Pension Risk Matters

David Oakley reports the imminent launch of a U.S. commercial property derivatives market trading platform as early as this week. (See "Property derivatives poised for US launch", Financial Times, March 5, 2007.) Estimated at $26 trillion in value, Oakley writes that "property is one of the few major asset classes without a developed derivatives market in the U.S."

Four banks have signed with the National Council of Real Estate Investment Fiduciaries to license their index data for three years - Bank of America, Credit Suisse, Goldman Sachs, and Merrill Lynch. Click here to read the NCREIF press release.

This type of financial instrument has already taken hold in the UK with a property derivatives market that has grown to nearly $10 billion in the two years since inception. No surprise then that US banks will plan to follow suit, especially with respect to the use of good data (cited as a driving factor behind the UK experience).

Note that the NCREIF Property Index (NPI) is self-described as "a unique property valuation and performance metric. It is the largest, oldest, and most recognized measure of institutional quality, privately owned commercial real estate in the U.S. The benchmark represents (as of Fourth Quarter 2006) marked-to-market valuations on 5333 U.S. properties reported quarterly by a large number of institutional owners and fiduciaries. It has a total market value of $247 billion. The NPI includes sub-indices by property type, and location."

Structured as a type of interest rate swap, one counterparty receives a cash flow tied to real estate market performance. A second counterparty receives a variable rate-driven cash flow every few months, tied to LIBOR (London Interbank Offered Rate).

For a pension fund unable to buy property and/or allocate monies to a real estate investment trust or real estate private equity fund, this new derivative may be a good workaround. Suitability will depend of course on many factors such as terms specific to the derivative instrument contract, what the plan is seeking to achieve and whether exposure to real estate makes sense.

The Baltimore Sun reports continued good performance as recently as two months ago. (See "Commercial real estate funds continue to thrive" by Andrew Leckey, originally published January 7, 2007.) On the other hand, valuation and liquidity must be taken into account. Future expected risk-adjusted returns and correlation patterns with other assets are similarly important.

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In case you missed it, Citizens Against Government Waste (CAGW) released their 2007 Pig Book on March 7. Reminding us all that insane spending of tax dollars DOES occur, a companion report rightly points out that waste likewise diminishes the competitiveness of the U.S. marketplace. Given the work of the Paulson Committee and other advocates of deregulation, excessive outlays should make news beyond CSPAN.

CAGW president Tom Schatz applauded some restraint but urged lawmakers to keep tightening their belts before spending other people's money. Here are a few of the goodies he cites as part of the "2,658 pork projects at a cost of $13.2 billion" included in the Defense and Homeland Security Appropriations Acts for fiscal 2007.

1. $1,190,000,000 for full funding of 20 F-22A fighter jets, which the Government Accountability Office criticized as unnecessary and out of date;

2. $5,500,000 for the Gallo Center to study the effects of alcohol and drug abuse on the brain;

3. $1,650,000 to improve the shelf life of vegetables;

4. $1,350,000 for the Obesity in the Military Research Program; and

5. $1,000,000 for a telescope searching for extra-terrestrial intelligence. >>

Click here to download the 2007 Pig Book in its entirety. As you read, don't forget the words of British historian Lord Acton - "Power tends to corrupt; absolute power corrupts absolutely."

At a time when programs like Social Security and Medicare represent behemoth unfunded liabilities to taxpayers (not to mention more than a few state and municipal pension and health care programs), do we really need a space alien telescope or vegetable research? Decide for yourself next election cycle.

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Before I realized the importance of being a fiduciary, work was fun. I have a fondness for the good old days when I had more financial freedom. That was before the failure of our high risk portfolio. What folly! Now the lawyers tell me our strategy is not a good fit, our process is feeble and breach may be a felony with personal liability not far behind. I wish I could flee! >>

Perhaps a bit too gimmicky, my goal was to get the audience to think about the ultimate F word - FIDUCIARY - and the related consequences associated with a job poorly done. My contention? We're all risk managers now.

Think about what's happened in the last few days. Volatility is up. Assets that typically move inversely with one another are moving in the same direction - down, more than a few investors are liquidating positions to meet margin calls, credit problems are rearing their ugly head in the form of sub-prime loan losses and there is overall nervousness about how risk is priced.

Is this the tipping point that compels pension fiduciaries to examine their risk management policies and procedures - and those of their appointed money managers - or do they instead shrug off bad times as short-term and likely to reverse? If not market turbulence, what will get fiduciaries to focus on risk-adjusted return in a more meaningful way?

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Former U.S. Senator Alan Simpson is said to have claimed "If you have integrity, nothing else matters. If you don't have integrity, nothing else matters."

After reading the SEC's March 1 press release about insider trading, these words ring loud and clear.

If you haven't seen it yet, click here for details about charges against fourteen individuals "in connection with two related insider trading schemes in which Wall Street professionals serially traded on material, nonpublic information tipped, in exchange for cash kickbacks."

Efficient markets are crucial for the pension funds which invest over $10 trillion in global assets. Trust, integrity and internal controls are the lifeblood of a system that works.

If there is a silver lining attached to these allegations, it is to remind fiduciaries of the importance of a due diligence process that goes beyond financial risk management. Credit checks, questions about oversight of traders and continued verification of trades are just the beginning.

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According to David Hammerstein of Yanni Partners, ("Fewer Second Chances For Failed Fundies" - Hedge Fund Daily, February 27, 2007), "There is an extra standard of caution and care that has to be demonstrated among institutional investors" when it comes to giving failed hedge funds another chance. Noting the significant amount of pension dollars going into alternatives, Hammerstein emphasizes the need to assess risk controls.

He's not alone. Next week, I will join other speakers at the 23rd Annual Risk Management Conference to wax and wane about all sorts of investment-related risks. Hosted by the Chicago Board Options Exchange, Chicago Board of Trade, Chicago Mercantile Exchange and OneChicago LLC, the conference brings together a variety of researchers, investors and consultants.

