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

In "How Creative CFOs are Funding Pension Plans with IP" (Valuation Researcher Alert, June 2011), its authors describe how some Chief Financial Officers are transferring intellectual property assets to their respective pension plans. To add up to 275 million Great British Pounds to its UK defined benefit plans, "TUI Travel PLC is utilizing a partnership arrangement, backed by its Thomson and First Choice brands."

The idea is novel as was Diageo's use of "whiskey" assets to top off its retirement plan funding status. See "Diageo pledges whiskey against pension deficit" by Cecilia Valente, Reuters, July 1, 2010.

As with any "hard to value" security, there is merit in using an independent third party appraiser who can objectively incorporate risk factors in projecting future expected cash flows associated with an intangible asset like a trademark or patent.

Increasingly, expert work with which I am involved has focused on questions about whether an illiquid instrument was properly valued. As I stated during my September 11, 2008 testimony on this topic before the ERISA Advisory Council, bad valuations and related poor policies and procedures can have a costly domino effect because valuation numbers directly impact asset allocation and risk management decisions over time, not to mention fees that are paid to service providers. This is not good news for fiduciaries who are already faced with numerous challenges, each of which puts them squarely in the spotlight of regulators and litigators who see many ERISA plans as needing to do much more in the way of best practices. In the United States, should the U.S. Department of Labor expand its definition of a fiduciary to include appraisers, it may discourage valuation professionals from working with ERISA plans. This itself could be a problem.

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According to a July 13, 2011 press release from the U.S. Department of Labor, a final regulation is now in place regarding retirement plan fee disclosures. Pursuant to ERISA Section 408(b)(2), a rule issued in interim form on July 16, 2010, will now be made permanent with an effective date of April 1, 2012. The goal is to enhance transparency about how much money is paid to pension plans by service providers.

Click here to read the official announcement. Click here to read 29 CFS Part 2550, "Reasonable Contract or Arrangement Under Section 408(b)(2) - Fee Disclosure; Interim Final Rule," issued on July 16, 2010.

Given the lawsuits on the topic of ERISA plan fees paid to service providers, it will be interesting to review disclosure results after full implementation occurs.

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As I've written many times herein, understanding transferability restrictions is a "must do" for institutional investors who allocate monies to asset managers. While a pension, endowment, foundation or family office may decide to invest part of its portfolio in illiquid securities for strategic reasons, it is still necessary to understand how to exit if necessary. In "Hedge Fund Lock Ups and Pension Inflows" (July 4, 2011), the point is made that investors who want to redeem but are barred from doing so may seek redress in a court of law. Regulators are paying close attention too.

According to recent news accounts, several Louisiana pension funds that sought to withdraw some of their money from a New York hedge fund were given promissory notes with assurances that it could get cash in several years. Moreover, it may be that the hedge fund in question has counted assets under management more than once due to a feeder fund organizational structure that boasts over a dozen smaller vehicles which cross trade with one another.

In a joint statement dated July 11, 2011, the Firefighters' Retirement System ("FRS"), New Orleans Firefighters' Retirement System and the Municipal Employees' Retirement System ("MERS") describe how attempts by FRS and MERS "to capture some of the profits that had been earned in an investment known as the FIA Leveraged Fund" initially met with resistance on the part of the fund manager to provide cash right away. Instead, the two requesting institutions were told to expect paper IOUs while certain assets were to be liquidated in an orderly manner over a period of up to two years. The statement goes on to say that the pension plans had each been promised a return of at least 12 percent per annum and that if the "collateral supporting the preferred return declines to a level that is 20% above the systems' collective account values, there is a trigger mechanism requiring a mandatory redemption of the systems' investment" with the 20% cushion" designed to protect the systems' accounts against any loss in value."

