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

In "Test case looms on backdating" (June 1, 2007), FEI journalists Jeffrey Marshall and Ellen Heffes write that a legal precedent may soon be set in the form of a class action case against builder KB Home. Many managers and board members who participated in backdating decisions and also act as company fiduciaries for the 401(k) plan are named in the lawsuit. Alleging ERISA fiduciary breach due to the backdating of stock options, plan sponsors and their attorneys await the outcome.

"If this case survives summary judgment, plaintiff's attorneys will be emboldened and bring more employees onto the class-action backdating bandwagon," suggests attorney John Gamble, with Fisher & Phillips, a labor and employment law firm. Marshall and Heffes caution that a post-Enron amendment of ERISA  increases punishment. "Individuals who are caught willfully violating ERISA face 10 years in prison and fines up to $100,000."

A few months ago, I predicted an ERISA litigation fallout if companies recommend stock for the 401(k) plan yet do not properly vet the process by which executives receive options. Click here to read "Will Executive Option Issues Drive the Next Wave of Pension Litigation?" by Susan M. Mangiero (Journal of Compensation and Benefits, March/April 2007).

This case is sure to attract attention.

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Reuters.com reporters, Karey Wutkowski and John Poirier, relay the SEC's intention to review valuation methods used by hedge funds.  Testifying before the House Financial Services Committee on June 26, Chairman Christopher Cox said that "We are going to further review, using the SEC staff, the valuation and other issues that managers for these funds have." Apparently, his message to the press, after the hearing, was serious, citing "concern that hedge funds and the investment banks that manage them are not marking assets to their proper value," something that "is of interest to the SEC's examinations and enforcement departments." Click here to read more.

So what does this portend for the plan sponsors knee deep in "hard-to-value" hedge funds? In the event of an asset write-down, fiduciaries are going to be grilled about the extent to which they vetted the valuation policies and procedures of hedge funds in which they invested. Absent any documentation to explain the (hopefully thorough) due diligence process they employed, pension decision-makers will squirm. A pretty picture - NOT!

In some circumstances, the use of an external consultant may provide little refuge, especially if a plan sponsor is unable to demonstrate that the consultant has a good command of valuation principles as applied to hedge funds. Having just co-led a workshop about hedge fund valuation, I was appalled to hear a colleague describe the "not my job" mentality of some service providers who act as pass-throughs for valuation numbers. That begs the question - If the consultant, administrator, prime broker or custodian are accepting traders' marks with no review (however formal), who exactly is overseeing the valuation activity at a particular hedge fund or fund of funds? Moreover, how independent are numbers that are generated by traders whose bonus is almost always tied to reported performance? (We'll talk about valuation standards and best practices in later posts.)

Stormy days ahead?

If you'd like our insight or want to learn more about the work we do in this area (before the fact, during the investment process or after trouble begins), email us. All inquiries are kept confidential. Also note that we'll be devoting seventy-five (75) minutes to the topic of hedge fund valuation from noon to 1:15 p.m. EST on June 28. Click here for more information.

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Since the mid 1600's, tulips have come to symbolize economic bubbles. Excess demand for the floral beauties led Dutchmen to pay a hefty price, resulting in the tulip mania of the early 17th century.

One wonders if a June 24 article by New York Times reporter Gretchen Morgenson hadn't been inspired by this tale of yore. Entitled "When Models Misbehave," this prize-winning business columnist describes the challenges of assessing securities that trade in relatively illiquid markets. In the absence of ready buyers and sellers, traders mark to model, making assumptions about the future behavior of inputs such as interest rates. Unfortunately, problems may arise if the underlying assumptions make no sense. Consider the notion that past is prologue. Referring to the sub-prime debacle currently plaguing several large financial institutions, Morgenson describes 2006 and 2007 lending practices as overly generous and likely to tighten. Correctly recognizing that future supply-demand conditions for credit might change leads to an altogether different model outcome.

Lack of independence or "the fantasy that a firm's principals prefer" is another concern. Blind acceptance of model-generated outputs as gospel could mean a subsequent, and arguably tainted, outlay of serious money to other trades.

Morgenson has a good point.

It's easy to be lulled into false security with computer-generated numbers. Unfortunately, bad values beget bad economics. A computational flaw, unstable or inappropriate model and/or low-integrity data could end up costing investors millions of dollars. Trading decisions based on garbage are expensive mistakes.

