Pension Risk Matters : Pension Risk News & Analysis : Investment Governance, Inc. : Pension Risk & Investment

A recent trend in class action litigation circles is the pension plan opt-out. Choosing not to settle with the rest of the "class," several large institutional investors are getting recompense that reflects multiples of what they could otherwise receive.

Pension Governance contributing editor, attorney Kevin Lacroix talks about this significant shift in class action outcomes, citing a sea change in the cost of litigation. Click here for more information about Kevin's interesting article and here to read more about our first class team of contributing editors.

PG Editor's Note: We have just posted an interesting and complementary item to www.pensiongovernance.com. In "Predicting Corporate Governance Risk: Evidence from the Directors' & Officers' Liability Insurance Market," authors Tom Baker and Sean J. Griffith examine how liability insurance underwriters assess corporate governance behavior - and related expectations of risk - when pricing coverage. The authors also examine whether corporations are deterred by the cost of liability insurance, especially since "virtually all corporations purchase D&O insurance to cover the risk of shareholder litigation, and because virtually all shareholder litigation settles within the D&O insurance limits, the D&O insurance premium represents the insurer’s best guess of the insured’s expected liability costs." The authors conclude that governance factors such as culture and character are taken into account by insurance underwriters. Click here for more information.

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After many months of work, we're proud to launch our website, www.pensiongovernance.com, and invite you to check us out.

You can sign up for a free two-week trial by clicking on SUBSCRIBE. We won't ask you for your credit card information UNLESS and UNTIL you decide to subscribe after the free two-week trial.

Here are some of the many items we've added this week.

• "The Amaranth Debacle: Failure of Risk Measures or Failure of Risk Management?"
  
• "Alternative" investment managers and bankruptcy: the brave new world of Chapter 11" 
• "Airline pilots file suit over retirement rule"
• "You want to diversify risk? Consider economic derivatives"
• "United States Court of Appeals for the District of Columbia Circuit Argued October 5, 2006 Decided March 30, 2007, No. 04-1242, Financial Planning Association, Petitioner, v. Securities and Exchange Commission, Respondent"
• 401(k) Plan Governance Webinar - Join a panel of experts to address 401(k) governance on June 4, 2007 (Note: Good news - PG subscribers get to attend all webinars for no additional charge!)
• "Fitch: Ratings Beneficial for Hedge Funds but Few Will Achieve Investment Grade"
• Interview with Mr. Gary W. Findlay, Executive Director - MOSERS about board governance
• Interview with Mr. Donald B. Trone, CEO - Fiduciary360 about fiduciary investment standards
• "Predicting Corporate Governance Risk: Evidence from the Directors' & Officers' Liability Insurance Market" 
• San Diego v. Amaranth Legal Complaint
• SEC Chief Economist Debates Merits of Passive Versus Active Investing
  

Some of the new additions coming very soon ...

• A board member's perspective about what pension governance means as compared to corporate governance
• Interview with Mr. Skip Halpern, president of Independent Fiduciary Services
• Article about pension plan opt-outs and the impact on class action litigation
• Interview with Mr. Ron Ryan, president of Ryan ALM, about liability benchmarking
• Details about the Hedge Fund Toolbox webinar series
• Details about the Private Equity Toolbox webinar series
• Many legal cases about pension finance issues

Don't miss out. We are still offering charter subscriptions at a discount of $200 less than the regular 6-month rate. Other benefits include:

• Unlimited access to the Subscribers-Only website - including timely news, articles, checklists, interviews with market leaders, practice aids, surveys, and reference material
• Unlimited access to topical PG webinars, with expert guests - each individual webinar costs from $125 to $200, if purchased separately
• Free PG webinar recordings, if you cannot attend live events
• Limited access to specialized researchers and analysts - ask the questions you need answered
• Discounts on selected PG Partner products and services
• Advance notice of invitation-only research sessions
• Free access to soon-to-be-released pension risk newsletter (details soon!)

