Taking Custody forward

With LDI on the increase, more and more pension funds are diversifying into unusual sources of alpha, whilst simultaneously upping their use of derivatives and structured products. What steps are custodians taking to keep up with these changes?

Michael Walsh: New administrative services will be required for products geared to alternative investment strategies, particularly derivatives.

Derivatives have become an increasingly important component of many investment strategies and yet the market still lacks the infrastructure to support what has largely been a manual environment.

State Street is developing a comprehensive asset servicing capability for OTC derivatives designed to maximise flexibility and efficiency while covering the full range of OTC derivative products available.

Benjie Fraser: Diversifying into these types of instruments provides a number of post-trade challenges for the pension fund manager, including accounting, valuation compliance monitoring and performance measurement issues - all more complex activities than for the more traditional securities portfolio.

For those funds that are a mix of investment types, for example long/short funds, which have both traditional and alternative assets in the same fund, at JPMorgan we have built new technology that interfaces with the investment counterparty (eg prime broker) and provides independent valuations for these structured products.

These valuations then feed the main accounting platform of the pension fund, allowing us to provide the manager with a consolidated view of all the investments of the pension fund. At the same time, our expertise and comprehensive offerings in compliance monitoring and performance measurement help managers to mitigate risk and manage regulations.

We believe our product offering for these funds represents a market-leading service. In the case of other alternatives, we have built a strong administration service locally in the UK to handle such investment as private equity and hedge fund services - capturing all the relevant information on behalf of the pension fund client. We provide further services to pension funds in the form of our long/short trading service - whereby the fund can borrow (go short) against its own long stock positions and by the use of our market leading collateralisation product suite.

Any use of synthetics/leveraging means managing cash and other collateral for margin requirements, however, managing collateral effectively is both complex and time consuming.

An efficient collateral management programme managed by a professional third party enhances efficiency, reduces administration and, at the same time, provides more flexibility for both collateral takers and providers in terms of the collateral instruments given or received.

In Europe, cross-border pension funds are close to becoming a reality. Are custodians ready for this?
Benjie Fraser: At JPMorgan we have been working closely with a number of franchise names to build a customised solution for pooling the assets of their pan-European assets. Our approach has been bespoke and focused on some major household names.

Michael Walsh: The capability to oversee an entire investment platform that a cross-border pension fund could span is a large task. However, custodians like State Street which has broad global expertise, as well as expertise in a range of capabilities including transition management, liability driven investment strategies, performance and analytics, foreign exchange, securities lending and proprietary research services, will have the edge in offering comprehensive services to these cross-border funds.

The development of leading technologies and the continued investment in investigating and producing innovative solutions will help drive custodians' success in this new frontier.

In the last issue of Global Pensions, concerns were raised that some pension funds might be unaware of where the cash reinvestment component of their securities lending programme is being invested - possibly leading to unwanted risk being taken in today's troubled markets. How can pension funds ensure there are no nasty surprises in their sec lending contracts?

Michael Walsh: It's important to remember with any pension investment to do the necessary due diligence and research. Pension funds should not rely solely on rating agencies for their information. It is imperative they do their own independent research and due diligence just as they would with any equity investment.

Benjie Fraser: Pension funds should work with their securites lending provider to ensure the cash reinvestment programme meets their needs and they are fully aware of the risks and processes.

There should be clarity around what are and what are not suitable reinvestment instruments and agreed-upon investment guidelines implemented.

Funds should remember that cash reinvested as part of lending programmes is an investment decision as any other and should managed accordingly. When choosing an agent-lender, the fund should give serious consideration to choice of providers in order that maximum flexibility and expertise can be offered, including:

* l Customisable cash reinvestment programme;

* l Significant expertise in asset management;

* l Daily reporting that allows visibility through to cash-reinvestment;

* l Client managers who provide regular and informative updates as to market conditions.

At the onset of the lending programme, discussions should be had to understand the appetite for risk and an appropriate reinvestment programme agreed.

By nature, the reinvestment programme itself should be generally conservative as the philosophy should be protection of principal. Generally, agent lenders tend to make reinvestment purchases of high grade assets with a short term bias and typically a ‘hold to maturity' strategy significantly reducing the possibility of realising losses.

The majority of securities lending returns should be generated from intrinsic value in the loan itself, as opposed to a means of generating yield through cash reinvestment.

Indeed a fund may choose to restrict cash as a form of collateral, however, with a prudently managed programme, cash collateral should be considered to maximise lending returns. In summary, agent lenders should be maintaining a close dialogue with their clients, offer daily transparency through to the reinvestment portfolio and be reactive to any concern with flexibility to change the parameters in which the programme is being operated on behalf of the fund.

In the case where a plan sponsor runs a defined contribution scheme and a defined benefit scheme, how easy is it for a custodian to combine the servicing of the two schemes?

Benjie Fraser: There is no difference from a custodian perspective in servicing these two types of funds.

Michael Walsh: For experienced custodians servicing defined benefit (DB) and defined contribution (DC) schemes should not be a problem. The funds in a defined benefit and a defined contribution cannot be commingled so, even if the plan sponsor is the same, the two plans would need to be treated as two accounts.

In terms of service, a custodian needs to understand the inherent differences between defined benefit and defined contribution plans. In many countries, the impact of changing accounting rules and greater solvency requirements are leading DB plans to close to new members.

As a result, the plan sponsor will increasingly seek to mitigate volatility and secure income by means of structured products. Liability-matching and return-seeking investments will be distinguished in separate portfolios. With DC plans, the impetus is on the individual worker rather than the employer to determine how much to contribute and how to allocate funds.

At the end of the day, it's all about helping to balance risk and return, whether it is a DB or a DC plan. The capabilities that a company like State Street offers, including securities lending, transition management and custody services, all impact how we help clients achieve their investment goals. Companies that offer a comprehensive suite of solutions to their clients are better suited to provide a more coordinated approach to servicing DB and DC plans.

Benjie Fraser is senior vice president, JPMorgan Worldwide Securities Services, and is responsible for UK relationship management and sales for pension funds and charities at JPMorgan Worldwide Securities Services based in London. He joined JPMorgan in February 2006. He previously worked for The Bank of New York. He has been working in this sector for 15 years. Benjie is registered with the FSA as an investment adviser and is a trustee of JPMorgan Chase Pension Plan UK.

Michael Walsh is head of State Street's investor services business in the UK, Middle East and Africa (UKMEA). Prior to this role, he managed State Street's investor services business in Scotland, in addition to his role as managing director of The WM Company. A qualified accountant, Mr Walsh has been in the industry for more than 25 years. He joined The WM Company from HSBC where he worked for 15 years. Prior to leaving HSBC he was head of investments (HSBC Bank, UK) and managing director of HSBC Investment Funds (UK) Limited.