The UCITS V legislative package being finalised in Brussels between the European Parliament and Council will usher in a new regime for fund managers’ remuneration in the EU. The legislation is expected to introduce requirements for managers to receive at least 50% of their variable remuneration in the form of shares in the funds they manage or equivalent instruments (precise details to be finalised), and at least 40% of variable pay shall be deferred for at least three years. The intent of these proposals is to more closely align the interests of managers with their investors and to promote sound risk management. But are the pay restrictions in the interests of investors, and will they serve their intended purpose?
First, a recap. The UCITS directive (Undertakings for Collective Investment in Transferable Securities) is the EU framework governing the management and distribution of retail investment funds. UCITS is the predominant product label for retail funds sold throughout Europe; such funds are also widely marketed in Asia. The latest legislative amendments to the directive (UCITS V) include provisions around depositary functions and liability, as well as rules on remuneration. As a directive, the legislation must be transposed into national law.
Political pressure over fund managers’ pay first surfaced last spring, following on the heels of the legislative agreement to cap bankers’ bonuses. The pivot towards UCITS fund managers in the remuneration debate reflected a collective desire among policymakers to apply similar remuneration restrictions across the financial sector. Indeed, this effort emphasised the wider policy agenda of comprehensive regulatory reform of all parts of the financial industry. However, perhaps in recognition of the unique systemic risks posed by the banking sector vis-à-vis the investment management industry, the push to apply bonus caps to fund managers was narrowly voted down by legislators.
But as policymakers’ focus has shifted in the intervening period from strengthening the regulatory perimeter toward promoting long-term investing and growth, so too has the remuneration debate. Instead of pursuing fund manager pay caps, the current provisions focus on greater alignment of interests between managers and investors through share-based compensation and deferred pay that more closely reflects investors’ average holding periods.
CFA Institute conducted a member poll on fund manager remuneration last July. When asked “What compensation practices best align asset managers’ interests with those of investors?” the most popular response was greater deferral of variable pay, cited by 61% of respondents. This response was followed by greater transparency over variable pay components (cited by 19%) and claw-back provisions (cited by 13%).
The current proposals to defer at least 40% of variable pay for at least three years should therefore be broadly welcomed. By way of comparison, the deferral amount and period for UCITS managers are toward the lower end of the spectrum prescribed for bankers, for whom 40-60% of total pay must be deferred over a three- to five-year period. The UCITS V proposals also seemingly stop short of prescribing an arbitrary ratio of variable to fixed pay. Thus, in these two respects at least, the pay provisions appropriately reflect the different risk profiles of banks and investment management firms and the functions of their respective staff.
However, perhaps a more contentious aspect of the legislation is the requirement for fund managers to have “skin in the game,” possibly in the form of shares or units in the funds they manage, although important details are yet to be worked out. In general, share-based compensation helps to alleviate principal-agent conflicts by aligning the risk and reward profiles of managers and shareholders. But UCITS funds are already subject to investor protections designed to minimise agency problems.
First and foremost, UCITS managers are bound by a duty to act in the best interests of their clients. Second, these funds (as retail collective investment schemes) are subject to restrictions on eligible assets and portfolio investment limits. Furthermore, UCITS funds typically have tightly-specified mandates and are subject to depositary oversight. Each of these measures serves to protect investors by constraining the extent to which the manager can take risks with client money. One might therefore question the need to require fund managers to take the extra step of having skin in the game. Moreover, absent an alignment of individual risk tolerances (ability and willingness to take risks) between the manager and the investors, it is questionable whether share-based compensation in units of the fund is appropriate.
Such a requirement would also likely face implementation challenges and possibly prove prohibitive for fund managers domiciled outside the EU.
Further questions remain, such as whether the compensation mechanism will allow for managers to receive shares in the management company or other financial instruments providing equivalent exposure. Moreover, it remains to be seen whether investors will be better served by managers whose wealth is more concentrated in the funds they manage.
As policymakers finalise these rules, we welcome your views.
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