We'll keep you abreast of other things we're planning for the summer (lots in store).

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San Diego is hopping with over three hundred financial professionals attending the FI360 Annual Conference. Topics on the agenda include fiduciary requirements in the aftermath of the Pension Protection Act of 2006 (PPA), trends in fiduciary liability insurance claims, prudent investment fiduciary practices and 401(k) plan economics.

One item in particular - the PPA-required audit of  "eligible investment advice arrangements" (EIAA) - is taking center stage. By definition, an EIAA is "an arrangement that, among other things, provides that any fees (including any commission or other compensation) received by the fiduciary adviser for investment advice or with respect to the sale, holding, or acquisition of any security or other property for purposes of investment of plan assets do not vary depending on the basis of any investment option selected." Click here to read Field Assistance Bulletin No. 2007-01 (U.S. Department of Labor - February 2, 2007).

In response, the Centre for Fiduciary Excellence just announced an audit and certification program to ‘fiduciary advisers’ as defined by the PPA, "who intend to serve in EIAA’s. The fiduciary adviser certification program is supplemental to the existing CEFEX Investment Advisor Certification based on the fiduciary practices published by Fiduciary360 of Sewickley, PA. These practices are defined in the Fiduciary 360 publication "Prudent Practices for Investment Advisors" which was reviewed by Reish, Luftman Reicher & Cohen of Los Angeles, CA, and edited by the American Institute of Certified Public Accountants (AICPA)."

Read more by opening the press release file.

PG Editor's Note: The Centre for Fiduciary Excellence and the Foundation for Fiduciary Studies (and its affiliate, FI360) are partners with Pension Governance, LLC (owner of this blog). We all agree on a similar mission - to empower plan sponsors and their vendors and agents by providing educational information about fiduciary investment issues and promoting transparency about investment fiduciary practices. Click here to learn more about all of our partners.

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In case you haven't heard, most people think any pension problems are a walk in the park compared to a looming health care crisis. Some think the answer is national health care. Others persist - "Let the market do its thing." This blogger tends to be in the second camp but I am pretty sure we'll end up with socialized medicine at some point . Some say we are already there. After all, who REALLY knows the true cost of a particular service or pharmaceutical? There is seldom a supply-demand dynamic at work.

In a recent Wall Street Journal article, journalist Chad Terhune describes the Tennessee response in the form of a mini-medical plan called CoverTN. Made available to businesses that meet certain criteria, it allows employers to offer health care coverage at a cost far below that of catastrophic insurance. The bad news is an annual per capita limit of $25,000. One hospital stay could wipe this out in short order. Nevertheless, even a few corporate biggies are looking at mini-medical as a way to contain costs.

To read more, go to www.wsj.com and search for "Guarded Health: Covering the Uninsured, But Only Up to $25,000 - Tennessee Experiment Goes Against the Grain As States Remake Care", April 18, 2007.

Pension Risk Matters Editor's Note: Hear what guest blogger, Dr. Michael Kraten, CPA, has to say about health care. His recommendation for more transparency in benefits administration is one we soundly support. Founder and President of Enterprise Management Corporation, a management consultancy based in Connecticut, Kraten is doing interesting research in the area of virtual reality negotiations, health savings accounts and non-profit governance. He is also an accounting professor at Suffolk University in Boston, Massachusetts. To learn more, visit his website at www.enterpriseman.net.

Text from Dr. Kraten:

What is the Aflac duck selling?

If you answered “general health insurance” ... surprise! You are not correct. The Aflac web site offers dental, hospital confinement indemnity, hospital confinement sickness indemnity, hospital intensive care, and specified health event policies ... but not general health insurance.

What's the difference? Well, general policies are designed to cover most medically necessary services, with perhaps a few carve-outs and a relatively high lifetime maximum coverage limit tossed in for good measure. Aflac's policies, though, are only designed to cover a few narrowly defined services, and often include a relatively low annual coverage limit as well.

