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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In case you missed it, Donald Trump, co-owner of the Miss USA pageant, just announced that the reigning titleholder will be given a second chance, despite questions about her behavior, post-win.

In stark contrast, former CEO of Pfizer has been forced into early retirement "in part because of investor anger about his rich retirement benefits." Hang on to your hats. It's written that SEC disclosures describe truly golden years for this former executive - an $83 million pension and nearly $78 million in other deferred compensation. No second chance here but with that much in the bank, one might ask who cares. (For additional information about pensions at the top, see "Executive Paywatch.")

Well, reputation and legacy issues are important to some. Then there is the possibility that allegations of excess compensation could result in legal action. According to New York Times reporter Eric Dash, Fannie Mae's primary regulator has filed suit against top executives in an effort to take back more than $200 million in bonus payouts. Notwithstanding questions about recent accounting restatements, the former head received a "pension valued around $25 million." (See "Fannie Mae Ex-Officers Sued by U.S." by Eric Dash, December 19, 2006.)

So what's the takeaway for pension fiduciaries?

Second chances are a gift, allowing those in charge to improve current practices, stave off trouble and be good, or better, stewards on behalf of plan participants. However, not everyone gets a chance to go round again, begging a logical question.

Why not get it right from the outset?

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Where is Dr. Phil when you need him? According to a recent pension study, courtesy of the Toronto-based Rotman International Centre for Pension Management, problems "range from poor practices in board member selection to organizational dysfunction such as the lack of delegation clarity between board and management responsibilities. Weak oversight functions also have led to difficulties in sorting out the competing financial interests of differing stakeholder groups and self-evaluation of board effectiveness continues to be the exception rather than the rule."

Okay, so maybe we won't be holding hands and singing Kumbaya any time soon. However, failure to recognize behavioral impediments is a recipe for disaster. Since many companies accept the importance of employee benefit plans as a means to attract and retain talent, yet wince at their cost, HR and Treasury must find a way to work together. This is especially true as new accounting rules take effect, motivating shareholders to examine financials in a new light.

Public funds don't get a free ride. Taxpayers are frustrated and unhappy. With GASB 45 about to give the word deficit new meaning, public plan executives are going to hear the howls of protest in city halls throughout the U.S.

Working across disciplines and functions is the new mantra in employee benefits land. Pension decision-makers will need to coalesce or risk doing an incomplete or poor job of navigating stormy waters. A possible result? Increased personal and professional liability, coupled with a host of nasty financial outcomes for plan sponsors.

This is no time to argue over turf!

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Dear Santa:

I've been a good pension fiduciary this year so I hope you remember me in a few days. It's been a tough year, with 2007 definitely looking grim. Do I merit a few extra brownie points for tackling my work with a smile and "can do" attitude? I'm trying hard but each day seems to bring a bundle of new challenges.

Here's the rest of my wish list.

1. Ten percent or better equity returns

2. Conflict-free service providers who really try to understand what problems we need to solve

3. Regulatory guidance that promotes a better understanding of how to comply with the Pension Protection Act of 2006

4. Recognition that my job is important

5. Liability insurance protection that helps me do a good job without worrying about significant personal exposure

6. Clarity about the incremental risks associated with strategies such as liability-driven investing, portable alpha and plan design

7. No major hedge fund blow-ups

8. Consultants and money managers who speak plainly

9. User-friendly analytics that support fiduciary due diligence

10. Vacation between the "pension problem" and the "health care crisis"

I better stop here so I can get this note to the North Pole in time for a jolly holiday arrival. By the way, what is your pension plan like? Say hi to Rudolph.

Thanks Santa!

HWPF
Hard Working Pension Fiduciary


Editor's Note:

Click here if you'd like to add to the list or see what your peers think. Neither your name nor your email address will be made public.

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Strange bedfellows? Maybe not. Here's why.

1. Angelina Jolie has agreed to play the role of Dagney Taggart in the film verson of Ayn Rand's best-selling book, Atlas Shrugged.

2. Christopher Cox wrote a review of Letters of Ayn Rand.

3. Christopher Cox heads the SEC.

4. The SEC just proposed several major changes that potentially impact pension funds' investments in hedge funds, securities issued by companies that comply with the Sarbanes-Oxley Act of 2002 and non-U.S. issuers of equity, respectively.

In addition, U.S. Treasury Secretary Henry Paulson is busy advocating improved regulations in order to promote U.S. competitiveness. His remarks to the Economic Club of New York referenced a forthcoming Conference on Capital Markets and Economic Competitiveness early next year that will address regulatory, accounting and legal issues. He added that the strength of the U.S. economy can be a springboard to reform entitlement programs and "focus on economic and educational policies that will add jobs, improve productivity, and result in tangible income growth for all Americans."

With a new Congress and talk of regulatory investigations and oversight hearings, school's still out on how pension sponsors are likely to fare. At the same time, given the clear and significant link between regulation and pension finance, we all have a vested interest in monitoring what's happening in Washington.

Angelina may do a terrific job at entertaining us as capitalist heroine but it's the lawmakers and chief regulators who are getting the big reviews in pension land. No popcorn but lots of action.

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An homage to Norwegian painter Edvard Munch (born on December 12, 1863) Google's same day banner is reprinted herein. A reminder perhaps that 2007 is sure to create some agita for more than a few benefits managers and other related decision-makers?

Here are a few reasons for upset:

1. New pension accounting rules for companies

2. New OPEB (other post-employment benefit) accounting rules for municipalities

3. Forthcoming derivative accounting rules for public funds, similar to FAS 133 for companies (Remember that derivatives are getting more attention as possible elements of a liability-driven investment strategy.)

4. Anticipated Congressional oversight hearings about pension funds, 401(k) fees and hedge funds

5. Stated SEC consideration of rule changes as they apply to alternative investments (and possible impact on pension funds investing in hedge funds)

6. Proposed Form 5500 disclosure rule changes regarding service providers, fees and other elements of pension investing

7. Continued taxpayer upset regarding the cost of municipal benefits and a desire for lower property and state income taxes

8. Continued escalation in pension litigation

9. Continued focus on plan design and expected impact on an organization's cash flow

10. Continued focus on the Sarbanes Oxley - ERISA (corporate governance-pension governance) link

11. Anticipated guidance about default options for defined contribution plans (and related fiduciary impact)

12. The remaining 900+ pages of the Pension Protection Act of 2006

13. Projected worsening of the Social Security situation and likely impact on financing of the "three-legged" stool

14. Continued longevity patterns (good for retirees but expensive for employers)

15. Projected lower interest rates that increase liabilities

16. Anticipated pressure on asset returns

17. International pension woes and possible contagion for the U.S.

18. Predicted health care benefit cost increases that make pensions pale in comparison

19. Continued need to attract and retain scarce pool of talented workers with good benefits while keeping costs low

20. Continued scrutiny from ERISA and D&O liability insurance underwriters (and related impact on coverage and cost of coverage)

The good news is that there are lots of possible solutions but make no mistake. The new year will definitely entail major changes and challenges for all.

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In today's New York Times, reporter Jenny Anderson talks about lackluster returns for some hedge funds. In "Hedging '06: Year to Read the Caveats," she quotes Christy Wood, CALPERS senior investment officer, as saying that this year marks the third year that "the global equity markets and long-only managers outperformed hedge funds" and that "If you threw all these in an index fund net of fees, you would have done better than if you put it in the hedge fund industry."

The article continues that CALPERS has another $3.5 billion to invest, beyond the existing $4 billion in hedge fund investments. Their appeal, says Ms. Wood, is equitylike performance with bondlike risk.

The numbers are compelling. Courtesy of data from Hedge Fund Research, the article describes inflows in excess of $110 billion through Q3-2006, compared with $47 billion last year.

What caught my eye is the quote about leverage and the notion that markets have all but ignored situations like Amaranth and its reported $6 billion loss.

Excerpted from this piece, investment advisor Stewart R. Massey, founding partner of Massey, Quick & Company, is quoted as saying that "If there's a lesson in 2006 - and no one talks about it anymore - it's that leverage is a very dangerous thing" and "there's too much out there."

On the face of it, leverage is not necessarily bad (nor is it necessarily good). However, in bad times, levered investments can cause significant harm to a pension fund portfolio. Let's hope that fiduciaries are asking good questions about leverage and not forgetting that things can sour quickly. Far from an exhaustive list, here are a few basic queries for hedge fund managers.

1. How does your fund measure leverage?

2. What is the fund's average leverage measurement?

3. Are there particular market conditions and/or investment positions that worsen leverage?

4. What is the fund's stop-loss policy as a way to curtail trouble before it's too late?

5. How does the fund value its "hard-to-value" positions and what is the likely impact on reported leverage?

6. Does the fund's leverage vary over time or has it been relatively stable?

7. How does the fund's leverage metric compare with similar strategy hedge funds?

8. How does the fund' return compare with similarly leveraged peers?

9. Does the fund's risk management policy address leverage?

10. Does the fund plan to do anything different going forward that would materially impact leverage? If so, why and what policy changes will occur as a result?

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There is a lot of evidence, anecdotal and otherwise, that various capital markets are affected by policy. The impact on price and trading volume depends on a host of factors, not the least of which is the nature of the new rules and regulations. So it is with government bonds, domestic and foreign.

In the aftermath of the Pension Protection Act of 2006, many plan sponsors, under pressure to address funding gaps, are adopting an active stance towards interest rate risk management. While strategies can and do vary, trading in bond markets in the U.S. and elsewhere have been affected by a surge in demand for longer-term bonds. According to Reuters journalist Richard Leong, "Appetite for 30-year bonds and other long-dated assets has been fierce as pension fund managers have been stocking up on them to ensure they have enough income-generating assets to meet future obligations, traders and investors said." Additionally, stripped bonds "offer longer duration and more predictable income than a cash bond." (See "Pension demand leads to long bond stripping," December 7, 2006.)

By definition, a stripped bond represents a decoupling of the interest portion from the repayment of principal. The latter is sold as a zero coupon bond. According to Investor Words, "Strip is an acronym for Separate Trading of Registered Interest and Principal of Securities."

Much more will be written about interest rate risk management in later posts. For now, you can find definitions, checklists and step-by-step examples in a book I wrote in 2005 for John Wiley & Sons. Entitled Risk Management for Pensions, Endowments, and Foundations, there is an entire chapter about fundamental concepts. Other chapters address futures, options and swaps, respectively.

Competing methods and products to manage interest rate risk abound. However, the tradeoffs are far from identical. This means that plan sponsors are quickly having to learn about financial risk control, whether they like it or not.

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A question that arises again and again centers on who "owns" the benefits issue at a particular organization. There is increasing evidence that board members and C-level executives are becoming more involved, if not so already. One gentleman told me that his board has met four times this year about pension issues alone.

This comports with the notion that pension, health care and other types of deferred compensation benefit programs can significantly impact a corporate or government employer's financial health, lower debt ratings, diminish (or enhance) employee productivity and influence the ability to attract and retain skilled workers, already in short supply.

So it is with great pleasure that I will be part of a panel that addresses the ownership issue, enterprise risk management and "pension tensions" (though the issues extend to other benefit programs as well).

Entitled "Strategies for Managing Diverse Constituencies: Shareholders, Employees, Beneficiaries and Management" and part of an exciting risk management conference, sponsored by Pensions & Investments, the panel plans to address a host of important governance and financial issues.

Ms. Fern Jones, CFA is the conference moderator. Managing Partner of FJ Corp/THS Ltd, Jones will lead the following panelists in what is sure to be a lively discussion. Speakers include:

Mr. James H. Norman
Managing Director
Deutsche Asset Management

Dr. Susan M. Mangiero, CFA, AVA, FRM and Accredited Investment Fiduciary Analyst
Managing Member
BVA, LLC and Pension Governance, LLC

Mr. Jim M. Voytko
President & COO
R.V. Kuhns & Associates, Inc.

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Ever read about an issue that strikes you as obvious and yet, here you are, reading about its existence? In a November 30, 2006 press release, the National Taxpayers Union describes its recent communique to House Speaker-Elect Nancy Pelosi and Senate Majority Leader-Elect Harry Reid to "end the slimy practice of allowing convicted lawmakers to draw taxpayer-subsidized retirement benefits." Other groups in agreement include Citizens for Responsibility, Family Research Council and the Congressional Accountability Project.

For further information, read "Nearly Two Dozen Citizen Groups Tell Pelosi and Reid: No Tax-Funded Pensions for Congressional Criminals."

What else is there to say? This one seems like a no-brainer.

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In compliance with the provisions of the Government in the Sunshine Act, the SEC will hold a meeting today to discuss a variety of things, including the proposal of new rules to determine whether to (1.) "revise the criteria for natural persons to be considered 'accredited investors' for purposes of investing in certain privately offered investment vehicles" and (2.) "prohibit advisers from making false or misleading statements to investors in certain pooled investment vehicles they manage, including hedge funds."

Click here for the meeting announcement and here to access the webcast.

While both items merit discussion, the issue of accredited investor qualifications got people talking over lunch a few days ago. The current definition, pursuant to the General Rules and Regulations promulgated under the Securities Act of 1933, Rule 501, Definitions and Terms Used in Regulation D, applies various criteria including whether someone's individual net worth, "or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000."

