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

The following is an excerpt from an article written by Dr. Susan M. Mangiero and published in Mann on Wall Street (August 2007 issue). If you would like to receive a copy of the full text article, click here to send an email request.

<<Despite a recent study that all is okay in corporate pension land, changes are taking place to indicate otherwise. Preparing for lots of pension buy-out business, investment banks hire actuaries in droves. Swap trading desks similarly staff, anticipating a surge in liability-driven investing. CPA firms scurry to find qualified professionals who can handle the alphabet soup of new accounting rules. Even those who breathed a sigh of relief with the final enactment of the Pension Protection Act of 2006 (“the suspense is over”) acknowledge the beginning of the end of “the way things were.” Board members, CEOs and CFOs wait for the other shoe to drop, assuming that the sequel to FAS 158 will compel wide swings in earnings. Congress and regulatory agencies busy themselves with a flurry of investigations. On top of everything else, longevity is forcing plan sponsors to rethink how to cut costs without alienating productive workers. The only constant is change. For traders who embrace volatility, life is good. For those in search of stability, hang onto your hats.

With all of this tumult underway, a little noticed trend seems to be emerging that could make pension clients high risk for service providers - asset managers, brokers, bankers, administrators, custodians, advisors, consultants, auditors and ERISA counsel. At its simplest, there is a real question as to who has investment fiduciary responsibilities other than the plan sponsor. Some organizations wear the hat of “fiduciary” but charge steep fees to compensate for added liability exposure. Others disavow the role, going so far as to include text to that effect in their engagement letter. However, real questions remain. Will judges uphold the legitimacy of this stance or instead classify a service provider as a functional fiduciary against their will, thereby opening the door to claims of breach? If that occurs, asset managers, consultants and other persons peripheral to a plan sponsor get the worst possible outcome – increased liability exposure without compensation.>>

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Wall Street Journal reporter Craig Karmin reports that, post credit crunch, some public pension funds are having second thoughts about hedge fund and private equity investments. Cited as a "significant reversal in thinking," the article points out that pension funds have oft-cited alternatives as a way to diversify against shifts in market conditions. (See "Pension Managers Rethink Their Love of Hedge Funds," August 27, 2007.)

In an August 26 article entitled "Just How Contagious is That Hedge Fund," New York Times contributor and financial pundit, Mark Hulbert, debunks the notion that all hedge funds generate market-independent returns. He attributes asset class interconnections and similar strategies made by large hedge funds as culprits. A loss in one sector or fund is likely to appear elsewhere. Investing in "hard to value" positions is another challenge. (This blog's author, an accredited appraiser, is working with the National Association of Certified Valuation Analysts to develop a hedge fund valuation course for October 2007.)

The Pension Governance team has been playing the role of Cassandra for many months. Click here for our January 4, 2007 post about contagion, the notion that what occurs in one market or fund cascades throughout the system. Regarding valuation, we've described the issue ad nauseum. Click on the Hedge Funds and Valuation folders on the left side of this blog's home page for lots of posts about these two topics.

For those who missed our six webinar series entitled Hedge Fund Toolbox^SM, we're nearly finished with the ebook equivalent. Email us if you want to be notified when it's ready.

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While on a "sort of" vacation at a health spa in Arizona, this blog's author has treated herself to some "fun" reading, in between exercise classes and tending to business. As such, I came across an article in the Science Times section of the New York Times that I would have ordinarily set aside. Written about perception and reality, it seems to perfectly capture current happenings in pension land. Coincidentally, its August 21 publication date was the same day I fielded an invitation from CNBC to address whether pensions are taking on too much investment risk, where one goes to unearth information about pension investments and whether there is anything a plan participant or shareholder/taxpayer can do about "excess" pension risk. Unable to coordinate schedules, I will not appear on August 22. However, I encourage readers to download the Squawk Box video of the segment about pension risk. It promises to be interesting and timely.

Let me connect a few dots.

