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

Many financial market participants seem resigned to an onslaught of new regulations. For them, it is no longer a question of "if" but "when," with the unknown being the form of eventual rule-making. One area that is likely to receive more than a passing glance is the role of the service provider to pensions, endowments and foundations. Always important, the Madoff scandal has pushed the issue front and center as institutional investors, reeling from reported losses, ask their advisors for clarity about their exposure to the now defunct Bernard L. Madoff Investment Securities LLC. According to "Crackdown on hedge funds after Madoff affair" (December 29, 2008), Financial Times reporters Deborah Brewster and Joanna Chung suggest that funds of funds may be especially feeling the pinch, with an anticipated change in how due diligence is conducted.

Next week's Congressional hearing should be telling. Convened by U.S. Congressman Paul Kanjorski (Democrat - Pennsylvania), this investigative meeting may be "standing room only" as members of the Financial Services Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises seek to understand what went awry before being able to "craft a strong, effective, modern regulatory system for the financial services industry." 

Though best left to legal experts, one wonders if a likely inquiry will center on the allocation of fiduciary duties across investors and advisors. Under what circumstances might an advisor or consultant be seen as encouraging an "unsuitable" investment? This of course begs the question as to what is deemed "appropriate" for a particular buyer and on what basis should an investment be assessed for a particular pension, endowment or foundation? We've heard that some financial professionals are responding to l'affaire Madoff by imposing more stringent, and arguably prudent, literacy requirements BEFORE accepting client money.

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Dear Santa:

I've worked hard this year so I hope I get something other than a lump of coal or a pink slip. It's been a tough year, with market volatility, investment complexity and unexpected large-scale fraud making me nervous about allocating monies to anything other than cash and zero return government IOUs. What happened to the era of big bonus paychecks and change to spare?

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. Steady 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 plan for a retirement before I'm too old to enjoy it

4. Someone to help me figure out how to get a job at 70 if I can't afford to retire by then

6. Someone to explain why the U.S. national debt clock had to add extra digits

7. Lawmakers who give me the straight skinny on the financial health of national safety net programs

8. Matching contributions to my 401(k) plan

9. A meaningful chance to replenish my broken nest egg

10. An occasional chuckle now and then as a break from very somber economic and financial news

By the way, I heard that even the North Pole is cutting back. Maybe you can unfreeze the elves' pension plan when things rebound.

Hang in there Santa!

HWP
Hard Working Person

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 2009 and happy holidays!

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A key element of any valuation engagement is an assessment of "premise of value." Said another way, an appraiser must determine whether an economic entity is likely to remain in business (and therefore should be treated as an ongoing concern) or instead be put in the "not going to make it" bucket. If operations are thought to soon cease, imminent liquidation is almost sure to follow, (wherein the business sells assets and tries to make good on outstanding obligations, to the extent that proceeds are available.) According to a recent article, the "alive or dead" litmus test may be needed now, more than ever before.

CNNMoney.com reporter Ben Rooney cites a recent Hedge Fund Research study that documents 344 liquidations or "more than three times the 105 liquidations in the third quarter of 2007" or "77 more than the previous record of 267 liquidations in the fourth quarter of 2006." On an annual basis, failed hedge funds may reach nearly 1,000 for the full year or more than "the previous record of 848 of 2005." (See "Hedge fund graveyard: 693 and counting," December 18, 2008.)

Redemptions, wild market swings and idle cash, sitting on the sidelines, are a few likely culprits with respect to which hedge funds survive or fail. What this means to institutional investors is profound. Due diligence must address whether and for how long a particular hedge fund might be expected to be a viable commercial enterprise (and so much more). Without stating the obvious, who wants to plunk down good monies for a fund that has a low probability of being around for the foreseeable future?

In a related article, Financial Times reporter James Mackintosh reports that Switzerland's Union Bancaire Privée has told "managers of the $56bn it has allocated to hedge funds to put in immediate redemptions for any fund that does not have independent administrators and custodians." The article goes on to say that some hedge fund notables are on the redeem list while others have decided to appoint independent third parties. (See "Investor demands fund checks," December 23, 2008.)

Anecdotally, I've heard that institutional investors (either through the audit or compliance functions or both) are requiring more documentation (read "transparency") from their hedge fund managers. To date, they say they have had little push-back. One wonders if there is a balance of power shift underway, favoring institutional investors. After all, how many of us have heard some asset managers decline (sometimes vehemently so) to implement what they deem to be expensive and time-consuming procedures UNLESS pensions, endowments and foundations demand such?

Editor's Note: Valuation of a hedge fund as a business is not the same thing as assessing the worth of instruments inside the hedge fund's portfolio. Consider a particular hedge fund that successfully invests in distressed securities.

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Two items caught my eye of late, mostly because they seem to intimate new bargaining power for organized labor. Yes, I know, it hardly seems plausible when automotive workers are currently being challenged to accept lower benefits in order to keep their employers afloat.

In "Organized labor 'thrilled' with Obama's pick for labor secretary" (December 18, 2008), CNN.com reports that Representative Hilda Solis, if confirmed, would be considered a "voice for people who work." Hailing from California, this Democrat lawmaker is the "daughter of two immigrant workers and union members."

