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

As 2008 rolls in, uncertainty is on the minds of many. Will there be a recession? Will market volatility persist? Will asset prices continue to converge, making it more difficult to diversify? One question in particular is oft-discussed, notably the issue of strategic asset allocation for defined benefit plans. In a December 17, 2007 news release, the California Public Employees’ Retirement System Board of Administration announced its intent to invest nearly 70 percent of its $250 billion under management to stocks. Private equity will account for 10 percent, up from 6 percent. According to Charles P. Valdes, Investment Committee Chair, “These revised allocation markers reflect the promise of our private equity, real estate, and asset-linked investment classes."

In stark contrast, the Pension Benefit Guaranty Corporation went in the opposite direction a few years ago, now bearing the burden of a positive equity risk premium. In a December 20, 2007 article entitled "The $4 billion trade-off: PBGC misses out by eschewing stocks in favor of LDI," Financial Week reporter Doug Halonen points out the perils of allocating a high percentage of assets to fixed income. He rightly points out "the irony" that numerous companies are seriously investigating the economics of adopting a liability-driven investing strategy which almost always entails a shift away from stocks to bonds and/or interest rate derivatives.

Importantly, the decision to invest in alternatives, including private equity, must reflect a careful analysis of the likely risk-return tradeoff, mapped to the objectives and constraints of a particular pension plan. A short-term focus could create upset for those exposed to holdings that more logically lend themselves to a long-term commitment. In today's "Wall St. Way: Smart People Seeking Dumb Money," New York Times reporter Eric Dash writes that investors in Ohio Public Employees Retirement System and Fidelity Investors "would have made more money this year investing in an old-fashioned index fund that tracks the S&P 500-stock index" rather than plunking down money for the IPO of "private equity powerhouse" Blackstone Group. Perhaps that's true but does it matter if their respective goals are to realize capital gain over the next five to seven years? (Note that this blog's author has no knowledge of the intent of either investor.)

Allowing for upside potential (and statistics do validate a big move into private equity by pensions, endowments and foundations), lack of liquidity and valuation difficulties are harsh realities. However, barriers are starting to soften. Barry Silbert, CEO of Restricted Stock Partners, operates the Restricted Securities Trading Network, a mechanism for trading insider stock options, convertible bonds and private investments in public equity. A recent venture capital injection is arguably a validation of this attempt to enhance fungibility of otherwise "infrequently traded" instruments. The PORTAL Alliance, brings together the Nasdaq Stock Market and leading securities firms to "create an open, industry-standard facility for the private offering, trading, shareholder tracking and settlement of unregistered equity securities sold to qualified institutional buyers ("QIBs")." If successful in allowing for ready buys and sells, institutions may be more open to kicking the private equity tires.

For further reading, these websites (a few of many) may be of interest:

• Private Equity Council
• Private Equity Industry Guidelines Group
• PrivateEquity.com.
  

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In "Morgan Stanley reviews position of risk officer over writedowns" (December 22, 2007), Financial Times reporter Henny Sender describes the hostile environment in which some risk management gurus live. Declaring that critics now accuse the Morgan Stanley Chief Risk Officer of being late in "sounding the alarm about the dangers stemming from the bank's exposure to sub-prime related trades" or having used "language that was too technical or obscure," advocates counter that his warnings were ignored. Not surprisingly, other banks are "overhauling their risk management function after announcing multi-billion dollar losses on subprime-related trades. (Morgan Stanley reported an approximate $10 billion loss.) 

The article adds that Morgan Stanley's risk guru "was very vocal in saying that there were no proper pricing models for such trades, that positions were not being properly measured, and that the history traders used in their models was not a reliable guide." A further investigation will ultimately shed light on whether Mr. Risk at Morgan Stanley had the authority to effect significant change or was instead unaware of mounting exposures until it was too late.

The lessons to be learned here are far from trivial. Spending significant money to hire a risk wizard or team of pundits is a waste unless (a) the risk control function is recognized as essential to core operating activity and (b) these individuals are empowered to work independently of line managers. A new study suggests that the tide is turning though there is room for improvement.

