Written by Christine Senior
Christine Senior explains how custodians are providing an expanded range of services to pension funds
Global custodians have made great strides in developing services on top of their basic function as providers of safe keeping for investors’ assets, and the administration that goes with that. While the core function remains important, custodians’ accumulation of portfolio data has enabled them to build up a portfolio of value-added services that pension fund investors find indispensable.
In turn this has affected the relationship between custodian and pension fund. One effect is that custodians are increasingly being asked to take on administration tasks investors previously performed in-house. As a way of streamlining their operations to concentrate on their core role, pension funds are outsourcing some functions they have historically performed themselves. Outsourcing can involve basic data management or more complex tasks for pension funds managing investments internally.
“Investors are looking for any way they can to save themselves time, effort and money,” says Northern Trust’s Institutional Investor Group for EMEA head Penelope Biggs. “They are saying: ‘I could outsource elements of my back or middle office, non-core functions, and increase efficiency’. For example, an in-house managed pension fund would be managing and maintaining investment systems and processes such as record-keeping for portfolios they manage in-house or someone else manages. They realise custodians are experts in maintaining data books and records, and ask themselves, can they do that for me?”
For multinational companies with operations across multiple locations, maintaining an overall strategy and avoiding duplication of activities are particularly important to increase efficiency. Custodians are helping pension funds achieve economies of scale through pooling of assets.
Northern Trust head of sales for institutional investor group UK and Ireland Douglas Gee says: “Pension funds are bringing assets from different schemes either in the same country or across different countries into a single pool so they can make a more efficient manager selection strategy and give different schemes of varying sizes access to the best managers and best asset classes at the most competitive rates.”
Technological advances have enabled greater manipulation of complex data, which helps pension schemes keep tabs on the position of their funds. Custody clients have online access to information at the click of a mouse at any time. The days when reporting might be on a monthly, six monthly or annual basis have given way to minute by minute availability of accurate data. And it’s not just the asset performance.
Kas Bank UK managing director Laurens Vis comments: “For DB schemes we try to allow the board of trustees, the owners, to be in control of the health of their entire pension scheme, both of the assets and the liabilities, to compare the performance of the assets and the ‘performance’ of the liabilities. They can do a daily health check on whether the pension fund is moving in the right direction or not.”
One consequence of that is a greater use of derivatives to manage exposure to interest rate and inflation risk. JP Morgan Securities Services head of pensions Benjie Fraser says this is something that pension funds in the UK and the Nordic regions are particularly keen on.
“In the UK and Nordic regions pension funds are looking to manage their liabilities pretty closely to their assets,” says Fraser. “As people are living longer, pension funds are managing those liabilities by making use of strategic swaps in areas such as interest rate and inflation to actually manage the cash flow they have to pay pensions. Custodians are potentially helping manage the collateral and value the swaps independently of the fund manager or investment bank.”
Access to complex data held by custodians enables pension funds to isolate where performance is coming from, down to individual stocks, and illuminates managers’ performance and where they might have deviated from the conditions attached to the mandate.
“For example, trustees can see a particular manager has been hugely successful but has consistently overstepped the risk parameters set for them,” says Vis. “They know they can’t allow the additional risk. It’s very important to have this at their fingertips when they discuss the next mandate with asset managers. Trustees are now as well informed as asset managers are.”
The 2008 financial markets crisis had a profound effect on pension funds’ attitudes to risk, bringing risk management to the heart of their strategy. Increasing regulation has also affected behaviour relative to risk management. In the Netherlands this has been particularly evident.
Biggs says Dutch pension funds are subject to strict rules to ensure they are aware of how their underlying investment funds are invested “to the most granular level of detail”. “Pension funds have to be able to drill into every pooled fund they invest in and tell the regulator what is in that pooled fund in order that they can assess their exposure. We have a client with €20 billion of assets, €10 billion in pooled funds with about 100 funds. For every one of those funds every day we have to drill down so they can report to the regulators.”
Another aspect of risk management relates to monitoring of counterparty risk. The effects of the Lehman collapse have focused attention on risk associated with all the organisations that pension funds are exposed to.
“Our clients expect us to provide regular reporting on counterparty exposure of their respective under-lying asset managers,” says BNP Paribas Securities Services head of asset owner client segment, Dietmar Roessler. “They want to understand which trades were done with which asset managers over the last six months, for example, or what kind of trades are pending with what counterparties. This would have been an operational matter a couple of years ago.”
He adds: “Custodians are being challenged as to what they are doing to protect clients against the likes of Madoff and Lehman happening again. They are asking: ‘How can you as my global custodian help me to make my asset manager aware and stop them trading with counterparties I don’t feel comfortable with?’”
Another strand to risk management concerns investment of cash collateral in securities lending deals. Pension funds pulled back from securities lending in the immediate aftermath of the Lehman collapse but have started to come back.
Pre-crisis, when the emphasis was on increasing returns, more lax attitudes to investment of collateral led to losses. Investment of cash collateral into AAA-rated money market funds that contained illiquid structured products proved disastrous. Lessons were learnt, and investors are now more circumspect.
“Many institutional investors shied away from securities lending overall [post Lehman],” says Roessler. “By and large they are coming back. They understand they can choose the level of risk – choose the counterparties, choose the collateral. They have many options to keep risk as low as they wish.”
Again keeping tabs on the overall position of their lending activities is a key demand of investors. With sophisticated technology custodians offer pension funds the ability to check their exposure at any time.
Gee says: “Reporting on clients’ securities lending online enables them on a daily basis to see what is the makeup of their collateral, what stocks are on loan, who they are exposed to, who is borrowing their stock.”
Other demands from institutional investors have grown on the back of more diversified portfolios. As investment has expanded beyond the traditional bonds and equities to incorporate more alternative assets, different types of asset servicing is required. More complex assets like private equity have their
own challenges, not least getting accurate up-to-date valuations, but this also includes the ongoing management of capital calls. These can now be organised automatically by custodians.
Gee says: “For private equity investments our clients are increasingly asking us to automate the payment of capital calls on their behalf and work with them to reduce the servicing complexity of these asset classes. Increasingly we are taking on some of the administration overhead from them.”
Looking ahead, if the Dutch model of greater consolidation of pension funds came to the UK, with the arrival of supertrusts - which is favoured by some in the pensions industry - that could hit custodians. “When pension funds consolidated that meant the need for one custodian,” says Fraser. “If we saw the ‘supertrust’ industry-wide model of the Dutch exported over the North Sea, perhaps that would create new and exciting challenges for custodians.”
Written by Christine Senior, a freelance journalist