My presentation is entitled "What Every Institutional Investor Fiduciary Must Know About Derivatives" and will cover investment fiduciary practices related to risk control. (Click here to view the agenda.

Can the risk lion be tamed?

Absolutely - but only if one is willing to open the cage door and acknowledge its presence!

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On February 22, 2007, the President's Working Group on Financial Markets (PWG) released a set of principles and guidelines concerning "private pools of capital, including hedge funds." In concert with various U.S. agencies, the PWG report urges investors, creditors, counterparties, pool managers and supervisors to identify and understand fund-specific risks or walk away.

For fiduciaries, the guidelines (some of which are excerpted below) are clear. Individuals who are unable to demonstrate that a rigorous investigation of risk has taken place, BEFORE investing, put themselves in the line of fire with respect to personal and professional liability.

<< 1. Fiduciaries should consider the suitability of an investment in a private pool within the context of the overall portfolio and in light of the investment objectives and risk tolerances.

2. Fiduciary evaluation should include the investment objectives, strategies, risks, fees, liquidity, performance history, and other relevant characteristics of a private pool.

3. Fiduciaries should evaluate the pool’s manager and personnel, including background, experience, and disciplinary history. Fiduciaries also should assess the pool’s service providers and evaluate their independence from the pool’s managers.

4. Fiduciaries should consider the private pool’s manager’s conflicts-of-interest and whether the manager has appropriate controls in place to manage those conflicts.

5. Fiduciaries should conduct the appropriate due diligence regarding valuation methodology and performance calculation processes and business and operational risk management systems employed by a private pool, including the extent of independent audit evaluation of such processes and systems. >>

It will be interesting to watch what happens. Will some pension decision-makers forego investing in alternatives because the risks are considered too difficult to understand, let alone accept? Who will embrace the challenge and recognize the reality that risk management is an integral part of investment management? You simply cannot select funds without understanding how managers address financial and operational risk. When a fund invests in less liquid and/or complex instruments, the plot thickens.

Click here to read Agreement Among PWG and U.S. Agency Principals on Principles and Guidelines Regarding Private Pools of Capital.

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February 18, 2007 marks the Chinese New Year (the Year of the Boar). Also known as the Spring Festival or Lunar New Year, it is the "most important of the traditional Chinese holidays." Interestingly, Chinese New Year's Eve is known as the eve of change and indeed, China is on the verge of significant change.

According to a new study, co-authored by Reuters and KMPG, the demographics are compelling. "By 2050 the number of people aged 60 or over is expected to rise to more than 430 million, or 31 percent of the population, from just 147.8 million, or 11 percent today. This would put it well above the projected world average. More worryingly, the percentage of China’s population that is working is expected to peak in 2010, with the ratio of workers to retirees declining from six to one in 2000 to two to one by 2040." Click here for a copy of the study.

"The heavenly mandate: Winning a piece of China’s pensions market" describes a 401(k) look-alike known as enterprise annuities. Fixed fees and a local investment requirement are two notable features. Asset allocation constraints are another. Equity investments are limited to no more than 30 percent of assets under management, 20 percent in money market instruments, and up to one half to be invested in fixed-income securities "but at least 20 percent must be kept in government bonds."

Asset allocation is touted by many experts as THE most important of all investment decisions, leading one to ponder. Will an arguably "conservative" mix require yet additional change? People can't pay bills with rates of returns and depend instead on having sufficient cash on hand. What happens if (when) people come up short?

From the "glass is half full" camp, reform comes none too soon. As an anonymous Chinese sage suggests: "Do not fear going forward slowly; fear only to stand still."

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How do we need you? Let us count the ways.
We need you from the depth and breadth and height
Our portfolio statements will allow
We need you to the level of everyday's
Most urgent wants, for food and shelter

With apologies to Elizabeth Barrett Browning, it's true that pension fiduciaries often stand between a comfortable retirement and a financial struggle. Their job, if done properly, can make a real difference in the lives of individuals, still working or now retired.

This blog primarily addresses pension financial risk issues from a fiduciary perspective. Yet we've received more than a few emails from persons seeking assistance to recover lost or diminished pensions. Descriptions of tough economic times are poignant. They serve as a constant reminder that what pension fiduciaries decide has consequences.

Happy Valentine's Day!

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If you don't have a stress ball on your desk, now might be the time to splurge. Pension fiduciaries have a lot on their plate and it seems that every day brings new challenges, operational risk management included. According to a recent Advanced Micro Devices (AMD) white paper, written in conjunction with Toomre Capital Markets, "internal processes, people and systems periodically fail" and could possibly threaten a firm's survival. The authors describe "fat finger loss" wherein "incorrect keys were pressed with no malicious intent" to illustrate the importance of controls. Being able to catch data errors before they get out of hand is the lifeblood of a well-run organization.

Rogue trading likewise illustrates operations-related vulnerability. Think back ten years. Barings Bank, a venerable global financial institution, was literally driven out of business due to the actions of a single derivatives trader. Where was the proper oversight? It's an amazing story that some still find hard to believe.

I saw this firsthand while getting my Ph.D. and teaching finance. Not a fan of showing videos in class, I made an exception for the risk management students and asked them to view the HBO movie about Barings. At the end of the film, you could hear a pin drop. Finally, a student asked if I thought such a debacle could occur again. My response? Absolutely. Any time people are part of the process (and they always are), there is room for error. That's why effective operational risk management policies and procedures are so important.

Click here to read the AMD paper. It includes a nice summary of "Ten Sound Practices for the Management and Supervision of Operational Risk" as provided by the Bank for International Settlements (BIS). Click here to access the full version of the BIS document.

Technology is a critical component of operational risk. Without the ability to capture and analyze data, it is virtually impossible to create and monitor limits, check for odd exposures or even detect fraud. Even with a good system, it is far from easy.

Interested readers can click here to read "The Five Keys to Risk and Risk Management" or read the several chapters in my book about operational risk, technology and modeling.