Getting a promissory note has not made for happy campers who now worry about the liquidity of the FIA fund and "the accuracy of the financial statements issued by the two renowned independent auditors." The statement goes on to say that the hedge fund manager has been apprised that the pension plans intend to "closely examine" performance records by putting together a team that consists of their board members, internal auditors and investment consultant. A forensic economist may be added to the team.

Click to read the July 11, 2011 joint statement from these Louisiana pension plans about hedge fund liquidity concerns for this particular manager.

Having just checked the SEC website, this blogger does not yet see the formal inquiry statement. Speaking from experience, complexity is never a good thing. Someone somewhere has to understand what risks might give rise to material problems. Moreover, proper due diligence of funds that invest in "hard to value" instruments has to take into account how they are modeled and who is vetting the integrity of the model numbers. Regarding organizational structures that encompass multiple money pools, it is imperative to understand who exactly has a claim to assets in a worst case situation of forced liquidation.

A few years ago, I refused to continue with a valuation engagement of a hedge fund because neither the general partner nor the master fund's attorney could adequately answer my questions about priority of claims for a complex offshore-onshore ownership structure. In several recent matters where I have served as expert witness, concerns about restrictions of transferability and collateral monitoring have taken center stage. Be reminded that in distress, book values often fall seriously short of fire sale or even orderly liquidation (auction) values.

Let's hope that questions can be cleared up in a timely fashion.

Readers may want to check out these articles:

• "S.E.C. and Pension Systems to Examine Fletcher Fund" by Peter Lattman, New York Times, July 12, 2011; and
• "Pensions Want Look Into Fund's Records" by Josh Barbanel, Steve Eder and Jean Eaglesham, Wall Street Journal, July 13, 2011.

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Since I launched my second blog in early 2011 to discuss risk management and investment best practices for a wider institutional audience beyond pension plans alone, I've seldom posted items in both places. Instead, I've tried to provide unique insights for employee benefit plan decision-makers on www.PensionRiskMatters.com and address broader regulatory, litigation and compliance issues on www.GoodRiskGovernancePays.com.

Today is an exception. I am reprinting my comments about risk management on both blogs because I believe so strongly in the importance of effective risk management as an integral component of investment governance. I hope you enjoy reading my comments, originally published on The Glass Hammer website. For those who are not familiar with the group, check out www.TheGlassHammer.com to learn about this award-winning blog and online community created for women executives in finance, law, technology and big business. See below or click on "Thought Leaders: Prioritizing Risk Management" to read the full text of this commentary about the benefits of risk mitigation well done and the costly consequences of inattention or sloppy practices.

Full Text:

Thought Leaders: Prioritizing Risk Management, July 14, 2011, 1:00 pm

Contributed by Susan Mangiero, PhD, Investment Risk Governance Consultant and Author

For those financial institutions which have yet to grasp the importance of identifying, measuring, managing, and monitoring risks on a comprehensive basis, time may not be on their side. Regulators and litigators alike are forcing change.

There are countless individuals who want better information from their service providers about risk and are prepared to vote with their feet if they don’t get good answers. After all, these institutional investors themselves are confronted with a bevy of new mandates that require transparency. The good news is that change opens the door to business opportunities. Enlightened organizations that have good processes in place and have nothing to hide can differentiate themselves from competitors. Providing clients with education and data tools offers yet another way for asset managers, consultants, banks, and advisors to forge stronger relationships with their pension, endowment, foundation and family office clients. On the flip side, those who are reluctant to explain how they manage their financial, operational and legal risks may lose clients or worse yet, could end up as defendants in a lawsuit.

Pay to play conflicts, questions about hidden fees, state and federal legislation and new accounting rules are a few of the forces at work to ensure that trillions of institutional dollars are in good hands. Effective investment stewardship is no longer a luxury. Recent surveys confirm that buy side decision-makers continue to emphasize governance and risk management for their organizations as well as providers of products and services. Institutional investors can ill afford to lose money after a tumultuous few years. Investment committee members who give short shrift to fiduciary duties could end up being investigated by regulators or sued. According to federal court data, the number of ERISA lawsuits is going up. Factor in investment arbitrations, enforcement actions and “piggyback” securities litigation allegations and it is clear that unhappy investors are not going to accept the status quo.