In "The Employee No Choice Act" (CEO Magazine, November/December 2008), law professor Richard Epstein writes that a new political regime in the United States will force a "major sea change in labor relations law." This notable University of Chicago free marketeer opines that interest arbitration, a key component of this proposed legislation, empowers an arbitration panel to "dictate a 'first contract' lasting two years that will govern all aspects of the employment relationship." Wages, work conditions, job security and outsourcing are a few of the items that can be decided by those outside of any particular corporation.

Epstein offers that unionization could become a foregone conclusion, with employers having little or no sway over the final outcome, once an initiative to organize commences. In stark contrast, he writes that arbitrators "are empowered to flesh out all the book-length terms of that first key contract, terms never put to a vote." He adds that workers who sign cards to authorize the creation of a union will not be permitted to withdraw them if they change their view later on. Epstein further adds that this legislation, if approved, would be "tantamount to giving a new union a powerful claim on  firm assets."

If Epstein is right, how will shareholders, plan participants and union members co-exist peacefully, if at all? Many questions arise, a few of which are shown below:

• Will shareholders' economic interests in an ongoing concern become inferior to those of union members and, if so, how will that reveal itself in share price?
• How will union members deal with conflicts that arise from wearing multiple hats as might be the case if a Taft-Hartley plan owns stock issued by contributing employers?
• In the event of a bankruptcy filing, who gets what and when? Will union members rank pari passu or superior to everyone else?
• How will a multinational firm fare if its U.S. operations fall under the auspices of the Employer Free Choice Act but offshore units are unaffected by similar rules?

This next year will be an interesting one for sure but not likely to be one in which everyone sits on the same side of the table.

Editor's Note: For an opposing perspective about the Employee Free Choice Act, click to visit a site sponsored by AFL-CIO.

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According to the Bank for International Settlements ("BIS"), the global market size for over-the-counter ("OTC") derivatives, as of June 2008, exceeded $683 trillion (yes trillion) or $683,725 billion. (These numbers reflect notional amounts outstanding.) Notably, an expanded use of interest rate swaps helped to push non-exchange traded interest rate derivative product outstandings above $450 trillion, a rise of 17% over the last half-year. It would be helpful to know whether, and to what extent, pensions' use of Liability-Driven Investing strategies influenced the numbers. Click to access "Table 1: The global OTC derivatives market."

Since June, a lot has happened in the global market place. Until BIS reports updated figures, it is hard to quantify how various players have responded to increased volatility with respect to their use of OTC instruments such as swaps, options and structured products. One might logically assume that valuation and liquidity concerns will reflect themselves in lower numbers for H2-2008. On the other hand, uncertainty could encourage hedging, in which case both OTC and exchange-traded activity might see a boost.

In the meantime, I asked a few financial market participants for their feedback. Here is what they had to say in answer to the following query.

Do You Think More Regulations Will Inhibit the Use of OTC Derivatives by Institutional Investors?

• A director at a non-U.S. financial organization advises regulators not to throw the baby out with the bath water, adding that "Regulation should be framed to drive generic flows into more efficient 'plumbing' systems, while allowing custom-built trades to proceed when standardized terms don't make sense. Unless the market volunteers solutions, one must fear that knee jerk regulation will fail to differentiate, and therefore deprive end-users access to these undeniably valuable risk management tools."
• Mr. Daniel Chertok, a quant by background, writes that "Any regulation inherently stifles innovation. However, it may deter those who should not be in this business from entering in the first place or encourage someone to rightly exit the market. There is likely to be a loss of liquidity but a drop in defaults should follow. What regulation will not do is eliminate the next bubble that occurs due to reckless derivative trading."
• Mr. Luis Antonio Rangel, commodity derivatives professional and now President of Rockford Brownstone Rangel, thinks that regulation will inhibit use of OTC swaps and other kinds of derivatives by institutional investors. He adds that "the big downturn in this market recently has less to do with fear of regulation and more to do with counterparty risk. Regulators may help to repair the OTC market if their rules: (a) can improve market transparency as relates to how much leverage a particular manager employs (b) shed light on risk exposures to various counterparties across the spectrum For example, if Company DEF has a plain vanilla swap with Bank ABC but Bank ABC has a complex swap with Hedge Fund XYZ, how is Company DEF potentially hurt if Hedge Fund XYZ goes belly up? (c) improve investors' knowledge of liquidity, especially for instruments that have heretofore been deemed "low risk" and (d) mandate issuers of credit default swaps to reserve capital, in the same way that insurance companies must set aside monies. Too much regulation could push business offshore or impede transactions that, for viable economic reasons, should take place."
• Mr. Patrick Rooney, Business Analyst at Trading Technologies, writes that "Initially, yes, more regulation will freeze OTC trading. As participants adjust to the new environment, the OTC market will flourish as new participants join. There are many misconceptions regarding the complexities and risks involved associated with OTC transactions. A centralized clearing environment is likely to vastly improve things."