According to "Beyond Compliance: The Maturation of CROs and Other Senior Executives" (GARP Risk Review, November/December 2007), researchers Annette Mikes and David Townsend describe the way Chief Risk Officers are encouraged to participate in "capital allocation and group-level budgeting and planning." At the same time, more than two-thirds of surveyed bank CROs expressed frustration at not being able to convince top management to improve risk disclosures included in public financial statements. Over reliance on risk models was cited as a concern of CROs, especially when credit allocation decisions are based on "automated model responses, with little oversight from humans." The article concludes that "the ultimate test remains the ability of risk managers to influence risk-taking behavior in the business lines."

As this blog's author wrote several years ago, Chief Risk Officers are part diplomat and part rocket scientist. Ultimately, their contributions are constrained by whether a risk culture exists within an organization. One can be technically competent but lack the organizational wherewithal to put out a fire. Read "Life in Financial Risk Management: Shrinking Violets Need Not Apply" by Dr. Susan Mangiero, Accredited Valuation Analyst, CFA and certified Financial Risk Manager.

Should pension and 401(k) plan sponsors care about bank risk management? Absolutely.

Since many retirement plans hire banks to manage assets or recommend bank funds to defined contribution plan participants, fiduciaries MUST include risk controls as part of their due diligence process when selecting, monitoring and perhaps firing money managers.

Some plan sponsors create and implement risk management policies that are separate from their formal Investment Policy Statement. Elsewhere, ERISA and public plans are hiring risk management professionals to go in-house. For example, the Ohio Public Employee Retirement System (OPERS) seeks a risk analyst who can perform tasks such as those shown below.

<< 1. Develops a comprehensive risk management program to identify, assess, manage and report investment related risks.

2. Oversees in coordination with the appropriate parties, the management of market, credit/counterparty, operations, reputation and other investment related risks.

3. Develops and participates in processes and procedures of reviewing, discussing and prioritizing risks in each major category.

4. Develops and reports risk metrics to monitor market, credit/counterparty, operations and other related risks.

5. Prepares periodic reports for senior management and OPERS Board to review investment related risks and makes recommendations, as appropriate.

6. Assesses risk management tools and capabilities, recommends improvements and implements approved solutions.

7. Reviews, monitors and oversees derivatives activities and capabilities for internal operations and for external managers in coordination with appropriate staff.

8. Performs on-site manager due diligence reviews from a risk assessment, management and monitoring perspective.

9. Leads and/or participates in various risk management committees.

10. Establishes and maintains a customer service focus work policy through example and clear, timely delineation of expectations. >>

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In today's edition, New York Times reporter Robert Pear describes a recent action by the Equal Employment Opportunity Commission ("EEOC") that gives employers free rein to cut back benefits for persons 65 and older. (See "Many Retirees May Lose Benefits From Employers.") The rationale seems to be that, once eligible for Medicare, senior workers should transition fully or partially out of private benefit programs because they are otherwise covered. Quoting EEOC Chair, Naomi C. Earp, the goal is to encourage plan sponsors to continue voluntarily providing and maintaining health benefits. Premiums deemed "too high" and the fact that people are living so much longer than ever before is creating havoc with corporate bottom lines. As a result, "many employers refuse to provide retiree health benefits or even to negotiate the issue." In some cases, if they are unable to contain costs for benefits offered to older workers, companies may decide to cut back altogether. This means that younger workers would be exposed - no employer provided coverage, no Medicare.

According to the December 26,2007 Federal Register, the new policy protects plan sponsors from legal threats of age discrimination in the event that they create a two-class benefits program. The "Appendix to Sec. 1625.32--Questions and Answers Regarding Coordination of Retiree Health Benefits With Medicare and State Health Benefits" provides additional information. The upshot is that employers now enjoy flexibility to (a) provide retiree healthcare benefits “only to those retirees who are not yet eligible for Medicare" (b) modify, reduce or eliminate benefits upon an employee's 65th birthday and (c) decrease or eliminate health benefits for the spouse or children of a retiree of a certain age.  

How many companies rush to the door remains to be seen. As employers struggle to attract and retain good workers, including those with a bit of gray, providing or reinstating diminished benefits may come to pass. Only time will tell.