In the event that the SEC applies more rigor to the definition of accredited investor, how will they proceed? Will they increase the minimum net worth number and if so, why? Is the implication that wealthier investors are smarter or just that their losses don't count as much in proportionate terms? While accredited investors are excluded for purposes of calculating the number of purchasers under relevant securities rules, why is a "non-contributory employee benefit plan within the meaning of Title I of the Employee Retirement Income Security Act of 1974" counted as one purchaser when the "trustee makes all investment decisions for the plan?"

Hopefully a detailed explanation will accompany any decisions made in the aftermath of this meeting. Better understanding what responsibilities regulators want each hedge fund investor to shoulder by virtue of changing the rules can only be a good thing.

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Jerry Kalish tells us to buckle up for a bumpy ride now that Congress is ready to explore the issue of 401(k) fees. Click here to read his informative post.

Reiterating the emphasis on process, as written in an earlier post about 401(k) fees, "lower" fees are not necessarily "better" if plan participants "pay" for them in terms of additional restrictions on their money. Analogous to the idea of buying a luxury sedan versus something less fancy, price should reflect a variety of features for which people are willing to pay a premium. Whether fees are "high" or "low" for a specific plan and particular investment choice depends on a host of factors and requires a rigorous assessment of relevant information.

Process is everything!

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Thanks to attorney Stephen Rosenberg for giving our 401(k) fee webinar a round of applause. In "401(k) Plan Fees and Breaches of Fiduciary Duty", Rosenberg writes "On the key issue of how to avoid incurring liability for breach of fiduciary duty as a result of the fees incurred by 401(k) plans and their impact on plan performance, the speakers emphasized a commitment to due diligence. In particular, the speakers favor a systemic and periodic review of the entire issue of the fees affecting the plan, and proper investigation and selection of funds and advisors with the issue of fees firmly in mind. In other words, don't put the plan together without thinking about the issues of fees and ensuring that the applicable fees are consistent with industry benchmarks, and even after you do that, don't just forget about the issue, but instead return to the topic regularly and make sure fees and performance remain appropriate."

Some other points are noteworthy, especially given questions that arose after the event.

1. A comprehensive fee analysis, done before manager selection and regularly thereafter, benefits multiple constituencies - plan sponsors, participants, shareholders, money managers and consultants.

2. While plan participants arguably have limited information, relative to what is available to plan sponsors, both groups should understand fee structures and the expected economic effect of different types of fees. Remember that all fees are not "created equal." For example, some fees may be front-ended or tied to performance and therefore differ as regards portfolio performance impact.

3. What looks like "higher" fees on the surface may not be necessarily "bad" (and this is a gross simplification). In part, it depends on what they represent. A plan participant could have more flexibility in one situation (i.e. fewer restrictions perhaps), thereby boosting base fees. It likewise depends on, apples-to-apples, how a particular fund's fee structure compares to an appropriate fee benchmark. Other issues might come into play. Bottom line - A thorough analysis is paramount.

4. Fees are influenced by many factors, including asset class, investment strategy, market structure, fund structure, performance, terms, regulation and competitiveness.

Regarding the process itself, the U.S. Department of Labor provides guidance in its online publication, "A Look At 401(k) Plan Fees."

Here are a few excerpts:

"Establish a prudent process for selecting investment alternatives and service providers

Ensure that fees paid to service providers and other expenses of the plan are reasonable in light of the level and quality of services provided

Select investment alternatives that are prudent and adequately diversified

Monitor investment alternatives and service providers once selected to see that they continue to be appropriate choices"

Other resources exist in the form of checklists such as those provided by the Foundation for Fiduciary Studies. Click here to access the "Self-Assessment of Fiduciary Excellence" for investment stewards, investment advisors and money managers, respectively.

More to come...

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According to Fulbright & Jaworski partner and global chair of the Litigation Department, Stephen C. Dillard, fear may be appropriate with respect to all things litigation. In "Litigation Nation" (Wall Street Journal, November 25, 2006), Dillard describes results from their third Litigation Trend Survey, emphasizing an increasing upward trend in lawsuits here and abroad. "Even we were surprised by the volume and scope of legal actions across all major industries and regardless of company size."

Besides finding that "Some 89% of companies report being hit with at least one new lawsuit in the past year," companies stateside "face an average of 305 lawsuits pending world-wide." At the same time, "companies with sales of $1 billion or more" face an average of 556 cases, "with 50 fresh suits emerging each year for nearly half of these firms."

The cost of litigation is far from trivial. The survey cites corporate legal expenditures averaging $12 million, up from $8 million last year and with some industries - engineering and insurance - spending over $35 million.

Given the nature of this blog, www.pensionriskmatters.com, what caught my eye were the assertions that "more than half of the in-house counsel cited employment as their top litigation concern" and that "disputes over wages and hours can be brought as class actions in many jurisdictions, creating more waves of litigation."

Other press accounts about corporate lawsuits are similarly engaging.

According to the Chief Legal Officer Survey 2006, compliance and litigation are huge concerns. Conducted by Altman Weil, Inc. and LexisNexis Martindale-Hubbell, respondents lament that time and money used to fight and/or prevent lawsuits could not be otherwise used to grow the company.

New York Times reporter Paul B. Brown describes the concept of litigation funding companies in "What's Offline: Next, a Lawsuit Futures Exchange?" Citing Joshua Lipton in "Litigation 2006," Brown informs that hedge funds are researching the possibilities of investing now in anticipation of enjoying hefty case outcomes later on. That same supplement to the American Lawyer & Corporate Counsel includes a piece by Alison Frankel that offers insight about the globalization of litigation.

Lest you need more of a reminder that a sea change is upon us, consider the U.S. Appeals Court decision that found a fiduciary personally liable for nearly $180,000 due to losses realized by the International Brotherhood of Industrial Workers Health and Welfare Fund. In "Ruling highlights fiduciary need for hindsight", Reid and Riege attorneys David M.S. Shaiken and Eileen M. Marks describe the serious fallout from Chao v. Merino, 452 F.3d 174 (2d Cir. 2006), stating that the individual in question "was permanently prohibited from serving as a fiduciary or service provider to any employee benefit plan."

Other excerpts from the November 2006 Employee Benefit News article merit attention.

1. "The Court of Appeals' holding underscores how important it is for new plan fiduciaries to inform themselves thoroughly about a plan's operations, consultants and service providers with whom the plan has contracted. New fiduciaries should raise with co-fiduciaries any concerns about existing relationships after conducting their review.

2. The mere fact that an imprudent relationship predates a fiduciary's tenure does not shield the fiduciary from liability. The duties to be informed about plan business and to act prudently include a duty to be informed about, raise objections to, and protect the fund from any imprudent relationships that are in place with consultants and service providers when a fiduciary's term begins.

3. Plan fiduciaries may wish to review their and their plan's insurance coverage. ERISA plan fiduciary liability insurance covers claims against current and former plan trustees and, if they are named in the policy, plan administrators who have fiduciary duties. In case of a claim of breach of fiduciary duty, within the insurance policy's limits the insurer provides and pays for defense counsel, and indemnifies the plan fiduciary from liability, provided that the claim is not excluded from the policy's coverage."

Given the tsunami of litigation (with all indications that more is on its way), pension fiduciaries need to assess their personal and professional risk.

It's scary stuff indeed. Email us if you want to know more about our fiduciary and board training programs. If you are an attorney, ask to receive our complimentary pension governance kit.

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With an estimated $40 billion at stake, pets are a big business. According to the American Pet Products Manufacturers Association, 63 percent of U.S. households own a pet with more than 90 million cats, 73 million dogs and 139 million freshwater fish claiming a place in more than 69 million homes.

While many of us work hard to prepare for life after work, serious pet owners are just as concerned that Fido and Puss have enough biscuits and balls in their golden years.

The Humane Society of the United States offers a free kit, Providing for Your Pet's Future Without You, including a "six-page fact sheet, wallet alert cards, emergency decals for windows and doors, and caregiver information forms." Click here for more information.

USA Today reports that many states have relaxed rules to set up trusts for pets, with an average bequest of $25,000. (See "Animal owners set up trust funds for their pets" by Richard Willing, August 15, 2002.)

So to those friends and family members who dote on their cats, dogs, rabbits, hamsters, birds and fish, retirement planning takes on a whole new meaning.

Arf!

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According to its website, the SEC sanctioned the City of San Diego "for committing securities fraud by failing to disclose to the investing public important information about its pension and retiree health care obligations in the sale of its municipal bonds in 2002 and 2003."

The SEC-issued Order "finds that the city failed to disclose that the city's unfunded liability to its pension plan was projected to dramatically increase, growing from $284 million at the beginning of fiscal year 2002 to an estimated $2 billion by 2009, and that the city's liability for retiree health care was another estimated $1.1 billion.

According to the Order, the city also failed to disclose that it had been intentionally under-funding its pension obligations so that it could increase pension benefits but defer the costs, and that it would face severe difficulty funding its future pension and retiree health care obligations unless new revenues were obtained, pension and health care benefits were reduced, or city services were cut. The Order further finds that the city knew or was reckless in not knowing that its disclosures were materially misleading."

The Order makes for fascinating reading. For one thing, an eight percent assumed rate of return on investments was used "without regard to its actual historical rate of return." Some increased benefits were treated as contingent liabilities that were not reflected in certain liability calculations.

Some general observations ensue.

1. Assuming no fraud, a plan's actuarial report should be read in conjunction with any other disclosures about a plan. To the extent that there are differences, responsible fiduciaries must ask hard questions in order to reconcile the "tale of two pensions."

2. This is unlikely to be the last event of its kind. Does this put additional pressure on rating agencies and other watchdog groups to identify potential red flags before the fact, to the extent possible?

3. What is the future of public plan pension and health care benefits? Courtesy of Sean McShea, president of Ryan Labs, a recent Economist article about Other Post-Employment Benefits ("OPEB") augurs poorly for taxpayers in states adversely affected by a new government accounting decree. "Going into effect on December 15, the rule requires municipal government employers to "treat their health-care promises to workers the same way they already handle their pension obligations: by reporting on the total size of their future commitment, instead of just this year's cost." (See "The known unknowns, Economist, November 16, 2006)

4. The size of the liability is important as is the rate of growth in the liability, netted against the expected change in asset performance.

5. Plans in crisis will be tempted to reach for higher expected returns. Identifying and evaluating incremental risk is essential. A bad choice could exacerbate an already grave situation.

With Thanksgiving in the U.S. only a few days away, we'll have to think long and hard about why we are grateful in benefits land.

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In the aftermath of the Pension Protection Act of 2006, 401(k) plan sponsors are required to carefully select "fiduciary advisors", identify appropriate default investment choices for participants and comply with more rigorous federal reporting procedures. All of this could spell trouble for retirement plan fiduciaries who fail to realize that regulation, public awareness and employee angst put them in the spotlight as never before. This is especially apropos with respect to plan fees.

In a flurry of lawsuits involving nearly a dozen U.S. corporations, allegations of fiduciary breach regarding "excessive" compensation are making headlines. At the same time, the U.S. Department of Labor urges decision-makers to take care in assessing the reasonableness of fees and to uncover hidden costs.

Join us on November 28, 2006 from 11:00 a.m. to noon (EST) for an informative and timely webinar about 401(k) plan fees - what they are, how they can affect reported performance and the fiduciary practices that address investment management fees. Click here to register. There is a small charge to cover production expenses.

Featured Panel:

Edward M. Lynch, Jr.
Accredited Investment Fiduciary Analyst
SVP - Dietz & Lynch Financial Strategies Group of Wachovia Securities LLC

J. Richard Lynch
Accredited Investment Fiduciary Analyst
Executive Director - Foundation for Fiduciary Studies

Dr. Susan M. Mangiero
CFA, FRM, AVA and Accredited Investment Fiduciary Analyst
Managing Member - BVA, LLC and Founder - Pension Governance, LLC

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While November 16, 2006 marks the passing of famed economist, Dr. Milton Friedman, his ideas will no doubt live on for years to come. Economists in the U.S. and abroad embrace his work for its clarity, originality and impact. Recipient of the 1976 Nobel Prize for Economic Science, Friedman was a staunch advocate of free markets, something that put him at odds with the big government crowd. Author of Capitalism and Freedom and co-author (with his wife Rose) of Free to Choose (book and television show), Friedman wrote about the "tyranny of controls" in 1979, adding that "restrictions on economic freedom inevitably affect freedom in general, even such areas as freedom of speech and press." Taking a page from Adam Smith's Wealth of Nations, this well-respected Ph.D. wrote that "it is in the self-interest of the businessman to serve the consumer" and by doing so, everyone wins.

Post-mortem tributes that review Friedman's work as part of a general discussion about free markets versus regulation come at a time when laws such as the Sarbanes-Oxley Act of 2002 are being critically examined. In early September of this year, the Committee on Capital Markets Regulation, "a newly formed independent group of U.S. business, financial, investor and corporate governance, legal, accounting and academic leaders" announced its intent to study ways to "improve the competitiveness of the U.S. public capital markets."

