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

In its "hot off the press" report about pension fund investments in hedge funds, the U.S. Government Accountability Office encourages additional focus on risk management. (We agree and in fact said as much when we were invited to provide background information for this report.) We will write more about this official study as we reflect on its content. In the meantime, click to read "Hedge Funds: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued Attention Is Needed" (January 24, 2008).

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Despite colorful tales of medieval historians disputing its shape, most people then and now realize that the earth is not flat. We won't get to the end and fall off. Indeed, we're arguably more interconnected than ever before. So it's not surprising that a galaxy of international speakers convened in Sydney with many of the same problems, challenges and concerns as US peers. A recurring theme emerged for everyone in attendance at the Asset Allocation Summit 2008 - Investment management is all about risk. Identification, measurement and control are important,. regardless of plan design and country of origin. In fact, the similarities as to what keeps folks up at night are eerily striking, whether voiced by a plan sponsor from Europe, Asia, Australia or North America. Here are a few concerns that resonated with all in attendance.

1. How can investment fiduciaries minimize their liability exposure, especially when investment strategies are becoming more complex and diverse?

2. What is the responsibility to defined contribution plan participants, knowing that many will retire without ample means to maintain a particular lifestyle?

3. How can one avoid paying "excess fees" to managers?

4. What is the proper way to separate beta from alpha?

5. What is the role of infrastructure investing?

6. Should allocations to 130/30 strategies (and equivalents) come from equity or alternatives?

7. Will a recession be global in nature?

8. How much oversight is required by internal fiduciaries who delegate manager selection to consultants?

9. Is ESG (Environmental, Social, Corporate Governance) investing a plus or minus in terms of fiduciary duties?

10. How should derivatives be properly used and by whom (the plan, the money manager or both)?

Sound familiar? If so, perhaps we should be thinking about how to operate within a flat pension world. Credit Thomas Friedman for pointing out the oneness that pervades global thinking. In his best-selling "The World is Flat," he emphasizes the connections among seemingly disparate markets. Should we care about the governance of pension funds outside our borders? In a word, "yes." What is done elsewhere impacts an increasingly "flat" network of capital which in turn influences the investment opportunity set within our borders..

Isolationism is over for most everyone. What about you?

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Just as US banks and hedge funds are coming to grips with a maze of pricing rules in the form of FAS 157, other countries are joining the fray. It's no surprise that institutional investors and their regulators favor more disclosure and evidence of tighter policies and procedures (if they don't already exist at a particular firm). Private and government plan sponsors from around the world will be convening in Sydney next week to discuss alternatives, strategic asset allocation, valuation, global regulation and pension risk management techniques.

This blog's author looks forward to participating in the Asset Allocation Summit. (Pension Governance, LLC is a conference media sponsor.) I will be leading the master class entitled "Global best practices in hedge fund valuation and risk management" and another workshop on 130/30 strategies. Click here to learn more. If you need to find a speaker or want to provide investment risk/valuation training for your team, we'd love to hear from you. Drop us a line.

Until then, look for news from Down Under this coming week!

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In "Chile set to boost foreign investment," Financial News reporter Johanna Symmons (January 28, 2008) describes a proposed law that increases maximum international holdings from the current 40 percent to 80 percent. This means that the half dozen authorized private fund administration companies will have more latitude in how they manage the country's mandatory individual savings accounts. When approved, non-Chilean holdings could rise as much as USD 50 billion. In addition, reform will add to retirement plans of impoverished citizens, "funded by windfalls from copper production." Credit goes to President Michelle Bachelet who identified the need for change as "her administration's most important task."

This blogger is proud to say that she worked as a financial risk management expert on an official fact-finding team in early 2006. Led by Dr. Roberto Rocha (World Bank), colleagues and report co-authors included Mr. Graeme Thompson (former Australian regulatory chief and now pension consultant) and Dr. Eduardo Walker (Pontificia Universidad Catolica de Chile). If you are interested in learning more, know that pension professionals from around the world will be presenting at The 4th Contractual Savings Conference: Supervisory and Regulatory Issues In Private Pensions and Life Insurance. Hosted by the World Bank and occurring on April 2 through 4, 2008, the discussions will emphasize the "brave new world" of pension risk management. Yours truly is presenting a session entiled "Risk Management of Pension Funds: A Practitioners View."