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Some investors may be getting coal for Christmas. According to a December 20, 2007 Financial Times article ("Hedge funds assess exposure to banks"), reporter Saskia Scholtes describes a role reversal with respect to risk. Whereas banks worried about hedge fund losses in the aftermath of the 1998 collapse of Long Term Capital Management, hedge funds now tally their exposure to credit-challenged banks. Noteworthy is an observation by attorney Lauren Tiegland-Hunt that one-way derivatives-related collateral agreements expose hedge funds to risk of bank failure. She adds that, even if an agreement was bilateral, banks sometimes amended terms to "prevent hedge funds from calling for collateral before a bank’s losses on the trade reached a certain threshold, with the bank’s threshold marked as 'infinity'."

Kudos to this managing  partner of law firm Tiegland-Hunt for calling attention to an important risk factor. As this blog has pointed out several times, the posting of fungible assets such as U.S. treasury bills is one way to mitigate counterparty risk. A thorough assessment of the credit worthiness of the counterparty, consideration of the expected risk associated with a particular derivative instrument and/or strategy and analysis of overall exposure to a given name are similarly important.

For those pension funds sending money to hedge fund land, make collateral assessment part of your due diligence. Derivative instruments, used properly, can sometimes offer a bevy of advantages over investing in the underlying "cash" asset. However, as Nobel prize-winning economist Milton Friedman oft-declared, "there is no free lunch." Once a derivative instrument is created, its fair value (zero at inception) changes. Unfortunately, gains can only be realized by the winner in this zero sum game if the loser does not default.

Editor's Note: To learn more about collateral issues as relates to derivative trading, check out the 2005 ISDA Collateral Guidelines. (ISDA stands for International Swaps and Derivatives Association, Inc.)

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If you are looking for a few chuckles and a satiric view of the sub-prime crisis, this video of British humorists John Bird and John Fortune may be the answer. On a very serious note, listen for the last line about pension funds.

Enjoy!

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According to a just released study by the Pew Center on the States, state pension plans in aggregate owe nearly $3 trillion in pension benefits, of which about $400 billion is unfunded. Unfortunately, for some state residents, the financial pain is not evenly spread throughout the nation. Consider some of the findings.

• "Only a third of the states have consistently set aside the amount their own actuaries said was necessary to cover the cost of promised benefits over the long term.
• Twenty states had funding levels of less than 80 percent at the end of FY 2006—below what most experts consider healthy.
• Several states have seen particularly troubling drops in their pension funding levels. Some of the biggest drops have occurred in Hawaii, Kentucky, New Jersey, Pennsylvania and Washington."

Hold onto your hats.

The study further reports that post-employment healthcare benefits have a price tag of about $381 billion with only 3 percent of this total liability having been funded to date. "None of the five largest states—California, Texas, New York, Florida and Illinois—had put aside money for non-pension benefits as of FY 2006." and 11 states, including California, New York, New Jersery and Connecticut owe more than $10 billion to plan participants.

Ouch!

As this blog has pointed out repeatedly, there is no free lunch. Putting off the inevitable is going to be painful for employees, retirees and taxpayers.

Now imagine you are a resident of a state with post-employment funding woes. Your taxes go up to pay for someone else to retire at the same time that you are struggling with your own situation. That's exactly what is happening for millions of people, causing great angst for all.

Read "Promises with a Price" in full text. If you missed it, the October 2007 issue of Governing (by the same authors of this new Pew report) addresses anemic pension governance standards at the state level in "The $3 Trillion Challenge." Part of that article includes a sidebar with yours truly on suggested questions to ask as part of a governance check-up for a particular plan. Read the Q&A with Susan Mangiero.

Also check out our earlier blog post entitled "Tea Party Redux: State Pensions in Turmoil." Written a year ago, the message is still the same. Ask your state legislators for their proposed solution to the retirement funding crisis.

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Dear Santa:

I've worked hard this year so I hope I get something other than coal. (Hey, we had to freeze the plan. Our stock was sagging.) It's been a tough year, with market volatility, investment complexity and ERISA lawsuits taking up much of my time. I thought 2008 would be a lay-up after a tough 2007 but it's not looking good. There's sub-prime fallout, low employee morale and a depressing outlook for growth in corporate profits. How much more can a fiduciary take?

