Retirement plan portfolios generate millions of dollars in brokerage commissions annually. Historically, the plan's portfolio managers have used these commission dollars to pay for proprietary research and other services from the brokerage houses. But a large and growing percentage of sponsors are directing managers to execute trades through particular brokers who will "return" a portion of the commissions to the plan, enabling them to reduce significantly plan investment expenses.
According to a study we conducted this year, 53% of all plan sponsors now use directed brokerage to buy investment services with a portion of their commission dollars. The study shows 48% of corporate plans used directed brokerage, compared with 58% of public plans, and 56% of endowments and foundations.
Directed trading evolved after "May Day," the establishment of fully negotiated brokerage rates in May 1975. As new, lower rates became relatively uniform, brokers sought competitive advantage by offering proprietary research and other services in exchange for an investment manager's trading business. As the sizable commission dollar amounts attracted the attention of plan sponsors, some brokers then responded by offering to refund "excess" commissions to the sponsor in exchange for trading executions.
Today, directed brokerage is the subject of considerable debate within the plan sponsor community. Despite the opportunity to benefit plan participants through lower expenses, some plan sponsors are listening to their investment managers' claims that directed trades restrict the managers' ability to achieve "best execution."
Best execution, defined as the optimum trading price for a transaction, is composed of commissions, market impact and opportunity costs. Plan officials who do not direct trades say a plan's commission dollar savings must be weighed against the less-quantifiable market-impact and opportunity costs their managers claim might result from directed brokerage transactions.
This article presents both perspectives in the directed brokerage debate. Taken together, this information should help undecided plan sponsors answer the question: Will directed brokerage benefit my plan and its participants?
Directed brokerage may undermine managers' performance by preventing "best execution."
Management of a plan's commission dollars includes the responsibility to confirm that managers are obtaining best execution. Plan sponsors worry that overriding a manager's normal trading activities could have an impact on best execution - albeit one that is difficult to quantify.
Commission costs are easy to identify, but a trade's execution costs also are affected by other factors, such as the timing of the trade, the market impact and the spread between the buy and sell prices of the security. Plan sponsors who don't direct have been told by managers it's difficult to minimize these factors when hampered by directed trade requirements.
They cite the main difficulty as "sequencing" of client orders. If a manager determines his portfolios would benefit from buying a certain stock, he would prefer to buy in a block for all of his clients to get the best price and thereby treat each client equally. But if a large number of his clients have instructed him to direct trades to a variety of brokers, the manager's best-price efforts are thwarted. Individual directed orders can't be included in the block trade of non-directed orders; instead they might get backed up on the trading desk.
By trading later in the sequence, directed orders could miss the best price. When a block trades, it makes the price move, so subsequent directed trades could pay more for a buy (or get less from a sell), which could lead to disparate performance among a manager's portfolios.
Also, managers say they might be directed to use an unprofessional or non-competitive broker. Managers believe they, not the plan sponsors, are in the best position to assess the quality of a broker's trades. They say plan sponsors who specify a broker are making investment quality decisions that go beyond the sponsors' expertise.
Finally, sponsors have been told directed trading can interfere with a manager's investment process and can undermine the performance record that lead to the manager's selection. Managers also say the higher costs that might result from directed trading can erode portfolio returns - through no fault of the manager.
Managers do agree that directing a small portion of a plan's commission dollars back to the plan won't hurt their process; however, they say their efforts are significantly undermined when plan sponsors "get greedy" by directing the lion's share of the commission dollars.
Managers can use commission dollars to purchase research.
Proprietary and soft-dollar broker research purchased by managers with client commission dollars is pointed to as necessary for quality investing - improving the manager's information base and ultimately benefiting the client plan.
Managers also note they generally use commission dollars to enlist a broker's willingness to accommodate special trades, including "first calls" and the commitment of broker capital to achieve liquidity to a stock. Without such cooperation, managers say, their ability to effectively manage the plan portfolio might be undermined.
The management of directed trading seems to be an unnecessary burden for plan sponsors.
Managers say successful directed trading requires the use of several brokers to handle the range of asset classes in a plan's portfolio. Because commissions are only pennies a share, plan savings from directed brokerage might be too small to justify the time plan sponsors spend in monitoring these brokers.
Such multiple agreements appear to be cumbersome arrangements with no centralized reporting, creating many statements, bills and other correspondence for plan sponsors to handle. Managers point out their work also increases when individual directed trades must be allocated among many brokers.
Both commission cost savings and "best execution" can be achieved with directed brokerage.
Years ago, directed brokerage might have restricted best execution by creating sequencing problems or specifying underqualified brokers. But directed brokerage has evolved dramatically; today, plan sponsors who direct are able to save a large amount of money without affecting execution at all.