In other words, these are not general insurance policies at all. They're really prepaid service plans, where the plan manager (i.e. Aflac) keeps the premium if the services are not used by the end of the coverage period. And because the services frequently reflect relatively rare catastrophic events, the premium often goes unused ... and are thus typically converted to profits.

This type of plan is certainly not new to the commercial markets. Delta Dental, for instance, has been offering narrowly defined service contracts with low annual reimbursement ceilings for many years. But now many states are considering the implementation of such programs as well. Tennessee, for instance, recently launched a government subsidized small business plan called Cover TN. Its Program Summary states that it simply covers “basic health needs” only, with an annual maximum coverage limit of $25,000 per year ... not nearly enough to cover many complicated hospital stays.

Other states, such as California and Massachusetts, have opted to pursue a different path, proposing universal coverage programs that would cover most medically necessary services. But the costs of such plans are far more significant, and critics complain that their resultant taxation financing mechanisms are both onerous and self-defeating.

Time will tell whether the universal coverage programs will prove to be cost-effective, or whether the prepaid service programs can provide more than “band aid” protection for bleeding state program budgets. The American public might benefit, though, by receiving honest and transparent explanations from their health plan funding organizations regarding what they can expect ... and what they cannot expect ... for their premium dollars.

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Hot off the press, the U.S. House of Representatives says okay to amending the Securities Exchange Act of 1934 to provide stockholders more power in approving executive pay. Click here to read the Shareholder Vote on Executive Compensation Act. Arguably the rationale is to empower shareholders to veto executive pay packages deemed "excessive." One can argue about the efficacy of the legislation (and likely will). However, it begs an interesting question for citizens of pension land.

What type of say do they get about the operation of a defined contribution and/or defined benefit plan? How can they corral perceived conflicts of interest, alleged misdeeds and/or questionable decisions? On the flip side, how can they say "bravo" to effective investment stewards, perhaps voting for better financial rewards and job title recognition for good do bees (honest players)?

The answer - Not much!

This topic arose in 2005 when I was asked to appear on CNN Financial to talk about United Airlines. The anchor asked me to cite steps that defined benefit plan participants could take when they know a company is encountering financial difficulties and want to exit the plan or change their share of the investment mix. When I explained to the producer that employees are extremely limited in being able to exert influence over the management of the trust (other than through litigation, and only after losses have occurred), we all agreed that a gloomy message may not make for great ratings.

Sob - my fifteen seconds of fame, evaporated in a moment of candor.

So now that Congress is taking steps to empower shareholders, why not tackle the same for plan participants? Yes, post-Enron, reforms were made. No, to this day, plan participants still have little influence on whether a plan is well run or not.

Part of the problem arises because information is scattered, often obtuse when available and sometimes contradictory (depending on the source). And for those on the outside looking in, access to documents such as the Summary Plan Description (SPD) is nil.

Just an aside - This issue of limited beneficiary control extends to defined contribution plans as well.

Hence, plan participants MUST depend on the integrity, knowledge, experience and solid intentions of the persons in charge.

So to all of those plan beneficiaries everywhere - ask yourself this. How much do you know about the people in charge? Would you like to know more?

To plan stewards - If you aren't providing transparency about everyone with authority to make decisions about plan design and investment governance, wouldn't it be a good idea to do so? Besides creating a sense of "I don't want to hide anything," you open the door to suggestions for improvement and possibly close a door to litigation or otherwise unwanted scrutiny.

Why wait?
Continue Reading...

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With all due respect to Gordon Gekko, replace the "d" (as in "Greed") with an "n" (as in "Green") and we end up with a way to both belately celebrate Earth Day and acknowlege an emerging trend in pension funds' allocation to Socially Responsible Investments (SRI).

Click here to access a nice primer from the UK. Checklists and case studies make it useful to anyone interested in knowing more about the topic. 

Stateside, Mercer Consulting's survey of U.S. pension funds about SRI suggests continued growth. Click here to access the survey.