1. Fiduciary Focus

Besides efforts underway by the U.S. Securities and Exchange Commission (SEC), the U.S. Department of Labor (DOL) has proposed an expanded definition of who should serve as a fiduciary to ERISA employee benefit plans. If adopted, countless more professionals will be tasked with demonstrating procedural prudence when it comes to the investment of over $30 trillion in money from corporate retirement plan sponsors. States are likewise seeking change in the form of trust law reforms that tighten accountability for the investment of monies held by endowments, foundations and charities. The questions now being addressed by judges and arbitration panels relate to “excessive” risk-taking, insufficient diversification, absence of independent assessments of hard-to-value instruments and oversight failures that have led to large losses that might have been highly preventable.

One asset management firm recently settled with the SEC for $242 million over a mistake with one of its risk management models. Another firm just settled with the SEC for $200 million due to problems in the way subprime securities were marked. A few years ago, a Northeast pension plan was sanctioned by the DOL for not having thoroughly vetted valuation numbers provided by one of its hedge fund managers.

When I testified before the ERISA Advisory Council in 2008, I emphasized that having good valuation policies and procedures is essential because it impacts so many decisions having to do with asset allocation, hedging and fees paid.

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In "Shock of Gray: The Aging of the World's Population and How it Pits Young Against Old, Child Against Parent, Worker Against Boss, Company Against Rival, and Nation Against Nation," Ted C. Fishman states that "when a society does not have enough young people, it is forced to change, often in surprising ways." He explains that in forty years, the number of centenarians will exceed three million persons versus 182,000 persons who were older than 100 years in 2000. Moreover, family size is shrinking in many countries at the same time that relatives are geographically dispersed.

Drawing on trends in countries that include China, Japan, Spain and the United States, this best-selling author suggests that businesses and individuals will confront unprecedented challenges as relates to both economics and politics. For one thing, numerous companies jettison older employees (perhaps by offering early retirement) at the same time that having them work more years can be a societal plus (versus having younger workers pay higher taxes to fund programs for a larger and fast-growing cohort of seniors). Second, aging and globalization go hand in hand with lower cost immigrant workers representing a bigger proportion of senior caregivers. Third, if unemployment rates continue to plague youth around the world, economic pressures will disproportionately hit those who are working.

This blogger has long commented on the radically changing demographics in the United States and elsewhere. As with any crisis, innovators tend to rise to the challenge of providing solutions for profit. Already, entire industries such as travel, health care and financial services are segmenting targets by age. However, not surprisingly, those with means have the greatest appeal as potential customers. That means that those less endowed could end up fighting for a smaller sliver of available public goods, especially as nations decide how best to deal with mounting national debts by scaling back on safety net outlays.

Fishman offers that age may be less a chronological phenomenon and more a situation where one should be better categorized by his or her dependency on others. With nearly 80 million people turning 65 this year in the USA, understanding the economic and sociopolitical dimensions of aging is paramount.

Click to view a 9:05 minute video entitled "U.S. Faces 'Explosion of Senior Citizens': Will Baby Boomers Strain Economy?" (January 3, 2011). In this interview by PBS News Hour anchor Judy Woodruff, Dr. Nicholas Eberstadt (with the American Enterprise Institute) and Ted Fishman talk about runaway entitlement spending such as Medicare that must be addressed. One stated solution to the aging crisis is for people to work longer, something that is plausible, especially for those with education who can contribute to a service sector with ease. Staying healthy and saving as much as possible are two other solutions put forth by the interviewees.

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On June 29, 2011, the Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Board of Governors of the Federal Reserve System and the Office of Thrift Supervision issued its latest thinking on derivatives trading by banks. "Interagency Supervisory Guidance on Counterparty Credit Risk Management" considers the role of senior management, methods to measure risk, ways to manage risk and model validation.

