When investing pension plan funds, governmental units participate in security transactions (purchases and sales) that can incur millions of dollars in brokerage costs annually. As fiduciaries to plan members, administrators should explore ways to reduce brokerage costs without sacrificing best execution of plan transactions. (Best execution refers to obtaining the best price available for securities trades, given the type and size of the transaction, with the best speed).
Historically, in a commission recapture program, a pension plan informs its investment managers that the plan has an agreement with a participating broker or brokers to recapture a mutually agreed upon percentage of brokerage costs incurred in making the plan’s securities trades. Plans encourage their investment managers to contact the plans’ commission recapture brokers when searching for best execution of plan security transactions. The plan should receive all recaptured commissions in hard dollars (as opposed to soft dollars, a directed brokerage practice in which the rebate is received in the form of services such as research), which can be used to reduce overall administrative expense. An alternative to the recapture of commissions is for plans or their investment managers to negotiate a lower transaction fee directly with participating brokerage firms. This type of agreement is normally focused on execution-only services (in which the broker assists with trading securities but does not offer investment advice) and may require achieving a certain level of trading volume.
A pension plan should first determine whether a commission recapture program will actually produce lower costs overall. If the pension plan’s board of trustees decides to have such a program, or if it is required by law, GFOA recommends the following guidelines for proper administration.
- Policy Document – Establish a policy for commission recapture that includes information concerning how the program would operate, and maintain it within the pension plan’s overall procedural manual, which includes all of the plan’s policies and operational procedures.
- Choosing Recapture Programs – The parties that would qualify to participate in recapture programs should be defined by the pension plan’s policy document and any statutory requirements. Normally, only investments within separate accounts can participate in recapture programs; it is not an option for accounts that are invested through commingled vehicles. To eliminate any potential conflict of interest, programs should include only brokers that are acting on an agency-only basis (an agency-only broker acts as a middle man to the stock exchange and places trades on behalf of clients, as opposed to brokerdealers, which purchase orders from clients and then sell these blocks into the market). All agreements should be in writing, with precise definitions of all services to be provided and the rights of the parties executing the trades. As trading costs can be a drag on investment performance, plan officials should take care to select the best-qualified firms, based on:
- The firm’s historic ability to achieve best execution, which should always be the first and foremost concern.
- The volume of trades a firm conducts, its level of experience in working with a large number of institutional clients, and that the firm currently participates in other recapture programs.1
- Basic due diligence. Verify that all firms involved in the program are financially solvent, compliant with Securities and Exchange Commission regulations and all relevant state and federal laws,2 and have proper controls in place. Also, examine the firms’ references.
- Reporting and Disclosure – Investment managers and brokers that participate in recapture programs should provide the pension plan with comprehensive reporting quarterly. Reports should be reconciled to the plan’s custodial reports before they are submitted to the pension plan.
- Review – The pension plan should conduct a regular formal review of brokerage costs and arrangements to ensure that the net costs of transactions and services are as low as possible, subject to best execution. If the plan does not have adequate resources to conduct this review, it can determine the true costs by outsourcing the work to an independent third-party with analytic capacity.
1 Certain trades – usually for large institutional clients – are difficult because they involve a high percentage of thesecurity’s average daily trading volume, or they must be traded in multiple lots, or they require the broker to commit capital. It is important that the firm be an active participant in other directed brokerage programs because of the possibility that a firm that does not direct trades for other clients might make other clients’ trades first (per its usual trading style). This would lead to less than optimal price and timing for the directed trades, as the market would have been affected by the trades that had gone before.
2 Under Section 28(e) of the Securities Exchange Act of 1934, only brokerage and research services can be covered under the program. A directed brokerage program’s soft-dollar services must meet three criteria to receive protection under section 28(e): providing advice about the value of securities and investing in securities; providing analysis and reports about economic and investment issues; and providing securities transactions and associated functions. The provisions of Section 28(e) do not allow a broker to cover expenses for computer hardware, professional licensing fees, or general office overhead expenses.
- PWBA Advisory Council Working Group Reports for 1997, Advisory Council on Employee Welfare and Benefit Plans Report of the Working Group on Soft Dollars/Commission Recapture, November 13, 1997.
- Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds, The Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, September 22, 1998.
- California Public Employees’ Retirement System Statement of Investment Policy for Directed Brokerage Arrangement, August 14, 2006.