"At the end of the bull market in equities, when equity returns were rolling over at 15% year over year, 30 basis points of cost didn't seem very important to people," says Mike Heale, a director at Cost Effectiveness Measurement Inc. (CEM), a company in Toronto that provides performance benchmarking for retirement plans. "Given the correction in the market, I think people have undergone a sea change in expectations. If you expect 6% or 7% or 8% [returns] going forward, that magnitude of costs becomes more meaningful to people." CEM shows that the average cost for U.S. and Canadian funds in 2003 equaled 38 basis points: 32 basis points for direct investment management costs and six basis points for oversight and administration.

One simple way to improve your plan's return: reduce the commissions that brokerages pay to investment managers for trades or direct some of those commissions back to the plan. Compared to some of the other approaches to saving pension plans money, commission recapture has been around for some time. Bob Werner, managing director of implementation services at investment consultants and asset management firm Russell Investment Group, recalls it started in 1969, when J.C. Penney Corp., a Russell client, decided that the commissions on trades made for Penney's plan belonged to the plan, not to the investment manager. Tacoma, Wash.-based Russell worked out an arrangement with brokerages to have a percentage of the commissions flow back to the plan. Russell now deals with 22 brokerages on commission recapture, Werner says. A typical pension plan could add two to six basis points of return by using commission recapture, he says.

Research from Greenwich Associates shows that 58% of plan sponsors used commission recapture programs in 2004, and $790 million flowed through commission recapture programs. Boston-based State Street Global Markets also does commission recapture, and Ross McLellan, a senior vice president at State Street, notes that most plan sponsors direct only a portion of their trades, usually 25%, into the commission recapture program. Some plans ask their managers to negotiate lower commission rates with brokers instead of using commission recapture, McLellan says.

NO MORE IDLE CASH

But recapture alone is only part of an efficiency strategy. It's also becoming common practice to use the services of a transition manager to minimize any impact on a plan's return when pension funds decide to move a sizable amount from one investment manager to another, or from one asset class to another. This manager could be a custodian, consultant or brokerage–anyone with the trading savvy to reduce costs and keep the cash working.

"There's no cookbook for transition management," says State Street's McLellan, who heads the bank's transition management effort in North America. "For each transition, you have a different set of assets, different timing and different events going on in the market." But the goals are always the same. "You need to eliminate the implied costs associated with a transition: the bid-ask spread and the market impact," he says. "You also need to avoid large opportunity costs associated with being out of the market for one or two days."

Investment managers at Hydro One Inc., a power distributor in Ontario, employed Russell's transition management services when they were handed securities worth roughly $3 billion (U.S.) in 2001. The securities represented Hydro One's portion of the retirement plan assets of its predecessor firm, Ontario Hydro, which the Canadian government broke up into two new entities. Russell took charge of transforming that group of securities into portfolios selected by the new investment managers, and it did so with notable success: The transition, which was expected to subtract about 21 basis points from Hydro One's return, instead added eight basis points, after taking into account the transition management fee. "The strength of the transition service provider is [that] they can typically take advantage of skills they have in the marketplace to minimize the market impact and trading cost," says John Formusa, director of pension fund operations at Hydro One. "For example, when they compare the securities in your target portfolio, there may be an opportunity for them to cross certain blocks of shares at very, very low costs."

Transition management has taken off in recent years, with the amount of assets transitioned doubling in size from 2000 to 2003, according to Gavin Little-Gill, a senior analyst at Needham, Mass.-based financial services research firm TowerGroup. He puts the total assets transitioned in 2003 at $1.9 trillion, or about 15% to 20% of all institutional assets. Little-Gill says the rise reflects the growing cost-consciousness of institutional investors, the volatility of the financial markets in recent years, which encouraged plans to reassign assets, and the scandals involving fund companies, which led to still more shifts.