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According to reporter and financial professional Julie Fishman-Lapin, Connecticut could soon become less hedge-fund friendly if state legislators have their way.
In " State readies for a debate on regulation..." (Greenwich Times, February 9, 2007), Fishman-Lapin describes an initiative by Fairfield County Republican John E. Stripp that, if passed, would "require Connecticut-based hedge funds that receive more than $10 million from a pension fund to report the investment to the state banking commissioner within 30 days. The disclosure would include the name of the pension fund, the beneficiary organization and the address of the fund manager." Click here to read Proposed H.B. No. 5102, Session Year 2007 - An Act Concerning Hedge Fund Activity With Respect To Pension Funds.

Democratic state senator Bob Duff cites hedge fund disclosure requirements as part of his overall intent to focus on consumer protection. He will soon introduce a bill that likewise emphasizes disclosure. Click here to read his January 25, 2007 press release.

On December 5, 2006, addressing the U.S. Senate Committee on the Judiciary, CT Attorney General Richard Blumenthal urged federal regulators to increase penalties for fraud, raise the amount of money to qualify investors and adopt federal standards before states take matters into their own hands. Click here to read his remarks. Blumenthal is walking the walk, having formed the Hedge Fund Task Force last fall. The goal? To improve things and hopefully avoid an expensive Amaranth-type meltdown. (See "Hedge hunting season in Connecticut - In the wake of the Amaranth disaster, Connecticut Attorney General Richard Blumenthal seeks to reform the hedge fund industry" by Ellen Florian Kratz, Fortune, October 4, 2006.)

There is so much to write about the hedge fund - pension fund nexus. We will continue to focus on this important topic area. Until then, and in case you missed them, here are a few links to prior blog posts about hedge funds, along with links to some articles about hedge fund risk management and valuation.

Hedge Fund Notables for Pension Investors (December 29, 2006)

Hedge Fund Disclosure - Round Three (November 12, 2006)

Will Private Equity Stay Private? U.S. Dept. of Justice Makes Inquiries (November 5, 2006)

Pensions, Hedge Funds and Disclosure (October 27, 2006)

Legislative Matchmaker: Hedge Funds and ERISA (August 1, 2006)

Survey Shows That Institutional Investors Are Worried (July 28, 2006)

Will Hedge Funds Displace Pension Plans in Court? (July 9, 2006)

Hedge Fund Valuation: What Pension Fiduciaries Need to Know (Journal of Compensation and Benefits - July/August 2006)

Do You Know the True Cost of Your Retirement Plan? (May 14, 2006)

Hedge Fund Basics: Risk, Return and Reality (Family Foundation Advisor - January/February 2005)

Hedge Fund Imperatives (Hedge Fund Manager - December 2004)

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You can probably never start saving soon enough for retirement. Estimated longer lifespans and competition for scarce disposable dollars are critical factors. Making matters worse, countless "Career Builders," fresh from college, are deep in debt. According to the American Association of State Colleges and Universities, "the average borrower graduating from a public college owes $17,250 in debt" while "one in four finishes school owing at least $22,822. Particularly worrisome is that the number of college graduates with at least $40,000 in student loan debt has increased 10-fold in the past decade." The problem is worse for those who do not earn a degree.

For financial advisors, the challenge is significant. Busy with work and families, how do you get the attention of 25 to 34 year olds?

Enter the American Institute of Certified Public Accountants (AICPA)and state-level CPA societies. In partnership with the Ad Council, they have created a new website called Feed the Pig™, replete with videos that convey the importance of thrift. The main character, Benajmin Bankes, even has his own My Space page.

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In a pension jam? Think tontines, not saltines, according to a newly published article about what to do as the benefits landscape quickly changes. Defined as a type of investment pool, tontines pay dividends only to survivors. Similar to an annuity "in that it provides a life income to a participant," a tontine could help millions of individuals who want retirement security without too much involvement (selecting and managing investments, forecasting post-employment spending and so on).

According to Ralph Goldsticker, author of "A Mutual Fund to Yield Annuity-Like Benefits" (Financial Analysts Journal, January/February 2007), making modern versions of the tontine a reality comes in the knick of time. Hundreds of companies are jettisoning traditional defined benefit plans as fast as you can say "senior citizen."

One version - a mutual fund/tontine hybrid - has the advantage of arguably lower default risk in contrast to a purchased annuity. Upon creation of an age- and gender-specific mutual fund/tontine structure, contributed monies are invested in a "diversified portfolio of high-grade fixed-income securities." A downside is the fact that heirs do not participate, forcing breadwinners to think about financial planning on a family-wide basis (not a bad thing to do anyhow).

Allegedly the brainchild of banker Lorenzo de Tonti, this 350-year old invention may deserve a fresh look.

Editor's Note:
Thanks to Hank Stern, Life Underwriter Training Council Fellow (LUTCF) and contributor to InsureBlog, for alerting me to the news about tontines. Winner of the 2005 Weblog Award, InsureBlog focuses on life and health insurance issues, with an emphasis on Consumer Driven Health Care.

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If you think means testing of benefits is well, mean, then get ready to defend yourself, if you can. In the just released, long-awaited "best seller", Budget of the United States Government-Fiscal Year 2008, President Bush lays out his plan to tax the wealthy. Click here to download all or part of the budget.

According to Financial Times reporters Caroline Daniel and Krishna Guha ("Bush wants to means-test middle-class benefits," February 5, 2007), the $2.9 trillion budget "represents a challenge to parts of the system of entitlements enacted as part of the Great Society agenda of the 1960s."

Key questions arise, some of which are listed below.

1. What constitutes "wealthy" and how often will the definition change?

2. How will wealth be measured for purposes of means testing? Income? Property? Private Benefits? Gross? Net? Nominal? Real? Adjusted by Geographic Region or Household Size?

3. Is means testing really fair?

4. Would privatization of federal benefits empower more people financially by changing incentives to save?

5. What is the likely economic impact of means testing?

6. How will companies and municipalities be adversely affected by means testing of Social Security and Medicare or will they gain?

