What Are Retrocessions?
Retrocession is the German term for kickbacks, trailer fees, finder’s fees, and other payments made to asset managers by banks and other financial institutions in Switzerland. Although these payments come from client money and are thus the client’s property, they are still all too often not disclosed to the client. Retrocessions (retros, for short) have been a highly contentious issue over the past few years. In Switzerland, as elsewhere, a client entrusts the care of his money to an independent asset manager (IAM). The IAM works with the third-party bank where the client has deposited the assets. The IAM receives a limited power of attorney to trade the account on the client’s behalf. The management fee is generally about one percent of AUM per year. In addition, completely apart from the management fee, most IAMs receive retrocessions and other kickbacks on trading commissions, brokerage, custodian administration fees, funds, and structured product commissions. Moreover, the IAM often receives a finder’s fee (of 0.2 percent to one percent) from the bank for bringing in new money. Prior to the landmark Swiss Supreme Court ruling in 2006, most IAMs did not disclose these payments to their clients in any way. IAMs often denied the very existence of retrocessions.

Background and Statistics
Switzerland has about 2,600 asset managers (AMs) with some SFr500 billion of private client money under management. The total amount of retros paid annually is estimated to be about SFr2 billion. Of these 2,600 AMs, around 100 are banks and 2,500 are independent asset managers. About 80 percent of the IAMs take retrocessions as part of revenue. Although the disclosure of retros is slowly improving, the “how much gets paid” is still generally not disclosed. Best estimates are that retrocessions make up about 35 percent of the average IAM’s total annual revenue (see Figure 1).

Figure 1.  Gross Income on Private Client Assets for Swiss IAM

Basic retrocessions paid to IAMs by one globally active private bank in Zürich are as follows:

For every SFr1.00 brokerage paid to the bank by the client, the IAM receives SFr0.50 back from the bank, which is not disclosed to the client. The conflict of interest is not subtle; the IAM has a strong incentive to trade the account. With 50 cents on the dollar back for every trade, one would expect high turnover on IAM-managed accounts, which is what we tend to see in practice. Unfortunately, we have only anecdotal evidence to go on, and both banks and IAMs are tight-lipped on account turnover. Moreover, selection of custodian and broker is too often driven not by best execution, cost, or service quality, but rather by the question, who pays the highest retros?

Assessing the Impact
Consider retros as a tax — specifically, a wealth tax. Assuming “blanket” constant retro rates and ignoring management fees and charges, Table 1 shows the effect of retros on a SFr1,000,000 portfolio, with an assumed annual return of 6 percent over 20 years and with retro rates ranging from 0 percent to 1 percent. We will call the total impact on return the retro drag. Let the rate of return be r, the retro rate be t, and the number of years be N. The assumed future value interest factor (FVIF) for our wealth tax analogy is FVIF = [(1+r)(1-t)]N.

Table 1: Assets under Management and Retro Drag

The retro drag column is the percentage of total return that the IAM appropriates from the client over 20 years. The average IAM takes an estimated 40 bps a year in retros. Note that the drag is far greater than the retro rate itself; an annual retro rate of 0.4 percent has a negative 11.2 percent effect on portfolio performance over 20 years. The retro rate on funds and structured products ranges from 1percent to 3 percent. Should the client end up with a 50–60 percent allocation, with frequent rebalancing retros can really add up. Like a tax, retros consume a greater share of investment growth as the retro rate or investment horizon increases. Unlike with taxes, the client is generally unaware that these payments are being made. Today, in most cases, the level of retros is still not disclosed to the client, even when their existence is disclosed. Moreover, portfolios are subject to an almost infinite variety of different retro regimes, depending on asset classes held, types of security, the custodian bank holding the assets, and trading frequency/account turnover.

Table 2 shows the ease with which a 1 percent annual retro rate can be achieved on an individual account. The asset classes have been intentionally chosen to illustrate the retro effect and the potential income for an IAM. Figures do not include the IAM management fee.

 
Table 2.  Custodian Account with SFr1 Million under Management

Source: Florian Schubiger, Vermoegens-Partner AG.