If you are unable to join us in Washington, DC, I invite you to read about what other countries are doing in the area of pension reform for different types of plans. Chile is a particularly interesting case inasmuch as politicians and public policy leaders often reference this Latin American system as a noteworthy and innovative model. Think of it as a national 401(k) plan of sorts. While not perfect (no system is), many people like having their own account rather than being part of a "pay as you go" system. For more information, visit the site for the Superintendency of Pension Fund Administrators and click on the English overview.

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On February 20, 2008, the U.S. Supreme Court released an opinion heard round Corporate America. In LaRue v. DeWolff, Boberg & Associates, Inc., these nine top justices held that ERISA does "authorize recovery for fiduciary breaches that impair the value of plan assets in a participant's individual account" and allows for lawsuits to enforce "liability-creating provisions" that involve fiduciary breach of duty. This is big news indeed, opening the door for individual participants in 401(k) plans to seek legal redress when their investment directives are ignored or incorrectly processed. In "Top Court Allows Suit Over 401(k)," New York Times legal reporter Linda Greenhouse describes this as "one of the most important rulings in years." It clarifies an otherwise somewhat ambiguous element of ERISA (Employee Retirement Income Security Act of 1974) as to whether fiduciary duty relates to the financial health of the plan versus that of an individual participant.

Click to read our November 28, 2007 post entitled "LaRue, Corporate Governance and the Next Pension Enron."

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According to its February 18, 2008 press release, the Pension Benefit Guaranty Corporation is changing its asset allocation mix to 45 percent invested in fixed income, 45 percent invested in equity and 10 percent left for alternative investments. A spokesman explains that ratcheting up on private equity funds and real estate is expected to generate higher returns but reduce risk because of greater diversification, giving "the Corporation a 57 percent likelihood of full funding within ten years compared to 19 percent under the previous policy." In the past, the PBGC mix favored bonds with 75 to 85 percent being invested in fixed income securities, including some monies earmarked for liability-driven investing ("LDI") strategies. Some PBGC critics recently cited high opportunity costs by concentrating on notes and bonds.

With an accumulated deficit of $14 billion at the end of fiscal year 2007 and the recognition of the long-term nature of its obligations, the decision was arrived at, after "an extensive review process that began in mid-2007." Interestingly, an "Investment Program Fact Sheet" seems to contradict the newfound logic, stating that "Because of the statutory restrictions on investment of the Revolving Funds and a change in PBGC's investment policy adopted in 2004, fixed-income securities dominate PBGC's asset mix." Additional text emphasizes a relatively low tolerance for uncertainty. "The current investment policy continues PBGC's investment focus of limiting financial risk exposure by investing the majority of PBGC's assets in long duration fixed-income securities in order to reduce balance sheet volatility."

It would be interesting to know more about exactly why the PBGC decided to move into real estate and private capital pools now. How did they net the expected lower risk (due to diversification) against incremental risks association with interests that seldom trade? Access to meeting minutes would make for good reading. Though it is not an official U.S. government agency ("financed by premiums paid by employers, assets from failed pension plans, recoveries from bankruptcies and returns on invested assets"), many people believe that American taxpayers are ultimately on the hook in the event of a PBGC bailout. With a recession on the way and relatively low interest rates that push liabilities upward, bad news for this insurance agency is not out of the realm of possibility. Additionally, though premiums have increased, few economists believe that risky plans are paying their "fair share" and that "good" plans are subsidizing poor financial management elsewhere. If true, PBGC's exposure to default is that much higher.

The PBGC says it reviews its investment policy every two years. How often does it assess its outside managers? Will due diligence for alternative fund managers differ from the check-up imposed on traditional managers? How will the PBGC address valuation issues related to private equity, venture capital and real estate? What performance metrics can we expect PBGC to share with interested parties if "hard to value" assets are held at cost versus "fair market value?" Is there or will there be a Chief Risk Officer for PBGC who addresses asset-liability management on an enterprise risk basis? How will banks be impacted if private plans decide to follow PBGC's example and shy away from LDI? Will corporate plans follow suit?

