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

I caught a few minutes of the November 28 Republican Party presidential debate while exercising at the gym. Though I did not watch the entire event, the clip about Social Security is noteworthy. In response to a viewer's question about entitlement spending, former Senator Fred Thompson described an impending tsunami. He suggested that one stance would entail protecting the younger generation from his peers (Baby Boomers and older). His reference to current funding woes as a moral issue as well as an economic issue is not unique. Read "Running on Empty: How the Democratic and Republican Parties Are Bankrupting Our Future and What Americans Can Do About It" by prominent banker Pete Peterson.

This blog has discussed Social Security before. We agree with the now famous Law and Order television star. The younger generation is going to get squeezed big time if entitlement programs continue unchecked.  Increased longevity, staggering national debt (a problem not unique to the U.S.). and what can only be described as a horribly deficient savings rate are some of the many factors that will make life difficult for Gen Xers. The economic toll will be significant and long-term in nature. It does not take a rocket scientist to know that higher taxes (inevitable without changes in benefit payouts) mean lower disposable income. Fewer dollars in the wallet mean reduced spending and that, as some pundits suggest, slows economic growth.

Given the gravity of the "retirement problem," might we entice CNN/YouTube to sponsor a national debate (Republicans, Democrats, Independents, etc) that focuses exclusively on entitlement spending and (hope springs eternal) viable solutions?

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In response to my query about Justice Roberts and his comment about a plan's SPD, ERISA attorney Stephen Rosenberg wrote "Susan Mangiero was taken by the discussion in the oral argument of what powers may or may not have been identified in the summary plan description appended to LaRue’s complaint. I took this discussion by the Justices to be part of an inquiry into what are the constraining parameters of a claim such as the one brought by LaRue." Go to Boston ERISA & Insurance Litigation Blog for additional discussion.

The Wall Street Journal's Law Blog had an interesting post on LaRue. (I included the link a few days ago and am including it here again.) Several folks commented in response, including this blog's author. See below for my response (with a bit of editing).

<< I concur with the Nov. 27 post by the ERISA Consultant. Pension governance is serious business for millions of individuals who are impacted by the decisions made by plan fiduciaries. Hopefully, the LaRue case (regardless of outcome) will prompt a vigorous debate about fiduciary issues - who has responsibilities for what tasks and how retirees are impacted if breach occurs. Shareholders should be paying attention to LaRue as well. Poor governance of retirement plans can have a material adverse impact on earnings. >>

As I have said many times and will no doubt say many more times, pension governance (broadly defined as best practices, applied to all retirement plan types) is an integral part of corporate governance. While this message is gaining currency, most experts in the fiduciary space assert that there is vast room for improvement. If you agree (and not everyone does), a critical question comes to mind.

What will it take for pension governance to be viewed as equally important as mainstream corporate governance issues such as (a) proxy voting (b) executive compensation (c) financial statement certification (d) internal controls and (e) agency conflicts between managers and shareholders?

Negative headlines about Enron and other troubled companies forced shareholders and lawmakers to pay attention. Do we need a pension meltdown a la Enron to force change in the retirement industry?

We would love to get your feedback on what you think will force pension governance to quickly climb the "high priority" list for organizations not already concentrating on such. Click here to drop us a line.

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We are proud to say that our investment commentary posts are now being picked up by Seeking Alpha. Check out their site for discussions about market conditions and various stocks and bonds.

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Inside the hallowed halls of the U.S. Supreme Court, pension history may be in the making. On November 26, 2007, justices heard the case of LaRue v. DeWolff, Boberg & Associates Inc. The long awaited outcome could put employers in the ERISA litigation spotlight as never before by allowing individuals to sue, one person at a time.

