Choosing the best compensation program: fee or non-fee? It's a quandary many corporate decision-makers encounter when choosing cash managers. A noted cash manager--whose firm offers both types of services--provides some insights.

Corporate America is being subjected to increasing governmental as well as public scrutiny, and the word "accountability" is being redefined daily in board-rooms across the landscape.

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Some believe that the current climate is rooted in the savings and loan crisis of the early 1990s and the ensuing outcry for regulatory reforms. Whatever the cause, demands for greater oversight and stricter account-ability have impacted virtually every area of the corporate ledger, including cash management.

In December 1993, the Financial Accounting Standards Board (FASB) implemented a series of mandatory guidelines, all of which were designed to impose new responsibilities on corporations and the accounting firms that audit their books. Among these guidelines is FASB No. 115, Accounting for Certain Investments in Debt and Equity Securities. This guideline prompted this author to introduce an alternative to the then-traditional fee- or asset-based cash management compensation programs--a non-fee, or transaction-based compensation model. In due course, other corporate cash managers also elected to offer non-fee compensation programs.

With the advent of the non-fee alternative, CFOs outsourcing cash management were charged with determining which type of compensation program was more appropriate. Because of the complexities involved, these executives often found that process especially challenging and, as a consequence, many elected to establish relationships with both fee- and non-fee-based money managers. For a number of years, this strategy appeared to be a reasonable solution.

Then, in 2002, Congress enacted The Sarbanes-Oxley Act--legislation that provided for the creation of the Public Company Accounting Over-sight Board (PCAOB) to regulate and monitor the manner in which accounting firms throughout the U.S. conduct and report corporate audits.

As a result of this legislation, increasing numbers of CFOs and other financial executives are now carefully documenting the rationale behind the numerous decisions they make on behalf of the company and its stockholders. Among these decisions are those relating to outsourcing cash management and the process by which money managers are selected and compensated. Because the practice of outsourcing cash management is being subjected to closer examination, those responsible must perform significant due diligence before deciding whether to establish a relationship with a fee-based manager or non-fee-based manager.

Although there are exceptions, Bear Stearns has found that the decision as to which compensation program is more appropriate is generally driven by a company's accounting requirements and overall investment objectives. The following addresses the criteria for defining those objectives and for developing an informed approach to addressing cash management considerations.

Fee-Based Programs

Numerous fee-based strategies are available, all of which are designed for companies seeking returns that exceed selected benchmark indices. Depending on the strategy, pursuing above-benchmark performance often requires active trading, as well as a wide range of approved securities. Additional factors that may impact performance include credit quality, portfolio duration or a combination of these and other elements.

This overview of fee-based programs assumes a traditional, investment-grade cash management assignment and, further, that the portfolio manager will have the flexibility to actively trade securities within the portfolio to maximize the potential for above-benchmark returns.

Although trading activity may be driven by market movement and credit spreads, the portfolio manager generally will take advantage of the following opportunities to maximize returns:

Asset Class Rotation: Shifting weighting from one asset class to another. Asset classes typically include treasuries, agencies, auction-rate securities, mortgage-backed securities, asset-backed securities, municipals and corporates.

Sector Rotation: Shifting weighting within an asset class from one sector to another. For example, raising the exposure to financial issuers and lowering the exposure to industrial issuers.

Credit Quality Adjustments: Adjusting average credit quality within the portfolio, such as shifting a portion of the securities from AAA ratings to A ratings.

Varying Security Structures: Rotation among different types of bond structures, including bullet maturities, callables, step-ups, floating-rate and amortizing structures.

Yield Curve Adjustments: Extending or shortening average duration. Portfolio duration is typically positioned to be within a range (+/-) of the specified benchmark and, depending on interest rate forecasts, managers may adjust the portfolio duration.

Portfolio Structure: Targeting specific maturity ranges or making adjustments as necessary to achieve a predetermined structure. Structures may include barbells, bullets, ladders or variations on these strategies.

Fee-Based: Compensation

Clients pay a fee based on a percentage of assets under management. Securities are purchased at dealer cost, and the asset-based fee is charged to the account on a monthly or quarterly basis without regard to portfolio activity, returns or prevailing interest rate levels.

In order to realize the greatest "value" from fee-based programs, clients should allow for active portfolio management, when appropriate.

Fee-Based: Additional Considerations

One advantage fee-based programs offer is the opportunity to review and evaluate historical performance. Typically, fee-based managers construct composites that combine performance of multiple accounts within a specific strategy. These composites usually conform to standards established by the Association for Investment Management and Research (AIMR). Armed with this data, clients can compare total returns over various time periods against multiple managers and benchmark indices and gauge the magnitude of risk undertaken to achieve those returns.

Non-Fee-Based Programs

Compared to fee-based programs, non-fee-based programs typically involve significantly less trading activity and are designed primarily for companies pursuing a buy-and-hold strategy.

In structuring the portfolio, non-fee-based managers often follow the same general guidelines as fee-based managers with regard to sector, asset class, security type, credit selections, portfolio duration and yield curve placement. However, the non-fee-based manager typically does not actively make adjustments to the portfolio once it has been fully invested. Rather, adjustments typically are made in the event of a change in an issuer's credit quality or in the client's liquidity requirements. Non-fee-based managers may also make trading adjustments as a result of market movements. As with all trading activity, market-driven portfolio adjustments may result in increased transaction charges and jeopardize a FASB 115 "buy and hold" classification.

Non-Fee-Based: Compensation

Portfolio managers derive compensation from the spread or mark-up reflected in the price clients pay for the securities purchased for their portfolios. Industry standards generally dictate the amount of the spread that, in certain instances, is set and paid by the entities issuing the securities.