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According to Infoplease.com, not all fifty states celebrate President's Day but instead acknowledge George Washington (1st U.S. President) and Abraham Lincoln (16th U.S. President) with two separate holidays. (Click here for a visual history for each leader.) Whatever February 18, 2008 represents to you, here's the scoop on pensions for presidents.

• The Internet Public Library reports that pensions paid to U.S. Presidents vary according to the "current salary of Cabinet members."
• In 1998, the National Taxpayers Union estimated then President Bill Clinton's cumulative pension at over $6 million if he "lives to the age of 81.4 years." In comparision, they estimated the lifetime pension amounts for earlier predecessors as follows: Jimmy Carter, $4.15 million; Ronald Reagan, $2.28 million; George Bush, $2.96 million.
• Many U.S. Presidents will receive income from state or local coffers, reflecting other offices held before moving to 1600 Pennsylvania Avenue.
• In January 2008, the Congressional Research Service issued a report that details all sorts of goodies owed to former Presidents. Click to read "Former Presidents: Federal Pension and Retirement Benefits" by Stephanie Smith.
• Harry Truman was the first U.S. President to receive monies under the Former Presidents Act of 1958, though benefits were applied retroactively. When he left office, he had only his Army pension of $112.56 per month. Under this new law, he would receive $25,000 per year in retirement benefits.

If you have any interesting tidbits to share about Presidential pensions, drop us a line.

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Free market economist Ludwig von Mises wrote that the aim of Socialism is to "transfer the means of production from private ownership to the ownership of organized society." Originally published in 1922, Socialism: An Economic and Sociological Analysis remains a widely read critique of what this famous Austrian refers to as an anti-social and destructive force. While numerous countries have abandoned a statist system (at least in part), an ongoing debate about health care and pensions suggests a reincarnation. Certainly here in the USA, ongoing debates among Presidential candidates keep the topic alive. So too do those who take the pulse of "Joe and Betty Everyperson."

A February 14, 2008 press release, issued by the Harvard Opinion Research Program at the Harvard School of Public Health and Harris Interactive suggests that consensus is nowhere to be found with respect to the delivery of medical treatment and pharmaceuticals. According to the survey results, younger adults consider Medicare a form of socialized medicine and are more favorably predisposed to universal coverage. Not surprisingly, those without insurance view socialized medicient as a good thing. Notwithstanding political party differences, in aggregate, "only 19 percent of the uninsured think that a socialized medicine system would be worse than our current system while 57 percent think it would be better." Those with health insurance are pretty evenly split on the issue. 

Interestingly, politicians and pundits seldom address socialized retirement with the same vigor reserved for medical care. Before he dropped out as a possible Democratic party candidate, John Edwards spoke about his intent to create Universal Retirement Accounts. In late November 2007, we gave then Republican candidate Fred Thompson blog time, posting his video comments about Social Security, wherein he bemoaned the current generational weath transfer from young to old.

Anecdotally, the response to our musical video ("Pension Tension Blues") has been pretty much the same across the board. Viewers appreciate the humor but remark on the seriousness of the situation for many individuals - limited benefits and anemic savings accounts.

So whatever your party affiliation or philosphy, there is one thing on which we should all agree. The retirement benefits "issue" is fast becoming a public policy pain point, in the US and elsewhere. And since so many of us embrace that "It's the economy stupid," know that we are all impacted as tax policies, available credit, borrowing costs and wages change as a result of corporate and government decision-making about post-employment schemes.

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In what should be seen as a giant step forward for anyone interested in pension fund financial health, the Financial Accounting Standards Board (FASB) just approved a proposal that could force additional disclosures about investments. The rationale should be obvious. Defined benefit plans are allocating billions of dollars to alternative investments. When these capital pools invest in "hard to value" assets, trying to gauge pension risk is like catching jello. It's a near impossible task.

According to the Board Meeting Handout for February 13, 2008, few plan sponsors have gone beyond what is required of them by FAS 132(R), essentially reporting asset class categories "without further disaggregation." Additionally, the Board decided in November 2007 that FASB Statement No. 157 (fair value rule) would not apply to pension plans. In the absence of other mandates and voluntary disclosure (something free market economists favor, myself included), retirees and shareholders are nearly clueless when trying to gauge potential fallout from "risky" investing. If approved as an amendment of Statement 132(R), the new rule would "include a principle for disaggration of plan assets and a list of required asset categories" and "require further disclosure of categories or subcategories for concentratons of risk."