By way of background, Mr. James LaRue sought to have his employer switch his 401(k) monies from one mutual fund to another, in his attempt to migrate to "safer" investments. The plan administrator failed to make the change, allegedly costing LaRue an estimated $150,000 in lost profits. In August 1996, the United States Court of Appeals for the Fourth Circuit, in Richmond, Virginia denied LaRue an opportunity to seek redress, claiming that ERISA emphasizes harm to a plan in aggregate. The opinion reads:

<< In ERISA, Congress sought to provide fair and generous remedies for plan participants without imposing ruinous personal liability on plan fiduciaries. That balance pervades the statute, and it is not for us to readjust it. With respect, we think the Secretary’s view does recalibrate the balance, and we do not possess authority to modify plain statutory text, several Supreme Court decisions, and the corpus of circuit law on the subject. If the Department believes fiduciaries should face personal liability for every wrong alleged by individual beneficiaries, even in the absence of personal profit or misuse of plan assets, it will have to seek a forum other than this court. >>

This begs the question then as to how an individual plan participant can hold administrators and relevant parties accountable for mistakes. The import of this issue is huge. At a time when countless companies are terminating defined benefit plans and opting to offer 401(k) plans in their stead, anything that makes that strategy more expensive and/or troublesome could create pushback. If this occurs, employees are going to be under even more pressure to save for their retirement on their own. Add Social Security and Medicare woes, along with what some predict is an imminent recession, and Joe Everyman is likely to truly feel the pinch in a major way. On the other hand, employers fear an honest mistake that arguably opens the floodgates to costly litigation.

A read of the June 19, 2006 and August 8, 2006 LaRue opinions is instructive, as are the salient documents presented to the U.S. Supreme Court. Click here to download relevant files. Click here to read an informative overview provided by law professor Paul Secunda (who predicts a 6-3 victory for LaRue). One item in Secunda's text that struck me as notable is the line of inquiry by Chief Justice Roberts wherein he "points out that the SPD does not say administrators have to follow the investment directions of participants."  Reading these words catches one's breath. Is the honorable jurist suggesting that the Summary Plan Description ( a guiding document as regards the administration of the plan) preclude an asset allocation change? If so, how are employees to deal with market volatility or altered circumstances that mandate a different investment risk-return tradeoff? I await feedback from ERISA attorneys on this and other points.

Pay close attention when this opinion is rendered. It will make a difference! 

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In a recent interview on the John Batchelor show, Globalprivatequity.com, Inc. CEO Doug Miles described the current credit crisis as a "black swan" event. This summer, Miles predicted the valuation fallout associated with complex derivative instruments. Adding that banks can't know the extent of their problems anytime soon, an uncertain interest rate environment, new valuation accounting rules such as FAS 157 and infrequent trading in instruments such as Collateralized Debt Obligations make life very uncomfortable. Click here to listen to the November 11, 2007 interview with John Batchelor and Doug Miles.

In his bestselling book, The Black Swan: The Impact of the Highly Improbable, essayist Nassim Nicholas Taleb assigns three attributes to a black swan event in business. "First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable." Click here to read the first chapter, as reprinted by the New York Times on April 22, 2007. In his video interview entitled "Learning to Expect the Unexpected," Taleb describes the human brain as "designed to retain, for efficient storage, past information that fits into a compressed narrative." He adds that "this distortion, called the hindsight bias" makes it difficult to learn from past mistakes.

If true that the sub-prime situation is a black swan as Miles asserts, and taking a page from Taleb, we embrace the notion that we are blind to randomness, what then is the proper role of risk management? According to Financial Week reporter Matthew Quinn, inquiring minds are asking "Where were the risk managers?" He avers that some pundits debate whether technology can keep up with product innovation or adequately assess leverage. He suggests that, even if rocket scientists raise their hand, warnings may go unheeded, especially given banks' dependence on proprietary trading. See "Risk managers return (belatedly) to Street: Chastened banks, brokerages get religion on minimizing exposure to hidden bombs. Coulda, woulda, shoulda?" (Financial Week, November 19, 2007). 

