One of the most radical recommendations in the report by Gartmore chairman Paul Myners into the UK institutional investment industry is the proposal that fund managers should include trading commissions in their fees rather than passing the cost directly on to the pension fund, as is present practice.
According to Myners report, pension funds are paying about the same in commissions to investment houses for dealing services and research as they are for active fund management. While fees paid to fund managers are scrutinised by the trustee and the investment consultant and are easily compared with similar rates in other countries, in the case of commissions, they are settled at the pension fund’s custodian account. Or in other words, pension funds are at present paying directly for commission.
Although the level of commission is disclosed, Myners says the aggregate cost to a fund over a prolonged period is not something that needs to be calculated. Instead details are included on the trade documents, things Myners describes as being of little interest to trustees. More importantly, firms providing the commissionable services are selected by the fund manager who acts as the institutional client’s agent. Pension funds have no say in picking the securities firm and negotiating fees; a strange set up since they foot the bill.
Myners argues the existing system creates an artificial bias for fund managers to have services provided by the sell-side, since the costs for these will not be scrutinised by the client and are not a direct charge to the fund manager’s profit. “In effect the fund manager outsources a business input to the sell-side with the cost charged directly to the client,” says the report.
Andrew Kirton, head of the UK investment consulting practice at consultants William Mercer describes the decision to treat broking commissions as a business expense as very sensible. “The current framework whereby investment managers control the direction of broking spend with no reference to pension funds who will stump up the cost, is riddled with potential conflicts of interest and lack of accountability,” he says.
Myners says that pension funds’ interests would be better served if fund managers absorb the cost of commissions and the report recommends that it would be good practice for institutional investment management mandates to incorporate a management fee inclusive of any external research, information or transaction services.
Fund managers would understandably try and offset this additional cost through higher fees and the report says this would be open to negotiation with their clients. Under the new approach, institutions would be able to see exactly what they pay to invest their funds while fund managers would choose which services to buy and which to provide themselves. As the report suggests, fund managers would be forced to take a close look at the standard of service that securities firms provide. Paying for something with another’s money is one thing; with your own, quite another.
The report says such a change would not favour fund managers over broking businesses, nor large fund managers over small. “Any organisation which could add value through the provision of efficient and effective business services, whether fund managers or broking businesses, large or small, should succeed in this environment.” It even goes as far to suggest this approach may attract new service providers and promote greater diversity of input and service. Perhaps.
But those securities firms producing mediocre research will either have to improve the standard of research and execution or face the consequences and some will naturally lack the resources to do so. Then there’s the issue of economies of scale. Securities houses with large volumes will pass on lower commission costs to the fund manager. The only small beneficiaries will be the suppliers of ECNs and other alternative trading systems.
Elsewhere in the report, Paul Myners recommends that pension funds should be forced to employ independent custodians. For some reason, such a logical more was excluded from the 1995 pension act, all the more peculiar given the Maxwell affair some years before. The UK’s National Association of Pension Funds has long supported the proposal since it was excluded by the 1995 act.
Says the report: “The question of pension fund assets should be looked at again. Although the great majority of schemes use custodians independent of the employer, not all do. Protection for pension scheme members from the risk of fraud could be improved by making custody independent of the employer a mandatory requirement for pension funds. This would make it more difficult for improper use to be made of a pension fund’s assets.”
Just as chancellor Gordon Brown agreed to the abolition of the MFR, so the UK Treasury has agreed to back the proposals. Speaking at the NAPF’s annual conference, Melanie Johnson, economic secretary to the Treasury, agreed with Paul Myners’ recommendations and agreed that fund managers’ fees should include cost of commissions.
If the recommendation goes ahead, the consequences for the securities industry are enormous. It is a big if though. Paul Myners’ report is a set of voluntary recommendations that the institutional investment industry is meant to adopt. Chancellor Brown has said he will legislate if the measures are not embraced. After the dust settles, whether he really will is another matter.

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