A critical question? How much regulation is enough?

In "Businesses Seek New Protection on Legal Front," journalist Stephen Labaton (New York Times, October 29, 2006) writes that the Committee on Capital Markets Regulation and a parallel group "aim to limit the liability of accounting firms for the work they do on behalf of clients, to force prosecutors to target individual wrongdoers rather than entire companies, and to scale back shareholder lawsuits."

Dr. Friedman was not only prescient but correct to observe that "there is no such thing as a free lunch." Someone, somewhere, somehow pays.

What is an appropriate cost to pay for a relaxation of current rules? More self-policing at the industry level? At the individual company level? At the shareholder level?

With regard to pension funds, should we abandon ERISA and ask company sponsors to provide more transparency and financial backing on their own? How do we reward companies that do that already and without prodding from government watchdogs? Will the aftermath of the Pension Protection Act of 2006 reflect the law of unintended consequences, i.e. outcomes that are antithetical to the original intent of legislators?

Only time will tell but, until then, thank you Dr. Friedman. Your legacy of thought-provoking ideas is a rich one indeed.

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Hi everyone,

Please bear with us. We are working to make our blog as user friendly as possible. We'll be back in action this weekend. Thank you for your patience.

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The life of a pension fiduciary is no bowl of cherries. As I wrote on May 16 of this year, I parenthetically asked why anyone would want to be a fiduciary. Their job is critical to the process but less than easy.

"Often the pay is bad and the hours are long. (Individuals seldom receive any additional compensation at the same time that they are asked to assume significant responsibilities that put them directly in the 'line of fiduciary fire.') One might say it's like being asked to constantly eat your peas without any hope of ever getting dessert." (Click here if you want to read the entire post entitled "Who Wants to be a Fiduciary Anyhow?")

In "Liability of plan fiduciaries a still-growing concern", journalist Marion Davis (Providence Business News, November 11, 2006) writes that, post-Enron, employers are more aware of their fiduciary duties to "manage the plan honestly" and to "manage it reasonably well and provide accurate and complete information to participants."

She cites attorney Richard D. Hoffman with Nixon Peabody as saying that "he has seen a growing number of employers buy insurance to protect themselves from ERISA claims" at the same time that the "number of claims has increased as well" and "plantiffs have become more sophisticated."

Issues such as fees are just the tip of the iceberg. The Pension Protection Act of 2006 adddresses valuation and a cornucopia of investment-related issues such as qualified alternatives for 401(K) plan participants. The article quotes attorney David C. Morganelli with Partridge, Snow & Hahn as recognizing a heightened awareness of what is at stake, adding that "lawyers such as himself have been answering an increasing number of questions about obligations and liabilities under that law and under ERISA."

In January 2007, our sister company, Pension Governance, LLC, will be unveiling a searchable pension litigation database, along with regular updates about trends and highlighted cases as pertains to financial issues. We started on the database over ten months ago and quickly realized that the volume of cases to be analyzed and catalogued dwarfed our original expectations.

The good news is that there are many things that can be done upfront to mitigate fiduciary risk. The questions for pension fiduciaries are threefold. Are they fully aware of all relevant risks? Do they know what has to be done? Are they ready to move forward?

We'd love to give you our take. Email us if you want to be notified of the pension litigation database launch and/or would like to get our thoughts about the challenges that loom ahead.

Editor's Note:
Please be reminded that we do not provide accounting, investment or legal advice. We provide independent research and analysis to pension fiduciaries and/or their attorneys in the areas of financial risk, derivatives, valuation, fee economics, disclosure best practices, questions of suitability and prudential process as relates to financial/economic issues. In addition, we offer training and consultation to boards, investment committees, trustees, regulators and pension-focused money managers in the areas of financial risk and valuation.

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On November 8, 2006, I spoke again about the issue of hedge fund transparency and disclosure as relates to ERISA fiduciaries. Part of a three-person panel focused on hedge fund risk management (co-sponsored by BVA, LLC, ING Investment Management and law firm Alston Bird LLP), my comments were directed to an audience of about ninety people, representing hedge funds and service providers.

Since my remarks were picked up by several publications, and because this issue has now become a cause celebre of sorts, I'd like to clarify a few things. (Click here to read "The Law Giveth, The Law Can Taketh Away", 11/10/06, Institutional Investor.com and here to read "Amaranth, New Law Puts Onus on Pension Trustees" by Chidem Kurdas, New York Bureau Chief, 11/08/06, Hedgeworld.com. Registration may be required.)

In case you missed my earlier two posts on the topic of information and economic value, click here and here.

1. No investment is "good" or "bad" on its face. An investor must carry out a careful analysis of characteristics that are thought to contribute to the expected risk-return tradeoff. Moreover, an investor must consider its objectives and constraints.

2. Current law requires ERISA fiduciaries to make informed decisions. (Other criteria apply and fiduciaries are urged to seek legal counsel to better understand their responsibilities.)

3. Notwithstanding current law, common sense mandates a modicum of information and analysis before plunking down money. Why would someone invest in something resembling a black box, especially when they are acting as stewards of other people's money?

4. Some fund managers can choose to provide limited information to potential investors, to the extent permitted by prevailing law. ERISA fiduciaries may be subsequently forced to look at other funds that provide whatever information is deemed necessary to discharge their duties. (Click here for an interesting debate about information and its economic value.)

5. The Pension Protection Act of 2006 sheds arguably more light on what a fiduciary must do with respect to proper investment decision-making. However, it is not a standalone document and references opinions that will ultimately have to come from the U.S. Department of Labor and elsewhere.

6. The point about due diligence was emphasized by attorney Nir Yarden with Bryan Cave LLP as part of a recent Financial Research Associates conference about liability-driven investing. Yarden urged fiduciaries, including consultants and money managers, to thoroughly consider their exposure under ERISA, adding that "it won't take another blow-up to get people in trouble. Fiduciaries do not have the luxury of walking away from their statutory responsibilities. ERISA may apply even in the event of sub-performance."

7. Having a healthy debate about information requirements is a good thing. Please send or post comments. (If you have any difficulty posting to the blog, please email right away.)

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With so many companies in the red when it comes to defined benefit plans, a green light from the U.S. Department of Labor to consider liabilities when making investing decisions is a big deal.

That's why over one hundred pension fiduciaries have signed up for a Financial Research Associates, LLC conference about liability-driven investing. Chaired by Dr. Susan M. Mangiero, CFA and Accredited Investment Fiduciary Analyst, the event promises to be timely and informative. Following the conference is a workshop entitled "Derivatives in an LDI Framework".

Led by Dr. Mangiero, founder of Pension Governance, LLC and Managing Member with BVA, LLC and Mr. Gavin Watson, Business Manager with the RiskMetrics Group, workshop attendees will hear about the following topics.

1. Identifying Liability-Driven Objectives and Alternative Solutions

2. Derivative Instrument Strategies

3. Modeling and Valuation Issues

Despite the many challenges of managing pension risk, fiduciaries now have some concrete solution possibilities to consider.

Editor's Note:
I'll return in a few days with much more (!) to say about LDI.

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In "Workers' suit highlights secrecy over 401(k) fees" (Baltimore Sun, November 5, 2006), journalist Eileen Ambrose looks at the effect of nearly a dozen plan-related lawsuits filed against large U.S. companies. Her conclusion? "Regardless of the merits of the lawsuits, consumer advocates and benefits experts say that increased attention to fees is a good thing."

Unfortunately, getting good information about fees is not a walk in the park since no one document tells a complete story. "Workers with sharp eyes and a calculator can generally figure out what they pay by going through the prospectus and quarterly statement, but they will have little luck uncovering the soft-dollar arrangements that could affect their nest eggs." Then there is the fact that there are many kinds of fees, with disparate effects on economic performance.

Edward M. Lynch Jr., a benefits expert with Dietz & Lynch Financial Strategies Group, a retirement plan consulting firm in Massachusetts, offers that no standard exists. Some mutual funds may charge a small or no administrative fee, planning instead to earn management fees. Other arrangements such as revenue-sharing do not show up on Form 5500 and are not always disclosed to plan participants. According to Lynch, "Revenue sharing could be a good thing if it is fully disclosed and reduces costs for workers." Otherwise, "it can be a problem if it influences the decisions on which mutual funds end up in the 401(k)."

Ambrose points out that, absent lawsuits, reform is on its way with the U.S. Department of Labor recommending improved disclosure about fees and the relationship between plan decision-makers and service providers. (In case you missed my blog about Form 5500 revisions and information resources, click here.)

Regarding employees, I am quoted as saying the following. "Ask about fees that you pay, even indirectly, for administration and record keeping" as well as the employer's selection process. "How often does that process get vetted" and on what basis?

With so much attention being paid to the topic of 401(k) fees, this may be the beginning of the end for performance reporting as it exists today.

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In "U.S. Department of Justice Comes Knocking, Raising Specter of Private Equity Antitrust Concerns," law firm Goodwin Procter, LLP writes that "the DOJ has sent out requests to some of the industry's largest and most well-known firms, asking that these firms provide information and documents relating to company auctions since 2003."

Reported earlier by the Wall Street Journal ("Private-Equity Firms Face Anticompetitive Probe" by Dennis K. Berman and Henny Sender - October 10, 2006) and Red Herring.com, the DOJ is interested in knowing how firms transact and the extent to which competition in bidding occurs.

At the same time, Investment Dealers' Digest reports on the imminent launch of a new trade association, the Private Equity Council ("PE Trade Group Nearing Launch Amid Intensifying Scrutiny" by Ken MacFadyen - October 30, 2006). Slated as its new head, Mr. Harry Clark "insists that the group's genesis was in no way a response to the Justice Department's inquiry and he notes its role will not be in reacting to such events."

At a time when pension funds are increasingly looking at alternative investments such as hedge funds and private equity opportunities, an issue that resurfaces time and time again is transparency. In August 2005, the State of Illinois enacted legislation to protect "the commercially sensitive information of companies that receive private equity funding from public pension funds." One of five other states at the time, the then-cited goal was to "provide transparency in public investments in private equity without damaging portfolio companies' ability to compete."

You may recall an earlier post about hedge fund competitiveness and transparency. (Click here to read "Pensions, Hedge Funds and Disclosure" about Mr. Phillip Goldstein's letter to the U.S. SEC in which he requests exemption from the filing of Form 13F. In that post, I talked about the relationship between information and fiduciary responsibility.

No doubt the issues of transparency and market structure will continue to grab headlines. It's far from trivial.

Editor's Note:
Mr. Goldstein sent a copy of the letter to share with readers. Click below.
(GoldsteinLetter.pdf)

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Courtesy of law professor Paul Secunda, click here for a legal take on trying to get staff in shape. (In the interest of full disclosure, I could lose ten or fifteen pounds myself, and yes, I'm trying).

Related to today's post about healthcare costs, Professor Secunda raises an interesting question. What can an employer do to improve healthfulness in the workplace without getting in trouble?

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New York Times reporter Nicholas Wade describes research by the Harvard Medical School and the National Institute of Aging that could be a boon for vintners worldwide. Using experimental mice, scientists allege possible benefits of a "natural substance found in red wine, known as resveratrol". One group of furry creatures, fed a high-fat diet, accompanied with daily doses of resveratrol, gained weight but did not experience signs of medical problems and, "even more striking, the substance sharply extended the mice's lifetimes."

Wade describes a second gateway to expanded years - put the cupcakes away. Research done since 1935 shows that "mice fed a calorically restricted diet - one with all necessary vitamins and nutrients but 40 percent fewer calories - live up to 50 percent longer than mice on ordinary diets."

Elsewhere, Medicinenet.com quotes Mark Mattson, Ph.D and chief of the Laboratory of Neurosciences at the National Institute on Aging as likewise extolling the benefits of this approach.

"First, it reduces free radical production, or the production of highly damaging forms of oxygen, and the second is that calorie restriction increases the resistance of cells to stress. We think that both of these are important in protecting against a number of different diseases that have a negative impact on life span, such as cardiovascular diseases and cancer."

If you're panting to try cold kale soup and other goodies (similar to what my husband eats), click here to visit the site of the Calorie Restricted Society for more information.

Lest you are asking what this has to do with benefits, many experts now describe pension "problems" as tiny compared to a looming health care crisis - one that could wreak financial havoc across companies, big and small. So while the prospect of living longer is an amazing gift for many, there is a real cost of providing medical services to retirees. In some cases, post-employment exceeds work span by a significant amount.

At my request, Mr. Robert James Cimasi, president of Health Capital Consultants and author of The U.S. Healthcare Certificate of Need Sourcebook and countless articles and speeches, describes the situation this way.

"The US Healthcare Delivery System is facing what is perhaps its greatest challenge in the expected demand for increased health services from the aging of the baby-boom generation, the fastest-growing segment of the population. With the over 65 years old portion of the US population expected to increase from 20 million in 1970 to 69.4 million in 2030, the entire system by which healthcare services are dispensed in the U.S. is subject to radical change in the next two decades. As healthcare costs continue to rise faster than inflation in the overall economy, driven by advances in technology and treatment (as well as the growing baby-boomer population), pressures to reduce costs will result in a changed paradigm for healthcare delivery, most likely leading to some form of healthcare rationing. The potential result is that the quality of care received will depend increasingly on the individual's ability to pay.