What a field day for the economists and politicians!

Editor's Note:
Check out the online U.S. debt clock. Hit the refresh button a few times for a real scare as estimated indebtedness increases by large amounts within a matter of seconds.

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Alleging questionable stock option practices at technology giant Apple Inc, the New York City Employees' Retirement System ("NYCERS") will serve as lead plaintiff in a lawsuit filed a few months ago. Citing the Private Securities Litigation Reform Act of 1995 ("PSLRA"), NYCERS claims the largest financial interest in the lawsuit. (Click here to read the original filing and here to read "Recent Developments Under the PSLRA.")

According to Reuters (January 22, 2007), the NY fund's ownership stake is roughly one million shares or about $87 million in current value terms. Its 2006 Comprehensive Annual Financial Report shows $46.34177 billion as plan net assets as of June 30, 2006. While NYCERS equity exposure to Apple is large in absolute terms, it is small compared to the equity interests held by institutional investors such as Fidelity Management & Research (60,316,011 shares as of September 30, 2006) or AllianceBernstein L.P. (48,637,731 shares in second place). Click here to review ownership statistics, courtesy of Thomson Financial (and reprinted by the Wall Street Journal.)

The intent of this post is not to single out any one company nor to imply that the filing of a complaint supports any or all of the allegations. That's for the trier of fact to determine. What is important is to understand that executive compensation practices can (and often do) impact shareholder value. If the market interprets a particular practice as far removed from economic reality and/or regulators start sniffing around, defined benefit and defined contribution participants stand to lose a bundle. In order to reduce the likelihood of an adverse outcome due to investing in company stock, pension fiduciaries must carefully consider relevant risk factors. That includes the percentage of company stock already part of a particular plan (whether self-directed or not). See "Options, Pensions and the SEC" for additional comments about backdating and pension fiduciary duty.

With more than 120 companies being asked questions about their respective option practices, there is surely much more to say on this topic!

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It's hard to pick up a newspaper these days without reading some story about stock options - when they are granted, how often they are repriced, what portion of an executive's total compensation they represent and so on. What has authorities particularly busy is a fast-expanding review of practices such as option backdating and spring loading. As of December 31, 2006, the Wall Street Journal counts 120 companies on their option backdate list. Click here to view the options scorecard and learn about executive departures and various regulatory agency investigations.

The Free Dictionary defines backdating as "dating any document by a date earlier than the one on which the document was originally drawn up." Spring loading can mean either that "a company purposely schedules an option grant ahead of expected good news or delays it until after it discloses business setbacks likely to send shares lower." See "SEC eyes 'springloading'" as published by the New York State Society of Certified Public Accountants. In both cases, the idea is to inflate the value of the executive's stock option. (Experts remind that neither backdating nor spring loading is necessarily illegal per se, a conclusion that is best left to attorneys and regulators.)

These and other practices are important to pension fiduciaries and plan participants alike. Defined benefit plans sometimes invest in company stock. Defined contribution plan participants are often given a similar choice. Any problems with option grants, especially when they result in tax and/or accounting penalties, not to mention regulatory enforcement levies or litigation payouts, can do serious harm to an employee's retirement plan. From a fiduciary perspective, real questions could arise about the ex-ante assessment of company stock as a viable investment vehicle for a sponsored plan(s). Did an adequate due diligence review of risk factors that influence company stock price occur? Did pension fiduciaries sufficiently understand existing practices regarding executive compensation, including option awards? How often did pension fiduciaries assess option grant practices and/or inquire about industry norms, internal controls and likely impact on "shareholder" retirement plan participants?

For interested readers, the D&O Diary, authored by attorney Kevin LaCroix, has an excellent collection of articles about option backdating.

Option valuation is another topic with considerable import. Relatively new accounting rules in the form of FAS 123R set the stage for a vigorous debate about how to value employee and executive stock options (ESO's). Unlike shorter-term options that actively trade in ready markets, ESO's are more challenging to value for a host of reasons. Though a bit outdated with respect to regulations, readers may nevertheless find my article about option valuation of interest because it highlights the importance of having good inputs and an appropriate model. (Click here to read "Model Risk and Valuation," Valuation Strategies, March/April 2003.)

In a recent decision, the SEC notified Zions Bancorporation that its Employee Stock Option Appreciation Rights Securities (ESOARS) is "sufficiently designed to be used as a market-based approach for valuing employee stock option grants for accounting purposes under Financial Accounting Standards (FAS) No. 123R." According to Zion's press release, it is their intent to assist other public companies in valuing ESOs. I took a quick look at their site and plan to read more. Certainly a mechanism that facilitates marketability is a step in the right direction. After all, the coming together of willing buyers and sellers, under ideal circumstances, permits a flow of information that should result in the "right" price.

Editor's Note:
I am currently writing an article about option backdating as it relates to pension fiduciaries.

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No more cream for fat cats if Congress gets its way. According to Financial Times journalists, Francesco Guerrera and Eoin Callan, the U.S. Senate votes this Tuesday to curb tax breaks tied to executive retirements. (See "Retirement tax will hit US executives - January 29, 2007). They write: "Under the new regime, executives would be allowed to defer up to $1m a year or the average of the previous five years' taxable salary, whichever is lower. Any sum above that would incur taxes and a 20 per cent penalty."

I could not find any details posted yet to the U.S. Senate Finance Committee website but I'll scour C-SPAN tomorrow for the exciting showdown.

The real shame is that, once again, we have a "one size fits all solution" that does not differentiate between "excessive" compensation arrangements and what's required to attract and retain leadership talent. Ben & Jerry's earlier use of a salary cap made it difficult to lure a CEO to Vermont, despite the promise of an unlimited supply of Chunky Monkey and Cherry Garcia (the low-fat version being my personal favorite). Ditto for other companies that did not heed the supply-demand dynamics of a competitive marketplace. (Click here to read "Putting a Ceiling on Pay: No Whole Foods executive can earn cash pay of more than 14 times what its average worker makes. Will other companies follow?" by Andrew Blackman, Wall Street Journal - April 12, 2004).