Good model-building is a start. Validating, testing, revising and testing anew should follow. Heady stuff but anything else might be considered remiss. Importantly, it's up to investors to query asset managers about what's inside the black box.

Anecdotally, I'm not sure there is enough of this rigorous oversight happening right now. As an accredited appraiser, I'm disturbed by the laxity of investigation about valuation and the related process of risk management.

With new accounting rules on their way, we'll talk much more about models and model risk in future posts. In the meantime, click here if you'd like us to send you information about valuation and modeling.

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In a June 22 article, Lipper HedgeWorld reporter Emma Trincal writes about the imminent debut of a hedge fund replication index product, courtesy of Barclays Capital. According to Managing Director and Head of Equity Derivatives, Hassan Houari cites research that "up to 80% of the performance of hedge fund indexes" can be explained by changes in the market. Houari further adds that Barclays seeks to offer a "cheaper, more liquid and more transparent alternative." Click here to read the article entitled "Barclays to Debut Hedge Fund Clone." (Registration is required.)

Clones are a popular topic these days. Last week, during Part Two of the Hedge Fund Toolbox^SM, sponsored by Pension Governance, LLC, Dr. Susan Mangiero, CFA and Accredited Valuation Analyst talked about increasing pressure for fiduciaries to justify fees. "Amid a flurry of 401(k) lawsuits alleging 'excessive' fees, it doesn't take a rocket scientist to know that hedge fund fees are next. If a plan sponsor can synthesize a signicant portion of expected returns for a particular hedge fund strategy, how can they justify paying for active management?"

Not everyone concurs that replication is possible. During the June 19 online event, co-founder of Bulldog Investors and the David who conquered Goliath SEC in the battle over regulation of hedge funds, Philip Goldstein challenged the notion that investors would be better off with a passive approach. "An Elvis impersonator is not Elvis." Ed Stavetski, CFA and Chief Investment Strategist for CMG Investment Advisors, LLC added that "Many hedge fund professionals work hard to identify value on behalf of their investors."

Emphasizing fiduciary duty, Ed Lynch, Senior Vice President and Investment Officer with Dietz & Lynch Financial Strategies Group of Wachovia Securities, LLC, reminded listeners that ERISA is clear on fiduciary duties that mandate a rigorous analysis of fees. Echoing the urgent need for discipline in the form of a systematic process to assess alternatives (in fact, any type of investment), Mangiero elaborated. "Fees drive performance and performance drives strategic asset allocation and re-balancing decisions. Plan sponsors need to get it right. Every trade costs money."

Click here to purchase the broadcast and slides for a nominal fee. (Past webinars are listed in chronological order.) Pension Governance subscribers enjoy webinar access for no additional charge. Click here to subscribe.

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In his pension blog, ERISA litigator Stephen Rosenberg recently wrote about the forthcoming legal battle between the San Diego County Employees Retirement Association ("SDCERA") and Amaranth Advisors, LLC. In response to an original complaint against the once mighty energy hedge fund, its high-power attorneys countered with a motion to dismiss. Claiming caveat emptor, defendants assert that the plan sponsor understood the risks and went ahead anyhow. Click here to read the original complaint and here to read the motion to dismiss.

How this case will be adjudicated is anyone's guess. Nevertheless, the outcome will be closely watched as it goes to the very heart of investment disputes by asking who bears responsibility.

In our kick-off of the Hedge Fund Toolbox^SM webinar series on June 14, 2007, we heard from former FBI agent Mr. Ken Springer (now president of Corporate Resolutions) and senior attorney and former regulator, Rick Slavin (now partner of law firm Cohen and Wolf P.C.). Both gentlemen vigorously urged pension investors to undertake a background investigation of key principals, check documents and never shy away from asking tough questions. Springer added that "material non-disclosure of critical events in one's career" represents a major concern, along with the need to do additional follow-up to explain discrepancies. Late payment of credit card bills or a faillure to pay child support suggest carelessness with other people's money.

In his overview of case precedent and enforcement actions, Slavin offered that sloppy, obtuse or incomplete paperwork is usually the beginning of trouble. He reiterated that the use of outside parties does not absolve plan sponsors of their fiduciary duties. Oversight obligations remain.

Springer told listeners that Bayou's problems, pre-meltdown, were evident had investors carefully reviewed available facts. "Blatant conflicts of interest, overstating of employees' accomplishments, suits by former employees, suits filed by investors and even suits filed by hedge fund managers" should have caught investors' attention before money changed hands. Slavin suggests that we're in for a bumpy ride. "There is every indication that more litigation and enforcement is on its way."