Explanatory Notes
1. There are extra fees and charges (e.g., administrative, postage, or numbered account costs) on which retrocessions can also be paid.
2. These amounts are the effective fees and charges paid by the client when the IAM retains all retro payments.
3. Common types of retrocessions are shown in this example. IAMs may pass retros on as discounts.
4. This represents the true cost to the client if the IAM would reimburse the client for all retros.
5. Assuming 16 transactions with an average volume of SFr25,000. The account is being turned over every two and a half years. Retros on Forex trades can vary greatly.  
6. The level of funds in the portfolio is intentional at 40 percent. Some IAMs still invest total AUM in actively managed funds. This sum of up-front loads results when SFr102,000 active funds with a 2 percent up-front load (NAV 100,000 plus 2,000 up-front load) are purchased annually. With structured products, commissions are contained in the gross fee, which varies from product to product by several percentage points. In general, no retros are paid on index products and ETFs.  

The client pays SFr20,300, of which SFr10,050 is passed back to the IAM. The effective cost of services provided to the client: SFr10,250. Obviously, the high retrocessions on funds and structured products make it rather challenging to act in the client’s best interests. We see this in practice, with many IAMs buying large volumes of funds and structured products for their clients, even when the client is wealthy enough to achieve diversification through other means.  

Regulatory Issues and Some Perspective
IAMs are self-regulated in Switzerland and are subject to the Swiss Financial Markets Authority (FINMA). There are 11 recognized Self-Regulatory Organisations (SROs), and each IAM is required to join one. In 2007, FINMA asked the SROs and banks to develop a set of minimum standards for independent asset management. The SROs and banks, however, were completely unable to agree; they submitted a range of different and inconsistent standards, with the proposal that each SRO have its rules approved separately. FINMA finally gave up on the SROs, and in October 2008 it released a set of guidelines, Eckwerte zur Vermögensverwaltung (Cornerstones of Asset Management). This document contained the first concrete, recommended minimum standards for disclosure, transparency, reporting, fees, content of the asset management contract, and, yes, detailed requirements for the treatment and disclosure of retrocessions. Unfortunately, the standards are only recommendations and are in no way enforceable. Thus, it’s still business as usual.

From an Anglo-Saxon point of view, self-regulation appears to have failed. Switzerland, however, has never experienced the big blowups that plague hyper-regulated Anglo-Saxon systems. There has never been a Bernie Madoff, a Michael Milken, an Ivan Boesky, or a Dennis Levine. Large financial meltdowns in which investors lose their shirts (e.g., Lehman, Bear Stearns, AIG, Enron, and numerous others) are rare in Switzerland. Overall, the Swiss way of consensus seems to protect the investor — at a cost. In the last 80 years, there has not been a single major bank failure in Switzerland in which investors lost serious money. Consider the cost to investors in the wake of the S&L crisis, the petrodollar crisis, or the recent subprime debacle. Participants seem to understand that certain lines are not to be crossed and restrain themselves in collective self-interest. These unwritten rules — the spirit of the law rather than the letter — are broadly respected. Simply abolishing retros, attractive though the thought may be, is probably not feasible. Improving disclosure, transparency, and investor education seems to be the best answer.

Conclusion
The problem with retros is not that they exist; rather, the problem is that they are not disclosed and are not transparent. Improving disclosure and transparency will probably make retros go away of their own accord over time. FINMA’s point of view also seems to be that with the full disclosure of retros, clients will eventually migrate to other providers or demand better deals. Indeed, some IAMs are switching over to “retro-free” models, admittedly at a glacial pace. Following the global trend, the Swiss market is moving slowly toward increased transparency. Over the long term, retros should vanish or be transformed into other forms of disclosed compensation, without the need for heavy-handed regulation, which often creates bizarre incentives, distorts market signals, and leads to unexpected results. An opportunity exists for some IAMs to distinguish themselves through better service, for which clients are demonstrably willing to pay. FINMA appears to be taking the approach of requiring increased disclosure to enable both client and IAM to act in their own self-interest. This approach will either consign retros to the dustbin of history or make them a legitimate, disclosed, service-linked component of compensation.

Martin Straub is founder of Envisage Wealth Management Services in Zürich, Switzerland. The author thanks Florian Schubiger from Vermoegens-Partner AG and Philip Marcovici from Baker Mckenzie for reviewing this article.