According to George Johnson, author of the aforementioned article, "Sleights of Mind," magicians succeed by exploiting what are described as cognitive illusions - "disguising one action as another, implying data that isn't there, taking advantage of how the brain fills in gaps." According to The Amazing Randi, this means that assumptions are often mistaken for facts.  Courtesy of the Visual Cognition Laboratory at the University of Illinois, a short video illustrates that observation skills are mixed. Only a few audience members who watch a film of basketball players - and then count how many times a particular team (categorized by shirt color) scores - ever notice the man in a gorilla suit walking on stage. (By the way, did you know that there is such a thing as National Gorilla Suit Day? Click here to learn more.)  

How this relates to pension risk is as follows. We know that billions of pension dollars are moving into derivatives, hedge funds, private equity funds, commodity pools, infrastructure, real estate investment trusts and so on. We know that some of these funds invest in economic interests that are "hard to value." We know that not every fund has a solid risk management policy. (Current newspaper headlines make that point abundantly clear.) We know that not every pension fiduciary has a finance background, let alone investment expertise. We know that finding out about a pension fund's holdings and liability risk drivers is often difficult. Form 5500 reports filed by ERISA funds are stale and overly general. Public funds might provide some information online or in response to the Freedom of Information Act but likely not on a frequent enough basis. Even financial footnotes are notorious for what they don't say about pension risk (on both the asset and liability side). It's rare if we even know who is making multi-million decisions about employee benefit plans, let alone be able to review their resume to gauge "suitable" knowledge and experience. We've blogged many times about meaningful disclosure, or more precisely, lack thereof. Click here to access past posts on this topic.

In a soon-to-be released survey about pension risk (co-developed by Pension Governance, LLC and the Society of Actuaries), there is clear evidence that pension fiduciaries perceive that they are doing a great job of vetting external managers with respect to risk management at the same time that the questions they profess to ask are overly simplistic. (Look for the executive summary to be released in mid-September.) Our forthcoming www.pensionlitigationdata.com clearly indicates a surge in allegations of breach on the part of the investment fiduciary(ies).  Coincidence? Maybe not.

If the Fed and international central bankers are unable to quell investors' fears, we move into a recession and/or different asset classes get hit hard in terms of price volatility, life is going to be very tough for plan sponsors. Poor practices will likely come to light as large losses occur. Risk is truly a four-letter word. Absence of a rigorous risk identification, measurement and management system (policies, procedures, operations) will leave little room for defense.

 We are going to write much more on this topic in coming months. It's too important to ignore.

P.S. The nice photo comes to readers from the National Zoo.

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In today's "Investors Mull How to Get Out Of Hedge Funds: Market Turmoil Highlights Notoriously Tricky Rules For Redeeming Shares." Wall Street Journal reporters Jeff D. Opdyke and Eleanor Laise paint a grim picture for investors in search of an exit. Besides the fact that many funds only permit redemptions at the end of a month or quarter, written notice is often required, sometimes as much as sixty to ninety days in advance. Even then, punitive fees may be imposed. Additionally, not all investors are equal if side letters exist that favor some over others.

For hedge funds already in crisis mode, redemptions may not come in time to stem further problems nor will they shield an investor from already realized losses. Moreover, fund managers may freeze redemptions, arguing that to do otherwise would imperil their ability to stay in business.

If that isn't gloomy enough, consider that investors who successfully withdraw money from a struggling hedge fund may have to give back. "If a hedge fund fails, in some cases a bankruptcy trustee or other investors may sue investors who have already redeemed money and try to force them to pay that money back into the fund, say Nixon Peabody's Mr. Mungovan and his co-chair of the firm's alternative investments litigation practice, Jonathan Sablone. The trustee could argue that the hedge fund didn't value its assets correctly and that investors withdrew more money than they were entitled to."

Valuation alarm bells are nothing new to this blog. We've been touting the need to assess a manager's valuation policies and procedures for months. As stated countless times before, we've asserted that valuation critically drives reported performance. Reported performance determines fees and fees drive risk management and asset allocation decisions. Now we see firsthand that valuation likewise drives the ability to liquidate.

Being locked up is no fun. For pension funds in desperate need of cash, the current state of affairs is agonizing.