Rosenberg agrees. "We are currently watching the rise of a pension/401(k) investment plaintiffs bar, clearly modeled after the securities litigation class action bar, ready and waiting to sue pension advisors and anyone else in the line of fire for excessive fees, poor investment choices, and anything else that affects returns in the plans." He adds that, "If the hedge fund’s lawyers are right, then aren’t the plan’s fiduciaries and other advisors potentially liable for breaching their own obligations to the plan and its participants to properly select and monitor plan investments? And if so, then their best defense should the newly forming class action bar come after them for this mess would be that, contrary to what the hedge fund’s lawyers say, they actually did full and complete due diligence, and therefore lived up to their obligations and cannot themselves be liable for the fact that the investment went south."

Wise words to remind us of the importance of good process!

If you are interested in purchasing the recordings of any webinars that have already taken place, click here. (Webinars are listed in chronological order.) Click here to register for any or all of the forthcoming webinars in this exciting new series. Speakers will address the roles of financial advisor and consultant on June 26. Valuation is the topic of the June 28 event.

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According to Wall Street Journal reporter Craig Karmin, some legislators want public pension funds to shun companies that invest in terrorist countries such as Iran. Citing efforts by Missouri State Treasurer, Sarah Steelman, Karmin lays out the pros and cons of forced liquidation. (See "Missouri Treasurer's Demand: 'Terror-Free' Pension Funds," June 14, 2007.)

As part of a June 14 interview with CNBC's Maria Bartiromo, I offer four considerations (as much as I could say in a short on-air appearance). First, selling stocks because of statehouse mandates could cost taxpayers and plan participants in the form of "unexpected" transaction costs. This would in turn exacerbate funding problems for any states already in the red. Second, trustees would have to decide how to invest the proceeds of disposed equities, possibly earning less than before. Third, there could be a conflict for fiduciaries in terms of duty. Do they follow new rules that require divestiture, even if it forces them to violate state trust laws that demand careful analysis before deciding on an "appropriate" strategic asset allocation? Fourth, plan fiduciaries will likely need to spend considerable time and money in order to identify which companies offend, now and regularly thereafter.

No one supports terrorism but this "solution" might invite more problems. There is never a free lunch. Someone, somewhere pays.

Click here to watch the interview.

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In "A Conversation with a Fiduciary" (published by Morningstar), independent pension fiduciary Matthew D. Hutcheson provides a thought-provoking assessment of ERISA Section 404 and passive versus active investment choices for 401(k) plan participants. Click here to read the article and here to read Hutcheson's March 6,2007 testimony about 401(k) fees before the U.S. House of Representatives.

On the other side of the fence, Financial Times writer John Authers extolls the virtues of Dave Swenson's "uninstitutional portfolio" approach in his June 9, 2007 article about the Capital Asset Pricing Model and market efficiency. With more than two-thirds of the endowment fund for Yale University in alternative assets "which are not readily marketable," the contrast is telling. While the evidence seems to strongly support Swenson's approach for Yale, issues abound with respect to alternatives investments and command attention. "See "Yale puts academic theory of investment into practice.")

I co-led a workshop on the valuation of "hard to value" assets on June 12, 2007 and came away with a renewed appreciation of the fact that more than a few institutions may truly be in the dark with respect to risk factors. Worth mentioning again is that risk itself is not bad. However, risk that is ignored cannot be measured and, by extension, can certainly not be managed. For most investors, limited resources make it difficult to replicate the Connecticut Ivy's success. Addressing a recent gathering of alumni, Swenson said that "Yale is set up to make high-quality active management decisions" with a staff of twenty and a long time horizon.

The debate continues with respect to style because it is a crucial (nay impossible to ignore) element of investment management. Strategic asset allocation and tactical implementation are likewise integral determinants of fiduciary liability for a given organization. To the extent that Hutcheson reminds us to focus on the "F" word and move the conversation to process that supports duty, plan beneficiaries applaud.

Tell us what you think. Should fiduciaries do a better job of justifying when active strategies make sense? We will talk more about these issues because there is a lot to say.

Click here to email your comments. Please indicate if you would like the comments kept private.