By the way, it's not just Ayn Rand who rejects altruism. Institutional investors say that opportunities to reduce risk, enhance returns or better align economic interests with socially-oriented values are key drivers behind their decision to invest in SRI funds.

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I am the author of a book entitled Risk Management for Pensions, Endowments and Foundations (John Wiley & Sons, 2005). A primer about risk management (no math by design), the feedback has been gratifying. I'm particularly proud of the comments citing ease of use. (The book is replete with examples, checklists and references).

However, it's no Da Vinci Code in terms of sales. While I'd like to write a sequel at some point, few are competing for the honor and no one is knocking down my door to buy the movie rights. (You can visit our online bookstore at www.pensiongovernance.com - Products, Books for what we think constitutes a good readling list.) True, it's non-fiction and written for a limited audience. Yet one wonders why, in today's benefits climate, more people aren't fast and furiously laying pen to paper to describe how to tackle what is arguably one of the most important topics in pension land - risk management. If there is a single message I can impart to those who will listen, it is this.

ANYONE involved in pension investing is a de facto risk manager. Believe it. You are.

Whether focused on the asset or liability side (or both), risk is an integral part of financial management. Those who deny this truism expose themselves to possible trouble down the road. Personal and professional liability aside, plan sponsors who passively manage risk (whether defined benefit or defined contribution) through ignorance or benign neglect invite unwelcome scrutiny. Unless they are lucky, litigation, economic loss and/or damaging headlines are high probability events.

Besides, plan sponsors who give risk management short shrift lose a precious opportunity to improve things. An effective process forces a plan sponsor to identify, measure and control risk on an ongoing basis. Taking inventory (in terms of uncovering sources of risk) enables plan sponsors to make meaningful changes. Lower costs or enhanced diversification are two of many possible benefits associated with the activity of collecting and analyzing data as part of the identification of risk drivers.

So a natural question arises.

Why don't more plan sponsors pay attention to risk management, whether for themselves or as part of hiring, reviewing and perhaps firing money managers and consultants? Asked another way, what is the tipping point beyond which risk management becomes front and center at meetings of board members, trustees, investment committees and so on?

Here are a few thoughts.

1. Based on the preliminary results of the pension risk management survey now underway, and co-sponsored by Pension Governance, LLC and the Society of Actuaries, there seems to be a HUGE gap between belief and reality. Many respondents say they actively pay attention to risk management. At the same time, they cite limited or no use of risk metrics other than standard deviation and/or correlation. (We'll talk about limitations of basic risk metrics elsewhere.) How can you improve on something you think you are already doing well?

2. Many plan sponsors are tasked with benefits-related work as an add-on to their regular job. Often, there is little organizational incentive for them to excel. In a way, it's a lose-lose proposition. They assume significant fiduciary liability with little or no recognition in the form of additional money, better title or other types of perquisites. At the same time, if they do a bad job, there is no escape. It's all downside. Sadly, there is so much perceived ambiguity about what constitutes a "good" job that it's often difficult to hold someone accountable. (Note the term "perceived" versus "real.")

3. Not all attorneys (litigators and transactional) feel comfortable with finance concepts, let alone financial risk management. That knowledge void arguably makes it easier to let risk control gaps slide unless, or until, an egregious act occurs.

4. Establishing a financial risk management process is seldom fun (or at least sort of enjoyable) for most people. It is often a complex activity that requires copious amounts of money, time, concentration and energy, especially if a plan's investment mix (DB or DC) extends to multiple asset classes. Moreover, benchmarking the process, and making appropriate changes thereafter, likewise consumes large chunks of time and money. Is it any wonder then that its ranking on one's "to do" list plummets in the absence of a strong risk culture?

5. When market conditions are "good" and benefit costs decline as a result, people tend to get lulled into false security. Instead of focusing on structural issues, it's easier to breath a sigh of relief and say "problem solved." Alas, markets change all the time and putting off the inevitable is hardly a smart move.