In an article I wrote in mid 2003, I commented that the life of a risk manager is challenging to say the least. In addition to a plethora of data analysis skills, a Chief Risk Officer ("CRO") or someone with similar functional duties must be a diplomat, a motivator and a keen student of human behavior. Most people don't want to hear bad news since it usually means more work for them, not to mention the added stress and the potential damage to one's career of being tainted with a problem. Read "Life in Financial Risk Management: Shrinking Violets Need Not Apply" (AFP Exchange, July/August 2003).

Unfortunately, for retirement plan decision-makers, risk management is going to be impossible to ignore. Pension funds that include allocations to bank stocks or equity in bank-like financial organizations are already feeling the pinch. Plan sponsors who hired bank asset managers or hedge funds/mutual funds that invested in banks are going to be asked tough questions about the due diligence they performed. Did they sufficiently kick the tires with respect to understanding how the banks managed risk? Fiduciaries of banks' 401(k) plans who recommended company stock are getting sued for allegedly having done too little to assess the attendant risks. Just last week, a complaint was filed against the Federal Home Loan Mortgage Corporation ("Freddie Mac"), citing poor controls that encouraged the acceptance of "risky" loans and inappropriate appraisals of those loans. Click here to read the class action complaint against Freddie Mac.

Black swan or not, the current credit crisis is going to get nastier. Expect many more litigation complaints in the ensuing months.

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Ooh la la! Parisians take to the street to protest proposed pension cuts. (Fresh in the memory of many New Yorkers, transit workers stateside went on strike in late 2005 for similar reasons. Read the CNN account  entitled "Union votes to end New York transit walkout.")

Over a week ago, Gallic transportation employees said "no" to suggested cuts in their pension benefits. BBC News reports that "Opinion polls suggest voters back the French leader's plans to reform 'special' pensions which allow transport and utility workers to retire early, but a majority sympathises with civil servant grievances." While French President Nicolas Sarkozy holds firm, large crowds of teachers, hospital workers, air traffic controllers and postal clerks actively sympathize. Click here to read more about what is being described as a massive strike. The video below presents the opposing point of view.

The outcome will speak volumes for France and other countries, struggling to achieve greater economic growth, at the same time that unions seek to protect workers' rights.

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Bloomberg reporter Christine Harper reports an average Wall Street bonus of just over $200,000, from a wealth pie of $38 billion, spread out over 180,000+ individuals. In stark contrast, she adds that "Shareholders in the securities industry are having their worst year since 2002, losing $74 billion of their equity." About this same time last year, USA Today reported an average investment banking bonus of $137,580. (Read "It's a Wall Street bonus bonanza, December 20, 2006.)

With approximately 45 percent more in year-end goodies to take to the bank, financial professionals will be in fine mettle to celebrate Thanksgiving on November 22 this year. Yippee!

Even folks like Freddie Mac CEO's Richard F. Syron must be happy in the piggybank department. According to the Washington Post, their accounting of 2006 rewards ("Top 100 Executives by Total Compensation") lists his take as a mere $1.1 million in salary but $15.5 million in aggregate. Never mind that a November 20, 2007 press release reports a third quarter loss of $2.0 billion, reflecting "a higher provision for credit losses and losses on mark-to-market items" and "total GAAP mark-to-market losses of $3.6 billion," including $1.5 billion in "interest-rate related items."  (Read "FREDDIE MAC REPORTS THIRD QUARTER 2007 NET LOSS OF $2.0 BILLION OR $3.29 PER DILUTED SHARE: Core Business Growth Offset by Credit and Valuation Losses.")

Even if you believe in the power of free markets to determine performance-linked compensation (and further acknowledge that some Wall Streeters contributed to shareholder wealth), these big numbers don't play well in Peoria. They especially don't go over well in pensionland.

At a time of strained state budgets and company layoffs, enticing qualified persons to work on pension issues is not a walk in the park. As we've discussed MANY times, it's tough to attract experienced, knowledgeable persons to sign on as fiduciaries. The payoffs are asymmetric at best. Do a great job and the reward is small. Do a bad job and the liability is great.