The situation has improved because the brokerage industry responded to the perceived loss of best execution by creating vast "correspondent" brokerage networks that include many of the major global brokerage firms - the same brokers that managers already use for block trades.
Managers can trade the directed shares as part of a block of non-directed shares, using their choice of these correspondent brokers or through "step-out" trades. As a result, the trading for every account is exactly the same. Problems noted earlier regarding sequencing and performance dispersion have been eliminated.
The only difference now is that the plan sponsor who directs significantly lowers his commission costs; the client who doesn't direct, on the other hand, sees no commission cost reductions at all. In fact, his commission dollars serve to subsidize the research purchased for the manager's other clients.
Because directed trades can now be executed just like non-directed trades, trading is no longer the issue. The question that remains, then, is: Where are the plan's commission dollars best spent? Is it best that the management firm uses all of them to pay their soft-dollar expenses? Or should the plan sponsor use some commissions to benefit the plan by purchasing research and consultant services.
Commission dollars are an asset of the plan and should provide needed investment services of the plan.
Pension funds generate millions of dollars in commissions, far in excess of what managers need to spend on research - certainly enough for both managers and plans to use for investment needs. Nevertheless, all commission dollars historically have been directed by managers to fund their investment expenses. Managers should recognize that plans, too, have valid and necessary investment expenses that should be covered by the commission dollars they generate.
Because commission costs affect the plan participants' bottom line, plan sponsors have a responsibility to direct commission dollars to pay for necessary expenses or services that will have a positive impact on the plan's performance. Strategic decisions, such as asset allocation and manager selection, have been proven to produce 80% of a portfolio's return; the manager's specific stock selections are responsible for only 20% of the return. Therefore, it is argued plan sponsors should direct the largest share of the commission dollars for the benefit of the plan, because their decisions result in the largest part of the return.
Plan sponsors also need their own research services to generate investment ideas for funds they manage internally. Many plans with limited budgets rely heavily on commission dollars to pay for all of the outside services necessary to run a plan properly, in addition to acquiring strategic services for better fund performance.
Plan sponsors can negotiate to direct a reasonable percentage of directed commission dollars without limiting their managers' research purchases. An optimal percentage, with consideration for the capitalization and liquidity of the portfolio, can result in annual savings of hundreds of thousands of the plan's investment expense dollars - or even millions of dollars, in some cases.
Plan sponsors who direct trades also note the Securities and Exchange Commission studies of soft-dollar abuses by managers. They make sure the managers are purchasing research that indeed benefits the fund and not the management firm itself. Some managers are using clients' commissions for soft-dollar purchases of equipment and services that benefit their firms and should therefore be paid for as a part of their firm's regular operating costs.
Managers can be expected to continue such purchases; therefore, because more than 50% of plans are directing a portion of their commission dollars, those plan sponsors who do not direct will see their dollars used to subsidize the manager's research. Because more than 50% of typical plan sponsors direct a portion of their commission dollars, managers must use commission dollars of the non-directing plans to subsidize research for all of their clients.
The small effort needed to manage directed trading is well worth the cost savings.
Plan sponsors already are obligated to monitor the spending of their commission dollars. The U.S. Department of Labor states commissions are an asset of the retirement plan, and the plan fiduciary must have a process in place to "control investment expenses" as long as best execution is achieved.
Thus, if the sponsor selects well-qualified, professional brokers and is monitoring commission dollars anyway, a directed brokerage plan requires very little incremental management effort. The hundreds of thousands or even millions of dollars in commission savings that can result are worth the small effort involved.
Although brokers can be monitored individually by the plan sponsor, a more efficient approach is to hire a single broker that then manages a broker correspondent network and provides a centralized record-keeping system.
Another benefit of the correspondent network is that it provides a single broker interface between plan sponsors and investment managers. It places responsibility for multiple broker management on the one managing broker, not the plan sponsor. The managing broker has a strong incentive to keep the directed trading program on track and will provide close monitoring of trading costs.
The 'ayes' have it
The main question for any plan sponsor to ask when deciding whether to implement directed brokerage is: Will directed brokerage benefit the plan's participant?
The answer is "yes" for all the reasons noted above:
Both commission cost savings and "best execution" can be achieved with directed brokerage.
Commission dollars are an asset of the plan and should provide needed investment services for the plan.
The small effort needed to manage directed trading is well worth the resulting cost savings.
Plan sponsors should realize that some managers initially will resist directed brokerage. Their natural tendency will be to keep excess commissions to pay for research and services that benefit their firm, rather than relinquish them for the individual client's benefit.
A plan sponsor's fiduciary duty includes making sure that the funds are ably managed and that plan assets are appropriately used. Directed trading with a highly qualified broker goes far toward meeting both aspects of that duty.