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The war between man and machine is no longer science fiction. As market turmoil continues, some experts suggest that "quant" funds may be making things worse. In "Blind to Trend, 'Quant' Funds Pay Heavy Price" (August 9, 2007), Wall Street Journal reporters Henny Sender and Kate Kelly describe the inadequacy of statistical models to accurately estimate "how risky the market environment had become." Losses by more than a few hedge funds are one result of automated trading.

In today's paper, New York Times reporter Landon Thomas Jr. adds that banks are starting to feel the pain as well and not just because of questionable credit issues in the sub-prime market. "Strategies employed tend to be not only duplicable but broadly followed — the result being a packlike tendency that has helped increase market volatility."

Investors seeking to withdraw funds has exacerbated liquidity concerns. Leverage is another stated worry. By definition, borrowing money allows a trader to take a bigger position than would otherwise be possible. Short selling and derivatives are oft-cited as other leverage-inducing techniques. When times are good, leverage can magnify positive returns. The flip side is that leverage results in bigger losses when things deteriorate.

Leverage is not per se "good" or "bad." However, investors must understand the extent to which a fund levers its trading and therein lies the rub. There are multiple ways to measure leverage and its impact on reported performance is not  well understood. (There is no universal consensus about how returns should reflect the "L" word.) Click here to see some examples recently added to the CFA Institute's site about Global Investment Performance Standards. (Choose Leverage/Derivatives from the pull-down menu.)

This blog's author adds "There is so much more work to be done in the area of disclosure and transparency. The amount of information that outsiders are missing is staggering. Even insiders may not have the full picture unless they know what questions to ask." Email us if you want a copy of "Deciphering Risk Management Disclosures" by Dr. Susan M. Mangiero, AIFA, AVA, CFA, FRM.

If pension fiduciaries thought that interviewing traders and portfolio managers was tough, try asking questions of R2D2.

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In "How Street Rode The Risk Ledge And Fell Over," Wall Street Journal reporter Justin Lahart writes that "many lenders, funds and brokerages were following statistical models that grossly underestimated how risky the market environment had become." Warnings about model error or "model risk" are not new. In "Model Risk and Valuation" (Valuation Strategies - March/April 2003), Dr. Susan M. Mangiero, CFA and Accredited Valuation Analyst, suggests possible red flags, adding that the consequences of a poor, inaccurate or incomplete model (or problems with data) can be dire. She adds that what constitutes a "good" model is likewise important to assess. This is sometimes made more difficult when inputs themselves must be modeled. For example, in the case of derivatives related to credit risk or mortgage loans (dominating headlines of late), estimating variables such as prepayment or recovery rates is an important precursor to any valuation of the derivative instrument itself. Email us if you would like articles about model risk and valuation.

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The RiskMetrics Group and Susan Mangiero, author of Risk Management for Pensions, Endowments and Foundations, are pleased to present an introductory course on Investment Risk Management for Pension Funds. The two and a half day workshop addresses investment risk measurement and valuation fundamentals, along with an overview of new pension rules and regulations as they relate to procedural prudence. Combining lectures, cases and lab work, plan sponsors will learn about risk management standards, how to apply various risk assessment techniques and what to avoid in creating and implementing a risk management plan.

Who should attend: chief investment officers, portfolio managers, corporate governance officers, chief risk officers, trustees, risk analysts and board members

Instructor: Dr. Susan Mangiero, CFA, AIFA, AVA, and FRM, President and CEO Pension Governance, LLC.

Dates:
Wednesday- Friday, September 12-14, 2007

Time:
September 12-13 - 9:00 am - 5:00 pm
September 14 - 9:00 am - 12 noon

Location:
RiskMetrics office
1 Chase Manhattan Plaza
44th Floor
NY, NY 10005

Email education@riskmetrics.com to register for the course or to obtain additional information about cost or content. 

Space is limited so, please reserve your space today.

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Alleging breach of fiduciary duty, plaintiff South Cherry Street, LLC cited failure of consulting firm Hennessee Group to do proper due diligence of the now defunct hedge fund, Bayou Group. In response, federal judge Colleen McMahon "granted a defense motion to dismiss the case, finding that Hennessee wasn't alone in being duped by Bayou." (Click here to read the August 3, 2007 Reuters article.)