By extension, if deferred compensation at a certain level facilitates the hiring of a skilled CEO, why should it be discouraged? Shareholders may save money in the short-run but lose in the long-run. This could include 401(k) and defined benefit plan participants whose fortunes rise or fall with the price of company stock.

This story has legs, especially now that many experts predict a return to populism and a move against "mean, greedy executives."

Editor's Notes:

1. The topic of optimal executive compensation is broad and complex. However, there is real merit in letting companies self-police AS LONG AS shareholder stewards do what they are supposed to do. Be vigilant. Ask questions. Exercise proper fiduciary oversight.

2. Click here if you want to read last week's blog post about the proposed taxation of health care benefits.

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In response to a request from the United Brotherhood of Carpenters and Joiners of America, American Express Co. is slicing retirement benefits for top executives by more than ten percent. According to Wall Street Journal reporter Robin Sidel, the changes "come amid shareholder criticism over supplemental executive retirement plans, or SERPS, that award big pay packages to departing executives." (See "Top Executives at American Express Will See Retirement Benefits Shrink" - January 27-28, 2007).

This is not the first time that unions have taken an activist stance nor will it likely be the last. Check out the long list of Annual Group Meeting (AGM) resolutions brought by union pension plans, courtesy of Ms. Jackie Cook, a researcher on director interlocks and corporate social responsibility. Click here to access the list.

Now that new, and arguably more rigorous, SEC executive compensation disclosure rules are in effect, it will be interesting to observe union response. Will juicy corporate pay packages encourage even more attempts at reform? Will rank-and-file workers find it difficult to lobby for cuts in executive perks while asking for personal hikes? How will the dual role of employee and shareholder affect union clout?

"Workers unite" could start to take on an altogether different meaning.

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In his July 12, 2006 speech, SEC Chairman Christopher Cox describes soft dollars as "inflated brokerage commissions" and urges reform to ensure their use for research only. "Commission Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934," issued a week later, sought to clarify the extent to which money managers could properly purchase research without breaching their fiduciary duties to "seek the best execution for client trades, and limit money managers from using client assets for their own benefit." (Click here to access the 63-page file.)

Attempting to promote better transparency in trading costs, the SEC emphasizes "the statutory requirement that money managers must make a good faith determination that commissions paid are reasonable in relation to the value of the products and services provided by broker-dealers in connection with the managers' responsibilities to the advisory accounts for which the managers exercise investment discretion." Another stated goal is to help money managers with pension fund clients avoid ERISA non-compliance as relates to soft dollars.

At a time when Congress is joining the fray about pension fees, little has been said about the SEC's dictate that "Market participants may continue to rely on the Commission's prior interpretations for six months following the publication of this Release in the Federal Register, that is, until January 24, 2007."

January 24, 2007 has come and gone. Where's the fanfare? A topic as important as this merits discussion.

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According to Financial Times reporter David Wighton ("Regulation a threat to New York, report says", January 22, 2007), New York City stands to lose nearly 60,000 jobs over the next five years in the absence of significant regulatory reform. A McKinsey & Company report, commissioned by Mayor Michael Bloomberg and Senator Chuck Schumer, extols the virtues of London and other venues that are considered more user-friendly for derivatives trading and other financial service activities.

Mr. Kevin LaCroix, creator of the informative blog, The D&O Diary, provides a link to the report and some interesting comparisons with the Paulson report that likewise pleads for liberalization of U.S. capital markets.

While free marketeers applaud initiatives that permit capitalism to do its magic of bringing together diverse buyers and sellers, consider some recent statistics from the Conference Board.

1. In 2005, U.S. institutions such as pension funds, insurance companies, banks and foundations controlled $24.1 trillion in assets.

2. In 2005, these institutional giants owned 67.9% of the equity of the largest 1000 corporations versus 61.4% in 2000.

3. In 2005, four companies revealed institutional investor ownership in excess of 70%. In 2004, the number was two and one or none before then.

4. Public pension plans continue to prevail in important corporate matters. Co-author of the 2007 Institutional Investment Report (Report #1400, The Conference Board), Dr. Carolyn Kay Brancato, Senior Fellow and Director Emeritus of The Conference Board Governance Center describes their critical role. "Ten years ago, these funds weren't likely to join in lawsuits or exert pressure in out of court settlements, but now, having been severely burned by the Enron and WorldCom situations, these funds are asserting themselves as never before. In addition, as the election of directors becomes more heated, and as many companies adopt bylaws saying their directors will resign if they don't get a majority of shareholder votes, the voting clout of these activist investors becomes more meaningful."

What does this mean?

As stewards of trillions of dollars of retirement monies, pension fiduciaries must serve as the first line of defense with respect to sniffing out corporate misdeeds or identifying boards that are "oversight challenged." Already tasked with a daunting job, deregulation compels these watchdogs to do an even more rigorous search for red flag issues BEFORE they turn into financial calamities.

This goes back to a recurring theme of this pension blog. Do pension fiduciaries have what it takes? On what basis are they selected? How are they trained? Is there a pension fiduciary who can serve as a Sarbanes-Oxley type "financial expert," someone who understands how to go beyond financial statements to detect possible trouble? Are the right mechanisms in place for pension fiduciaries to gather adequate information about corporate policies, procedures and internal controls AND then evaluate the data in a meaningful way? Are fiduciaries compensated in such a way that encourages their active participation, before the fact? How has the role of lead plaintiff changed in the aftermath of the Private Securities Litigation Reform Act of 1995 and can litigation replace regulation?

I'm not saying that statutory regulation is a panacea. In fact, there is great comfort in being part of a system that permits a vigorous debate about the numerous merits of industry self-review.

As patriot Thomas Paine declared: "Those who expect to reap the blessings of freedom, must, like men, undergo the fatigue of supporting it."

