005. Many schemes, the great majority, now have no direct contact with custodians and little reason to pay custodian choice much attention. "There are always exceptions, but small to medium sized schemes spend their time choosing investment managers instead," says David Archer, a director at Pitman's Trustees. Most UK defined benefit schemes have assets in the £10-50m range, and most of these fall in the £10-25m range. They invest via suites of pooled funds, multi-managers, fund-of-funds and continental-style fiduciary managers.

In all of these arrangements, choice of custodian is delegated to the manager and their fees netted off fund performance figures. "It is often very hard to work out the real cost of custodians and administrators on a scheme specific basis," adds Archer. "The opacity of costs and expenses is troubling." The real question is whether it would be cost effective for trustees in small to medium sized schemes to spend any time on custodian choice; all the indications are that they don't think so.

"The point of custodian access to smaller pension scheme assets is via the asset management companies," adds Catt. "The likes of BlackRock, Legal & General, and Standard Life are likely to have super tanker sized custodians". Only the medium-large to super-sized pension schemes, those with assets of at least £400-500m or above, tend to run directly held asset portfolios. As a result, they directly employ custodians which compete ferociously for this business. Hence the degree of market concentration.

There is only one UK-listed custodian bank, HSBC, a couple of aspiring continental banks, notably Kas Bank, and the US originated global custodians, State Street, Northern Trust, BNY Mellon, JP Morgan, and Citi. There is no reliable data for market share, but we know that some custodians are more focused on some markets than others. HSBC has traditionally been associated with UK insurers and asset managers. State Street, BNY Mellon and JP Morgan could be said to have migrated here in the wake of top tier US asset managers and have won mandates from some of the largest UK pension funds. Citi, meanwhile, does business with asset managers and appears to have little direct pension business. "If a major UK pension scheme decides to review its custodian, we would expect at least four of five of these custodians to show an interest, although only two or three might survive to the second round," adds Catt.

What kind of business are they chasing? Firstly, with so many schemes closing to new members then going to wind-up, liability driven investment is reshaping portfolios. While few small to medium-sized DB schemes will invest directly into derivatives the number of medium to large scale ones with this exposure is rapidly increasing. Appropriate expertise is required from the custodian. Secondly, as defined benefit schemes close to new members they are being superseded by defined contribution schemes. "Being able to help clients make this transition from DB to DC is important, making the transition as seamless as possible," explains Penny Biggs, head of custody sales at Northern Trust.

Some employers opt to provide the legal minimum, while many, probably the majority, opt to bring in a DC scheme provider while paying for the plan to be badged and interfaced with the employer's identity. "So far DC has been primarily individual," notes Jan Willems, head of UK custody at Kas Bank. "But I question whether DC arrangements of this kind are the best option for building employee loyalty." Lastly, a small but growing number choose to retain a full trustee structure with choice of fund manager, administrator and custodian.

"Employers need to realise the benefit of having in-house DC schemes and should also consider a hybrid of the two, DB and DC, as an alternative," Willems adds.

Some custodians have built the platforms capable of servicing complex DC schemes but the cost of doing so is high. "We see fewer custodians prepared to invest enough to stay at the cutting edge of this rapidly developing market," believes Ian Hamilton, head of asset owners and consultant relations at State Street, which won the mandate to administer the National Employment Savings Trust (NEST) in 2010. Part of the reason for this is that DC assets remain small compared to DB and will do so for years to come. It may be years before custodian-administrators reap the benefit of their investment into new DC systems.

Meanwhile, the DB market is becoming more complex and risky for custodians. Fees for core custody have been falling in real terms for two decades or more. To offset this, global custodians have exploited economies of scale and reduction in direct labour costs through the use of IT and steadily increasing asset values. These trends have slowed and asset values have fallen since 2008. Custodians have also relied heavily on value-added services to generate income, notably from securities lending and cash management services both of which have suffered as a result of the credit crunch and low interest rates. Real interest rates for cash managed on overnight or short-term deposit is now at historically low levels. Meanwhile, many securities lending programmes have been curtailed. "Trustees, indeed all our clients, are now much more concerned about counterparty risk than was the case before 2008," adds Hamilton.

There has been little change to the generic form of contracts between custodians and clients. Expect a basis point charge on asset with fixed fees for transactions. Cash minimum charges are also a feature of the market, particularly for smaller clients. Contracts tend to run over three or five year cycles but are subject to annual review. It is been eight months since BNY Mellon raised its charges but none of the other custodians have followed. "The pressure on fees is still a constant factor," adds Hamilton, "neither will it go away any time soon".

The advent of a centralised clearing counterparty (CCP) for derivative trades and attendant collateral requirements has been mitigated by a two-year exemption for pension investors. But many providers of pooled LDI products are expected to clear from outset rather then use the exemption; not all their investors are pension funds. Exchange traded derivatives will be valued on exchange rather than via custodians thinning the income stream expected by custodians from this source. Uncleared trades will still require price valuation. Collateral management is expected to generate new fees and sources of income for custodians; the assumption is that custodians will hold collateral for cleared and uncleared trades and be permitted to pool these into overnight and short dated deposit accounts. "There may also be a requirement for collateral transformation services as a result of introducing a CCP," adds John van Verre, head of global custody products at HSBC Securities Services.
 

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