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ITEM PF15

PENSION FUND COMMITTEE – 25 FEBRUARY 2005

MONITORING TRANSACTION COSTS

Report by the Head of Finance & Procurement

1. In August 2002 Local Government Pension Scheme regulations came into force requiring administering authorities to report, in their Statements of Investment Principles, to what extent they comply with the ten investment principles contained in the CIPFA document "Principles for Investment Decision Making in the Local Government Pension Scheme in the UK".
2. Two reports went to the Pension Fund Committee during 2002, which reported that the Oxfordshire Pension Fund complied with all the principles, except on shareholder activism and the monitoring of transaction costs. The Pension Fund’s latest Statement of Investment Principles reports that these two principles are still not complied with.
3. This report investigates the current position on the progress made with the monitoring of transaction costs. A report on shareholder activism is being considered separately at this meeting.
4. The CIPFA Principle number 5 says "Trustees, or those to whom they have delegated the task, should have a full understanding of the transaction-related costs they incur, including commissions. They should understand all the options open to them in respect of these costs, and should have an active strategy – whether through direct financial incentives or otherwise – for ensuring that these costs are properly controlled without jeopardising the fund’s other objectives."

What are transaction costs?

5. Annex 1 (download as .doc file) provides a flow chart, which shows the main steps in turning an investment decision into a completed trade in the market. This is the context in which transaction costs are incurred. The chart identifies four different stages in the trading process – order generation, broker selection, order placement and order execution. The simplest way of identifying the cost of any transaction is the difference in stock price between the price available in the market at the time the order was generated and the net price of the execution (i.e. the price including commissions, fees and taxes).
6. According to research by Inalytics, a company specialising in measuring transaction costs, the average cost for a UK transaction is 101 basis points of which 16 basis points relates to commission and 85 to the less transparent impact and timing costs. The transaction costs on overseas markets tend to be higher. Annex 2 provides further details on the different elements of transaction costs.

Monitoring Transaction Costs

7. In May 2002 the Investment Management Association ("IMA") published a Code of Practice on the disclosure of costs and charges incurred in the management and custody of scheme assets. The Code was drawn up by a Joint Working Party of Members of the IMA and the National Association of Pension Funds (NAPF) and was endorsed by the NAPF Investment Council.
8. Level One of the Disclosure requires managers to set out their policies, procedures and control processes on certain issues such as broker selection, dealing efficiency monitoring and conflicts of interests. Level Two covers the reporting of numerical and statistical information on commissions and use of brokers. Oxfordshire’s four fund managers comply with both Levels One and Two of the Disclosure Code.
9. Level Two information is now reported within the managers’ quarterly valuations but it is the larger costs such as timing costs and market impact, which are less easy to monitor. These less transparent costs are not included within the Level Two reporting.
10. The Pension Fund Committee received a report in November 2003, which recommended that the Oxfordshire Pension Fund should subscribe to the Inalytics Transaction Cost Reporting Service. The attraction of this independent service was that it measured all transaction cost elements and enabled comparisons with a universe of other pension funds and managers. The cost of this service was £15,000 but after the two managers present at this meeting, Baillie Gifford and UBS, offered to share the information they get from their own external specialists, it was decided not to subscribe to an independent measurement service for the time being.
11. All four of Oxfordshire’s managers use third party specialists such as Elkins/McSherry, Plexus and Abel Noser. During the last twelve months, the officers and Independent Financial Adviser have seen copies of the various external reports used by the managers, and have discussed the results and conclusions with them. In all instances officers were satisfied that the Pension Fund’s transaction costs were at a reasonable level and more often than not well below the benchmark average. The monitoring of transaction costs is now a standard agenda item at the officer/manager meetings.
12. Legal and General, who manage the Fund’s bond portfolio, have not been asked for an analysis of trading costs as they deal net (i.e. do not pay commissions) and in highly liquid markets for most bonds. Moreover, the Pension Fund did use Legal and General as the transition manager to move the Fund’s portfolio from two balanced managers to the current four specialist managers as their tender cost was estimated to be the lowest.

Conclusion

13. Since the last occasion when officers reviewed the monitoring of transactions costs much progress has been made. All four managers now comply with levels one and two of the IMA Disclosure Code. The more transparent costs like commissions and fees (IMA level 2 costs) are reported to the Committee. The less transparent costs, like market impact and timing, are measured and monitored by the managers, who employ external specialist firms. Figures and statistics from the reports are shared and discussed with the officers and Independent Financial Adviser at the officer/manager meetings held throughout the year.
14. The Pension Fund has signed up for a transaction measurement service with Euraplan. This service is being provided free for a trial period and will compare Oxfordshire’s transaction costs with other local authority pension funds. Officers will keep members informed on the progress and results of this project.

RECOMMENDATION

15. The Committee is RECOMMENDED to note this report and to amend the Pension Fund’s Statement of Investment Principles to reflect that the CIPFA principle covering transaction costs is now being fully complied with.

SUE SCANE
Head of Finance & Procurement

Background papers: CIPFA document "Principles for Investment Decision Making in the Local Government Pension Scheme in the UK" Data supplied by Alliance Bernstein, Baillie Gifford and UBS

Contact officer: Tony Wheeler, Pension Fund Investments Manager Tel: (01865) 815287.

February 2005.

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