As several related cases make their way through the courts, pay attention to how the judge rules. Some experts suggest that institutions could be asked to assume more responsibility for the investments they make, even after hiring a consultant.

If true, things are likely to change. After all, why hire someone else if ultimate responsibility stays with the plan sponsor? The import is considerable. Trustees and other internal fiduciaries who now look to outside experts will have to become more expert themselves. (We've long advocated for better fiduciary training and selection standards, whether an outside firm is employed or not. Click here to read a recent blog post on the topic.)

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Summertime and the livin' may be easy for Porgy and Bess. If you're an investor caught in the middle of a scorching hot credit meltdown, things are far from tranquil. Besides the fact that many deals are being put on hold (thereby reducing the universe of available stocks and bonds), more than a few asset managers are reporting giant write-downs. If you haven't seen it, the Wall Street Journal's list of affected deals and organizations is sobering. Click here to read "Scorecard: Debt Dilemmas - How Credit-Market Tremors Have Affected Junk Bonds, LBOs and Hedge Funds."

Jittery traders are starting to wonder how quickly sub-prime loan problems will spread to other market sectors, ultimately impacting the ability of corporations and individuals to borrow and spend. In "Strategies correlate after credit market crunch hits," Financial Times reporters Peter Garnham and Paul J. Davies describe changing patterns across markets and strategies. What does this mean for institutional investors? Quite simply, a lot.

Hedge funds and private equity managers who tout absolute return (based on uncorrelated return patterns) are going to have a tough challenge ahead if convergence occurs. Defined benefit plan sponsors are going to have no less a difficult time.

Strategic asset allocations are going to be directly (and arguably materially) impacted by the notion that "the investment world is getting smaller." To read an earlier post about contagion, click here to access "Pension Contagion - Should We Worry?"

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According to Wall Street Journal  reporters Kate Kelly, Liam Pleven and James R. Hagerty, at least ten funds struggle with sub-prime loan woes in the form of diminished portfolio values. As if that isn't bad enough, some institutional investors are being given the unhappy news that withdrawals are suspended. For pension funds in search of liquidity, look elsewhere. (See "Wall Street, Bear Stearns Hit Again By Investors Fleeing Mortgage Sector," Wall Street Journal, August 1, 2007.)

As the fallout continues, with no end in sight, it is worth repeating that fiduciaries are on the hook for creating, and then following, a prudent process with respect to investment selection. ERISA itself mandates that employee benefit plan fiduciaries must carry out their duties in the sole interest of the plan's participants and with the "care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims."

These few words speak volumes about the many things a plan sponsor must consider before committing money to a particular instrument, strategy or asset manager. Questions naturally arise. A few of them are shown below.

1. Have plan sponsors sufficiently queried asset managers about how they measure default risk ?

2. How are structured financial transactions collateralized?

3. Who is responsible for collateral management?

4. What safeguards exist to enforce collateral quality and amount?

5. Do asset managers make their policies and procedures available to plan sponsors who want to know more about valuation, operational controls, collateral issues and trading limits?

6. Are positions being marked to model?

7. Who reviews the integrity of the model and related data inputs?

8. What could cause estimated default risk to rise for "questionable" borrowers and how are asset managers tracking identified risk drivers?

9. What are the investors' rights to withdraw funds?

10. Does an asset manager reserve any capital against its expected risk exposure, voluntarily or otherwise?

Several observations are in order. First, investment problems are not unique to small funds. To the contrary, some large mortgage-related funds (in terms of assets) are currently in crisis mode. Second, recent market drops and rising credit spreads are forcing companies to delay IPOs or incur higher costs of capital. This means that all investors are invariably impacted. Third, the fallout is global, with several prominent non-U.S. funds announcing big hits.

This may be the beginning of the end for easy credit and the start of a "brave new world" for plan sponsors who cannot afford a "see no evil, hear no evil, speak no evil" approach.

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