So what's the tipping point that has everyone wearing "I'm a risk manager" button? Certainly lower interest rates and/or an anemic equity sector are factors, as is regulation. A few recent surveys cite mandates as a central force in encouraging, sometimes forcing, plan sponsors to radically revise their asset allocation strategies and focus on plan risk.

Most folks think we're moving closer to the pension risk management tipping point. I agree but counter that movement is relative. Until (and hopefully not "unless") plan sponsors recognize the URGENT need for financial risk management, investment stewards remain vulnerable on many counts and that is not a good thing for anyone!

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For those who don't know, RiskCenter.com has recently started broadcasting interviews with risk management professionals. I had the pleasure of being interviewed a week ago about a few of the many steps that pension funds can take to assess hedge fund risk. Clearly, in just a few minutes, it's impossible to provide more than a few soundbites. However, allow me to reiterate one point.

Before plunking down monies to invest in a hedge fund or fund of funds, ask to meet with the risk manager and request a copy of their risk management policy. If the fund has no official risk manager, ask to meet the person who assumes functional duties (if not the title). If the fund tells you that their risk management policy is proprietary, ask for a general description of risk controls and the system of oversight. If you still get push back, think about your comfort level if something goes awry and you are asked why you invested anyhow, even though your request for information was rejected. (Even if information is provided to you, you may want to assess whether the information is "enough.")

Some may assert that the Private Placement Memorandum (PPM) is sufficient. See for yourself. In my view, the PPM often addresses risk in overly broad and vague terms, certainly not enough to give a pension investor any meaningful amount of information about the risk management process.

If you would like to see the short interview, go to www.riskcenter.com and click on the relevant video. If you would like more information about hedge fund risk and valuation issues, contact us at PG-Info@pensiongovernance.com. We will be uploading information next week to www.pensiongovernance.com about a forthcoming series of webinars we call the Hedge Fund Toolbox^SM. Our series of webinars known as the Private Equity Toolbox^SM is already in the works. We have a spectacular line-up of speakers.

P.S. These comments do not reflect investment, legal or governance advice. Readers still need to meet with their counsel about their fiduciary responsibilities as regards hedge fund investing.

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According to money management letter (April 9, 2007 issue), Rocaton Investment Advisors paid $2.75 million to the San Diego County Employees Retirement Association "for recommending Amaranth Advisors." The article also goes on to say that no information is forthcoming about whether Rocaton did anything wrong and whether this money is covered by professional liability insurance.

The reason for citing this article is not to put any one particular firm in the spotlight but rather to suggest that pension fiduciaries check with their appropriate counsel and do sufficient homework internally to make sure that everything that should be done is being done. This includes, but is not limited to, seeking answers to the following questions:

1. How much experience does a particular consultant and/or financial advisor under consideration have with respect to examining hedge funds or fund of funds?

2. Does the consultant and/or financial advisor have an adequate understanding of the hedge fund or fund of funds' use of leverage through short-selling and/or use of derivatives, if relevant? What is their systematic process for examination of leverage? How do they define leverage and does that comport with industry norms?

3. Has the consultant and/or financial advisor identified (and explained to plan sponsors) possible risk factors associated with a given hedge fund or fund of funds? Sector concentration, management style, specific ownership structure of the limited liability company or partnership, availability of risk analytics, stop loss triggers, primary and secondary plans for liquidation, valuation policy, redemption restrictions and use of side pockets are JUST the beginning.

We'll talk much more about the issue of investment risk review in coming days. Why? Plan sponsors are still on the hook for monitoring their monitors. It's simply not as easy as passing along a hot potato regarding due diligence to someone else.

P.S. There is a rumor that another pension consultant has offered recompense in conjunction with this hedge fund case. If true, could this be a trend in going after consultants and/or financial advisors in the event of losses?

 

 

 

 

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Pension Governance, LLC is proud to announce the launch of a new website for pension investment fiduciaries. In what is believed to be a unique online information portal devoted to pension investment risk and valuation issues, and reflecting original content from practitioners, www.pensiongovernance.com combines independent analysis and research with commentary about urgent issues affecting both defined contribution and defined benefit plans.