One example of this trend is the accelerating movement from the traditional U.S. health coverage system of 'defined benefits' (where employers provide a package of defined benefits to their employees) to a system of 'defined contributions' (where employers contribute a set amount and then require employees to decide how much of their health benefit dollars to spend by selecting from a range of benefit plans), which is being driven by employers seeking to limit their exposure to what has become double-digit health insurance premium rate increases. These arrangements represent a fundamental shifting of the financial risk of health coverage from the employer to employees, whereby employers can limit their contributions, while employees must contribute increasing amounts of their own money to pay for health insurance cost increases in attempting to maintain the same level and quality of health care for themselves and their families.

This 'sea-change' in the U.S. Healthcare Delivery System presents both challenges and opportunities for the investment community, based to a great degree on the scope of their understanding of the risks related to these fundamental underlying factors."

For additional information, visit the HCC website library.

Other online resources that may be of interest are listed below.

1. National Center for Policy Analysis Health Care Economics

2. About.com Health Care Economics

3. Council on Health Care Economics and Policy

4. U.S. National Library of Medicine Health Care Economics

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A new study by the Bank of New York and Casey, Quirk & Associates predicts a trend upwards in hedge fund investments by pension funds. Entitled "Institutional Demand for Hedge Funds 2: A Global Perspective," the authors predict that hedge funds are here to stay.

What does this imply for pension fiduciaries? Quite simply, a lot. Understanding how a hedge fund (or fund of funds) manages its risk and values its holdings is paramount.

If you are interested in learning more, these events may be of interest.

1. Risk Management for Hedge Funds: Best Practices in a Changing Environment - November 8, 2006
(This complimentary NYC breakfast meeting is near capacity. If you cannot attend because of space, click here to request that materials be sent to you.)

2. Hedge Fund Valuation Toolbox - November 21, 2006 - first of four webinars (There is a charge.)

3. Hedge Fund Valuation and Red Flags - December 1, 2006 workshop (There is a charge.)

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In "Retirement funds fear untested consultants" (HFM Week, August 17-30, 2006), Jefferson Wells engagement manager Aileen Doherty describes a need for independent hedge fund valuations and a concern that pension consultants may not be doing as much as possible to vet valuation issues. Attorney Doherty adds that "There is going to be more pressure on pension funds to make sure the managers they hire are doing what they are supposed to be doing", especially at a time when "Pressure from the SEC and individual states is growing."

In the same article, Wilmer Hale partner Alexandra Poe asserts the need for "trustworthy third party valuations", adding that pension fund trustees "may feel they have hired consultants to get to the bottom of it, and they may feel underserved."

Any pension consultant who wishes to comment has an open invitation from this blog to offer your perspective. The same invitation extends to investors. Please be reminded that we do not endorse any particular firm for any type of product or service. We would simply be acting as a communication conduit.

As I've written before, valuation is a cornerstone of a hedge fund's activities, including, but not limited to, asset allocation, trading, risk management, performance reporting, compliance and auditing.

A point which CANNOT be emphasized enough is the need for independence and objectivity. Regulatory bodies such as the IRS and various courts continue to emphasize specialized valuation training and designations. This applies regardless of purpose - rendering an opinion of value of a particular position or portfolio, assessment of the economic interest of a hedge fund partner or the business itself (such as when a new person exits or enters, key person insurance, divorce) and/or a review of the process employed by organizations providing valuation numbers.

As an Accredited Valuation Analyst, I have written extensively about valuation issues. Please email if you want a copy of any or all of these items:

1. Chart that describes various valuation designations
2. Aforementioned article
3. Hedge fund valuation panel transcript from earlier this year

In case you missed these items, these links may be of interest.

"Hedge Fund Valuation is a Big Deal for Pension Fiduciaries" (Source: www.pensionriskmatters.com)

"Do You Really Know the Value of Your Portfolio?" (Source: www.pensionriskmatters.com)

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

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Having read more than a few blog posts about a company called Monitor110, I decided to spend some time at their website. While I know nothing about the company other than what I read, their graphic of the "New Information Dissemination Cycle" fascinates. If true that blog content, local news and other types of non-traditional venues offer a competitive edge to investors, capital markets could be turned upside down.

Just in the last ten or so years, rocket speed transmission of data - aided in part by advanced technology developments and cross-border deregulation - has improved efficiencies, thereby reducing costs and shrinking diversification potential. Some posit this is a good thing. Others complain that it makes it difficult to "beat" the market by accessing and analyzing information not widely known by others. This is a topic that is near and dear to my heart, having spent several years writing a doctoral dissertation about market microstructure. (I looked at information economics in the form of bid-ask spreads for NYSE-traded stocks across levels of institutional investor ownership and analyst following. Send an email if you would like a copy.)

According to their website, Monitor110 envisions revolutionizing "financial services by enabling Institutional Investors to turn Internet information into alpha generation." At a time when countless pensions, endowments and foundations are scrambling for returns, potential wins have great appeal. (This is not an endorsement of any particular company or strategy. Readers are responsible for their own analysis.)

The role of information in making investment decisions is a topic of great interest to us all. Debating the economic value of information deserves far more space than can be provided here. However, the notion that blogs - and other "non main stream" sources of information - contain pearls of wisdom not yet assimilated by the market certainly merits discussion. One question that arises. Do blogs lead or lag major news announcements? Journalist Chris Nolan has an interesting take on the power of blogs in an article for EWeek.com, writing that, beyond politics, "their value as forums for collective knowledge is becoming known in other areas as well."

What did people do before the Internet came along?

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According to a recent article in the Press-Enterprise, University of California workers expressed their outrage at being asked to contribute to their pension plans. Likely to impact 18,000 workers, "UC officials maintain that employees must contribute to the pensions to preserve them." A university spokesman, Mr. Brad Hayward, said that this sharing of responsibility is nothing new. "UC employees did contribute to their pensions until the early 1990s." He added that employee contributions wil occur gradually with no expected impact on take-home pay during the first post-reform year.

Critics argue that clerical and other lower-wage workers are already in a financial pickle without adding additional burdens.

This story caught my eye for several reasons, not the least of which is what I believe is the beginning of a heated (perhaps incendiary) debate about the rights of taxpayers versus municipal workers. This would include public universities such as the University of California, self-described as among the best in the world.

(In case you missed it, click here to read about the modern day version of the Boston Tea Party.)

An oft-cited position is that municipal workers agree to accept relatively lower wages in exchange for generous benefits. Accepting this point as reality (and ignoring for a moment that some do not accept that view), does a public employer's proposed rule change suggest a violation of an implicit work arrangement with employees? (The situation is arguably different when a labor-negotiated contract exists.)

What are the rights of the taxpayers who fund these benefits? Do they ever get a chance to approve or veto benefit payments or are they simply expected to pony up when benefits are due?

Moreover, this event illustrates the undeniable trend towards shifting post-retirement financial responsibility to employees and away from employers. Low-wage workers are not the only ones affected. Even middle managers know that the array of post-employment benefits is dwindling. Many companies no longer offer a defined benefit plan or, in some cases, any type of defined contribution plan.

Then there is the issue of fiduciary responsibility with respect to oversight of a growing net unfunded liability. Returning to the article, Hayward is quoted as saying "We need to be in a position where employees who retire actually receive the benefit that has been promised to them."

On the outside looking in, this statement is disturbing. It seems to suggest that there are insufficient funds to make current retirees whole without getting monies from those who still draw a regular paycheck.

This sounds familiar, doesn't it?

Think Social Security and any other "pay as you go" scheme that cannot survive without cash from current payrolls.

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According to Bloomberg reporter Jenny Strasburg ("Goldstein Asks SEC for Hedge-Fund Filing Exemption", October 24, 2006), Phillip Goldstein, "the investment manager who successfully blocked the U.S. Securities and Exchange Commission from requiring hedge funds to register, asked the agency to exempt him from stock disclosure rules." Ms. Strasburg reports his claim that mandated disclosure of holdings on Form 13-F would create economic harm as they constitute "valuable trade secrets." (It does not appear that his letter to the SEC has yet to be published. I will keep searching and post, if and once it is available.)

At the same time, Institutional Investor reports Paul Myners, chairman of the Ermitrage Group, as telling UK conference attendees that hedge funds provide protection against otherwise low returns. "Myners is pressing pension plans to pump up their allocation to 10 times the current level, to 30%."

Stateside, a new study by the Bank of New York and Casey, Quirk & Associates predicts a trend upwards in hedge fund investments by pension funds. Entitled "Institutional Demand for Hedge Funds 2: A Global Perspective," the authors predict that retirement plans around the world will triple their current hedge fund holdings to over one trillion dollars.

If Mr. Goldstein is successful in preserving confidentiality on behalf of his investors, more power to him. However, as a pension fiduciary, prudence would be difficult to justify in the absence of "sufficient and necessary" disclosure. (U.S. Code Title 29, Chapter 18 mandates "the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.")

While reasonable people can disagree about what constitutes "necessary and sufficient" information, certain questions come to mind with respect to hedge fund disclosure. (This is far from an exhaustive list.)

1. Is the hedge fund deviating from the stated strategy? If so, how does that affect asset allocation decisions for the pension fund investor?

2. How do holdings of the hedge fund change over time? What is the impact on transaction costs and, by extension, reported performance?

3. Do hedge fund holdings pose any problem for a pension fund with respect to liquidity?

4. Are the hedge fund's particular holdings difficult to value?

5. In the case of Form 13F, reported information reflects holdings of at least $100,000, a non-trivial amount by most accounts. If a hedge fund holds a large stake in a particular company, how is that likely to affect company policies and, by extension, how shares perform? (See the September 2006 issue of Chief Executive for an interesting article entitled "Do Hedge Fund Activists Have You in Their Sights?")

The list is long but the takeaway is simple. If investors plunk down millions of dollars, they should know enough to make an informed decision.

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Ever have a sleepless night? You find yourself watching late night television and pondering whether to call overseas clients in their time zone as a way to score points. If so, you may have come across a police reality show known simply as COPS. According to the Fox Television website, COPS is "still one of the most popular television shows on the air," leading one to wonder about the national fascination with crime and disgrace.

Unfortunately, there never seems to be a shortage of bad boys and gals who flaunt the law. The temptation of easy money is too intoxicating for some, ensuring that the saga will likely continue for a long time to come.

Just recently, former Enron CEO Jeffrey Skilling was sentenced to twenty-four years over a corporate scandal that has received significant press attention and prompted a new wave of governance standards and rules. New York Times reporter Alexei Barrionuevo describes Skilling's sentence as slightly shorter than the twenty-five years metered out to Bernie J. Ebbers, former head of WorldCom "who was sentenced to 25 years last year for his role in the $11 billion fraud that led to that company's collapse." (In the spirit of full disclosure, let me confess to owning some two hundred shares of Enron common stock.)

Financial Times reporter Kevin Allison writes that David Kreinberg, former CFO of voicemail software company Converse, "became the first top executive to plead guilty to conspiracy and securities fraud in connection with options backdating." Rumour has it that others are in the hot seat and have hired criminal lawyers.

Financial wrongdoing accounts for an entire industry of specialists. Benchmark Financial Services bills itself as an expert "in investigations of pension fraud, money management abuses and wrongdoing involving securities brokerages and pension investment consultants," adding that their "investigations frequently focus upon illegal or unethical business practices that are commonplace in the securities brokerage, asset management and consulting industries, as well as hidden or poorly disclosed financial arrangements between vendors to pensions."

Another organization, Corporate Resolutions, focuses on fraud, money laundering, risk management and competitive intelligence. President Ken Springer, a Certified Fraud Examiner and former special agent of the Federal Bureau of Investigation, provides an interesting update in the company's monthly newsletter about security issues.

Notwithstanding their efforts, some interesting questions come to mind with respect to how people respond to problems in pension land and elsewhere.

1. Does news about white collar criminal punishments deter others from misdeeds?

2. What type and magnitude of loss roils people to the point of lobbying for changes in the system, with the goal of minimizing future mishaps?

3. Does the avoidance of shame play a role in keeping financial abuses to a minimum? (How many rogue traders are now making a nice living as commentators, security consultants or well-published writers?)

4. What is the fine line between fraud and unethical practices?

5. Who is responsible for early detection of fraud within an organization?

6. What can investors and/or plan beneficiaries do to protect themselves from fraud and "ethically challenged" decision-makers?

Taking a pro-active approach can go a long way to calming jitters. For pension fiduciaries, providing transparency about the investment process, including choice of money managers and related vendors, is huge.

Why then is it often difficult to get meaningful information about a plan and how it is being managed? Why do we pay attention to the bad boys and gals instead of more emphatically rewarding all the good players?

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In response to "Retirement for Three Hundred People", a colleague wrote the following. I publish it here because it is (a) thought-provoking and (b) reminds us that global integration of capital is here to stay.