I need a few goodies to keep me going. I'll won't forget you. The cookies and milk are waiting in the usual spot by the fireplace.

Here's my wish list.

1. Stable returns that don't cost me a fortune in terms of hidden fees or excessive risk

2. Independent service providers who take risk management seriously

3. Someone to help me select the right qualified default alternative investments, taking new rules into account

4. Recognition that my job adds value to thousands, perhaps millions of employees ( a thank you now and then)

5. Adequate resources to do my job properly

6. Someone to explain the ABC's of liability-driven investing, portable alpha and variable annuities without putting me to sleep or causing me to tear my hair out

7. Hedge funds that gladly offer full disclosure and don't require long-term lock-ups

8. Actuaries and accountants who agree on what constitutes the correct defined benefit plan liability (that ideally reflects economic reality)

9. Attorneys who will keep me up to date on my fiduciary duties and tell me how to avoid allegations of breach

10. An occasional chuckle now and then as a break from my very serious (but important) job - We have attorney, actuary and CPA jokes but nothing for pension fiduciaries. I wonder why.

By the way, I heard that even the North Pole had to cut back on legacy benefits for the hard-working elves. I hope you are giving them a good 401(k) plan instead.

Hang in there Santa!

HWPF
Hard Working Pension Fiduciary

P.S. If you want a bit of silliness, "elf yourself."

Editor's Note: Drop us a note and tell us what is on your wish list for 2008 and happy holidays!

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At this rate, one could spend hours blogging about sub-prime woes, risk and whether adequate controls were in place. In a December 4, 2007 Washington Post article entitled "Losses Stack Up: Local Officials in Florida Try to Assess Damage To Investments Linked to Soured Subprime Loans " by Tomoeh Murakami Tse, I was interviewed about pension risk management implications. (Click here to access the article. You may be asked to register.) The State Board of Administration of Florida itself acknowledges the importance of risk controls, both in a November 2007 account of their sub-prime losses and in later interviews about fund withdrawals, subsequent freezes prohibiting further withdrawals and the hiring of Blackrock to develop a financial game plan.

In a recent study by the Towers Group, risk management was found to be lacking at some organizations, arguably one cause for large losses. Describing the adverse consequences of siloed risk management functions in financial institutions, authors of "Multifunctional Integration: The Positive Side of Risk," cite the need to work across divisions. They add that  "Beyond defending against threats to the organization, a more integrated approach to risk management can drive other business and client-centric benefits, including: improved quality and transparency of information; relationship pricing; process simplicity and efficiency; more effective decision making; and overall resilience."

No surprise to this risk manager and blogger who has spent over 20 years in the areas of risk management consulting, forensic analysis, board and trustee training and process assessment. In trying to convey the importance of acting before the fact, our Pension Governance team oft-repeats the importance of a holistic investment risk orientation, commencing with comprehensive training for everyone - front, middle and back office staff included. Importantly, buy-in from the top drives the acceptance of an organizational-wide risk culture and allows for resources to purchase analytical systems, hire professionals and make sure everyone has a good understanding of checks and balances. (In a recent workshop I led on risk management, I encouraged pension fund professionals to spend time with the chief risk officers employed by their banks, mutual fund and hedge fund managers.) 

Whether separate risk management activity reflects a "penny wise, pound foolish" behavior depends on a host of factors and will vary across organizations. However, delay in implementing an effective process can be costly as pointed out in a December 2007 assessment of sub-prime litigation risk by Guy Carpenter & Company, LLC. In "What’s the State of Your State? E&O Risk Uneven across the Country," authors list six factors that give rise to litigation risk for real estate professionals (though noteworthy for other related parties, given the flurry of lawsuits now being filed). See below for excerpted text:

• Percentage of mortgages in foreclosure
• Percentage of subprime mortgages that are delinquent
• Number of litigation attorneys per mortgage industry professional
• Frequency of Truth in Lending lawsuits (per million households) through Q32006
• Frequency of banking-related lawsuits (per million households) through Q32006
• Extent to which a state is plaintiff-friendly, i.e., is deemed a “Judicial Hellhole” by the
  American Tort Reform Association (ATRA).