This blog's author has written ad nauseum about the critical information void with respect to pension investment risk. In fact, I literally just submitted a provocative piece on this topic for CFA Magazine. It will be part of the March/April 2008 issue.

Here are some initial thoughts. (I could write a book on this topic of pension risk disclosure.)

• Could disaggregation veil true risk exposure in much the same way that single asset performance is not the same as portfolio performance?
• Will there be a universal consensus about how to properly measure risk?
• Will certain risk metrics be accepted as superior for a particular asset class (an approach I advocate)?
• Will increased disclosures discourage some plan sponsors from dipping their toes into alternative investment waters?
• Will pensions be encouraged to hire Chief Risk Officers as pension risk management takes its rightful place on stage?
• Will some instruments such as derivatives be decomposed as standalone versus embedded?
• Will alternative managers push back from pension clients when asked to open their trading books to more scrutiny? (Remember the response when several endowments asked alternative fund managers for more information as part of the Freedom of Information Act a few years back? They were  shut out of deals.)

The U.S. Government Accountability Office is soon to release its study about pension fund investments in hedge funds. It will be interesting to compare their recommendations with those from the folks in Norwalk, home of FASB.

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There will be no hearts and flowers for Yahoo from a Michigan pension fund. In "Yahoo Rejection of Microsoft Bid Draws First Shareholder Suit," Information Week reporter Antone Gonsalves writes that the Wayne County Employees' Retirement System of Michigan is taking Yahoo to court. Alleging failure to "meet its obligation to shareholders in evaluating the offer," Wayne County is asking Yahoo directors to thoroughly vet the computing giant's offer, especially given the bid price compared to where Yahoo common stock is currently trading ($31 versus roughly $19).

According to the 2006 Annual Report (most recent document posted on the Wayne County Employees' Retirement System website), their common stock holdings take the form of mutual funds. It's not clear if their reported 13,600 shares of Yahoo are held as part of a pool. An asset allocation pie chart shows equity with a 66 percent sliver. As of September 30, 2006, Wayne County's assets came close to $1 billion. What will be interesting to watch is whether WCER is left in the dust as pension funds with larger stakes compete for a more visible litigation role.

According to the Yahoo company website, its 401(k) plan includes a company match. If that match takes the form of Yahoo stock, a 401(k) stock drop lawsuit may be just around the corner.

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A few months ago, Pension Governance, LLC introduced PENSION TENSION BLUES in MP3 file form. We now present our 5-minute musical commentary, written for fiduciaries and beneficiaries, as a video for your viewing pleasure. We hope PENSION TENSION BLUES will make you laugh and cry at the same time. (Email us if you want a medium or high resolution version of this video.) You can also watch the video directly on YouTube.com.

Inspired by those who bring attention to serious issues through humor, Dr. Susan M. Mangiero (President and founder of Pension Governance, LLC) and Mr. Steven Zelin (The Singing CPA) have co-created a (hopefully) memorable ballad about the state of affairs in retirement benefits land. Pension Governance, LLC is committed to helping fiduciaries do a better job of identifying, measuring and managing financial risk. We hope the song is a friendly reminder of the hard work ahead. The decision to use satire is in no way meant to impugn the countless fiduciaries already on the right track. We simply want to draw attention to areas of growing concern to employees, retirees, shareholders and taxpayers alike.

To those in the vanguard of pension governance, bravo! Email your success stories and we will gladly publish them.

If you want to sing along, here are the lyrics.

PENSION TENSION BLUES
Words by Susan M. Mangiero and Steven Zelin
Music by Steven Zelin
Copyright 2007 Pension Governance, LLC and Steven Zelin.
All rights reserved.
71 bpm

I work for a corporation. I’ve been there 30 years
But my pension plan went bankrupt;
It has left me in tears
They’re telling me now I gotta work till I’m 432
I got the pension tension bliss suspension nobody ever mentioned blues

I signed that stupid paper 100 years ago
It said if I worked forever, they’d give me lots of dough
I wish I knew what happed; I can’t find many clues
I got the pension tension bliss suspension nobody ever mentioned blues

I thought the plan was looked at by a bunch of CPAs
Thought they said it all looked just fine, then gave their Okay’s
But I guess something was happening outside their view, now
I got the pension tension bliss suspension nobody ever mentioned blues

They invested in some hedge funds and paid up lots of fees
They gambled all my money, with no guarantees, now
I’ve got nothin’ for tomorrow and you know I’m gonna sue
I got the pension tension bliss suspension nobody ever mentioned blues

Guess I should have realized my account was discretionary
Now all I got is these papers. What’s a fiduciary?