<< The interesting thing will be the cross-border wealth transfer. As we in the US begin to liquidate investments after retirement, there will be an upsurge in demand from India and China, where the general level of wealth is rising rapidly and the population is growing. Combine that with a probable higher marginal propensity to save and you will see more and more US companies taken over by Chinese and Indian companies. >>

What happens in one country necessarily influences what occurs elsewhere. Migration of capital across borders is a snap in an era of lightning speed information transmission, consolidation of global exchanges and continued deregulation of financial rules.

In the spirit of this notion about one global marketplace, a 2006 book entitled The New Capitalists: How Citizen Investors Are Reshaping the Corporate Agenda makes a compelling case for the power of the institutional investor. Authors Stephen Davis, Jon Lukomnik and David Pitt-Watson chronicle "milestones in the owner revolution", in the United States and abroad. While they concede that shares alone do not guarantee a particular outcome, the trend is unmistakable. Investor clout is on the rise.

Consider these examples.

1. "In 2002 three U.S. state pension funds took steps to squeeze conflicts and misalignments out of the investment chain. The 'Investment Protection Principles' commit funds to require money managers to report on conflicts, how they pay their portfolio managers, and what they do to act as real owners of citizen capital."

2. "In October 2004 a group of big European funds founded the Enhanced Analytics Initiative (EAI), which commits each member to steer 5 percent of broker commission fees to stock research firms that analyze extra-financial factors affecting corporations."

3. "Coalitions of funds are forming within and across national frontiers to address overlooked long-term investment risks. Forums in the United Kingdom, North America, Australia, and New Zealand now focus on climate change as a portfolio issue."

Spending and saving patterns around the world influence what goes on in corporate boardrooms. Regardless of your view about nationalism versus globalization, one fact is undeniable.

Investors reign supreme.

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According to the Census Bureau, U.S. population now exceeds three hundred million people. In contrast, the headcount was roughly two hundred million in 1968.

Additional numbers are noteworthy. With one birth every seven seconds, a death every thirteen seconds and one net international migration occurring every thirty-one seconds, it's easy to see that population will continue to grow.

Shades of Thomas Malthus, the English economist who warned that more mouths would deplete the available food supply, or an opportunity for innovation due to additional brainpower?

It likely depends on whether you see the glass as half full or half empty. However, one thing is clear. The population is graying at a rapid rate and there is real concern about the economic well-being of seniors who exit the workforce and younger persons who will be called upon to support them.

According to William Poole, president of the Federal Reserve Bank of St. Louis, "Changing demographics make it impossible both to maintain that traditional retirement age, with the level of benefits defined in current law, and to maintain the current level of taxation on the working population to support the retirement system." Global Action on Aging provides a vast collection of country reports about pensions. The message is the same sobering sentiment. Fewer and fewer people are going to have sufficient funds for their later years.

News from the federal front is equally grim. In "Status of the Social Security and Medicare Programs, A Summary of the 2006 Annual Reports", the Social Security and Medicare Boards of Trustees report that "The fundamentals of the financial status of Social Security and Medicare remain problematic under the intermediate economic and demographic assumptions. Social Security's current annual surpluses of tax income over expenditures will soon begin to decline, and will be followed by deficits that begin to grow rapidly toward the end of the next decade as the baby-boom generation retires."

My friends and I have this discussion often. Our conclusions?

1. We will work for a long time, perhaps well beyond the "typical" retirement age.

2. An increasing number of people will move into poverty as national benefits are cut, taxes are raised and private pensions are reduced or terminated altogether.

3. Taxpayers will struggle to fund troubled municipal plans while trying to save for themselves.

4. Fewer companies will offer benefits to new employees, forcing a lifestyle change that requires diminished spending, increased use of debt or both.

5. Health care problems will soon dwarf the pension crisis.

6. There is a perverse incentive for politicians to ignore making unpopular changes that might help in the long-run but hurt voters now. (Besides which, when is the last time a legislator had to worry about his or her retirement account?)

7. Individuals must get smarter and better about taking responsibility for their financial well-being.

8. Effective financial education is paramount.

9. Many individuals favor immediate consumption in lieu of systematic saving.

10. No particular individual or organization seems to "own" the issue.

You get the picture. It's a veritable challenge to be upbeat about what is fast becoming a global retirement crisis.

Is there a sunny side?

Yes but only if one is receptive to making changes. There will be winners and clever investors who identify them early on will do well. Some industries are already showing continued robust growth as our population ages in both absolute and relative terms. Health care is an example. Some see the forced move towards economic individualism as a return to the "get up and go" attitude of our forefathers. (Self-employed persons are already familiar with paying for their own benefits.)

According to an ancient Chinese proverb, "Many grains of sand piled up will make a pagoda."

It's time to get started on a serious savings plan.

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Chances are you've read about the flurry of cases recently filed against nearly a dozen 401(k) plan sponsors, alleging fiduciary breach by allowing plans to levy unreasonably high fees. Regardless of the legal outcome, the complaints are creating a buzz while encouraging plan sponsors everywhere to reassess their own situation.

In a recent client alert, law firm Dechert LLP wrote that "Under ERISA, an employer that provides a 401(k) plan to its employees is a "Plan Sponsor" and may also serve as "Plan Administrator." Both the Sponsor and Administrator are fiduciaries of the 401(k) plan. ERISA requires that that the Sponsor and Administrator ensure that fees borne by the plans be reasonable, and be incurred solely for the benefit of plan participants. In addition, 401(k) plans generally provide for participant-directed investment and are designed to comply with the rules under ERISA Section 404(c) which permit Plan Sponsors and Administrators to avail themselves, under certain circumstances, of a statutory safe harbor from fiduciary liability for the results of such investment elections. The safe harbor under ERISA Section 404(c) is available only where the fiduciaries allow the participants "the opportunity to obtain sufficient information to make informed decisions with regard to investment alternatives available under the plan."

More recently, Mr. Robert J. Grassi (Director, Pensions & Investments - Corning Inc.) and Attorney Michael J. Prame (Principal, The Groom Law Group) addressed this important issue as part of the Association for Financial Professionals Annual Conference - "401(k) Plan Fees: What You Need to Know and What You Need to Do." Citing concerns such as lack of fee transparency, hidden costs and potential conflicts of interest, Grassi and Prame provided audience members with a laundry list of types of direct and indirect compensation, respectively.

Both gentlemen talked about "the other shoe still to drop", adding that the U.S. Department of Labor is "formulating guidance that would essentially require plan fiduciaries, before contracting with a service provider, to consider the indirect compensation to be received by the service provider." They described a basis for imposing this obligation on fiduciaries in the form of the Frost/Aetna letters whereby "fiduciaries have a duty to obtain 'sufficient information' about the compensation that service providers receive from third-parties so that plan fiduciaries can make 'informed decisions' about whether the amounts that the plan pays are reasonable." Expected U.S. Department of Labor initiatives to amend 408(b)(2) regulations are likely to accelerate additional disclosure about plan fees.

Regulatory and policy-making scrutiny is on the rise. As we wrote in an earlier post, the U.S. Department of Labor wants to amend Form 5500, Schedule C, to include more stringent information about fee arrangements with service providers beyond what is currently required. U.S. Congressman George Miller has requested a report from the General Accounting Office about pension fees and the SEC reported on the relationship between pension consultants and fees in 2005.

Noteworthy is the sentiment that company decision-makers in the hot seat today will likely be followed by external plan fiduciaries next. According to attorney Stephen D. Rosenberg, author of the Boston ERISA & Insurance Litigation Blog, "Given the number of different advisors and other players involved in the operations of these types of retirement vehicles, there are bound to be plenty of fiduciaries - as that term is understood in the context of ERISA - involved in almost any 401(k) plan, making for plenty of targets for such suits."

One thing is certain. The spotlight will not dim on the fee issue any time soon.


Editor's Note:
The paper about fees by banker Ed Lynch, attorney Fred Reish and Dr. Susan M. Mangiero, Accredited Investment Fiduciary Analyst will be completed soon. We have created a list of recipients who requested our paper.

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I've been in sunny Las Vegas the last few days, courtesy of the Association for Financial Professionals (AFP). Part of AFP's concerted effort to provide its members with additional risk management resources, I led a Sunday workshop on getting started, creating an effective process and choosing an appropriate risk metric.

During my talk, I cited the importance of having a risk culture in place, without which (in my view) it is virtually impossible to make meaningful changes.

So what is a risk culture? How does it reflect an organization's willingness to act before the fact? Can some organizations differentiate themselves by taking a prescriptive approach to minimize litigation, reputation and non-compliance risk? What are some characteristics of a company with a risk culture?

Here are a few thoughts.

1. A company described as having a risk culture is one for which risk management is embedded in every aspect of the company's operations and not seen as a separate, stand alone activity. It is integral to each policy, procedure, strategy and tactic adoped by the firm.

2. By acting before the fact, a company can save money and time by anticipating problems and determining appropriate solutions now, avoid unwanted stress from outside investigators - regulators, litigators, watchdog groups - and maximize shareholder wealth by identifying oportunities for improvement.

3. Studies increasingly suggest that shareholders and consumers favor companies that do the right thing on their own rather than being forced into good behavior. This implies that effective risk management has an economic value beyond the obvious loss avoidance potential.

4. When evaluating whether a company has a risk culture, consider the following questions.

(a) Do senior level executives and board members "talk up" the company's commitment to a risk culture?

(b) Are risk management policies and procedures made public? At a minimum, employees and shareholders need to know.

(c) Are risk issues communicated clearly and with sufficient detail?

(d) Are employees reviewed and/or promoted on the basis of their adherence to risk management objectives? By extension, are they demoted or otherwise penalized for not wearing the risk badge of honor?

(e) Have ample systems and staff been provided to support a meaningful risk management effort?

(f) Does the company have a Chief Risk Officer? If so, does that person report to the board and enjoy adequate independence to make exceptions to the rule, as needed?

Applied to pension funds, the issue of a risk culture and taking steps to act before the fact is huge. ERISA fiduciary breach litigation is skyrocketing as are ERISA liability insurance costs, not to mention the economic urgency for mitigating risk in the presence of large and growing liabilities.

What better way to convey a message to shareholders and plan participants alike than to say "We recognize risk and actively manage it. It does not manage us."

Here are some things that companies (and public plans) can do to get started.

1. Create a table that lists various types of pension fund risk drivers, estimated probability of occurrence and financial impact.

2. Create, and publicize, a risk management policy for each plan. It should include the vetting process for money managers with respect to their risk management policies and procedures. In addition, it should address alternative strategies for controlling risks identified in step 1. (The list is long. Write us if you want to know more.)

3. Hire a Chief Risk Officer (CRO) who has responsibility for retirement plans. In most companies, it is simply not feasible to have a benefits CRO. However, a CRO with responsibility for enterprise value creation and/or protection should be asked to consider all benefit plans when building a storm-proof risk shelter.

4. Get the team onboard by including risk issues in performance reviews. For example, someone with pension investment responsibilities should be rewarded on the basis of risk-adjusted performance.

5. Recognize that a process is ongoing and requires care and feeding.

It's never too late to get started. To do otherwise invites trouble. Gambling is great in Las Vegas but do you really want to explain losses or sub-par performance to the inquiring public, let alone a regulator or opposing side attorney?

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In the aftermath of losses incurred by several Connecticut-based hedge funds and a recent court case that no longer requires hedge funds to register with the U.S. SEC, Attorney General Richard Blumenthal has convened a state-level Hedge Fund Task Force. Fortune writer Ellen Florian Kratz quotes Blumenthal as saying: "The facts about mammoth losses by Amaranth offer additional powerful and compelling evidence about the need to reform disclosure and oversight requirements [for hedge funds]."

According to a Reuters release on September 27, 2006, the U.S. House of Representatives has now passed a bill that mandates a federal study of hedge funds. "The bill, written by Delaware Republican Rep. Michael Castle, would require a wide-ranging study of hedge funds, their risks and regulation by the President's Working Group on Financial Markets, a multi-agency committee."

These two regulatory initiatives come around the same time that a new study augurs favorably for significant growth in the hedge fund industry. Just released by the Bank of New York and consulting firm Casey, Quirk & Associates LLC, the study concludes that "by 2010 institutions investing in hedge funds will increase to nearly 25% of all institutions, up from 15% today, representing a more than 60% increase. Retirement plans globally will account for the vast majority of asset flows, with corporate and public pension plans in the United States accounting for the largest percentage increase overall."

As with any investment, procedural prudence is paramount before committing funds. In the case of those hedge funds that purchase and sell complex securities that trade in thin markets, decision-makers absolutely must ask tough questions about risk management and valuation. Moreover, they need to feel comfortable with answers provided and understand how the oversight process changes over time and why.

If you are in the neighborhood, join us for a complimentary breakfast meeting on November 7 in midtown Manhattan from 8:30 to 9:30. Co-sponsored by valuation and risk company BVA, LLC, law firm Alston Bird LLP and ING Investment Management, we'll talk about hedge fund risk management and valuation issues that simply cannot be ignored by pension fiduciaries. Click here to have an invitation sent to you and/or to receive information about other upcoming events.