How will they express gratitude when the discussion turns to pecuniary rewards?

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As of November 15, 2007, those organizations who did not adopt FAS 157 early on will be obliged to disclose much more information about their "hard to value" assets and liabilities. Despite industry's attempts to forestall compliance for another year, the Financial Accounting Standards Board reiterated its intent to force implementation for financial assets and liabilities. Read "FASB Rejects Deferral of Statement 157 for Financial Assets and Liabilities" (November 14, 2007 FASB press release).

For those seeking a user friendly version of this new accounting rule, check out "A FAS 157 Primer" by Mark Gongloff (Wall Street Journal, November 15, 2007). Also check out "A Summary of Statement No. 157" on the FASB website. One important element of FAS 157 is the requirement that items be categorized as belonging to Level 1, 2 or 3 in order of ease of valuation with respect to observable prices (or lack thereof). Predictions abound that FAS 157 will force larger asset write-downs, creating jitters for pensions, endowments and foundations who invest in Level 2 and Level 3 sensitive funds. In a November 15, 2007 CNBC video, economist Nouriel Roubini warns of an impending global recession and a financial meltdown that could roil financial markets for months to come. He is not alone.

In "Why FAS 157 strikes dread into bankers - Just when we hoped the worst was over," William Rees-Mogg (The Times, November 12, 2007) cites research by financial analyst Martin Hutchinson. Financial giants such as Bear Stearns, Lehman  and J.P. Morgan Chase account for more than $100 bilion of FAS 157 Level 3 assets, requiring mark to model information not heretofore provided. The author adds "Even these figures may be understated, since the banks have themselves decided whether assets belong to level three or the more acceptable level two, and they have an interest in placing as little in level three and as much in level two as they reasonably can." Noteworthy is Hutchinson's analysis that Goldman Sachs has disclosed $72 billion of Level 3 assets. That number is relatively big or small, depending on the point of comparison - a $900 billion asset base but capital of $36 billion.

Lest pension decision-makers think they are immune from valuation issues, nothing could be further from the truth. Decision-makers for both 401(k) and defined benefit plans are squarely on the hook for vetting external money managers. This absolutely includes asking copious questions about managers' valuation policies and procedures. A poor job, or ignoring the issue altogether, is going to keep the plaintiff's bar busy indeed.

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According to "Clean Up" (Global Proxy Watch, November 2, 2007), the California State Teachers' Retirement System ("CalSTRS")  has approved new rules that seek to prevent the practice of "pay to play." Set to become effective as of November 28, 2007, California Code of Regulation, Title 5, Division 3, Chapter 1, Article 14 prohibits campaign contributions to board members in excess of $5,000 per year from any firm providing investment services. CalSTRS self-identifies as the "first public pension fund in California to pursue ethics reform of this scope."

Editor Stephen Davis writes that the focus on pension fund governance continues unabated in the UK, US and elsewhere. We appreciate the nod to our efforts at Pension Governance, LLC.

Davis concludes with a quote by former U.S. SEC chief Arthur Levitt who, in a recent speech, emphasizes the need for improvement. Referring to pension fund governance as a "ticking time bomb," he urges trustee literacy as one of several solutions. See "Ex-Chief of S.E.C. Says Pension Funds in Danger" by Mary Williams Walsh, New York Times, October 31,2007.

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We are seekng two or three additional beta testers, preferably attorneys. Please email us if you have an interest in learning more.

We plan to launch in just a few weeks. Click here to be notified of our official launch!