Given the increasing number of institutional investors that deploy derivatives - directly or indirectly via third party organizations - for return enhancement or risk minimization purposes, this twenty-six page document is worth a read. Anything that impacts the costs of major derivatives dealers is likely to have a trickle down impact on pensions, endowments, foundations and family offices.

The list below offers a preview of takeaways from the regulators' perspective.

• Assessment of counterparty credit risk models should reflect their "conceptual soundness," along with "an ongoing monitoring process that includes verification of processes and benchmarking; and an outcomes-analysis process that includes backtesting."
• Develop a comprehensive process surrounding bank monitoring of collateral.
• Discuss how to control "wrong-way risk" which occurs "when the exposure to a particular counterparty is positively correlated with the probability of default of the counterparty itself."
• Banks need to regularly measure the "largest counterparty-level impacts across portfolios, material concentrations within segments of a portfolio (such as industries or regions), and relevant portfolio-and counterparty-specific trends."

Pension fund investment committee members can use the guide to draft or add to an existing questionnaire for interviews they conduct with their asset managers, banks and consultants.

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As this blogger, Dr. Susan Mangiero, has pointed out repeatedly since the March 2006 inception of www.PensionRiskMatters.com, pension governance counts.

There are numerous ways to quantify the positive impact of governance done well. By extension, the costs of poor pension governance can throw cold water on growth in corprorate earnings and free cash flow. As a result, not only can plan participants suffer but so too can shareholders and creditors should bad employee benefit plan decision-making depress the value of company issued securities.

In a recently issued survey, Towers Watson finds that four out of ten employers "expect to devote more time addressing retirement plan governance issues over the next two years." Reasons cited include the expense of providing benefits, along with more regulatory complexity. Investment volatility was another identified catalyst.

While the in-depth study is not yet published by its sponsor, Towers Watson, it will be interesting to explore later on why more than half of respondents acknowledge the importance of compliance but "only one in four (26%) schedule regular compliance reviews."

Visit www.towerswatson.com/governance-survey for more information.

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Various sources tout increasing inflows to hedge funds from public and corporate pension plans.

In "Strong start to hedge fund activity in 2011" (April 1, 2011), Pensions & Investments reporter Christine Williamson writes that "First-quarter institutional hedge fund activity, including net inflows and pending searches, totaled $18 billion - the highest since the intense investment pace of the first quarter 2007, which saw $25 billion in activity." James Armstrong of Traders Magazine describes the billions of dollars going to hedge funds in recent months as a catalyst to "increased trading volumes for the equities trading business." See "Hedge Funds Could Juice Volume" (June 2011). Imogen Rose-Smith of Institutional Investor gives readers a detailed look at the love affair with hedge funds in "Timeline 2000-2011: Public Pensions Invest in Hedge Funds" (June 20, 2011).

Fortune writer Katie Benner says "wait a minute" to what seems to be an upward trajectory in retirement plan allocations to hedge funds with a 51% increase since 2007 and a doubling of the mean allocation to 6.6% (according to a study by Preqin). In "Hedge fund returns won't save public pensions" (March 30, 2011), she cites willful underfunding and a "mish-mash of accounting tricks" as fundamental problems that will not be corrected with more money in alternatives.

In her May 16, 2011 article for Pensions & Investments and entitled "Promises, promises: $100 billion still locked up," Christine Williamson writes that assurances made to institutional investors in 2008 and 2009 about redemptions are not being met by some hedge fund managers. At that time, jittery pension funds, endowments and foundations that wanted out were asked to be patient rather than force hedge funds to unwind hard to value positions at sub-par prices. Quoting Geoff Varga, a senior executive with Kinetic Partners US LLP, a consultancy for asset management firms, there is an estimated $100 billion in "exotic" or non-standard investments that were stuffed into "emergency side pockets." He adds that it is hard to come up with an exact number, especially since managers' valuations of these illiquid positions are not always realistic.