At a time when pension finance dominates headlines around the world, investment committee members, treasurers, CFOs and trustees are confronted with a slew of new challenges and a need to “connect the pension governance dots.”

The primary goal is to empower investment fiduciaries with objective educational information about relevant issues before they commit millions of dollars and countless hours to a particular strategy. Dr. Susan M. Mangiero, president of Pension Governance, LLC and author of Risk Management for Pensions, Endowments and Foundations, adds, “We want to create a meaningful conversation about pressing and oft-complex investment and risk issues that are not going to go away any time soon. We have put together a top-notch group of contributing editors from a variety of disciplines, including law, insurance, treasury, alternative investments and corporate governance. Our strategic partners join us in our efforts to promote investment fiduciary education and best practices.”

In addition to the Knowledge Center Library, www.pensiongovernance.com includes interesting features such as Pension Chat (interviews with industry leaders), Courthouse Corner and Fiduciary Focus. Soon to come is the Pension Parade of Horribles, a source of information about bad practices and lessons learned.

Subscribers can read annotated online articles from a variety of news sources, access research team members via Ask Professor Pension, download original content from expert practitioners, receive Pension Risk Alert^SM and attend webinars for no additional fee. A forthcoming webinar is a June 4 discussion about 401(k) plan governance in the aftermath of the Pension Protection Act of 2006. Another webinar, part of the Hedge Fund Toolbox - a series of discussions from the pension fiduciary perspective - is a May 15 discussion about fees, documentation and key person background checks. Many other webinars about a variety of pension topics such as valuation, liability-driven investing and performance analytics are in the works and will be announced shortly.

Web designer Dawn Barson, co-founder of think creative group, llc, describes the care taken to build an infrastructure that permits Pension Governance editors maximum flexibility. “Knowing how much the editors want to keep the site fresh, we worked hard to build a robust administrative console so that new features can be added all the time.” Additional programming is already underway, with many more functions being designed to help investment fiduciaries access information and analysis quickly, easily and in a cost-effective manner.

With over thirty years of experience in the pension industry, Dan Carter, Pension Governance Vice President of Business Development, describes a sea change in the challenges that confront fiduciaries. “There is so much to know in this field and getting it from independent sources is critical as never before.” Mangiero concurs, “There is no shortage of content. We’ll be adding to the site all the time. People should check back often for updates.”

Visitors can sign up for a free two-week trial subscription by going to www.pensiongovernance.com and are encouraged to submit requests and comments to PG-Info@pensiongovernance.com.

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Pension Governance, LLC is proud to sponsor a brand new section of the Social Science Research Network (SSRN). Part of SSRN's Financial Economics Network (FEN), Pension Risk Management publishes working and accepted paper abstracts covering a range of topics in the field. These include liability-driven investing, fiduciary assessment of hedge fund and private equity investments, organization and governance of defined benefit and defined contribution plans, selection of default investments such as target date funds, appropriateness of company stock for 401(k) plans, evaluation of money managers' fees, strategic asset allocation, fiduciary duty to hedge and use of derivatives.

Working with the SSRN team, co-editors Dr. Shantaram Hegde and Dr. Susan M. Mangiero encourage contributions in this exciting and critically important research area. At no other time has there arguably been such an urgent need to understand pension investment risk issues and competing solutions. 

Dr. Hegde is Professor of Finance at the University of Connecticut and author of many papers on derivatives, market microstructure and risk management. Click here to read his bio. Dr. Mangiero is author of Risk Management for Pensions, Endowments and Foundations. An Accredited Valuation Analyst and certified Financial Risk Manager, she is President and CEO of Pension Governance, LLC. Click here to read her bio.