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In his November 11, 2007 blog entry, New York Times reporter Floyd Norris describes an interesting tidbit of information, tucked inside the just filed 10-Q by Wachovia Corporation. On page 27, it reads "In the third quarter of 2007, we purchased and placed in our available for sale portfolion $1.1 billion of asset-backed commercial paper from Evergreen money market funds, which we manage. We recorded a $40 million valuation loss on this purchase, which is included in our market disruption-related losses." As Norris explains, while the regulatory filing adds that Wachovia is "not required by contract to purchase these or any other assets from the Evergreen funds" they manage, a loss of that magnitude would "break the buck." When the $1 Net Asset Value typically associated with a money market fund no longer prevails, Wachovia or any other financial institution in a similar position is arguably obliged to stem the financial tide or risk loss of investors or worse. Click here to access the 10Q report.

In today's article entitled "SEI, Rival Money Funds Go on Offense to Avoid 'Breaking the Buck'," Wall Street Journal reporters Diya Gullapalli and Tom Lauricella write that money manager SEI Investments has said "it would provide financial guarantees for some of the funds' holdings of SIVs." CEO Alfred West explains the rationale for voluntarily providing credit support, in the aftermath of a threatened downgrade of SIV Cheyne Finance, LLC paper. Held by several SEI funds, "managed for SEI by Columbia Management, the money-management arm of Bank of America Corp," the funds' rating could likewise be compromised. Click here to listen to the recorded November 12, 2007 presentation to SEI investors. 

A recent IMF presentation, entitled "Regional Economic Outlook - Europe" stresses the importance of improving "risk assessment models, market and liquidity risk management, due diligence, and transparency regarding the loan origination process and counterparty risk exposure."

Color me confused. Haven't many banks held themselves out to be leaders in the area of risk control? What about the fact that banks are highly regulated? Doesn't that contribute to good oversight? What is the role of Basel II, looming right around the corner and meant to reflect robust risk management activities on the part of banks in the U.S. and abroad?

For those banks with pension clients, what is the process in place to vet all recommended money market funds, including their own? Is the process conflict-free? Conversely, are pension funds directly (or through pension consultants) asking sufficient questions about the safety of recommended short-term capital pools?

As the mysteries unfold, don't be surprised what we learn about the importance of good fund selection and risk review process.

Note: Wikipedia defines a structured investment vehicle as "an evergreen credit arbitrage fund, similar to a CDO or Conduit. They are usually from around $1bn to $30bn in size and invest in a range of asset-backed securities, as well as some financial corporate bonds. An SIV is formed to make profits from the difference between the short term borrowing rate and long term returns." Click here for more information.

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There is something for everyone when it comes to U.S. national debt. Unfortunately, that "something" is a gigantic IOU to the banks, insurance companies, mutual funds and international investors who buy our government bonds and bills. Click here to access statistics about ownership of U.S. government securities. According to "National Debt at Record $9 Trillion" by Associated Press International reporter Martin Crutsinger,  "It took the country from George Washington until Ronald Reagan to reach the first $1 trillion in debt."

Zowie!

Lest you confuse the deficit with debt, the U.S. Treasury offers Frequently Asked Questions that describe the deficit as "the fiscal year difference between what the United States Government (Government) takes in from taxes and other revenues, called receipts, and the amount of money the Government spends, called outlays." In contrast, the total debt includes accumulated deficits "plus accumulated off-budget surpluses." Click here to read other factoids about our crushing economic situation.

Ignore the finger pointers in Congress who explain why U.S. debt is racing past $9 trillion (that's 12 zeroes). Focus instead on the school of thought that taxpayers (especially younger ones) are on the hook. According to the U.S. debt clock site, "the estimated population of the United States is 303,509,977 so each citizen's share of this debt is $30,036.47."

In retirement land, this slice of Uncle Sam's spending frenzy hurts. With more than a few companies, and state and local plan sponsors, cutting back on benefits, taking on more debt has as much appeal as getting a tooth pulled, without novocaine. Click here to see how quickly national debt is mounting. Refresh your screen several times to appreciate the speed with which we are being pushed into an economic hot zone.