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According to "Bush Bids to Increase Focus on Health Care with Plan on Tax-Based Aid for Consumers" (Wall Street Journal, January 22, 2007), the White House intends to curb skyrocketing health care costs by seeking tax relief for some. Journalists John D. McKinnon and John Harwood write that independent buyers of health insurance would get a tax deduction, arguably a boon for the millions of persons who are self-employed or work for companies that do not provide insurance. In contrast, employer-provided health insurance benefits would constitute taxable income. Likely winners include an estimated 80% of employees for whom the average premium (for a family policy) is a reported $11,500. Executives, professionals and some "rank-and-file" union workers may not be so lucky.

In a related article, "UAW May Run Some Retiree Benefits" (Wall Street Journal, January 23, 2007), reporter Jeffrey McCracken describes a "potentially revolutionary plan" whereby the United Auto Workers could assume responsibility for a ten billion dollar plus liability. A critical question is whether big U.S. auto manufacturers can find the money to finance "a handover of future retiree health-care obligations to a union-managed fund." Beyond costs, McCracken posits that union leaders face a real dilemma. Accustomed to negotiating hard on behalf of their members, can or will they want to police members' health care activity as a way to control costs?

As stated here and elsewhere, health care has the potential to dwarf the pension issue in a serious way. (Click here to read our most recent post about health care economics.)

If employers decide they can't afford to offer insurance coverage in its current form, pensions may be curtailed even further as part of a serious look at employee benefits overall. This is not necessarily a good thing if companies and municipalities then find it difficult to attract and retain productive workers.

Add the questionable state of Medicare to the mix and the current situation looks bad. With the 2008 election frenzy already underway, we're sure to hear more about health care solutions. Generating a meaningful dialogue (no sound bites please) is good. Without radical surgery soon, we're in for a long recovery.

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Some things never change. On November 27, 1994, I wrote an op-ed piece for a local newspaper entitled "A prescription for Social Security" in which I warned of the entitlement mentality and the crushing debt load soon to be foisted upon young people everywhere. According to the editor, my suggestions for funding reform were not well-received, as evidenced by a flood of letters with the same message. "Keep your hands off my federal piggybank" and let someone else pay the price. (Like many others, I am an advocate of phased-in privatization for those who prefer to save on their own.)

Recognition of big problems ahead is certainly not unique to me. In his 1993 book, Generational Accounting: Knowing Who Pays, and When, for What We Spend, Dr. Laurence J. Kotlikoff warns of the great divide between the young and old. In their 2005 book, The Coming Generational Storm: What You Need to Know about America's Economic Future, Kotlikoff and co-author Scott Burns tell a grim tale of what has been chronicled many times before. A disproportionate number of persons are retiring from the work force, leaving those who remain to bear the staggering burden of a "pay as you go" system in the form of Social Security and Medicare.

Published last May, the 2006 Social Security Trustees Report states: "Over the 75-year period, the Trust Funds require additional revenue equivalent to $4.6 trillion in today's dollars to pay all scheduled benefits. This unfunded obligation is $600 billion higher than the amount estimated last year."

New York Times reporter Steven R. Weisman writes that Federal Reserve chairman Ben S. Bernanke is worried too, asserting that "Recent positive trends on the budget were a 'calm before the storm,' to be undone by huge deficits in federal entitlement programs. In "Fed Chief Warns That Entitlement Growth Could Harm Economy" (January 19, 2007), Weisman describes Senate testimony that sounds downright gloomy. "The longer we wait, the more severe, the more draconian, the more difficult the adjustment is going to be."

Unfortunately, as we know too well, attempts at entitlement reform are political folly and so the problem festers with little hope of short-term remedy

There are plausible solutions (hard ones but they do exist) IF only people would give up the ghost of an actual retirement piggybank in Washington, emblazoned with their names. In this case, Virginia - there is no Santa Claus.

Sorry kiddo!

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Credit illustrator Mike Dowdall for this delightful figurine. Now Art Director for Westland Giftware, after stints with Dakin, Portal, Hallmark and Bradford Exchange, Dowdall has created an entire line around the idea that "old is happening." (Click here to see more of his work.) Seeing a selection of this new product line in a local gift shop, I enjoyed a few chuckles but that's not all. It's yet another indicator that we are in for a radical change with respect to all things demographic. After all, no company is willing to commit funds unless they anticipate commercial success with lots of "geezers who get it."

Consider the following facts reported in "The Profile of Older Americans - 2005," published by the U.S. federal government. (Click here for a copy of the report.)

<< The older population (65+) numbered 36.3 million in 2004, an increase of 3.1 million or 9.3% since 1994. The number of Americans aged 45-64 - who will reach 65 over the next two decades - increased by 39% during this decade. About one in every eight, or 12.4 percent, of the population is an older American. Persons reaching age 65 have an average life expectancy of an additional 18.5 years (19.8 years for females and 16.8 years for males). Older women outnumber older men at 21.1 million. >>

This seismic shift in population make-up has the potential to impact every aspect of the U.S. labor landscape, not to mention the economic well-being of Corporate America. New York Times reporter Elizabeth Olson discusses the increased number of gray-friendly job boards. In "Some Web Job Sites Put Out 'Gray Hair Welcome' Signs," she writes: "Of the estimated 76 million baby boomers reaching retirement in coming years, some will start businesses. But the majority who continue to work will seek the familiarity and security of a regular paycheck."

At roughly twenty-five percent of total U.S. population, workers over 55 years could exert some serious bargaining power. Companies in desperate need of skilled workers will likely rethink their HR policies, including benefits that appeal to the "seasoned" set. That's on top of the oft-discussed cost of funding benefits for individuals whose lifespans are outpacing that of the trademarked Energizer Bunny.