Joining Dr. Hegde and Dr. Mangiero as part of the Pension Risk Management Abstracts Advisory Board is a team of experts in the areas of risk management, valuation and actuarial science:

Dr. Stephen Figlewski - Professor of Finance (New York University)

Allen Michel - Professor of Finance (Boston University)

Steven Siegel - Research Actuary (Society of Actuaries)

Gavin Watson - Business Manager for Asset Managers (RiskMetrics Group).

According to Dr. Mangiero,  "With many challenges facing pension fiduciaries, our goal is to help facilitate a conversation about pension finance, risk and valuation on behalf of investment stewards for millions of plan participants worldwide. The Pension Governance, LLC team is deeply grateful for the commitment of this top-notch team to promote good ideas in these areas. We look forward to making pension risk management the topic of choice for academic researchers and practitioners."

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According to the SEC website, a complaint has been launched against an economics professor and several funds he controlled. In "SEC v. Albert E. Parish, Jr., Parish Economics LLC and Summerville Hard Assets LLC, Civil Action No. 2:07-cv-00919-DCN" (D. S. C., April 5, 2007), the SEC charges fraud.

Shortly after the filing, in a somewhat sad turn of events, news outlets report a claim of amnesia. See "Fund Manager Offers Memorable Response to SEC's Fraud Charges" by Suzanne M. Schafer (Associated Press), April 7, 2007. Click here to read the article (one of many).

What's ironic is that the professor, apparently oft-cited as an economic forecasting expert, was quoted in May 2006 as happy with the Enron verdict. "It certainly provides a boost of faith." Click here to read the text of "Local businessman, economists pleased by Enron verdict," The Sun News, May 26, 2006.

Everyone should have their proper day in court but it does seem odd that $134 million is allegedly missing and a "smart" man suffers forgetfulness.

Nevertheless, in the spirit of lessons learned, plan sponsors can be reminded (for that matter, all investors should pay heed) that background checks of key players is desirable, nay essential.

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When I was a little girl, the spring holidays were a big deal. My sister and I would spend hours in search of hidden jellybeans and chocolate eggs. My favorite flavor was licorice and, once found, I would indulge. One year, to my delight, I found what I thought was a black jellybean. Luckily, upon closer inspection, I realized it was a gift from the cat (and of course I threw it away).

So what's the moral of the story for plan sponsors?

Look closely and act wisely.  What looks like a bonus could be a nasty surprise in disguise.

More specifically, sponsors who only look at the positive impact of short-term market conditions on funding status, without addressing long-term structural issues, miss the mark. What looks like a favored treat (relief from having to do anything now as long as nominal numbers "look good") could turn out to be just the opposite (a situation left untouched until it's too late to take corrective action in a cost-effective manner).

An examination of the short-term versus long-term also begs the question. Should the funding of benefit plans be considered strategic or tactical? Those organizations that address risk management on an enterprise basis are starting to more fully incorporate the cost and design of benefit programs as part of their planning. Unfortunately, there is evidence that things remain in disrepair.

"Corporate Directors May Not Be Providing Sufficiently Robust Enterprise Risk Oversight," published by the Conference Board in conjunction with the McKinsey & Company and KPMG's Audit Committee Institute, states that "Corporate directors could find themselves exposed to liability if they fail to keep pace with evolving best practices in enterprise risk management (ERM)." The study also found that "While 71.8% of directors believe they have the right risk metrics and methodologies in making strategic decisions, 47.6% of directors would like to see more data analysis related to the company's risk profile." Click here to read our prior blog post about Enterprise Risk Management entitled "Enterprise Risk Management in the Boardroom."

Enjoy what April has to offer but don't get lulled into false security.

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Continuing to exhibit meteoric growth, the global derivatives market is now estimated at around $400 trillion. That's a lot of zeros - $400,000,000,000,000. In contrast, the CIA World Fact Book estimates 2006 Gross World Product at $65 trillion. Said another way, aggregate economic production for the entire world has an approximate dollar value of only 1/6th the estimated market size for futures, options, swaps and various combinations.

