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Change And Challenge Define Today’s Custody Industry

For pension plan sponsors, both in Canada and around the world, 2003 was a year of daily routines that were anything but, says David Toyne, president of State Street Trust Company Canada.

Lower stock market returns and the threat of underfunded pension plans created a drive toward diverse, cross-border, and complex investment strategies such as hedge funds, derivatives, and income trusts.

With the added revenue potential of each new vehicle, strategy, or asset class came a host of risks and compliance requirements that needed to be carefully managed. Operational costs for plan sponsors continued to skyrocket, while budgets and resources remained constant or shrank, he says.

At the same time that these shifts have occurred, heightened regulatory scrutiny and investor sophistication continue to place demands on pension plan sponsors to provide more in-depth reporting, disclosure, and transparency. Keeping ahead of the ongoing technology upgrades needed to meet these demands also requires a substantial investment of financial resources and staff time, says Toyne.

As the industry, the investment environment, and the needs of institutional investors have changed dramatically, so too has the role of the custodian. No longer simply caretaker, trustee, and facilitator, today’s custodian must have the capabilities to guide clients through all areas of the investment process – and the industry expertise to anticipate where new challenges and opportunities will emerge.

In the following, Stuart Plummer, director, product management, sales and marketing, at CIBC Mellon Global Securities Services Company; John Courtney, director, corporate and group services, at Canadian Western Trust Company; Lise Charbonneau, vice-president, business development and client relationships, custody and pension plans, at Desjardins Trust; Scott Scobie, senior vice-president, corporate and institutional services, at The Northern Trust Company, Canada; José Placido, executive vice-president, RBC Global Services; Suzanne Bourgouin, vicepresident, corporate services, National Bank Trust Inc.; and Toyne share their thoughts on some of the key trends plan sponsors should be watching.

The main challenge for Defined Benefit pension plan sponsors over the last several years has been weathering a combination of dwindling market returns and underfunding of plans, says Placido. “It is well known that during the bull market, many companies took contribution holidays and are now paying the price – ranging from credit rating downgrades, severely constrained cash flows, and even debt issuance to cover liabilities.”

But, there are signs that the tide is turning for the better. Two years of decline have been reversed, with the median pension plan returning 6.5 per cent for the five years ending September 30, 2003, and getting closer to meeting liabilities in a sustainable way.

So, while there is good news on the horizon, Placido says pension plans still wrestle with issues related to allocations to alternative investments in an attempt to achieve non-correlated market returns. In addition, plan sponsors continue to seek ways to protect their corporate balance sheets by considering closing DB plans to new members and shifting investment risk to their employees in various ways including DC and hybrid plans.

Still, the past year was relatively calm for pension fund custodian accounts, says Charbonneau. The uncertainty that prevailed on the financial markets meant decisions on changing managers and asset allocation were being deferred.

Since the returns were not always as expected, pension funds favoured the use of value-added services – such as securities lending, asset allocation monitoring, and the production of more complex financial reports, she says.

This year, Charbonneau expects to see an upsurge in movements within the pension funds – changes in managers and the use of new asset allocation and specialized mandates.

In the months to come, Plummer sees many plan sponsors, concerned with the bottom line effect that an under-funded pension plan will have on their own company, returning to the basics – fund governance, driven also by regulators, and the need to control costs. “Understanding their investments, how and where returns are derived, and measuring and managing the risk exposure of their funds will benefit plan sponsors in the end,” he says.


From Courtney’s perspective, the challenges facing all Canadian sponsors of retirement plans, particularly small- to medium-sized sponsors, include finding affordable custodial and trustee services.

Consolidation in the trust industry has brought about increased fees without any apparent changes to service quality, he says.

The business model of the insurance industry – the ‘bundled’ approach of having all services delivered by one provider – clearly appeals to a plan sponsor’s desire for simplicity.

However, it may not provide the best alternative for each of the services, he says, and definitely reduces flexibility as all services must be re-tendered to effect a change in any one aspect of the overall offering.

The result may a movement towards an ‘unbundled’ approach where a sponsor can choose the best provider for each service.

This will result in niche players – with established ‘partnerships’ with consultants, investment managers, and record-keepers – entering this market and providing simple and affordable custody services.

Scobie says some of our challenges in Canada are indicative of broader global trends.

“The aging population is obvious and we are already being prepared for the message: ‘Live longer, work longer!’ ” he says.

However, Canada is also unique in a number of ways, he says. “We lack a unified and clearly defined set of pension regulations and, as such, are embroiled in lengthy and costly court cases in an effort to make sense of it all. No wonder plan sponsors struggle to stay abreast of regulatory and legislative changes given the nature of the current pension environment.”

Against this backdrop, the overall importance of the custodian to the plan sponsor (and to the investment process in general) is growing. Custodians, Scobie says, are ‘moving up the value chain.”

Straight-through Processing

This year will be a pivot one for the implementation of STP, says Charbonneau. All players on the transaction settlement market – the securities dealers, portfolio managers, custodians, and clearing houses – will have to work together to attain the objectives established by the industry.

However, one of the barriers is a lack of agreed-upon standards for communication of trade information. Both Plummer and Placido believe this should be resolved during 2004 with the recent release by the Canadian Capital Markets Association (CCMA) of a Best Practices paper that will standardize the definitions for trade information requirements.