Certainly the issue of side pockets is unlikely to go away any time soon. On October 19, 2010, Emily Chasan reported that the U.S. Securities and Exchange Commission ("SEC") had filed a civil complaint against several hedge fund managers for overvaluing illiquid assets. See "SEC charges hedge fund of inflating 'side pockets'" (Reuters). Click here to read the SEC complaint and October 19, 2010 press release from the SEC. On March 1, 2011, Azam Ahmed with the New York Times Deal Dook described another case in "Manager Accused of Putting $12 Million in Side Pockets."

This blogger, Dr. Susan Mangiero, has written extensively on the topic of hard to value investments and liquidity and served as expert witness on cases involving due diligence allegations. Acknowledging that not all hedge funds invest in hard to value instruments, the following items may be of interest to readers:

• "Financial Model Mistakes Can Cost Millions of Dollars" by Susan Mangiero, Expert Witnesses, Volume 7, Number 1, Spring/Summer 2011, American Bar Association
• "Critical Issues for Hedge Funds: Special Report - The State of Valuation," Interview With Susan Mangiero, Securities Industry News, 2007
• "Hedge Fund Valuation: What Pension Fiduciaries Need to Know" by Susan Mangiero, Journal of Compensation and Benefits, July/August 2006 (Note that BVA, LLC now does business as Fiduciary Leadership, LLC.)
• "Model Risk and Valuation" by Susan Mangiero, Valuation Strategies, March/April 2003.

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As many Americans celebrate the Fourth of July with sparklers and picnics, it is notable that public pension plans in the United States are undergoing radical changes. From their original inception as rewards for civil servants and military personnel, retirement plans are often now seen as costly drains on municipal and state coffers.

A few days ago, the Atlanta City Council voted unanimously to reform its pension plan and thereby "generate $22 million to $30 million in savings over the next 10 years and $500 million over the next 30 years."

Jurists in Colorado and Minnesota recently said "no" to public retirees who sued to reinstate reduced benefits on the basis of alleged contractual guarantees.

While Monday is an official day off for many individuals, it's back to work on Tuesday July 5 with continued debates in town halls throughout the nation (and abroad) about employee benefit plans.

Related Links For Readers:

• A History of Public Sector Pensions in the United States by Robert Louis Clark, Lee A. Craig, and Jack W. Wilson, University of Pennsylvania, March 2003;
• "Atlanta City Council Approves Pension Reform," WSBTV.com, June 29, 2011;
• "Gary R. Justus et al v. State of Colorado...," June 29, 2011;
• "Howard Swanson et al vs. State of Minnesota..." March 22, 2011; and
• "Two Rulings Find Cuts in Public Pensions Permissible" by Mary Williams Walsh, New York Times, June 30, 2011.

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According to "Washington Mutual settles class-action suit for $208.5 million," Associated Press, July 1, 2011, pension plans that include the Ontario Teachers' Pension Plan Board (as lead) will benefit as shareholders of the failed bank (if and once the Bankruptcy Court approves the terms).

On a related note, Judge Mary F. Walrath of the U.S. Bankruptcy Court for the District of Delaware tells certain Washington Mutual ("WaMu") employees that they are "entitled only to general unsecured claims because they do not have a right to the funds that is superior to the rights of the other general unsecured creditors." She added that "Because the plans were unfunded, and the funds were identified as property of WaMu," it was not possible to "impose a constructive trust because the money allegedly owed to the participants can no longer be clearly traced to funds or property in their possession." See "WaMu wins bankruptcy fight over employee retirement funds," Thomson Reuters News & Insight, June 20, 2011.

The two articles caught this blogger's attention as a timely example that financial distress can impact multiple constituencies in completely different ways.

