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UK pensions speedbrief: FCA’s Thematic Review reveals risks with transition management for pension plan trustees

    • Pensions - Speedbriefs


    Following the Financial Conduct Authority’s (“FCA”) recent enforcement action in respect of transition management, it has published its thematic review of the transition management industry (TR14/1). The review identifies a number of risks with transition management, including potential conflicts of interests and the mis-use of information, which pension plan trustees need to be aware of and should address in their contracts with transition managers.

    What is transition management? 

    Transition management is used by asset owners, such as pension funds, to help move investment portfolios between different managers or markets while managing market risk and reducing transaction costs. The main providers of transition management are investment banks, custody banks, asset managers and specialist firms.

    What are the FCA’s findings?

    The FCA has concluded that the FCA’s rules and guidance are adequate and fit for purpose.  It is not, therefore, proposing to make any changes to its rules.  It has, however, identified a number of key risks that have been compounded by inadequate oversight within firms. 

    The key risks identified include:

    • Pre-trade information – A conflict between what the client needs from pre-trade information (an accurate assessment of the complexity of the trade and an estimate of likely costs of the trade) and the transition manager’s desire to win business with an unrealistically low estimate.
    • Mis-use of information One of the drivers behind the use of transition managers is the client’s need to alter exposure to particular markets by executing a large volume of trading in a short period.  There is a risk of ‘front running’ (i.e. where the broker uses this information to trade on its own account) or market abuse.
    • Principal trading Some transition managers and associates are able to act both as agent and principal (i.e. as counterparty to the transactions themselves). Clients and transition managers may have a direct conflict over the transition manager’s choice of how (and with whom) it executes client orders.
    • Internal crossing – This can give rise to conflicts of interest between different clients if, for example, trading is delayed to allow the buy and sell orders in the same securities to be matched (crossed) with another client, or where crosses occur internally at a worse price than could have been obtained in the open market.
    • Execution venues Transition managers may direct the transactional flow from mandates towards particular execution venues (e.g. multilateral trading facilities) in which they have a commercial interest. This could lead to transactions being made in the interests of the transition manager at the cost of the client.
    • Affiliates/revenue sharing agreements – Execution of the mandate via an entity affiliated to the transition manager can give rise to conflicts, with the affiliate potentially seeking to maximise revenue rather than acting in the client’s best interests. Transition management clients may also find it harder to ascertain whether best execution has occurred, while costs may be increased by additional layers of fees.
    • ‘In specie’/substitution – Where there are common securities in the legacy and target portfolios, it may be in the client’s interest for these to be transferred via an ‘in specie’ transfer, but if the transition manager is remunerated by commission (as is industry standard), it may not be incentivised to choose the lower-cost option. On fixed income mandates, transition managers may not be incentivised to look for substitution opportunities that may be in a client’s best interest, as this would result in fewer trades being conducted.

    Combined with these risks, the FCA found that marketing materials do not always accurately reflect the transition manager’s role, that senior manager and control function oversight can be lacking, and that pre and post-implementation reports might not be sufficiently reliable.

    What happens next?

    The FCA will concentrate its efforts on its supervisory work, focussing on:

    • the management of conflicts of interest,
    • oversight, governance and controls,
    • transparency and communication, and
    • client understanding.

    How we can help

    Eversheds’ pensions and financial services teams are advising pension plans and transition managers on the implementation of transition arrangements. In particular, we can help pension plans put in place robust contractual arrangements with their transition managers, and we can help transition managers with their standard contracts and client literature.