The demand for transition management has generated a lot of supply: "Everybody is jumping in there and putting a shingle out," says Little-Gill, who questions whether all the new entrants have the skills required to execute a successful transition. "You need to have full access to liquidity…tremendous risk management capabilities and be extraordinarily skilled at trading large blocks of securities." Companies offering transition management services include custodial banks, consultants, asset management firms and brokerages.

"Most plans have come to appreciate the benefits a transition manager can offer," says State Street's McLellan. "Eighty-five [percent] to 90% of larger plan sponsors are using a transition manager most of the time," he says. State Street transitioned $275 billion of assets in 2003, and McLellan estimates that State Street's services typically save pension plans 25 to 30 basis points of return on transitions.

Companies with defined-benefit pension plans painstakingly work out the exact combination of stocks and bonds, domestic and foreign, that is best for them. Despite the care they lavish on such decisions, some of their assets may end up sitting in cash, either because an investment manager is not fully invested, the plan hasn't figured out how to invest a cash contribution or the plan is holding cash because it has payments due soon. "It's not uncommon to see managers, especially in active equity, hold 2% and 3% cash," says Tom Lee, a senior portfolio manager and principal at The Clifton Group in Minneapolis, which provides pension plans with overlay management, enhanced indexing and core fixed-income management. "They have frictional cash around just as a function of the way they operate their fund." Russell's Werner estimates that, on average, equity managers are only 95% invested.

Unfortunately, any money that's sitting in cash is earning a return far short of what the plan is expecting. The solution: a derivatives overlay, in which futures contracts are purchased to earn a better return on that cash. "You overlay the cash with S&P 500 futures so the cash earns an equity return," says Werner. Russell has been providing that service, which it calls cash equitization, since 1986. Werner says that in the early days, Russell had to call investment managers every day to get the level of cash they were holding. Advances in technology now allow Russell to see that information, as well as what cash flows the manager will see that day as a result of trades settling.

Tom Lee of The Clifton Group says that it's becoming more common for pension funds to use derivatives overlays. He notes that the technology has improved and the cost of trading futures has declined. In addition, "in this lower return environment, every basis point matters," he says. "[Fund sponsors] are willing to roll up their sleeves and find ways to operate more efficiently."

Futures contracts can also come in handy when a plan gets a big contribution from the company and needs time to figure out where to invest it. Both Clifton and Russell will figure out how to match a pension plan's overall asset allocation using different kinds of futures contracts. Both firms also use futures contracts to help plans stick more closely to their targeted asset allocation. Dave Ertel, manager of investments at Southern California Edison, says he used to rebalance by buying or selling securities if an asset class moved more than 5% over or under its target. Now, he employs Russell to buy or sell futures contracts to bring allocations back into line whenever assets are more than 1% over or under target. "You can have much narrower ranges for your policy targets and it doesn't cost that much because you're using derivatives," Ertel says. "The tracking error can be reduced pretty significantly by doing this."

BULK PRICING

Lee estimates that over the long run, a plan that uses futures contracts both to put idle cash to work and rebalance in a more disciplined manner can add about 15 to 25 basis points to its annual return. Clifton's fees for those services would come to a basis point or less, he says.

Werner says Russell's implementation services group is working on other ways to save pension plans money and ensure that their investments stay right in line with their targeted allocation. For example, Russell now does all foreign exchange trading for a small number of clients. And for a few clients, it executes all securities trades for all the plan's investment managers in order to eliminate wasteful trading, like the situation in which one investment manager plans to sell the same stock that another plans to buy. Werner says that channeling all execution through Russell "enables huge economies of scale and lower commissions."

He argues that all of the services his group offers are in a sense a response to inefficiencies that arose as defined benefit plans went from putting all their money with a manager running a balanced fund to divvying up their money among a number of specialized investment managers. Specialization "is good, but you lost central control," he says.

Werner says that while the various methods that pension plans can use to save money are "boring stuff," a plan that employed a number of them could boost its return by 30 basis points. And while alternative investments tend to raise risks, the effort to cut costs and stick closely to targeted allocations actually lowers a plan's risks, he says.