Global custodian banks have gotten virtually every public pension fund in the U.S. to sign what’s referred to in the industry as “bundled” fee contracts. The nation’s public pension boards—often composed of school teachers, cops, firefighters and garbage collectors—did not of their own accord conclude that such fees were in the best interest of their funds; rather, the global custody industry persuaded them to bundle fees by selling it as a cost-saving measure.
Global custody is a complex business, blending low margin administrative functions with highly lucrative add-on services. Often it involves investment management (including cash management), securities lending and trading, and foreign exchange. Custodians have led public pensions to believe that bundling fees together for these services will lower the client’s total costs.
Nothing could be further from the truth. Bundled fees utterly lack transparency and only ensure that pension fiduciaries will be ill-informed about what they’re paying for any given service. The more opaque the fee arrangement, the greater the risk that clients will be overcharged.
Decades ago I observed that under bundling arrangements my pension clients were being charged more for cash management than were paying their most talented bond managers. This made no sense. The only explanation was that cash management charges were buried inside bundled custodial fees.
My pension clients also had uncompetitive securities lending arrangements with custodial lending agents that ensured the funds, unbeknownst to them, took all the risk in exchange for only a sliver of the reward. Commission recapture and other securities trading were also priced un-competitively by custodians and trade executions were compromised.
International equity managers long complained to me that my pension clients were failing to reap the full benefits of their investments. This, they said, was because the pension funds’ custodian banks were forcing the external money managers to settle transactions with the custodians under unfavorable terms. Investment managers are not happy when, through no fault of their own, their investment performance suffers. The only explanation for the overcharges and abuses related to these services is a lack of transparency that resulted from bundled custodial fees.
Historically, public pension trustees have resisted investigating the investment firms they hire. The reasons include a lack of investment expertise among fund trustees and the efforts that bankers put into developing a sense of trust among their clients.
With budgets tight everywhere, the playing field is changing. State attorneys general are pursuing custodian banks for overcharging pensions on foreign exchange transactions. It is telling that public funds did not initiate this litigation but were instead forced into it by whistleblowers.
The SEC in January announced a $24 million settlement with BNY Mellon Securities, a unit of Bank of New York Mellon. It involved allegations that the custodian bank failed to fulfill its duty to provide best securities execution to pension funds and instead favored hedge fund clients. The pensions harmed were not identified in the settlement release. BNY Mellon Securities neither admitted nor denied wrongdoing.
Litigation involving the lending of securities from public pension portfolios is also beginning to pop up. Behind it is the realization that the incremental income pensions earned lending securities to hedge funds and other short sellers over the past decade was wiped out virtually overnight during the financial crisis. The big losses have, in fact, called into question whether it ever made sense to lend securities to those with a vested interest in driving down the value your own holdings.
Global custodians have spent decades using bundled fees to mask egregious conflicts of interest and overcharge pension funds, and by extension the taxpayers and public servants who underwrite them. I predict that public pensions—many of which face severe under-funding—will increasingly scrutinize their custodial arrangements and seek to claw back ill-gotten gains. The bundled fee arrangements which were promoted by custodians to benefit custodians have emerged as a costly flaw in the business model of the industry—and one whose days are numbered.
Edward Siedle is the president of Benchmark Financial Services, an Ocean Ridge, Fla., firm that investigates money management abuses primarily on behalf of pensions. He is a former SEC attorney and later served as legal counsel and director of Compliance at Putnam Investments.