Is it any wonder then that regulators  are asking questions about who does what in the world of derivatives? One false move and the intricate web of financial institutions which dominate derivatives trading could fall apart. Increased volatility for the market as a whole or an exogenous shock to a particular sector potentially spells trouble.

In her April 4, 2007 article, Wall Street Journal reporter Eleanor Laise writes that "automated trading of derivatives and increased use by fast-growing hedge funds have helped make the market more accessible to mutual funds" and that "mutual funds aim to stand out in a crowded field." She further points out that identifying the use of derivatives by portfolio managers requires a hard look at the fund's prospectus. I'd emphatically add that reading what is available is seldom sufficient. To the contrary, a pension fiduciary needs to ask a myriad of questions of and about the mutual fund manager. Here are a few suggestions from a long list. (Email me if you want additional information.)

1. Who determines the type of permitted derivative instruments and strategies, and on what basis?

2. Does the fund or family of funds have a risk manager? If so, does he or she have the authority to make meaningful decisions about risk controls? Who does that person report to?

3. How are mutual fund traders compensated with respect to return, risk and risk-adjusted return?

4. Is there a risk management policy (and related procedures) that can be reviewed before investing? If considered proprietary, is it possible to meet with the portfolio manager and/or risk manager to discuss?

5. What types of risk metrics are employed by the mutual fund?

6. Who authorizes derivatives-related trading limits, and on what basis?

7. Are the fund's auditors comfortable with how the derivative instruments are marked-to-market?

8. Does the portfolio manager rely on an external system to analyze and monitor risk? If a proprietary system is used instead, is there an independent party who validates the models and integrity of the data feed?

9. How is liquidity measured? What is the portfolio manager's plan for liquidating various positions if necessary?

10. Does the portfolio manager have the latitude to switch gears with respect to derivatives-related trading and not have to fully disclose to investors? (In other words, is there a chance that the mutual fund's use of derivatives in a risk-return sense could differ materially from the stated scope?)

American author Mark Twain once said - “There are two times in a man's life when he should not speculate: when he can't afford it, and when he can.” While clever, the fact remains. Financial engineering and derivatives are here to stay. Any pension fiduciary not yet familiar with the D-word needs to remedy that situation right away.

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If you read Thank You For Smoking (and/or saw the video), you understand Christopher Buckley 's ability to put things in perspective with humor. With his new book Boomsday, he seems to have done it again. The plot takes generational warfare to new heights. According to the book description on Amazon.com, escalating Social Security expenses compel "Cassandra Devine, a charismatic 29-year-old blogger and member of Generation Whatever" to suggest that "Baby Boomers be given government incentives to kill themselves by age 75." As you can imagine, the book is creating controversy. Click here to read more.

We've written extensively about the looming financial crisis due to increased lifespans. Click on the Demographics folder to access previously published posts (on the left hand side of the home page of this blog.)

Living longer if you are healthy, and have economics means, sounds like fun. Who wouldn't want to take a course in the classics or travel the high seas with family and friends? Unfortunately, for the younger folks who will be forced to foot the bill through higher taxes, things are not quite so grand. This is not to put blame on senior citizens. (Let's face it. We're all heading in that direction.) Unfunded benefits have never been a good idea.

If you don't mind some dismal reality with your coffee, check out The Coming Generational Storm: What You Need to Know about America's Economic Future by Laurence J. Kotlikoff and Scott Burns or Running on Empty: How the Democratic and Republican Parties Are Bankrupting Our Future and What Americans Can Do About It  by Peter G. Peterson.

The questions remain. Who has the power to solve what many believe is an imminent retirement system meltdown (including Social Security and Medicare)? What precludes them from doing something now? What is the consequence of playing ostrich, ignoring red flags and staying with the status quo? Take our 2 minute "Pension Crisis" survey and tell us what you think. Click here to start.

This post is written the day after April 1 by design. This is no April Fool's Day gag. Crushing "pay as you go" programs are here to stay until courageous leaders step up to the plate and take action or economies around the world implode.

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