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Today's post and the next few that follow focus on pension governance (the name of our new website and a term that is often used to describe fiduciary duties and best practices). For a discussion of what pension governance means, click here to read interviews with market leaders. It's such an important topic yet often overlooked. In fact, the U.S. Department of Labor created an educational program ("Getting It Right") in order to help individuals understand their duties. (The results of countless audits apparently left examiners nervous about the folks who did not properly self-identify as fiduciaries.)

"Hot off the press" is a set of standards devoted to the topic of pension governance. Newly published by the Stanford Law School, the so-called Clapman report urges pension funds, endowments and charitable funds to adopt principles that reflect prudence, ethics and transparency. Citing some big dollar "no-no's" on the part of institutional decision-makers, chief architect of the report, Peter Clapman,and others rightly point out that giant institutions must walk the walk if they admonish corporations to do the same. CEO of Governance for Owners USA and former chief investment counsel of TIAA-CREF, Clapman adds that “Bad governance also weakens funds by eroding public support for them." One element of the report calls for funds to provide clear (and make public) information about governance rules.

Yippee Yahoo!

A few of us sometimes feel as if we've been screaming in the wind about the urgent need to know who is in charge and how they are running the show. (I'm sure Clapman and others would agree.) To read how bad things are in terms of NOT being able to easily identify where the buck stops, check out "In Search of Hidden Treasure." More than a year ago, I wrote "that a systematic identification of who does what and why with respect to employee benefits is simply not a reality as things stand today. This makes it difficult (perhaps impossible) to effect change."

The Clapman Report suggests that funds hire "trustees who are competent in financial and accounting matters." Read "Practice What You Preach" for our list of basic questions about pension fiduciary selection, training and performance evaluation. Anecdotally, I've often queried trustees and  other types of fiduciaries - "How do you become and stay a fiduciary? Do you take a quiz? Do you possess a certain amount of relevant experience? Do you get paid what you're worth in terms of liability exposure and hours spent on plan-related tasks?"

Scary to say, selection is frequently a function of who is seen as having a few hours of free time. Unfortunately, being a plan fiduciary is arguably a full-time job. Moreover, with so many complex decisions to make, someone with a limited background in topics such as investing may truly struggle to understand basics, let alone nuances of evaluating risk-adjusted return expectations. Even when an external consultant is used, a fiduciary still retains oversight responsibilities (a topic deserving of its own separate post).

Another proffered recommendation from the Clapman Report is to "establish clear reporting authority between trustees and staff" and to "define appropriate responsibilities and delegation of duties among fund trustees, staff, and outside consultants." We couldn't agree more. Check out our earlier discussion about the importance of incentives in "Paper Clip Theory of Pension Governance."

One thing is clear. Pension governance is starting to attract attention. That's great news for the many fiduciaries already doing things the right way. (You deserve recognition.) For those who need to improve, perhaps the spotlight on practices, good and bad, will encourage change. That would be a huge plus for plan beneficiaries, taxpayers and shareholders.

Here are a few resources for interested readers.

1. Committee on Fund Governance: Best Practice Principles -"Clapman Report" (Stanford University)

2. Prudent Practices for Investment Stewards (Fiduciary 360, AICPA, Reish Luftman Reicher & Cohen)

3. Asset Manager Code of Professional Conduct (CFA institute)

4. Standards of Membership and Affiliation (The National Association of Personal Financial Advisors)

5. CFP Certification Standards (Financial Planning Standards Board)

6. Regular Member Code of Ethics (National Investor Relations Institute)

7. Code of Professional Responsibility (Society of Financial Service Professionals)

8. Also check the site for the Financial Planning Association. I understand that they are soon to release a new set of standards for financial advisors.

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According to the Daily Texan, the University of Texas Investment Management Company will soon have to rely on its internal audit staff. Chairman of the University System's Audit, Compliance and Management Review Committee, Regent Robert Estrada "reported to the board that Ernst & Young was uncomfortable with pricing the investment company's private equity and hedge fund investments. Regent Robert Rowling added that the firm also had issues with the time gap between UTIMCO's quarterly reports." Click here to read the article.

In a related piece, this blogger was interviewed about the topic of hedge fund valuation in Securities Industry News. Part of a June 4, 2007 special report entitled "Critical Issues for Hedge Funds," the topic of how, why and when hedge funds get valuation help (or don't as the case may be) arose. As an accredited appraiser, I know from firsthand experience that many people in hedge fund land do not acknowledge the presence of the traditional business valuation community. That's not necessarily good since the latter group has long ago acknowledged the regulatory prohibition against a formulaic approach and the need for specialized valuation training. Judges are none too happy and are tossing expert opinions out of their courtroom if they fail to reflect established valuation concepts and practices.