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A flurry of lawsuits and investigations about 401(k) plan fees is moving center stage. Wall Street Journal reporter Tom Lauricella writes that New York State Attorney General Elliot Spitzer is close to concluding a settlement with a large insurance company "over allegations that it took undisclosed fees to promote certain funds in a retirement plan for New York State teachers." (See "Spitzer Aims At Another Mark: Fee Disclosure," Wall Street Journal, October 10, 2006.)

In "Suits Claim Excessive 401(k) Fees at 7 Firms", LA Times reporter Kathy M. Kristof describes allegations of excessive fees being borne by 401(k) plan participants at some of this country's largest businesses. Seeking class action status, the cases focus on whether "employees were charged millions of dollars in excessive management fees, which often were hidden in obscure agreements and not disclosed to the workers."

According to the U.S. Department of Labor website page entitled "Meeting Your Fiduciary Responsibilities", decision-makers are urged to analyze whether fees are "reasonable" when deciding on a money manager. In addition, fiduciaries should "compare all services to be provided with the total cost for each provider", "ask prospective providers for a detailed explanation of all fees associated with their investment options" and "specify how fees are paid."

New regulation is a factor too. ERISA attorney Fred Reish offers that the selection of a fiduciary advisor, pursuant to the Pension Protection Act of 2006, requires employers to "satisfy a fairly complex set of requirements that they did not need to satisfy in the past". One possible effect is that participants are harmed because of higher fees, "due to increased compliance burdens."

In the interest of full disclosure, I am writing an article with senior banker Ed Lynch and attorney Fred Reish about the rigorous process of comparing fees on an "apples-to-apples" basis. Send an email if you would like a copy of the paper when it is published.

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Lest anyone think that pension plans are shrinking violets when it comes to corporate scandals, think again. During the recent two-day Institutional Investor Forum, public pension trustees learned about a variety of tools and techniques to preserve the capital invested in Corporate America. Topics ranged from hedge fund activism to settlement amounts and attorneys' fees, electronic discovery, the fiduciary mandate, investor recoveries in the case of bankruptcy and early detection of corporate fraud.

Billed as an educational event for fund trustees, administrators, executive directors, general counsel and other representatives of public funds, law firm Bernstein Litowitz Berger & Grossmann LLP has played host for a dozen years. Past speakers have included New York Attorney General Eliot Spitzer, New York Times financial columnist Gretchen Morgenson and SEC Commissioner Harvey Goldschmid.

Since the passage of the Private Securities Litigation Act in 1995, institutional investors continue to garner attention for their more active role in the class action process. Whether that has improved things is a point of debate.

In 2002, law professor Michael A. Perino published results of his examination of nearly 1,500 class action cases. In "Did the Private Securities Litigation Reform Act Work?", Perino questioned whether a greater number of filings reflected more corporate fraud or relaxed rules for filing.
More recently, Perino cited lower attorney fees as a result of public pension fund participation. (Click here to read "Markets and Monitors: The Impact of Competition and Experience on Attorneys' Fees in Securities Class Actions", St. John's Legal Studies Research Paper No. 06-0034, 2005.)

At a time when corporate scandals related to compensation loom large, pension trustees are unwilling to take a back seat. One questionable practice, option backdating, is causing real problems for some companies. As of late last week, the Wall Street Journal listed the investigative status of 115 organizations on its "Option Scorecard". In "Next Step in Stock Option Probes: 'Backdate' Lawsuits", reporter Amanda Bronstad, describes the billions of dollars at stake for pension fund plaintiffs. Many of the cases are filed as derivative suits, "allege breach of fiduciary duty and are filed by institutional shareholders on behalf of the company as a whole. They seek the return of the stock options."

No doubt we'll hear more about pension plaintiffs and class actions. Good, bad or indifferent, their size makes them real players, too big to ignore.


Note:
Legal professionals such as attorney Christopher J. Rillo write: "Backdating is not an illegal practice per se, provided that the disclosure, tax and accounting requirements are met. Companies have for legitimate reasons backdated stock options to provide additional incentive compensation to officers and employees. What has changed is that the disclosure, tax and accounting requirements were radically altered to require disclosure of back dating and additional taxation to both the grantor and the recipient." (Click here to read his September 2006 remarks as part of the symposium about D&O insurance.)

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As things change in pension land with respect to rules, regulations and funding issues, industry participants are getting creative about risk management. In September 2006, the Insurance Information Institute (III) wrote, "An increasing number of corporations are using captives to fund their employee benefits programs." One type of Alternative Risk Transfer (ART) mechanism, captives are a response to keeping a lid on commercial insurance costs. (For a primer on captives, visit Captive.com, a self-described "Business-to-Business Risk and Insurance Exchange.")

One wonders if this trend portends an increased emphasis on enterprise risk management (ERM) and, by extension, a strategic focus on benefits as an integral part of a corporation's assets and liabilities. According to a recent overview of ERM by Towers Perrin, "More than half of respondents - 57% in the U.S. and 72% in the U.K. - believe their company's pension related risk is significant relative to other financial and operational risks."

Reprinted with permission from the Association for Financial Professionals (AFP), the article below highlights one company's experience.

"The Latest to Place Employee Benefits Risk with Captive" by Kraig Conrad, CTP, September 27, 2006

<< The H.J. Heinz Co. earlier this month became the latest company to receive US Department of Labor (DOL) approval to cover employee benefits risks through their captive insurance company.

In the slowly growing trend to take advantage of program costs-savings with captives, the Pittsburgh-based company became the tenth company to receive DOL approval. DOL established EXPRO, or the standardized and expedited procedure, six years ago in order to grant advance approval of certain types of standard transactions-such as the use of captives to fund certain employee benefits- effectively removing roadblocks that prevented such transactions.

Heinz will use Heinz-Noble Inc., its Vermont captive, to reinsure employee and retiree group term life insurance policies, according to Business Insurance. Their Vermont-based captive is also used to cover a variety of property and casualty risks for the company.

In addition to group life insurance, the other nine companies with DOL approval have covered long-term disability and accidental death and dismemberment policies through their company's captive.

As a licensed insurance carrier a captive is under the control of its parent corporation with the primary purpose of insuring or reinsuring portions of the entire risk exposures of the parent and related companies. Though risks covered by captives typically have been related to property and casualty and workers' compensation, companies are looking to place other risks with their captives to help reduce risk management costs. >>

Copyright @ 2006 Association for Financial Professionals. All Rights Reserved.

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I can't tell you how many conversations I've had on the topic of governance and what motivates behavior, good or bad. Is it the proverbial carrot or stick? What is that one event (or series of events) that changes the collective mindset and spurs organizations to take action?

The answer I get most of the time is that people will act when they are forced to do so, either because of regulation, litigation, liability insurance hikes, regulatory investigation, losses that lead to headlines and so on.

Does that imply that bad news is a harbinger of corporate governance activity (and by extension, pension governance)?

If so, then a recent article about corporate counsel liability is a must read. According to "Gatekeeper GCs Increasingly Becoming Targets for Liability" by Sheri Qualters, gatekeepers like corporate attorneys are under "escalating government scrutiny" for failing to protect shareholders' interests. As a result, "in-house counsel and their law firm advisers say they're increasingly concerned about potential liability faced by in-house lawyers, who are stepping up their documentation of advice and even taking on additional professional liability insurance as precautionary measures."

Securities litigation lawyer William Schuman with McDermott Will & Emery's Chicago office offers that "The current mindset at enforcement agencies is that general counsel need to protect the shareholders' best interests, not just do the management team's bidding."

So how does this relate to life in pension land?

Let me count the ways.

1. There is increasing recognition that ERISA and Sarbanes-Oxley go hand in hand and that anyone involved in corporate governance is necessarily on the hook for pension governance. (In case you missed it, click here to read "Can Poor Pension Governance Land You in Jail?")

2. The first of several major accounting rule changes announced last week have the potential to wreak financial havoc for companies with underfunded plans. There is some talk that even companies with "healthy" plans may find the heightened scrutiny by investors a bit tough to take. Similar to stock drop cases, one wonders if adverse financial statement impact could lead to shareholder suits.

3. In the aftermath of several hedge fund blow-ups, do some ERISA plan fiduciaries leave themselves exposed if their selection process is anything but robust?

4. Will 401(k) plan providers be accused of selecting an inappropriate default investment option (pursuant to the Pension Protection Act of 2006) and have to quell participants' concerns in court?

5. How many more complaints will be filed on the basis of fiduciary breach with respect to the payment of investment fees? (See "Employers Face Suits Over 401(k) Fees" by Arden Dale and Jilian Mincer, Dow Jones Newswires, October 3, 2006.)

These are just a few of the many outcomes we think could lead shareholders to cry foul, sue and put the general counsel, board members and other parties in the liability hot seat.

Drop us a line if you want to talk further.

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Advertising executives in moo moo land must be deliriously happy. Who would have thought that Hollywood stars donning a calcium mustache would get such good press? Maybe it's time to recruit them to this side of the fence. With headlines dominated by stories about pension malaise, couldn't an ad campaign help to allay any fears about a possible funding meltdown and make pension governance seem cool, hip and happening?

Growing interest in knowing what works best for defined benefit and contribution plans alike is terrific news indeed but there's more work ahead.

How should good behavior be monetized? We know how to calculate damages associated with alleged misdeeds that get adjudicated in court or via liability insurance claims. Why then is it so hard to quantify adherence to high standards?

What motivates some organizations to stop at minimum compliance versus others who go the extra mile? Is it because we're accustomed to measuring explicit costs instead of foregone opportunities? Is it because knowing who owns the retirement issue is anyone's guess? (As I wrote in "Searching for Hidden Treasure", identifying names of pension fiduciaries is often a Herculean task.)

Is pension governance seen as nerdy, unimportant or too hard to understand? Do pension decision-makers feel that time and money spent on best practices is unappreciated and therefore not worthwhile? Do they feel protected by anonymity and/or fiduciary insurance policies with a hefty face value? Are they overwhelmed with their full-time jobs and not able to focus on the "extra" pension work? (This applies to the large number of individuals for whom playing the role of pension fiduciary is a job duty add-on.)

At the very least, transparency is a step in the right direction towards good pension governance, yet something that eludes many of those not directly involved with a particular plan.

Anecdotally, when I was writing Risk Management for Pensions, Endowments and Foundations, getting information about institutional investors was often like pulling teeth. Three years of research later, I was still hard pressed to get more than a few people to go on record about their policies and procedures.

One of several exceptions was Mr. Gary Findlay, now Executive Director of the Missouri State Employees' Retirement System. He freely shared information about governance, organizational structure and investment policy. The website is worth a visit for what appears to be a bounty of information. As Findlay offers, once a legal framework exists, "well developed governance policies that establish objectives, identify roles and responsibilities, and align interests are critical to the pursuit of excellence."

Shouldn't good policies be boldly announced to the public as a badge of honor? What is there to hide? At the very least, publicizing a fund's best practices could go a long way to demonstrating procedural prudence. Additionally, it could possibly minimize the chances of unhappy parties seeking redress later on, rather than allowing for the benefit of doubt.

So the question remains.

Got pension governance?

If not, why not?


Editor's Note: A few references to disclosure articles are provided below.

1. "Form 5500 Revisions" (explanation of what still remains unknown)

2. "Pension Risk: What We Don't Know Can Hurt" (first published in Mann on the Street, 2006)

3. "Deciphering Risk Management Disclosures" (first published in AFP Exchange, March/April 2004)

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In a September 26, 2006 press release from the Pennsylvania Department of the Auditor General, results of several special performance assessments are telling. State Auditor Jack Wagner encourages reforms, some of which are shown below:

1. Improve "how individual board members monitor and report conflicts of interest to improve transparency in governance"

2. Formalize "professional training for board members"

3. Make better the "structure of internal audit operations to improve independence"

4. Change "state law and fund policies to ensure that all board members are subject to a modern legal standard for judging their investment decisions."

Asking investment advisors to disclose campaign contributions whenever they present to the board is another suggestion. This is important since political appointees sit on the boards of the Public School Employees' Retirement System and the State Employees' Retirement System, respectively. Together, these two funds account for nearly $87 billion and 600,000 employees and retirees.

Given a reported funding gap in the neighborhood of $11 billion, a focus on conflicts of interest is noteworthy. The last thing any plan participant wants is an investment problem, whether it be an outright loss, sub-par performance, lack of suitability, excess fees or something else. Unfortunately, the absence of an independent review process leaves everyone guessing. (This applies to any fund.)

Was the right decision made for the right reason?

As a general rule, why aren't boards more independent in the first place? Is it really rocket science to recognize the importance of making decisions on the basis of solid investment analysis and not because money talks?

Editor's Note:
Other audits were performed by Independent Fiduciary Services, Inc. and looked at areas such as due diligence procedures, investment performance reporting, fiduciary liability insurance and costs and fees. For a copy of the two detailed reports, visit
http://www.independentfiduciary.com/resources.

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The long-awaited U.S. pension accounting overhaul is coming. According to their website, the Financial Accounting Standards Board ("FASB") will announce new rules tomorrow morning in the form of FASB Statement No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans.