I’m putting all my stuff on e-bay, I gotta raise some cash
My piggy bank is empty, my portfolio has crashed
I read that Social Security has gone down the tubes
I got the pension tension bliss suspension nobody ever mentioned blues
I got the pension tension blues
I got the pension tension blues

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February 11 was a bit of an equity rollercoaster. Reports of another big price gap were to blame. According to Reuters, PricewaterhouseCoopers LLP, external auditors for AIG, "concluded that the company had a material weakness in its internal control over financial reporting relating to the fair valuation of credit default swap portfolio obligations of AIG Financial Products Corp." Those in the know estimate the unrealized valuation loss relating to credit default swaps as being close to $5 billion, much bigger than originally believed. The stock closed down 12 percent lower. (Click to read "AIG discloses hole in derivatives valuation" by Lilla Zuill.)

Several questions come to mind, not the least of which is whether internal auditors came to the same conclusion at the same time and by the same route. How did the outside auditors decide on the adjustment? What models did they use? (AIG's Form 8-K, filed with the SEC as of February 11, 2008, mentions the Binomial Expansion Technique and Monte Carlo Simulation.) How often did auditors and traders kick the proverbial tires? On the business development front, how will this news impact organizations on the other side of AIG trades? Will they ask for more collateral? Will trade size fall to reflect a reappraisal of default risk?

To be sure, AIG is not the only name in the headlines. Irrespective of any particular company, and as we've mentioned many times before, pension funds are duly exposed when they transact derivatives, buy financial company stock or bonds or allocate money to multi-purpose behemoths. Now is not the time to be shy about asking tough questions as regards risk management and valuation policies and procedures of firms such as AIG. This holds true even when a consultant is engaged. Legal experts remind. Fiduciary oversight remains.

Awhile ago, this blogger authored "Asset Valuation: Not a Trivial Pursuit" for the Institute of Internal Auditors. Topics discussed include model risk, model validation and the internal auditor's role. Also check out "The Role of the Financial Expert in Valuation of Derivative Instruments." Yes Virginia, there is lots of litigation as a result of markdowns, disclosure questions and risk management process (or lack thereof). 

On March 5, 2008 (in case you missed our earlier announcement), Pension Governance, LLC is proud to sponsor a webinar entitled "Fiduciary Risk, Trading Controls and External Asset Manager Selection." Persons who attend this 75-minute webinar will learn the following:

• What Constitutes "Must Have" Elements of Effective Risk Management Systems
• Ways to Detect Deviation from Management Style and/or Excess Position Concentration
• Red Flags Regarding Possible Rogue Trading
• Industry Best Practices for Trading Controls and Lessons Learned About What to Avoid.

We hope to have you join us!

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At a time when pensions, endowments and foundations are investing billions of dollars in alternatives such as hedge funds, responsible decision-makers must understand financial and legal risks. If they fail to dig deep or negotiate their interests properly (even when they use a consultant or fund of funds manager), fiduciary breach lawsuits could result. Join Dr. Susan Mangiero, AIFA, AVA, CFA, FRM (President of Pension Governance, LLC); ERISA attorney Noah Weissman (Bryan Cave LLP); and hedge fund attorney Nir Yarden (Bryan Cave LLP) for a mock deposition involving a pension fund’s investment in hedge funds, gone awry. Part of the Fiduciary 360 National Conference, audience members can see what happens during this discovery phase of litigation, watch and hear firsthand what someone in the “hot seat” is likely to experience and learn lessons about proper investment fiduciary process. According to Mangiero, author of "Risk Management for Pensions, Endowments and Foundations" and countless articles about investment risk and valuation, "The challenge is particularly acute when hedge funds invest in 'hard to value' assets or employ complex derivative instrument strategies. Identifying hidden risks can save institutional investors money, reduce stress and avoid harm to reputation."