When asked why valuation is so important in this industry, I said the following:

<<  Valuation numbers drive nearly every financial decision. Hedge fund managers need to know how to rebalance their portfolios, adjust risk management positions and report numbers to investors upon which they earn their fees. Valuation becomes especially important in the case of illiquid investments like private equity, distressed securities, emerging-market securities and complex derivatives. It is also an issue as more hedge funds go public. How else will you come up with a net asset value for the initial public offering, without a formal assessment? Additionally, institutional investors are on the hook to understand how hedge funds value their holdings. The last thing pension fund, foundation or endowment fiduciaries want is a blowup that could have been prevented with a thorough vetting of the managers' valuation process. That includes assurance from the hedge fund managers that numbers are being provided by an independent third party. >> (To read "The State of Valuation", go to www.securitiesindustrynews.com. A subscription is required but you can register for a trial.)

If you would like a copy of some of the articles I've written about hedge fund, derivative instrument and asset valuation, click here to send an email.

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On June 4, 2007, Dr. Susan M. Mangiero, president of Pension Governance, LLC moderated a panel of experts who waxed poetic about current challenges for 401(k) plan stewards, their advisors and money managers. Click here to order the recording if you missed the event. (Past events are listed by original date with older events shown first.)

All three speakers agreed that more pressure on fiduciaries is inevitable. Mr. Blaine F. Aikin, AIF®, CFA, CFP® and Managing Partner (Fiduciary360) said that many people either do not understand their responsibilities or fail to recognize how to discharge duties properly. As the investment world becomes more complex, this gap between statutory requirements and reality is likely to grow.

Mr. David J. Bauer, Partner (Casey, Quirk & Associates LLC) explained how the asset management industry is changing to accommodate an undeniable trend away from traditional plans in favor of 401(k) offerings. He added that the asset management industry struggles with what products they can offer that will help plan sponsors manage their fiduciary risk. Everyone opined that both buyers and sellers are still too heavily focused on performance and should be more aware of risk-adjusted returns at a minimum.  It was also agreed that adopting new products and strategies could increase fiduciary liability exposure if approved without demonstrating a solid understanding of risk.

Mr. David Vriesenga, Chief Rating Officer, with the Centre for Fiduciary Excellence, LLC spoke about the wave of new pension litigation cases. He explained that asset managers will continue to be targeted as defendants. Susan M. Mangiero commented that a forthcoming website, www.pensionlitigationdata.com, has more than ninety (90) percent of its investment fiduciary cases cross-coded as alleged breach of duty. Scary stuff!

All speakers agreed that change is a constant. Challenges for plan sponsors and money managers abound. Part of that has to do with the heavy (literally and figuratively) nature of the Pension Protection Act (PPA) of 2006.

Note to Readers: Do you understand everything about the PPA? If not, you are far from alone.

From this blogger's perspective, the introduction of complex products could hurt more than help (given the current state of investment fiduciary literacy).

The audience was reminded that good process is everthing.

How true!

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In "Backdating Fine May Set Model - Brocade Is the First to Pay Penalty in Options Probe (June 1, 2007)," Wall Street Journal reporter Kara Scannell describes a $7 million settlement with the SEC over option backdating. Law.com reporter Jessie Seyfer describes a judge's refusal to dismiss the case, with significant focus surrounding the issue of material economic harm to shareholders. (Is there harm or not?) Click here to read the May 14, 2007 article.

In the wake of several stories about 401(k) stock drop litigation, one connects the backdating - company stock dots by asking: "How much extra homework should pension fiduciaries undertake before recommending company stock (if at all) when the terms of prevailing option awards are misunderstood, questionable or insufficiently transparent?" Should pension fiduciaries ask to meet with the compensation committee and more thoroughly vet company stock risk factors related to option awards for those at the top of the management ladder? Click here to read "Will Executive Option Issues Drive the Next Wave of Pension Litigation?" by Susan M. Mangiero (Journal of Compensation and Benefits, March/April 2007). 

Not addressed in the article but an interesting point to ponder relates to possible conflicts of interest. When the compensation committee and the pension investment committee are one in the same, will individuals who approve the granting of executive options be able to support an arm's length assessment of company stock as a viable defined contribution plan choice? The answer is not necessarily "no" but it does pose some added complexities.

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