Parenthetically, this pattern is not unique to the U.S. and arguaby more pronounced in countries such as Italy and Japan. Former U.S. Census Bureau Director Martha Farnsworth Riche describes "expensive housing, inflexible work practices, and persistence of traditional gender roles" as reasons for a reduction in new births, making seniors a large cohort in both an absolute and relative sense. (See "Population Aging: National Differences Make a Difference" - January 2004.)

Email us if you'd like some help in quantifying the relationship between demographics and your company's bottom line.

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With all the talk about problems (and there are plenty of them), I think it's important to focus on solutions (and there are plenty of them too).

What pension problem would you most like to solve? Click here to email us with your input. Please let us know if we have permission to post your response and, if so, whether you want us to include your name. (We will post comments anonymously unless you tell us expressly we can use your name.)

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I live in a lovely town of about 18,000 people. Thankfully, there is little crime other than an occasional act of mailbox vandalism or the theft of holiday inflatables. Credit good-hearted people and a vigilant police force, especially it seems, when it comes to driving. I know this firsthand because I was pulled over the other day for DUIM (driving under the influence of a muffin, blueberry in this case). Apparently, I was swerving slightly to the right even as I drove a cautious twenty-five miles per hour. When I rolled down my window to say hello, the police officer saw the muffin, gave me a warning not to eat while driving and said he was on the lookout for DUI's (driving under the influence). After I thanked him, a bit shaken for the experience, I got to thinking.

Can rules be too rigid and what happens when you cross the line ever so slightly?

These thoughts are not unique to me. The topic du jour in financial policy circles is whether regulation is too heavy-handed and thereby impedes capital market innovation. Just last week, wonk wizard and New York Times columnist Ben Stein queried the wisdom of the so-called Paulson Committee in seeking to redress the "onerous" audit standards attached to Sarbanes-Oxley. (See "So Many Millions, So Little Body Armor", January 7, 2007)

Citing a plethora of option problems on Corporate Boulevard, he asks: "Isn't backdating precisely an example of a failure of internal controls? Haven't we just found out that internal controls are far too lax, not too strict?"

The same question, applied to benefit plan governance, is apt. At a whopping 908 pages, the Pension Protection Act of 2006 has spawned a new industry to decipher the nooks and crannies of this far from simple regulation. Too soon to assess the fallout, one ponders. Could it be too much? If so, what can take its place?

I'm a big believer in industry self-regulation but that begs yet another question. Who represents the "pension industry" and do the players speak with one voice? Arguably, HR has a different perspective than Audit or Treasury. Without a unified world view about what pension governance means, it's hard to imagine a system without mandatory regulation.

Free marketeers will say this is troublesome. The regulatory burden is far from trivial. Real dollars are redirected to activities that may not reap rewards. Perverse incentives arise and the law of unintended consequences results. Look what happened in the UK. In the aftermath of FRS 17, a large number of companies terminated defined benefit plans as quickly as possible.

Then there is the issue of compliance. Many suggest that pension regulatory changes are outpacing the industry's ability to keep up. Does this put a fiduciary in harm's way (the equivalent of swerving slightly while eating a muffin)? You think you're doing the right thing but get "pulled over" nonetheless. How can a decision-maker protect herself (himself) from mounting personal and professional liability?

Here's to pension governance solutions - the sooner the better!

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A crisis is upon us. According to Wall Street Journal reporter Ronald Alsop, U.S. business schools are scrambling to find qualified professors in accounting, finance and management, respectively. (See "Ph.D. Shortage: Business Schools Seek Professors, January 9, 2007) Alsop offers sobering statistics, courtesy of the Association to Advance Collegiate Schools of Business (AACSB International). A current estimated shortage of 1,000 Ph.D.s is expected to grow to 2,400 by 2012. Supply and demand dynamics are in full force with B-school salaries on the rise. Unfortunately, money alone will not help. Someone starting doctoral studies today will be lucky to finish by 2011 and that's if they attend on a full-time basis, ignoring the lure of Wall Street.

While one can reasonably dispute the merits of putting Ph.D.s in the classroom (versus industry practitioners), the reality is that business school accreditation mandates certain coverage ratios. When too few academically qualified professors are available to teach, courses are cut, class size is reduced and/or admissions are scaled back.

Under any of these scenarios, fewer students become business school graduates. The resulting dearth of trained technicians is problematic. At a time when new pension accounting rules are upon us, investing is global and financial engineering requires more than a passing knowledge of basic concepts, where will much-needed expertise come from?

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In speaking to a colleague about managerial excesses the other day, I relayed the story of something that took place years ago. I was in college and worked as a bank teller in the afternoons and opened new accounts on Saturdays. The woman assigned to provide on-the-job training (long retired I'm sure) chided me for tossing a paperclip. "I'm a shareholder of this bank and every penny counts. We just don't throw away paperclips."

At the time, she struck me as old-fashioned and picky. Of course, when you're twenty, I suppose everyone seems un-cool.

What continues to amaze me is that I recall that event as clearly as if it had just happened. Her comment was an epiphany of sorts. This woman was not an executive. She wasn't even a bank officer. She was a secretary (administrative assistant in today's parlance). She wasn't responsible for the budget. No one counted supplies. Certainly one abandoned clip couldn't mean much. Yet her words resonate still. With skin in the game, she had a compelling motivation to be thrifty and encourage others to follow suit.

The relevance to pension governance is striking. When fiduciaries do not have a vested interest in adhering to best practices, will they be tempted instead to follow the path of least resistance? What motivates an individual to be a good steward of other people's money? Is it an increasing awareness of personal and professional liability that moves people to act or a concern that doing the right thing counts most?

A few days ago, I asked several financial advisors why they thought so many lawsuits focus on 401(k) fees rather than defined benefit plan fees. One response speaks volumes. "It's the company's money with DB plans but when employees pay, there is less managerial concern." Cynical or a reflection of the existing risk-reward system? Fiduciary responsibilities apply to both DB and DC plans. Yet decision-makers tend to feel pain faster and more fully when DB plan assets underperform and their compensation is tied to share price, cash flow or budget variance.

