For years, the separation of custodian and investment manager for defined benefit plans has been a topic of debate. On one side are those arguing that the separation can be a risk management technique; on the other, those contending that combining the two services can lead to better service and cost efficiencies. Below we discuss the pros and cons of both sides. As a firm offering both services, we are firmly in the camp of combining the two for the reasons noted above and explained below. We will begin by discussing cost efficiencies.
The Cost of Separation
It is well known that the separation of services often requires an investor to pay full price for each service. Below are two hypothetical asset management arrangements: arrangement A, offering the inclusion of custody with discretionary investment management, and arrangement B, separating the services. For the sake of the example, the same discretionary investment management firm would be providing services in both arrangements (Table 1).
Table 1: Services Provided Under Hypothetical Asset Management Arrangements
|Arrangement "A"||Arrangement "B"|
|Investment Management||0.50% of Assets||0.50% of Assets|
|Custody||Included||0.05% of Assets|
|Total Fee||0.50% of Assets||0.55% of Assets|
Source: PNC. Example is for illustrative purposes only. The results in this example are based on the stated assumptions. Results have inherent limitations because they are not based on actual transactions, and hypothetical results may under or over compensate for the impact of certain economic and market factors, all of which can adversely affect results. Past performance is no guarantee of future results.
The first question we ask is, why would the investment management firm charge the same amount for “with custody” as they would “without custody”? It is simpler and more efficient, with regard to portfolio management, for the investment manager to have custody of the assets. We discuss this in more detail in the next section. Returning to the example, it is clear that arrangement B, involving the separation of services, costs 5 basis points more than arrangement A. While this may seem like an inconsequential difference, on a $50 million defined benefit plan that difference equals $25,000 per year. We ask, is that money better spent on a separation of services or on benefits to plan participants?
Not every arrangement is as simple as the example, but it serves to illustrate how the combination of services can provide a cost efficiency to defined benefit plans.
In the previous section, we mentioned that it can be more effective for investment managers to manage portfolios when they also provide custody services. This benefit stems from two key factors: manager fee negotiations and trading efficiencies.
When we mention negotiations with underlying money managers, it is not to imply a quid pro quo relationship with said managers but rather regards the contracts necessary to include a money manager on an investment platform. In our opinion, a good investment manager should offer open architecture, providing access to a wide variety of non-proprietary funds and strategies. With that said, scale begins to come into play when negotiating on behalf of clients: for money managers that offer their strategy through separately managed accounts, fee negotiations are largely a function of size. On average, an investment manager with significant assets under management is going to be able to negotiate a better (lower) fee on behalf of its clients than, on average, a smaller investment manager. However, contracts between the investment manager and the money managers typically do not extend to third-party custodians. As a result, a client that uses an outside custodian may not have access to all of the investment manager’s investment platform options and pricing.
The second part of the benefit relates to the efficiency of making changes to a plan’s portfolio. With a third-party custodian, an investment manager often does not have access to the portfolio in real time from a monitoring and/or trading standpoint. The investment manager often has to wait for reports and, with trading, wait on the custodian to execute those trades. This can cause issues with managing downside volatility, potentially preventing managers from being able to act effectively on defensive trades. For long-term investors, the timing of executing a trade today versus executing a trade tomorrow might not mean as much; however, the lack of transparency in real time in executing that trade can cause unnecessary complications for both the investment manager and the portfolio itself.
In our experience, risk management is the reason most frequently cited by those who favor separation between investment management and custodian services. The argument here is that by separating services, you have two sets of “eyes” monitoring the portfolio. Implied in this concept is that it is harder for an investment manager to manually change performance upward or hide losses—to cook the books, that is,— when they are not custodian. As the custodian’s work is not measured by performance, the custodian would have no incentive to lie on behalf of the investment manager, thus helping to confirm the investment manager’s performance and statements are accurate.
While we believe the above line of reasoning is not unfounded given the behavior of certain, typically smaller, investment managers in the past, it is not necessarily as applicable in today’s era of regulatory oversight. Whether it is a bank providing investment management subject to the oversight of the Office of the Comptroller of the Currency or a registered investment advisor subject to the oversight of the Securities and Exchange Commission, today’s investment managers operate in a new age of compliance. While this may not entirely prevent an individual or group of individuals from acting in a malicious or fraudulent manner, it does heavily enforce the consequences of such an action. It is our opinion that such consequences, whether criminal or reputational, have driven investment managers to institute policies and procedures that allow them to be trustworthy stewards of both investment management and custody. Further, many investment managers with custody monitor investment performance through an outsourced, third-party provider that independently calculates and audits returns, adding an extra layer of scrutiny.
This would imply that the risk management technique of separating the two services does less now to mitigate risk than it does to increase cost, casting its use in a questionable light for defined benefit plan sponsors.
Which service provider(s) to hire is a decision that ultimately falls to the fiduciaries of a given defined benefit plan. In our opinion, if a plan currently uses separate providers for investment management and custodian services, it might be worth considering a request for proposal (RFP) for a single provider. Issuing an RFP does not necessitate that the existing structure be changed, but it can help provide valuable insight into the potential benefits or drawbacks of making a change.
For more information, please contact your PNC Institutional Asset Management representative.