Placido notes that The Canadian Securities Administrators conducted two surveys in 2003 to assess the STP readiness of industry participants and infrastructure providers. The results of that survey indicate that there is still much work to be done, he says. Some key observations from the survey are:  Infrastructure participants are ahead of the industry in STP progress  45 per cent of infrastructure respondents indicated that they have products or services that are STP compliant versus five per cent of industry participants  65 per cent of infrastructure respondents have major STP projects underway versus 10 per cent of industry respondents. The majority of respondents had no investment in STP initiatives in 2002 with the majority of their investment scheduled for 2004

To meet the requirements, continued investment in technology is a pre-requisite to enable the custodian to remain innovative and to ensure the automation of core processes, says Scobie. STP and the alignment of capabilities with the investment management process are also fundamental to assist plan sponsors to maintain and manage their focus on risk, he says.

However, Bourgouin does have some concerns.

She says “Competitiveness is the key word. If Canadian participants are less efficient than their U.S. competitors and cannot meet the pre-requisite to shortening the settlement cycle to the day following trade date, there will no doubt be a significant shift of the trading business south of the border.”

But, she asks, if affirming trades is not a problem, does STP work when dealing with selling loaned securities that have to be recalled for settlement within the day?

Another issue is securities lending. A system-to-system electronic connection between lenders (through their custodians) and borrowers (through their agents) is far from achieved. The same argument applies for the recommended use of a central hub for corporate actions.

While the recommended standard and practice to use a virtual matching utility (VMU) is certainly the ideal solution, the costs of this VMU is no doubt the “big issue which is far from resolved,” she says.

However, Bourgouin has some good news. Securities lending and corporate actions do not account for most trades. Once the issue of affirming trades is resolved, most probably without connectivity to a VMU, the large majority of the trades will be STP compliant, she says.

And while STP is primarily about operational efficiency, it leads to other key benefits, says Placido. Operational efficiency means saving money and every participant in the trade process stands to save money. Investment managers, brokers, and custodians processing trades in a high volume manner will dedicate less staff to manual processes such as data entry, resolving discrepancies, and failed trades, thereby lowering costs.

In addition to lowering costs, these organizations also benefit from having more accurate and timely information on which to base investment decisions, which in turn should result in greater investment returns. “The investor is the ultimate benefactor of the reduced cost of execution and improved investment returns,” he says.

Changing Role of the Custodian

Is the role of the custodian changing?

Plummer believes custodians have evolved from the role of providing pure custody and transaction processing and have become data warehouses, leveraging the information they have to add value to clients through securities lending, performance measurement, investment analytics, and risk measurement.

For Charbonneau, “The evolution of the custodian’s role is focused on the addition of value-added services and is driven by its technological capacity to guide its clients and by the proactivity of its personnel to meet their needs.”

However, Courtney disagrees. “In today’s environment of rapidly changing technology, increased global awareness, corporate governance responsibilities, and greater accountability, it is easy to believe that the role of the custodian is changing.

“Essentially, however, this role has changed little. Notwithstanding the aforementioned factors, the custodian must still take charge of, and safeguard, the assets, settle trades, collect contributions, collect income, make benefit payments, file the necessary tax returns, and report regularly to the trustees and plan sponsors.”

Emerging Trends

In a more partnership-oriented approach, clients will require custodians to be more closely aligned to their business lines and strategies, says Placido. More joint investment initiatives will see custodians and clients sharing costs and risks, so it will no longer be viable to go it alone.

This means new investment managers will have the advantage of not having to build the infrastructure in-house, instead they will partner with the custodian who provides an integrated and seamless product to support asset management. Clients gain access to technology and/or infrastructure that would otherwise be beyond their means, while custodians leverage their investment across the rest of their client base.

Outsourcing by both sponsors and investment managers continues to be an emerging trend. Plummer notes that large plans which had formerly taken care of their benefit payments in-house recognize that custodians have the scale and infrastructure – staff trained to deal with retirees, accessible online systems for reporting and research, and Websites dedicated to retiree needs – to outsource this service.

Worldwide, investment managers are looking to focus on their investment and client relationship strengths and are outsourcing their entire back office to custodians. “This is a strategic decision that relieves them of concerns about ongoing technology investments and streamlining operations to ensure STP compliance,” says Plummer.

As the relationship between institutional investor and custody provider moves ever closer to true collaborative partnership, Toyne says investors will be looking to their custodian to deliver increasingly sophisticated solutions across an even broader spectrum. “Leadership and counsel in the areas of contingency planning and disaster recovery, expense control, risk management, and transparency will take priority over basic financial service delivery.”

Scobie believes Canadian plan sponsors will increasingly rely on their service providers, so finding an understanding and agile partner to help guide them through an increasingly complex investment administration environment will be vital.

Courtney concurs, saying personal client service has become difficult to find. “Voice mail and automated switchboard ‘trees’ are now the norm with most of the suppliers of services, frustrating both the plan sponsors and their employees and pensioners.”

As a result, he suspects there may an effort by suppliers of specialized services to try to provide a human touch to their offering. While they believe in the efficient use of technology, this is combined with a service-focused front line where “clients are able to get through to their contact person directly, without the frustration of being sent into a telephone loop.”

While scale will always be a factor in any custodial appointment, Scobie says, it should not be a driving force in the decision.

“After all, history teaches us that a focused, nimble competitor has the ability to outperform a larger, sluggish opponent – isn’t that right Goliath?”

Based on material provided by Stuart Plummer, director, product management, sales and marketing, at CIBC Mellon Global Securities Services Company; John Courtney, director, corporate and group services, at Canadian Western Trust Company; Lise Charbonneau, vice-president, business development and client relationships, custody and pension plans, at Desjardins Trust; Scott Scobie, senior vice-president, corporate and institutional services, at The Northern Trust Company, Canada; José Placido, executive vice-president, RBC Global Services; Suzanne Bourgouin, vice-president, corporate services, National Bank Trust Inc.; and David Toyne, president of State Street Trust Company Canada.

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