Allegations that custodian banks overcharged pension funds for foreign-exchange transactions suggest there might be a costly flaw in the business model for custodial services.
Even if the allegations are disproved, they demonstrate that the trustees of the funds making the allegations were unclear about what the custodian banks were charging for foreign-exchange transactions, and possibly other custodial services. This is unacceptable.
The flaw is that the bundling of the services — from foreign-exchange trading to securities lending — might obfuscate the charges for each individual service, and because of that bundling, custodial fees often appear very low to the funds.
That lack of transparency, and the apparent minimal costs for custodial services have tended to encourage complacency among pension fund trustees and also, in many cases, on the part of the investment advisory firms managing portfolios with non-U.S. equities and fixed-income assets.
As a consequence, the custodial clients and money managers generally haven't examined whether the foreign-exchange costs implicit in the custodial fees, and execution costs, have been competitive; haven't sought out other service providers; or haven't made use of benchmarking and other performance measurement tools.
The custodial bank industry, for its part, has been content to keep services bundled, and costs hidden, unless clients asked for those costs to be itemized.
What gets measured gets managed, as the late management guru Peter Drucker reportedly said. Foreign exchange wasn't measured, and so, based on the lawsuits, wasn't managed well.
Lawsuits on the issue have been filed separately against Bank of New York Mellon on behalf of the Florida State Board of Administration and the Virginia Retirement System, and against State Street Corp. by the Arkansas Teacher Retirement System and jointly for the California Public Employees' Retirement System and the California State Teachers' Retirement System.
BNY Mellon and State Street, in separate statements, denied the charges and said they plan to defend themselves.
The allegations of overcharging could be a matter of retirement systems finally waking up to their own inattention to bundled costs and failure to seek better deals, and now looking for someone else to blame for their neglect. But they show trustees are at last paying attention to a previously neglected area, one that has become more important as pension funds have increased their foreign investments.
If the suits come to trial, they could reveal how the custodians charged for foreign-exchange transactions and other custodial activities within the bundled fees.
The issue should have never come to a lawsuit; the pension funds should have properly monitored and managed the costs of the services they were buying. What was out of sight was out of mind and in the eyes of the pension fund executives and trustees, out of control.
Investment managers, whose investment activities lead to foreign-exchange transactions on behalf of their pension fund clients, often defaulted to custodial banks for currency trading, even though instructed by pension fund clients to get best execution, whether for brokerage services or foreign-exchange transactions.
But investment managers considering building their own competency to better manage foreign-exchange costs have to consider the cost of building that expertise because the clients pay that additional cost. Managers have little incentive to seek better foreign-exchange rates, even though the costs of the transactions fall to the bottom line of portfolio performance, because such costs, amounting to a few basis points per transaction, have a very small impact on a portfolio's performance.
But those basis points on billions of dollars of transactions over a year can amount to millions of dollars and can finance lots of pension payments. Between 2001 and 2009, State Street overcharged CalPERS and CalSTRS a combined $56 million, their lawsuit alleges.
As fiduciaries, pension fund trustees have a relentless imperative to prudently maximize their funds' returns solely in the interest of beneficiaries, and that involves monitoring the pennies as well as the billions. In the wake of these suits, that will involve unbundling the fees of custodians and other service providers so the trustees can ensure the costs are reasonable. Investment managers too, as fiduciaries, should be monitoring these costs on behalf of their clients.
Pension fund fiduciaries that don't wake up to this new reality and seek greater transparency cannot count on someday suing to recoup any alleged overcharges. In fact, the lawsuits might be turned on them for neglecting their duties.