For companies seeking to grow, increased national debt crowds out other borrowers. This in turn has the effect of raising the cost of capital which typically means lower profits and decreased share price. Why is this important to plan participants?

Simply put, the probability of payout at current benefit levels critically depends on the plan sponsor's financial health. Additionally, troubled companies are not likely to hire. For those retirees seeking a return to the workforce, that's unwelcome news indeed. Don't forget the pension asset-liability management challenges associated with excess leverage. To finance its funding gap, the U.S. government issues more bonds and/or raises taxes. The former impacts the shape and magnitude of the yield curve, which affects a plan sponsor's ability to manage interest rate risk. The latter impedes new spending and truncates growth, dragging corporate earnings downward.

The bottom line is that none of us escapes this problem. What a mess!

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According to a November 8, 2007 Bloomberg report, Federal Reserve Chairman Ben S. Bernanke says `"We are working with the banks, the ones who sponsor these off-balance-sheet instruments, to make sure that they are getting true valuations,'" Click here to read the full story.

A few things come to mind.

1. What form of "help" is offered?

2. How can federal regulators assist with orderly asset write-downs and then still be in a position to independently review the banks' process?

3. Will tough questions be asked about how banks, going forward, will attempt to avoid another sub-prime (or related) debacle? If there is a silver lining, let it be good lessons learned about modeling and risk controls.

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Since Thomas Malthus predicted the end of mankind as population growth surged, economists have been known as the dismal scientists. (Click here to check out U.S. and global person counts.)

According to "Auditors set for tough talks with clients" by Jennifer Hughes (Financial Times, November 5, 2007), valuation challenges may force accountants to wear the mantle of "life of the party NOT." Though a current focus is on how clients plan to report valuations at year-end, a la FAS 157, auditors must be concerned about ongoing general lack of good process by some reporting entities.

Clients' failure to thoroughly document, and implement, a (hopefully) robust valuation process puts auditors squarely in the litigation crosshairs if they are seen as doing less than a good job of oversight. Though a few years old, the AICPA published a summary of problem areas based on SEC investigations. Four out of five times, the auditor failed "to gather sufficient audit evidence," with countless cases involving "inadequate evidence in areas such as asset valuation, asset ownership and management representations." Click here to access "Top 10 Audit Deficiencies" by Mark S. Beasley, Joseph V. Carcello and Dana R. Hermanson (Journal of Accountancy, April 2001).

It was not too long ago that the U.S. SEC Division of Enforcement and the Office of the Chief Accountant alleged that a CPA "failed to adequately assess the substantial evidence produced by the audits" that there were material "overstatements of the value of convertible bonds and convertible preferred stock." Click here to read the overview.

In "Auditor liability and caps get a hearing in Washington," Financial Week reporter Nicholas Rummell (October 15, 2007) quotes the co-chair of a newly formed committee, Donald Nicolaisen, former chief accountant at the SEC, as saying that "now is the ideal time to look at auditor liability because there is no crisis." Yet the article states that "audit expenses for the largest accounting firms related to litigation and liability had risen to $1.3 billion in 2004, 14.2% of total revenue. In 1999, related expenses were about 7.7% of revenue." (By the way, life sure has changed in the last few weeks as market volatility seems the norm.)

This blog author's take on things is that there will be some "issues" going forward. The math is simple: Investor Losses = Investigation Into What Went Wrong = Blame. While auditors may not be the only ones asked tough questions about oversight, issues abound.

• How much rigor should be applied by auditors in assessing the mark-to-market (model) process?
• How do internal auditors treat a lack of independence for those reporting entities that create their own marks in lieu of hiring an outside third party?
• How many auditors feel comfortable valuing complex derivative instruments?
• Is statistical sampling of holdings in a large portfolio of "hard to value" instruments considered sufficient?

Stay tuned...