Part of a multi-phase project to promote transparency as relates to post-retirement benefits accounting, companies will initially have to recognize the "overfunded or underfunded status of a defined benefit postretirement plan measured as the difference between the fair value of plan assets and the benefit obligation." Income statement adjustments are expected to follow thereafter.

Already, experts are predicting a dire impact for more than a few companies. According to the Center for Financial Research & Analysis, their survey of S&P 100 firms suggests a reduction to total equity of nearly eight percent. Their Portfolio Pension Monitor provides investors with details on a company by company basis.

What has most people worried is not only the direct impact of the new accounting rule but also the domino effect that is likely to occur. CFO.com earlier quoted John Ehrhardt, a principal with the actuarial consulting firm Milliman, as saying that new pension accounting requirements "could wipe out a company's entire net worth, forcing some to grapple with lenders on the terms of their loans or else fall into default. (See "FASB Pension Rule Could Spur Loan Woes" by David M. Katz, April 13, 2006.)

AltAsset.net just published summary results of a Grant Thornton survey that bears bad news for companies with defined benefit plans. They quote Mat Bhagrath, partner at Grant Thornton Corporate Finance as saying: "Following the introduction of new accounting rules, pension fund deficits have risen to the top of the corporate agenda. It is hardly surprising that private equity investors have become increasingly cautious about investing in companies with a defined pension shortfall." (See "Private equity investment in companies with a defined pension scheme deficit plummets", September 27, 2006)

Not one to underestimate the import of this brave new pension world, other accounting issues loom large. With little fanfare, FASB released its Statement of Financial Accounting Standards No. 157, Fair Value Measurements, a few weeks ago. Its potential impact is huge.

OPEB for public funds is right around the corner in the form of Statement No. 45, Accounting and Financial Reporting by Employers for Postemployment Benefits Other Than Pensions and the Government Accounting Standards Board has announced its intention to create what I call a "FAS 133 look alike" for states, cities and other municipal users of derivative instruments.

Add other regulatory mandates for reporting and the picture is clear. Pension professionals everywhere are going to be very busy.

Are you ready?

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During a September 26, 2006 panel discussion about the use of derivatives by pensions, mention was made of a U.S. Department of Labor letter. Several people asked for more information. (The Pensions & Investments conference focused on liability-driven investing.)

Click here to read the letter. Excerpts are provided below. Several items are noteworthy, especially since liability-driven investing strategies often rely on the use of derivatives.

1. There is a clear focus on process.

2. Regulators cite the need to identify operational and legal risks.

3. Passing the baton to a money manager does not absolve plan decision-makers of oversight duties with respect to the use of derivatives by outside firms.

4. Methods used to assess market risk should be appropriate and could include stress testing and simulation.

<< Investments in derivatives are subject to the fiduciary responsibility rules in the same manner as are any other plan investments. Thus, plan fiduciaries must determine that an investment in derivatives is, among other things, prudent and made solely in the interest of the plan's participants and beneficiaries.

In determining whether to invest in a particular derivative, plan fiduciaries are required to engage in the same general procedures and undertake the same type of analysis that they would in making any other investment decision. This would include, but not be limited to, a consideration of how the investment fits within the plan's investment policy, what role the particular derivative plays in the plan's portfolio, and the plan's potential exposure to losses. While derivatives may be a useful tool for managing a variety of risks and for broadening investment alternatives in a plan's portfolio, investments in certain derivatives, such as structured notes and collateralized mortgage obligations, may require a higher degree of sophistication and understanding on the part of plan fiduciaries than other investments. Characteristics of such derivatives may include extreme price volatility, a high degree of leverage, limited testing by markets, and difficulty in determining the market value of the derivative due to illiquid market conditions.

As with any investment made by a plan, plan fiduciaries with the authority for investing in derivatives are responsible for securing sufficient information to understand the investment prior to making the investment. For example, plan fiduciaries should secure from dealers and other sellers of derivatives, among other things, sufficient information to allow an independent analysis of the credit risk and market risk being undertaken by the plan in making the investment in the particular derivative. The market risks presented by the derivatives purchased by the plan should be understood and evaluated in terms of the effects that they will have on the relevant segments of the plan's portfolio as well as the portfolio's overall risk.

Plan fiduciaries have a duty to determine the appropriate methodology used to evaluate market risk and the information which must be collected to do so. Among other things, this would include, where appropriate, stress simulation models showing the projected performance of the derivatives and of the plan's portfolio under various market conditions. Stress simulations are particularly important because assumptions which may be valid for normal markets may not be valid in abnormal markets, resulting in significant losses. To the extent that there may be little pricing information available with respect to some derivatives, reliable price comparisons may be necessary. After entering into an investment, a plan fiduciary should be able to obtain timely information from the derivatives dealer regarding the plan's credit exposure and the current market value of its derivatives positions, and, where appropriate, should obtain such information from third parties to determine the current market value of the plan's derivatives positions, with a frequency that is appropriate to the nature and extent of these positions.

If the plan is investing in a pooled fund which is managed by a party other than the plan fiduciary who has chosen the fund, then that plan fiduciary should obtain, among other things, sufficient information to determine the pooled fund's strategy with respect to use of derivatives in its portfolio, the extent of investment by the fund in derivatives, and such other information as would be appropriate under the circumstances.

As part of its evaluation of the investment, a fiduciary must analyze the operational risks being undertaken in making the investment. Among other things, the fiduciary should determine whether it possesses the requisite expertise, knowledge, and information to understand and analyze the nature of the risks and potential returns involved in a particular derivative investment. In particular, the fiduciary must determine whether the plan has adequate information and risk management systems in place given the nature, size and complexity of the plan's derivatives activity, and whether the plan fiduciary has personnel who are competent to manage these systems. If the investments are made by outside investment managers hired by the plan fiduciary, that fiduciary should consider whether the investment managers have such personnel and controls and whether the plan fiduciary has personnel who are competent to monitor the derivatives activities of the investment managers.

Plan fiduciaries have a duty to evaluate the legal risk related to the investment. This would include assuring proper documentation of the derivative transaction and, where the transaction is pursuant to a contract, assuring written documentation of the contract before entering into the contract.Also, as with any other investment, plan fiduciaries have a duty to properly monitor their investments in derivatives to determine whether they are still appropriately fulfilling their role in the portfolio. The frequency and degree of the monitoring will, of course, depend on the nature of such investments and their role in the plan's portfolio. >>

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Are derivative instruments a recipe for disaster, an integral part of effective investment management or something in between? As explained in "Derivatives: The $270 Trillion Gorilla", meteoric growth around the world speaks volumes. At the same time, the incremental risks are real and cannot be dismissed.

Financial News reporter Renee Schultes writes that few fund managers "have the operational infrastructure and expertise to trade outside the listed and less-liquid listed derivatives market." (See "Managers struggle with OTC derivatives trading", Financial News, September 25, 2006.) Financial Times journalists Paul J. Davies, Gillian Tett and Saskia Scholtes chronicle efforts to address operational issues related to derivatives. (See "Derivatives dealers' tough match", Financial Times, September 25, 2006.)

New accounting rules and regulations encourage a paradigm shift that emphasizes risk analysis. Liability-driven investing is the new "it" topic and, by extension, derivatives are getting a serious look by public and ERISA pension fiduciaries alike. Money managers use derivative instruments as well for a variety of reasons such as transforming cash flows, leveraging exposure to a particular asset class or hedging. The Towers Group, a research and consulting firm, reports that "buy-side derivatives usage" is expected to "explode, bolstered by the shift to electronic trading, search for alpha, and more accommodating regulations (such as changes to ERISA and the adoption of the Prudent Investor Rule), which allows derivatives usage in pension funds and institutional money management." (See "Growth in Derivatives to Have Profound Impact on Wall Street Firms", September 18, 2006.)

The ultimate question is whether the expected benefits outweigh the costs. I wrote an entire book on this topic. Written for fiduciaries and related parties, Risk Management for Pension Funds, Endowments, and Foundations is a primer about the risks and benefits of derivatives and, more broadly, risk identification, measurement and control. I could easily write a second book about the topic. There is so much to say.

That is why subsequent posts will address the topic of derivatives, and the fiduciary implications of their use.

For those who want to read more, here are links to earlier blog posts and some articles I've written about risk management.

1. "Derivatives Get the Blame"

2. "Operational Risk and Derivatives"

3. "Derivatives Valuation: One Size Does Not Fit All"

4. "Pension Risk Management: What We Don't Know Can Hurt"

5. "Five Keys to Risk and Risk Management"

You can find lots more by going to our online library. You may also be interested in receiving our complimentary ezine about risk and valuation. Click here to sign up. (A link to our privacy policy is at the same URL.)

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New pension regulation text tips the scale at over nine hundred pages. No wonder then that discussions abound with respect to who wins, who loses and how to take the next step to comply.

Part of a three day conference about liability-driven investing, sponsored by Pensions & Investments, Dr. Susan M. Mangiero joins a panel of esteemed pension professionals to address the impact of regulation. More information is provided below.

"The regulatory environment in the US is set to change in response to widespread pension plan underfunding. However, no one knows when (or if) a change will be made to the actuarial discount rate used by the federal government in calculating pension liabilities. Changes are expected to accounting rules regarding pensions, particularly FAS 87, which will affect actuarial smoothing. And the Pension Benefit Guaranty Corp. is likely to impose risk-based premiums on the funding level of a company's pension scheme. So how does LDI help offset the predicted effects of changes in pension regulation? This panel will discuss the pros and cons."

For more information about this invitation-only event, click here.

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Travelers Canada announced a hard hat of sorts for money managers. According to the September 21, 2006 press release, the goal is to provide additional protection to "investment advisers, mutual funds and hedge funds for risks associated with providing asset management products and services to investors." Specific policy terms include coverage for incidents such as the ones listed below:

1. "Failure to adhere to investment guidelines and restrictions

2. Misrepresentations and failure to adequately disclose risks

3. Mismanagement of investments by an adviser on behalf of a pension fund

4. Breach of fiduciary duties to clients or pension plan participants

5. Unintentional errors committed in the course of performing regular investment adviser duties."

New pension laws, heightened scrutiny of fiduciary advisors and a surge in litigation would seem to make this type of enhanced coverage appealing to investment professionals in Canada, the U.S. and elsewhere.

Some interesting questions come to mind.

1. Should pension fiduciaries ask money managers for proof of insurance if they don't do so already?

2. Should pension fiduciaries eliminate a fund from consideration if they do not have this type of insurance?

3. Should the fund selection decision be tied to type and amount of insurance coverage? For example, would a fund with lots of liability protection be perceived as less of a risk-taker and perhaps more likely to deliver lower returns? Alternatively, would a money manager with ample coverage be seen as more of a risk-taker since insurance provides a safety net in the event that something goes awry?

4. Does the carrier matter? Specifically, do pension fiduciaries ask about the insurance underwriter and its financial capabilities to pay a claim?

5. Should a money manager ask pension fiduciaries if they are covered by liability insurance if they don't already inquire?

6. How would proof of plan fiduciary insurance be evaluated by the money manager? Is it an indication that a pension fund is inclined to have an established governance process that includes regular detailed assessments of money managers' risk controls? Would that discourage a more freewheeling money manager from doing business with that retirement plan?

It is our view that scant research has been done about the behavioral aspect of fiduciary insurance in pension land. Analysis of the insurance purchasing decision would be enlightening in several ways. First, it could shed light on process-related risks associated with pension plan investing. Second, it could (and probably already does) encourage a self-selection process that is directly tied to probability of loss on both sides of the fence. Few would argue that rational pension fiduciaries and investment professionals alike seek to avoid monetary losses and reputation-related harm.

Editor's Note: If you know of a study that examines these issues, please email pension@bvallc.com. Let us know if you would like to be credited for providing information.

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In "MBA students are 'biggest cheats'" Financial Times reporter Della Bradshaw conveys disappointing survey results that graduate students cheat. Business ranks first with fifty-six percent of those polled "admitting to misdemeanours such as using crib notes in exams, plagiarism and downloading essays from the web."

The news is not good elsewhere on campus. The survey, soon to be published in the Academy of Management Learning and Education journal, reveals that fifty-four percent of engineering students and fifty percent of science majors admit to cheating. Thirty-nine per cent of respondents in the humanities say "I do".

According to a report of the Ethics Education Task Force to the AACSB's International Board of Directors, "many schools have initiated new ethics instruction" but "more work must be done." (Note: The Association to Advance Collegiate Schools of Business is self-described as a "not-for-profit corporation of educational institutions, corporations and other organizations devoted to the promotion and improvement of higher education in business administration and management.")

Having taught the occasional MBA or executive MBA course, my experience has been positive (in fact extremely positive in terms of student motivation and integrity). That said, if the survey results hold true, some faculty members, somewhere, are either doing a lot of looking the other way or simply not catching the wrongdoers.

So why is this outcome something to ponder in pension land?

Pensions are set up as trusts. Stewards in charge of retirement plans are entrusted to make good decision on behalf of beneficiaries. Fiduciary duties speak to trust and loyalty. Employees trust that promises made will be kept.

Not every graduate student cheats and to imply otherwise would be grossly unjust. However, a culture of cheating does not bode well if future leaders are pulled from their ranks.