For more information about this May 7 - 9, 2008 conference, go to www.fi360.com. For more information about pension best practices, visit www.pensiongovernance.com.

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The ill-effect of aggressive mortgage lending on pension funds is still unfolding but actively monitored, given the sheer size of many plans. A February 5, 2008 news release, issued by the Massachusetts Institute of Technology (MIT), suggests that the sub-prime fallout is real. Citing a second straight drop in the quarterly Transaction-Based Index ("TBI"), a measure of commercial real estate trades by pension funds, MIT Center for Real Estate Director David Geltner blames the credit crunch. A 5 percent decline for the fourth quarter of 2007 follows a prior 2.5 percent three-month drop. These hits are in stark contrast to reported growth in the TBI of 64 percent from 2004 through 2006. Click here to read the MIT story. Also check out the February 6, 2008 CNBC broadcast.

In a related piece ("Risk of property defaults growing - February 6, 2008), Financial Times reporters Daniel Pimlott and Gillian Tett describe a disturbing (though not surprising) trend in commercial property loan defaults. They quote Sam Chandan, chief economist at research company Reis, as saying that "It will be very difficult to acquire refinancing." The article also references Wachovia Capital Markets by pointing out that $20+ billion of floating rate commercial mortgage-backed securities ("CMBS") come due this year, $2 billion of which "face the greatest risk of default" because they are final maturity loans "with no option to extend."

What remains to be seen is whether pensions' foray into real estate, direct or indirect, via an emerging real estate derivatives market, diminishes as values turn south. Shying away from this alternative investment class could have a dramatic impact on the strategic asset allocation of defined benefit plans, especially as relates to portfolio diversification. Certainly such a response will impact companies and individuals who want to sell property. A February 2007 Pension Real Estate Association (PREA) report estimates institutional real estate holdings for 2005 at $146.8 billion, an allocation of 6.92%.

Editor's Note: Click to read "Constructing the Real Estate Derivatives Market" (March 25, 2007 post) and "Are Pensions Ready for Property Derivatives?" (March 9, 2007 post).

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In "Trying to Clear Fog From Pension Plans" (February 3, 2008), New York Times uber pension reporter Mary Walsh describes a website that provides information about company plans. By going to www.AtPrime.com, one can set up a free account and then click on the "Pension Inspector" to input criteria such as company name. I did so for General Electric Company and up popped four plans, each with its own ID number and plan name. Ditto for Pitney Bowes with a result of 9 plans displayed, including the 401(k) plan.

A cursory review of information found at the site suggests a good start but hardly sufficient to gain a meaningful understanding of economic risk. One can find data about employer contributions, accountant name, plan administrator, funded status (for defined benefit plans), end of year "Current Value of Assets", "Interest Rate Utilized" and so on. However, detailed information about various plans remains a mystery. For example, Schedule H (Form 5500) should give some comfort as a snapshot of plan assets and liabilities. However, the granularity is so far from helpful (there is seldom any detail provided), one wonders why the US government requires the form at all. (Some plans do report detailed holdings at year-end though I could not find such in my investigation of this online tool.

Opacity is certainly not the fault of www.AtPrime.com. The fundamental shortcomings of pension reporting is something we've long anguished about. On April 17, 2006, this blog pointed out the near impossibility of identifying those in charge of a particular plan's investment decisions. Searching for a needle in a haystack may be easier by far. Other than the name of the plan administrator (mandated by law), good luck in identifying relevant persons from public records. Click here to read "Searching for Hidden Treasure."

In "Pension Investment Risk Disclosure - What Don't You Know?" (September 6, 2007), this blog's author compared a partially submerged truck to knowledge about pension risk transparency, asking "Are you seeing only half the truth or are you completely unaware of investment risks lurking in your plan's portfolio?" This goes for 401(k) plans too. What you choose as a "low-risk" investment may be anything but "safe." A read of recent headlines goes to this point. 

Kudos to www.AtPrime.com and sites such as www.FreeErisa.com. Until disclosure rules change, something is better than nothing. Still, for a worried employee, retiree or shareholder, wouldn't it be nice to have a better idea about what's going on in pensionland?

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