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In a November 5, 2007 statement, Citi announced that current CEO Charles Prince will step down. Robert E. Rubin will become Chairman of the Board and a search for a new leader will begin immediately. In a related story, Wall Street Journal reporters Carrick Mollenkamp and David Reilly describe Citigroup's struggles to estimate trading losses, in large part due to the fact that internal quantitative models relied heavily on credit ratings assigned to securities that were used in structuring Collateralized Debt Obligations (CDOs). With recent downgrades (to arguably better reflect risk levels), the value of Citi's sub-prime holdings similarly sank. Credit fears dampened already limited trading interest, forcing a heavy reliance on a mark-to-model approach.

As this blog's author has stated many times before, model risk is real. Bad or inappropriately used models lead to imprecise outputs. Decisions based on poor information can only lead to trouble. According to "Why Citi Struggles to Tally Losses Swelling Write-Downs Show Just How Fallible Pricing Models Can Be" (Wall Street Journal, November 5, 2007), modelers projected future expected payments for then high-rated sub-prime backed CDOs on the basis of how similar credit rated corporate bonds were trading. By not recognizing that default experience for corporate versus sub-primed backed securities differed dramatically, Citi's rocket scientists painted too rosy a valuation picture.

In a related article ("Where Did the Buck Stop at Merrill? November 4, 2007), New York Times reporters Graham Bowley and Jenny Anderson describe oversight problems at Merrill Lynch. Following a $8.4 billion charge and the recent resignation of CEO O'Neal, questions have arisen about whether board members should be more aware of daily operations, especially those areas that are likely to present problems if things go awry. Quoting Meredith Whitney, CIBC World Markets financial analyst, the point is made that Merrill had no one with sub-prime experience to serve on any of the committees charged with risk oversight and auditing. Despite creating a post for Chief Risk Officer in early September 2007, other experts cited in the article decry the lack of board/oversight committee independence from senior management, at the same time that large trading books were "hard to value."

By extension, this notion of oversight applies to pension fiduciaries. As this blog's author has repeatedly emphasized, plan sponsors MUST do a thorough job of vetting service providers (including banks) with respect to their "red flag" controls. How many pension fiduciaries ask about the existence of a Chief Risk Officer (or lack thereof)? How much detail do pension fiduciaries demand to know about each bank's risk management function, certainly for key parts of trading operations? Do pension fiduciaries ask to speak to members of the valuation team and/or those responsible for collateral management? Have pension fiduciaries asked banks about their progress with respect to preparing for Basel II and related model requirements? (Click here to read the November 2, 2007 press release from the Federal Reserve Board which describes their approval of new risk-based capital rules.) The list of other "must know" queries is long but nevertheless essential to proper due diligence.

Will clever attorneys make a case for poor process if pension fiduciaries have allocated monies to any or all of the banks now making headlines, citing breach if they failed to dig deep about risk and valuation policies and procedures?

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In case you missed it a few weeks ago, the Financial Accounting Standards Board voted 4-3 in favor of implementing FAS 157 on time. Ignoring early adopters, FAS 157 takes effect as of November 15, 2007. A company reporting at year-end (or any time after mid November) will be obliged to consider FAS 157. Its companion, FAS 159, allows organizations to "choose to measure many financial instruments and certain other items at fair value."

While "employers’ and plans’ obligations (or assets representing net overfunded positions) for pension benefits, other postretirement benefits (including health care and life insurance benefits)" are excluded from the list of eligible items that can be measured at fair value, plan sponsors are nevertheless impacted by both FAS 157 and FAS 159. 

• If an employer issues stocks or bonds or transacts in other eligible assets and liabilities, FAS 157 and 159 will apply and could, at the enterprise level, indirectly impact pension plan economics.
• If a plan invests in a wide variety of stocks and bonds issued by other reporting entities, fiduciaries will need to fully understand the gap between economic risk and the accounting representation.
• In selecting external money managers, defined benefit and defined contribution plan fiduciaries alike will need to add FAS 157 and FAS 159 questions to their RFPs. Focus on  valuation model selection and testing, choice of inputs and appropriate "level" of three possible categories are a few of the many items to vet.