Experts agree that pension governance is AWOL at more than a few companies and statehouses. Why is that? As I wrote in Executive Decision last year, incentives are everything. Reward people for good behavior and you get what you pay for. The converse is true as well.

For those already in the vanguard with respect to effective investment fiduciary practices, kudos and keep up the great work. For those doing the equivalent of the pension paperclip toss, a good New Year's resolution is to stop.

P.S. Click here if you'd like to read "Do Fiduciaries Need Better Incentives to Make the Retirement System Work?"

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Similar to many of my peers, I spent the last few days in the same shape as this fella. Anxious now to avoid suspicious coughs or sneezes, I've been pondering what contagion might look like in the pension world. The upshot? Not a pretty picture.

Broadly defined, the spread of bad financial news, like a transmitted disease, moves quickly, has the potential to wreak havoc and is hard to contain once unleashed. This is why policy-makers worry about anything that can accelerate diminished investor confidence and panic market participants into selling off positions they would otherwise choose to hold.

Contagion itself is dangerous but when you consider what some describe as an inevitable convergence towards one global market, with trading that occurs 24/7, the potential for serious harm is real. Continued technological advances, international deregulation and investors' willingness to go offshore promote lightening speed information flow. When bad news hits, it's the shot heard 'round the world. Having worked on three trading desks during volatile times, I know firsthand how quickly things can change.

Taking a page from science, the "butterfly effect" describes how tiny changes can lead to large-scale disturbances. Click here to read about meteorologist Edward Lorenz and his seminal work in chaos theory. Does his notion that the flap of a butterfly's wings in Brazil can set off a Tornado in Texas apply to pensions?

Let's consider some facts.

1. The graying of the global population is real.

2. Life expectancies are climbing in the U.S. and in most developed countries.

3. Countless U.S. and non U.S. government plans are hamstrung by reluctant taxpayers, binding labor contracts and defined benefit plans with fixed terms.

4. Regulatory reform here and abroad has accelerated the need for liquidity.

5. Companies around the world rely on higher return (read higher risk) investments to close the pension gap.

6. Shareholders in U.S. companies are preparing for the worst with the first batch of annual reports that reflect FAS 158 compliance, similar to the FRS 17 effect in the UK. GASB 45 is keeping public plan leaders up at night.

7. Many companies outsource or have global staffs with benefits offered to all.

8. Different country governments and multinational companies alike invest in each other's securities.

Market returns are correlated. Labor mobility exists. Companies buy and sell around the world. News travels fast.

What does that infer? Pension contagion is a real possibility.

Editor's Note:

The World Bank website links to some research papers about financial contagion that may be of interest.

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Given the flood of money making its way from pension land to alternatives, fiduciaries may be interested in today's New York Times article entitled "The Private Lives of Hedge Funds." Reporter Jenny Anderson celebrates the panache of more than a few hedgies with a colorful description of the Houdini award, the Better-Than-Barings Blow-Up award, and the Debutantes award, to name a few.

Mr. Phillip Goldstein gets the Braveheart award for playing David to the SEC Goliath when he questioned their authority to have hedge funds register. After winning his case, he has since taken to the airwaves, campaigning to be exempted from disclosing details about his fund's holdings.

I have written about Mr. Goldstein on three occasions as part of a continuing commentary about transparency versus the protection of proprietary (and arguably valuable) information. While this issue remains unsettled as of today, it's noteworthy that over 1,200 hedge fund professionals showed up at a recent industry event to hear about topics such as the impact of newly released AICPA document, "Alternative Investments Audit Considerations: A Practice Aid for Auditors". For those who have yet to read this beauty, auditors must have sufficient data to support fund valuation numbers, including position detail.

Here are the links to the three aforementioned posts.

1. "Pensions, Hedge Funds and Disclosure" (October 27, 2006)

2. "Will Private Equity Stay Private? U.S. Dept. of Justice Makes Inquiries" (November 5, 2006)

3. "Hedge Fund Disclosure-Round Three" (November 12, 2006)

Is this the start of a new trend?

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In an effort to expand my horizons and better understand the dynamics of team-building, I recently spent several hours with an expert in PI. Also known as the Predictive Index, this self-described "unique, in-house management tool" is used to "effectively motivate, lead and leverage a person's strengths to achieve company goals." (Click here for more information.)

I started off as somewhat of a skeptic. (I am after all a Ph.D. in finance with a minor in math.) By the end of the meeting, I think I came away with a much better understanding of how I can improve my communication and leadership skills, something that no doubt is well worth the cost of time and money.

While each individual needs to seek counsel from behavioral experts as they deem appropriate, anything that enhances team-building may merit more than a peek. A wide variety of other tools include Myers Brigg, Raymond Cattell's 16 personality factors, Strong Interest Inventory and Johnson O'Connor aptitude analysis.

This topic is broad and well beyond the scope of any blog post. An interesting takeaway is the extent to which effective team-building can help pension decision-makers in 2007 and beyond. After all, how do we characterize the benefits situation in modern times? A few thoughts follow.

1. Responsibilities involve multiple departments such as Human Resources, Operations, Compliance, Treasury, Accounting and Investor Relations.

2. The need to contain costs while trying to attract, retain and motivate productive workers is often seen as mutually exclusive and is therefore a possible cause for intra-organizational friction.

3. Competing and often disparate compensation rewards for benefit plan decision-makers exist and vary across functions and titles.

4. Penalties for getting the benefits mix "wrong" vary across functions and titles.

5. There is an alarming increase in personal and professional fiduciary liability that could encourage a counter-productive "blame game" unless everyone understands and adheres to a unified set of goals.

Team-building is tough, especially for complex issues. While critics disparage assessment tools as "warm and fuzzy," the reality is that "we're all in this thing together" when it comes to benefit plan decision-making.

Behavioral science and the bottom line? Not such an odd couple after all.

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We're taking two days off to spend with family. We'll be back next week with posts we hope you'll find informative and timely.

Our best wishes for a joyous holiday season!

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