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Alternative fund managers and regulators will convene in Washington, D.C. from July 19 through 21, 2011 to talk about pension investing in hedge funds and private equity funds. Over several days, those who present before the ERISA Advisory Council will be asked to address questions such as those listed below:

• What differentiates a hedge fund from other types of investments?
• What differentiates a private equity fund from other types of investments?
• How are hedge funds and private equity funds, respectively, correlated with the returns of traditional equity and fixed income investments?
• How can defined benefit and defined contribution plan sponsors mitigate "the lack of liquidity that is characteristic of these investments?"
• How can fee transparency be enhanced?
• "Are there any unique diversification benefits offered by hedge funds and private equity investments as opposed to a fund of funds?"
• What is the view of target date fund managers with respect to including hedge funds and/or private equity strategies within their funds?

According to U.S. Department of Labor documents, the aim is to create best practices guidance in areas such as leverage, liquidity, transparency. valuation, operational due diligence, client and asset concentration and offering documents. Click to download "2011 ERISA Advisory Council: Hedge Funds and Private Equity Investments." Click to read the June 22, 2011 U.S. Department of Labor news release about the forthcoming meetings to address hedge funds and private equity investments by ERISA plans.

Interested readers may want to check out the following of many items that are available for further research:

• "Testimony of Dr. Susan Mangiero About 'Hard to Value' Assets Before the ERISA Advisory Council," September 11, 2008;
• "The Growth and Impact of Direct Investing," Citi Prime Finance, June 2011;
• "Pension Fund Investment in Hedge Funds" by F. Stewart, OECD Working Papers on Insurance and Private Equity Pensions, No. 12, OECD Publishing, 2007;
• "Defined Benefit Pension Plans: Plans Face Valuation and Other Challenges When Investing in Hedge Funds and Private Equity Funds," U.S. Government Accountability Office, July 20, 2010;
• "A Guide to Institutional Investors' Views and Preferences Regarding Hedge Fund Operational Infrastructures," Alternative Investment Management Association, May 2011;
• "The Hedge Fund of Tomorrow: Building an Enduring Firm," Casey Quirk, April 2009;
• "Pensions and private equity: where does the relationship go from here?" by Toby Lewis, Global Pensions, June 6, 2011; and
• "Private Equity Principles, Version 2.0," Institutional Limited Partners Association, January 2011.

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Congratulations to Tom Hanks for his rendition of what a tough economy looks like for more than a few individuals. While his newest film falls short of legendary, it is an entertaining reminder that every day presents a second chance if one is open to Phase Two.

Playing a Navy veteran who gets downsized for lack of a college education, Hank's character Larry Crowne gets the idea of going back to school. With none other than Julia Roberts as his burnt out speech teacher who comes to life as her students progress, the movie's protagonist keeps his cool and sunny disposition as he navigates homework, financial distress and the uncertainty of a different tomorrow than what he originally planned.

I like the central message, however Hollywood it may seem.

It is always nice to think that the next day brings about renewal, excitement, satisfaction and maybe even a bit of fun.

Given current demographic patterns, a large number of individuals are working longer and living well past age 65. A cheery attitude (and hopefully the gift of good health too) are the stuff of fortunes.

Career consultant and transition coach Donna Bradshaw offers some unique advice. "Don't actually retire. Stay in shape. Take up a cause." Check out her top ten list by visiting "Making the Most of Retirement" (May 19, 2011).

On a practical note, check out "Special Report: Making the Most of Retirement" by Janet Novack, Forbes.com, September 15, 2010 for comments about savings and geographically desirable places to live after a certain age.

Charles Dickens describes Father Time as one who "often lays his hand lightly upon those who have used him well; making them old men and women inexorably enough, but leaving their hearts and spirits young and in full vigour. With such people the grey head is but the impression of the old fellow's hand in giving them his blessing, and every wrinkle but a notch in the quiet calendar of a well-spent life."

Words to live by and savor...

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