Fee or Non-Fee: Assessing Options

Determining which type of program is most consistent with a company's accounting requirements and investment objectives must include a number of factors. Primary among these is how a company elects to classify securities in the portfolio under FAS 115. When a company elects a "hold to maturity" (HTM) classification, active trading within the portfolio is not permitted and a buy-and-hold strategy must be pursued. When a company elects "available for sale" (AFS), an actively managed portfolio may be appropriate.

However, companies that elect the AFS classification may be sensitive to profits and losses resulting from active trading. Consequently, companies should specify maximum "bands" of acceptable capital gains and losses for each monthly or quarterly reporting period. In doing so, they can derive the benefits associated with an actively managed portfolio while minimizing the potential impact on the profit-and-loss statement.

However, when a company chooses to realize earnings on a fully accrued basis with minimal or no capital gains and losses, a non-fee-based program often is more appropriate than a fee-based program.

Investment Policy Considerations

Although investment policy statements (IPS) vary from company to company, they typically address four key provisions: approved securities, maturities, credit ratings and concentration limits. With the exception of concentration limits, these provisions often will have a direct bearing on the decision to choose a non-fee- or fee-based program.

In general, when these provisions are broader in nature, a fee-based program may be more appropriate. More restrictive provisions generally dictate a non-fee-based program.

Since fee-based portfolio managers seek to take advantage of opportunities resulting from market fluctuations, IPS guidelines that specify a broader range of approved securities, reduced credit ratings or longer duration generally provide a better "environment" for a fee-based program.

Examples of relevant IPS provisions include:

* Approved securities: Ideally, in addition to the most common securities such as treasuries, agencies, auction rates, municipals and corporates, fee-based portfolios will also include such amortizing vehicles as asset- and mortgage-backed securities.

* Maturities: The longer the maximum maturity and duration specified in the IPS, the greater the potential for portfolio volatility. Although this volatility increases risk, it also provides additional trading opportunities and the prospect for increased returns. Typically, a portfolio with a three- to five-year maximum maturity on any one security, combined with a 12- to 30-month overall maximum portfolio duration, is better suited for a fee-based program. Shorter maturity ranges--a two-year maximum with reduced volatility and trading opportunities, for example--are often better suited for a non-fee-based program.

* Credit ratings: In general, the lower the credit rating, the greater the volatility. While some fee-based managers may achieve performance objectives without assuming significant credit risk, many other fee-based managers have the resources necessary to evaluate and monitor lower-rated securities. This capability provides another source of potential return for companies with actively traded portfolios.

To illustrate, if Baa/BBB securities fall within the range of approved credit ratings as specified in the IPS, a fee-based program may be more desirable. Since some portfolio managers--both fee- and non-fee-based--set minimum credit ratings as the basis for creating an approved list of securities, it is important to determine if the credit provisions as outlined in the IPS are consistent with those of the portfolio manager.

* Liquidity. A critically important consideration is the company's "cash burn rate." Many companies require cash to fund ongoing operations, and these liquidity requirements generally are outlined in the IPS. Nevertheless, unforeseen circumstances can have a rapid and changing impact on the anticipated burn rate, meaning increased levels of liquidity are often necessary. Consequently, when a high percentage of the portfolio will be dedicated either to short-term investments (less than 90 days) or to funding liquidity needs, a non-fee-based program is typically recommended.

Clients are generally advised to begin the decision-making process by reviewing their investment objectives as they relate to the fundamental principles of safety, liquidity and yield in the context of FAS 115. Once these objectives are documented in a formal policy statement, companies will be in an excellent position to evaluate the criteria outlined here, and, subsequently, to chose the optimum cash management platform.

Typical Cash Management Portfolio Characteristics

Portfolio Attribute  Active Management          Passive Management
                     (Fee-Based)                (Non-Fee-Based)

Trading Activity     Strategies incorporate     Strategies can be
                     wider range of asset       similar to actively
                     classes, sector rotation,  managed portfolio but
                     duration changes and       with appreciably less
                     reflect greater credit     trading activity
                     flexibility
Compensation         Fixed fee based on assets  Spread/mark up on per-
                     under management.          transaction basis
                     Invoiced monthly or
                     quarterly
Typical Portfolio    12 to 30 months            Overnight to 18 months
Duration
Maximum Maturity     3 to 5 Years               Overnight to 5 years
(Any One Issuer)
Minimum Credit       Generally "A3/A-" or       Generally "A2/A" or
Quality              better                     better
FASB 115             Available for sale         Hold to maturity or
                                                available for sale
Primary Goal         Principal preservation     Principal preservation
Emphasis             Total return over          Fully accrued earnings
                     appropriate benchmark
                     index

Portfolio Attribute  Notes

Trading Activity     Passive management -- less flexible in pursuing
                     returns relative to benchmark indices.
                     Active management -- provides greater flexibility
                     to benchmark against major indices
Compensation         Active management -- generally more cost effective
                     when pursuing above benchmark returns.
                     Passive management -- generally more cost effective
                     for "buy and hold" strategies
Typical Portfolio    Client specific and varies by investment policy
Duration
Maximum Maturity     Client specific and varies by investment policy
(Any One Issuer)
Minimum Credit       Client specific. Fee-based more likely to permit
Quality              "BBB"
FASB 115             Actively managed portfolio--suggest setting maximum
                     limits of realized gains/losses monthly or
                     quarterly
Primary Goal         Liquidity also key criteria
Emphasis             Client investment policy and FASB 115
                     considerations generally help determine portfolio
                     emphasis

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Richard Saperstein is a Senior Managing Director at Bear, Stearns & Co. Inc, where, as head of the Corporate Cash Management Group, he and his team manage over $6 billion. With over 20 years of experience, he is consistently ranked among the country's top financial advisors. He can be reached at [e-mail] or 212.272.0800.