Email us your comments. It would be great to get your feedback.

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As this blogger has long maintained, what you see is not necessarily what you get and what you don't see could come back to bite you. It is therefore troublesome to think that billions of dollars of assets are likely to be classified as Level 3 or the international equivalent of FAS 157 "hard to value" items.

According to "Financial groups' problem assets hit $610bn" (December 10, 2008), a significant trend is already underway for banks to move securities to third tier status. Financial Times reporters Aline van Duyn and Francesco Guerrera cite a Standard & Poor's study that shows an increase in illiquid assets by more than 15 percent from Q2-2008. Difficulty in finding buyers for mortgage-backed securities and collateralized debt obligations accounts in part for the increase. Somewhat alarming, the article adds that "level-three assets are many times bigger than the market cap of the banks."

In "Running the Fund: Alternative Realities" (November 2008), PlanSponsor reporter Judy Ward quotes me extensively on the topic of valuation of "hard to value" assets from the investment fiduciary perspective. As regular readers will recall, the U.S. Department of Labor has made no secret that it would like to see pension decision-makers do a good job of vetting valuation numbers that are provided by its asset managers.

Litigation, sub-par asset allocation, anemic risk management, overpayment of fees and eventual losses due to hidden economic pot-holes are just a few of the possible nasties when valuation process is ignored. If true that banks themselves are struggling as to how properly classify a holding(s), how will plan sponsors need to respond? As I said to Ward, The number is important, but it is more important to know why that valuation number is what it is, and if the factors that contributed to that valuation number are likely to change. People take a sense of false security from that one number."

If regulatory filing statistics portend more recategorizations to "hard to value" status, there will be an awful lot of nervous pension decision-makers, deciding what to do next.

Editor's Note: Click to read a "Summary of Statement No. 157," provided by the Financial Accounting Standards Board. Wall Street Journal reporter Mark Gongloff provides a nice overview of the FAS 157 hierarchy, defining Level 3 assets as those for which inputs are not directly observable. See "A FAS 157 Primer" (November 15, 2007.)

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Mark your calendars for an exciting event about pension risk realities. Dr. Susan Mangiero, President of Pension Governance, Incorporated, will join other pension professionals for a half-day workshop entitled "Pensions at Risk: A Meeting of Fiduciary and Financial Minds." Presented by the New York Society of Security Analysts, Derivatives Committee, the event will be held in midtown Manhattan on January 21, 2009 from 8:30 am to noon.

Click to register. A description of the program is excerpted below.

<< Recent market turmoil, coupled with changes in pension funding and accounting rules, have helped produce a “perfect storm” of volatility and risk in our defined benefit pension plans. As pension investment and risk management strategies continue to evolve to meet these demands, so does the need for informed fiduciary decision-making. This program is intended to provide an up-to-date and in-depth discussion regarding the fiduciary legal and risk management considerations involved in the design and implementation of pension investment management strategy, including liability driven investing (LDI) approaches and those integrated within a framework of corporate finance. Topics will include performance benchmark development, asset/liability duration matching, timing of implementation and the use of derivatives, alternative asset classes and leverage. >>

Martin Rosenburgh, Esquire, will moderate a panel to include the following speakers:

• Nell Hennessy, President and Chief Executive Officer, Fiduciary Counselors Inc.
• Susan M. Mangiero, PhD, AIFA, AVA, CFA, FRM, President, Pension Governance, Inc
• James Moore, PhD, Executive Vice President, Pension Strategist, PIMCO
• Michael W. Peskin, CERA, Managing Director, Morgan Stanley.

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According to Hugh Wheelan ("Prince Charles to propose 'pension plan for the planet'," Responsible Investor, November 17, 2008), England's Prince Charles is working hard to save the rain forests. Since late 2007, His Royal Highness is described as actively encouraging long-term investors such as insurance companies and retirement plan sponsors to buy 15-year bonds "with competitive returns." Issued by companies that are creating "sustainable energy solutions," proceeds of the bonds would likewise be used to make developing companies less dependent on income earned by chopping down trees. The P8, a consortium of 10 (not 8) interested pension funds, is said to include the (1) Universities Superannuation Scheme (2) Dutch giant ABP (3) CalPERS and (4) CalSTRS. (See "Prince Charles lead 'P8' pensions powerhouse finalises climate change report ," Responsible Investor, July 31, 2008.)

Richard Palmer, Daily Express blogger has a different take. In "Prince Charles Wants to Raise Your Taxes to Save Rainforests" (November 4, 2008), eco-friendly investing would get a boost, courtesy of the UK taxpayers as well. Not only would wealthier countries guarantee rain forest bonds, their citizens could pay a utility tax for the alleged benefits provided by tropical jungles - "global air conditioning system, storing its largest body of freshwater and providing a livelihood for more than a billion people."

With the current market situation, one wonders if initiatives such as these will fall by the wayside, for some time, at least. Leaders of developed countries have their hands full as they try to stimulate their beleaguered economies. At the same time, funding status for more than a few pension plans worsens, leaving them with fewer monies to allocate.

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