Mortgage bankers and real estate brokers may be getting pink slips but litigators are busier than ever. For retirement plan fiduciaries, it bears repeating. Ask external money managers if they have sub-prime problems, query about how they are addressing risk gaps and demand to know what lessons they have learned from the credit crisis.

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Disappointing many, the Federal Reserve cut rates by a smaller amount than expected. Equity investors responded with a resounding hiss, sending the Dow Jones Industrial Average down nearly 300 points. Defined benefit plan managers can't be too happy either. After all, many of them have more money allocated to stocks than bonds. Then there is the matter of reported net unfunded liabilities rising as rates fall. What's an asset allocator to do?

This blog's author recently read survey results that suggest a significant migration to more complex securities. Not surprisingly, researchers describe a struggle on the part of investors and financial advisors who need higher returns but are not always comfortable that they understand the risks. (See "Financial Advisors to Embrace More Sophisticated Investment Products Over the Next Two Years, According to New Data from Cogent Research," Insurance Newscast, December 7, 2007.) 

I hate to say it folks but here goes. Why invest in something you don't understand? Isn't that part of the reason why the sub-prime debacle is starting to make the S&L crisis look like a walk in the park? Several incidents come to mind.

Following the 1987 market crash, equity put option writers sued their brokers, saying they did not understand the nearly unbounded downside, forcing some into bankruptcy. In the early 1980's, a handful of prominent institutional investors sued their bankers for putting them into complex, new fangled derivatives. One treasurer acknowledged the need to know more, exclaiming "Due to my inexperience, I placed a great deal of reliance on the advice of market professionals….. I wish I had more training in complex government securities."

Mark my words. The courts will be hearing a lot of cases that address who ultimately has responsibility for investment strategies gone awry. Pre-exemptively, pension funds must seek legal counsel to review their fiduciary duties. Nevertheless, as strategies become more complex, there will be sufficient numbers of investors who simply do not understand the risk and, absent good process, will lose money.

This gets back to a point made many times herein. Shouldn't pension decision makers (regardless of plan design) be required and/or encouraged to have a particular familiarity (experience, education) with investment and risk management?

The fact that no such certification requirement exists amazes and disturbs. 

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According to the The WashBiz Blog, Fannie Mae employees are feeling the pension benefit pinch.

• New employees will not  be eligible to join the pension plan.
• Current employees will see their benefits frozen if their "age and years of employment total less than 45."
• The company will "stop contributing to the ESOP (employee stock ownership plan).

In exchange, and similar to what many companies are doing, Fannie Mae will boost its support for a 401(k) plan. For those relying on more traditional offerings, get your letter to the North Pole fast. Click here to read the December 7, 2007 post.

While this may come as unwelcome news to some Fannie Mae employees, the flip side is that companies are trying to save money where they can, especially if it means being able to set the stage for renewed future growth.

This blog's author is not taking an advocacy position either way but simply pointing out the raging controversy as to which constituency fiduciaries are practically asked to serve. (Getting the advice of legal counsel is paramount for company decision-makers on these matters.) How should plan sponsors properly navigate the choppy waters? Companies need to attract and retain talent. At the same time, some (more than others) have no choice but to cut costs right away.

Our prediction is that this struggle between HR strategy and Treasury will be a major issue for 2008 and beyond.

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In "Pension Fund Litigation Could Slow Investments," New York Sun journalist Liz Peek quotes yours truly on the surge in pension lawsuits, notably those alleging breach of fiduciary duty. Attorney Stephen Rosenberg, and creator of a popular ERISA law blog, is likewise quoted as citing the Herculean challenge faced by plan sponsors. Charged with a bevy of everyday tasks, now added to the list is the need to familiarize themselves with increasingly complex instruments and investment strategies. The article suggests that "increased accountability could dampen institutional enthusiasm for alternative investments."

In contrast, a survey just released by Russell Investments finds a worldwide trend on the part of endowments, foundations and pensions towards continued allocation of monies to alternatives such as hedge funds and private equity funds. With increases expected by 2009 in most countries, the twin issues of risk management and valuation will become arguably even more important (though they have never been unimportant).

The next several years promise to be interesting ones, to say the least.

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