How FAS 157 relates to existing standards is not known with certainty at this time though FAS 133 accounting for derivative instruments is one affected area. While FAS 133 does not directly apply to a pension plan that trades derivative instruments, as investor, that plan must be savvy enough to access how issuer risk is impacted by new rules.  Consider a hypothetical scenario.

A defined benefit pension plan (Pension Plan Y) hires Bank X as a value-oriented equity portfolio manager. Bank X is a significant user of derivatives and has existing derivative instrument contracts with five different counterparties such a Bank Z, Corporation A and so on. Under FAS 157, Bank X must reflect counterparty risk in assessing fair value. Conceivably, this could result in a FAS 157 fair value for any or all of the five positions held by Bank X that is different enough from the fair value of the "hedged item." The result would be a nullification of favorable hedge accounting treatment for Bank X and reported post FAS 157 earnings that are more volatile. How does Pension Plan Y respond? Do they stop doing work with Bank X because their financial statements make them a higher risk? 

Reporting entities and investors alike are going to have to roll up their shirt sleeves and get to work. It doesn't take a rocket scientist to see the obvious. An incomplete understanding of FAS 157 and 159 lends itself to bad decision-making on the part of plan sponsors. 

Here we go...

Editor's Note: There are many ways to determine FAS 133 hedge effectiveness. If you want copies of selected articles on the topic, click here to send an email. Please include your name and company.) Click here to visit the FASB website to learn more about FAS 157 and 159.

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As plan sponsors ready themselves for new valuation rules, it's critical to understand that "FASB Speak" is not always the same language as that used by traditional business appraisers. Consider the term "fair value."

According to FAS 157, "The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price)." Click here to read a summary of Statement 157.

In contrast, the Model Business Corporation Act 3rd edition (copyrighted 2003 by the American Bar Foundation), defines "fair value" to mean "the value of the corporation’s shares determined:
(i) immediately before the effectuation of the corporate action to which the shareholder objects;
(ii) using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal; and (iii) without discounting for lack of marketability or minority." Dr. Shannon Pratt (in his book entitled The Lawyer's Business Valuation Handbook) describes "fair value" as a statutory standard of value applied in dissenting shareholder cases but influenced by the actual state venue. He goes on to say that "fair value" is seldom mistaken for "fair market value" in appraisal land.

According to the International Glossary of Business Valuation Terms  (2001),  fair market value is "the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts." Click here to access the full glossary.

What's the moral of the story? When people banty about valuation terms, ask exactly what they mean.

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In discussing his relationship with service providers, a plan sponsor recently told me that he feels like a juicy steak to a hungry lion. Everyone wants his business and he struggles to keep up with the many requests for meetings with consultants, actuaries and asset managers. According to "Pensions may be outsourced : Banks look to take the plans and their assets off the hands of employers" (October 31, 2007), that fiduciary may be even busier now, fending off requests to assume his company's defined benefit plan(s).  As Los Angeles Times reporter Jonathan Peterson describes, Citigroup has just received an okay from the Federal Reserve to "take over" a $400 million retirement plan, sponsored by Thomson Regional Newspapers.

If a harbinger of things to come (and banks are definitely gearing up for this business), risk management acumen and internal controls should be front and center. After all, if a liability is transferred from the original plan sponsor to a large bank, it will be discomfort indeed if that bank struggles with keeping its own house in order. The stakes are too high. Lest you think that big always means better, keep in mind that we've just gone through a rollercoaster summer with a handful of financial giants reporting losses.

As regulators examine the efficacy of pension buyouts by banks in the U.S. and elsewhere, this blog's author recommends that a bank's pension-related risk control abilities be made publicly available for analysis and review. The last thing we need is a concentration of pension assets in a few shaky hands. Better that everyone is comfortable upfront with the buyers' abilities in the areas of risk management, operational processing and good pension governance.

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