Who is responsible for ethical behavior and when does it start? How can we ensure that pension trustees and other fiduciaries are trustworthy, not just being honest but taking their responsibilities seriously?

Are there lots of capable and high integrity fiduciaries? Absolutely? Are there some who are ethically challenged? What do you think?

How can market participants self-police? How can we make good ethics the voluntary standard (assuming it is not already the case)? How can the system reward the good guys and gals and weed out the others? At the very least, what system best avoids penalizing fiduciaries when they try to do what they think is right, even if it means upsetting the apple cart? What is the role of regulation? What is the role of market structure in terms of transparency?

These and many other questions deserve a vigorous debate.

"What is left when honor is lost?"
Publilius Syrus

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Yes, amaranth is a grain but it's the CT based hedge fund by the same name that is making headlines. If you haven't read by now, Amaranth Advisors L.L.C. has reportedly lost $4 billion by taking long natural gas trades in anticipation of rising prices. (See "Amaranth's Risky Business" by Matthew Goldstein, TheStreet.com, September 18, 2006.)

Notwithstanding some obvious questions about oversight, the issue of risk management is unavoidable.

What was the organization doing to identify, measure and manage risk?

With about an hour of web sleuthing, I found a handful of job postings for Amaranth, all focused on analysis, modeling, risk and valuation. For example, an August 6 post describes the need for a technology analytics developer whose responsibilities would include the "development of real time systems supporting valuation and risk analytics".

Top name schools list (or listed) Amaranth as a recruiter of risk and computational graduates. More than a few Amaranth alums list their experience there as involving hedging, model building and/or risk analysis.

Amaranth is listed as a client by a UK risk management technology company.

In May 2006, the Chief Financial Officer was part of a panel entitled "Leading multi-strategy & single strategy funds explain the controls they use to maintain independence of the pricing function and the role of their administrators in fund valuation for different categories of illiquids and thinly traded securities".

On the face of things, it seems there was some focus on risk. Perhaps a lot. It's impossible to say from the outside looking in. It will be enlightening to all of us as we learn more about the firm's internal controls and risk trading systems.

Then, there are the investors.

What responsibility do they have to ask questions about a particular fund manager's risk management policies and procedures? New York Times reporter Mary Walsh writes that the County of San Diego had $160 million invested with Amaranth. No doubt we'll learn about other institutional investors as time goes by. (See "Pension Fund Tallies Losses and Rethinks Its Strategy" by Mary Williams Walsh, New York Times, September 20, 2006.)

What discussions took place between pension fund investors and Amaranth and/or the referring consulting firms? Was there a thorough drill down before writing a check? Can interested members of the public obtain the due diligence meeting notes?

What was the role of regulators?

In its September 15, 2004 letter rejecting the notion of SEC registration, the General Counsel for Amaranth at the time wrote that "Amaranth does not 'operate in the shadows' outside of regulatory scrutiny. Amaranth is registered as a commodity pool operator with the Commodity Futures Trading Commission, is a member of the National Futures Association and counts among its affiliates two SEC-registered broker-dealers who are members of the National Association of Securities Dealers and one investment counsel and portfolio manager registered with the Ontario Securities Commission. As a result, Amaranth already devotes significant resources to regulatory compliance and is subject to many compliance obligations that are duplicative of those that would be required by the Proposed Rule."

Could any or all of the regulators have identified problem areas before now?

Only insiders know what transpired and it is virtually impossible to do anything more at this point than conjecture about good or bad practices.

However, there are real lessons to be learned here, not the least of which is the urgent need for a rigorous and independent assessment of a fund's risk management and valuation practices, policies and controls (if it is not already being done).

Let's be very clear. This notion is not specific to any particular fund but rather a prescription for investment decision-making in general. Is it true that some investments are considered ex ante riskier than others and thereby demand more scrutiny? Yes. Is it true that pension fiduciaries have ultimate oversight authority? Not speaking as an attorney (and urging readers to check with counsel), oversight is a critical task. Is there a possibility that real people could lose real money? Yes. Is revisiting the money manager selection and review process - emphasizing risk management and valuation issues - time well spent? Yes. Is there any reason not to get started right away? No.

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CNNMoney.com reports its 2006 picks for "best places to retire." Geographic lovelies such as Walla Walla, Washington and St. Simons Island, Georgia top the list. If your tastes run counter to editorial wisdom, you can find the best locale by clicking on favored attributes such as climate, job growth, commuting time and cultural activities and then pressing the Search button.

While I'm the first to say "have at it" and "enjoy", it strikes me that dreams of a halcyon retirement, especially one at a relatively young age, are simply not a reality for most folks.

Consider some recent headlines and ask yourself - "How ready am I?"

"Ford Offering 75,000 Employees Buyout Packages"
(New York Times, September 14, 2006)

"DuPont to cut pension contributions by two-thirds"
(CNNMoney.com, August 28, 2006)

"Tenneco Freezes Pension Plan"
(CFO.com, August 23, 2006)

If hammocks, hobbies and fun trips with friends await you, congratulations on a job well done with respect to planning.

Everyone else?

Working during the golden years may be unavoidable. Is there hope of catching up? Well, that depends on many things, not the least of which is how much time remains until the paycheck stops coming on a regular basis.

If you aren't saving yet, start giving it some thought right away.

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The topic of portable alpha pops up in conversation a lot these days as defined benefit plan managers contemplate ways to enhance return.

What is portable alpha?

According to www.freedictionary.com, portable alpha is the strategy of "portfolio managers separating alpha from beta by investing in securities that differ from the market index from which their beta is derived."

Alpha itself is usually defined as a measure of excess return above expected return, adjusted for market risk. If alpha is positive, a money manager is thought to have done a good job.

Like any other investment, risk and expected return considerations are paramount. However, unlike more traditional choices, portable alpha strategies may employ additional leverage and/or investing in securities for which there is not always a ready market.

Learn more by attending the "4th Annual Portable Alpha Conference" on September 18 in New York City. Dr. Susan M. Mangiero, CFA will moderate a 2:00 p.m. panel entitled "The Trustee Perspective: Taking Us Into the Boardroom - Crucial Trustee Issues Associated With Portable Alpha." Panelists include:

Mr. Carlos Resendez, Plan Trustee
San Antonio Fire & Police Pension Fund

Mr. Bradley Imamura, Former Trustee
San Jose Federated City Employees Retirement System

Attorney Anthony Abboud, Of Counsel
Greenberg Traurig, LLP
Former Trustee, Illinois Teachers Retirement System

According to the brochure for the 4th Annual Portable Alpha Conference: Critical Issues During a Period of Change, "This conference is geared to institutional investors and investment professionals and examines three key themes associated with portable alpha that investors face: First the challenges and opportunities portable alpha presents to plan sponsor trustees and institutional investment professionals as seen through their eyes. Second, the emerging intersection between 'liability-driven investment strategies' and portable alpha. Third, key implementation challenges and risk management issues associated with portable alpha usage. We will examine each of these areas through a series of informative panel discussions and lectures."

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Pension size can be defined in a variety of ways such as assets under management (AUM), number of participants and so on. For investment analysis purposes, let's use AUM as the determinant of size and then discuss whether pension policies and practices vary across funds.

1. Are large funds more astute?

2. How does the available budget for larger funds impact their ability to hire specialists and engage in arguably more complex analyses?

3. Do governance practices improve or deteriorate as AUM grow?

4. Do plan participants expect more from a larger fund?

5. Can a fund be "too large" and lose the ability to respond quickly to new opportunities?

6. Are fees significantly lower for large funds, and if so, what threshhold constitutes "large"?

7. Do tiny funds struggle with transaction minimums? Can they afford to buy a comprehensive performance analysis technology system?

8. Is there a "too big to fail" doctrine for pensions, similar to what the banking industry has experienced?

9. Is the asset allocation mix materially different for big versus small funds?

10. Are larger funds more or less likely to examine alternative investments, and if so, why?

We could go on but you get the idea. While database vendors frequently categorize plans by assets under management, how many researchers examine the role of size with respect to pension best (worst) practices? What do they conclude?

There are published empirical answers to some of these questions.

We welcome your comments!

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"A Different Strategy on Pensions" by New York Times reporter Mary Williams Walsh (September 9, 2006) showcases International Paper Company for its use of swaps as a way to hedge interest rate risk. She writes that "International Paper's $7 billion pension fund, which covers 175,000 people, is three years into a broad revamping, one that the company believes will protect it from the forces that wreaked havoc in the last few years."

Several points are worth mentioning.

First, the Pension Protection Act of 2006 makes a practice known as smoothing more difficult. The implication? It will be harder for companies to disguise funding problems going forward. Changes due out any day from the Financial Accounting Standards Board are likewise expected to put the kibosh on this type of illusory reporting mechanism. CFO.com reporter Helen Shaw writes that FASB Chairman Bob Herz opposes smoothing and favors a more accurate representation of funding status. (Click here to read her 2005 article.)

Second, defined benefit plans are affected by changes in interest rates (and related yield curve shifts). As rates drop, pension liabilities increase. (The extent to which they rise depends on a host of factors.) Moreover, a drop in rates (depending on the cause) could depress the return (assumed and realized) on some (not all) investments, thereby widening the pension gap and making things worse.

Third, the effectiveness of any interest rate hedging technique is influenced by current levels of interest rates, capital market conditions, the shape of the yield curve, the steepness of the yield curve, choice of instrument and so on. That's why Fed watching is such a popular activity.

Fourth, the pension situation is not hopeless. While some companies and municipalities are in dire straights (perhaps well on their way to financial distress or outright failure), other organizations can and should consider what works, what doesn't work and why.

Pension governance best practices are worth the time. Millions of people count on decision-makers to evaluate plausible solutions as a way to keep their word.

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Did you know that September 8, 2006 is 401(k) Day? "An annual celebration spotlighting the importance of employer-sponsored profit sharing and 401(k) plans," this holiday follows Labor Day "as retirement follows work."

You can try out several planning tools such as the 401(k) Day Retirement Checkup, a glossary and a 401(k) calculator.

Provided by the Profit Sharing/401(k) Council of America (PSCA), a nonprofit association, these tools and many other resources can be retrieved and used throughout the year.

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Several days ago, I wrote about the link between employee happiness and the bottom line. I was pleasantly surprised therefore to read about a new study conducted by Auburn University professor, Dave Ketchen. Acknowledging the importance of incentives, his research results also suggest that "performance improvements are stronger when companies take a systematic approach to human resources rather than implementing one or two practices". He adds that "Executives need to adopt a strategic view of the human resource function and create sets of practices that reinforce each other."

In a related article, published in the August 2006 issue of Workforce Management, Dr. Theresa M. Welbourne echoes a similar sentiment about the strategic importance of the HR function. Author of "Human Resource Management: At the Table, or Under It?", Welbourne describes several of her studies which suggest that HR professionals are not given their proper due. This is a pity since "HR can, through various initiatives that reach out to employees, obtain employee insights and ideas about the business. HR can be the table because HR will have information about the business that no one else in the organization has at present. Employees are the stealth ingredient to creating a realignment culture. If you ask employees for information, and you use their input to realign, they are now part of the change, which means they are much more willing to move forward with the leadership team."

So what does this all mean in pension land? Plan design analysis should take into account immediate cash flow and earnings impact as well as trickle down effects that relate to employee productivity and retention. The expected demise of defined benefit plans may not come to pass if companies decide that attracting and keeping employees requires traditional benefits. Given today's article by New York Times reporter Jeremy W. Peters, labor shortages (and related cost pressurs) could nip defined benefit plan terminations in the bud. (See "Labor Costs Shake a Pillar of Fed Policy", September 7, 2006, New York Times.)

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Dr. Susan M. Mangiero, CFA, Accredited Investment Fiduciary Analyst, and author of the book Risk Management for Pensions, Endowments, and Foundations, will join forensic professionals with the Center for Financial Research & Analysis (CFRA) on a September 6 conference call to talk about the Pension Protection Act of 2006.

CFRA team members will address the key components of the Pension Protection Act of 2006 and update their report of April 11, 2006 which discussed at-risk companies. Dr. Mangiero will touch on the fiduciary implications of the Pension Protection Act, litigation vulnerabilities and possible financial concerns for institutional investors, ERISA and D&O liability insurance underwriters and regulators.

There are currently no more openings for this event. However, if you would like to have a copy of the transcript, click here to request information.

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Authors Dan Baker, Cathy Greenberg and Collins Hemingway write about successful organizations in What Happy Companies Know: How the New Science of Happiness Can Change Your Company for the Better. Using real-world case studies, their book "shows readers how to build a company where individuals at every level can apply their diverse strengths towards shared goals that are meaningful, positive, and profitable."

They offer that "motivated employees are the keystone to business success", suggesting that "companies built around people, positive mindsets and long-term goals consistently out-perform unhappy companies." (Click here for a short book review.)

Having just been interviewed by two journalists about significant changes to corporate pension plans and having met Dr. Dan Baker, author of What Happy People Know: How the New Science of Happiness Can Change Your Life for the Better, I started thinking about benefits and job satisfaction.

1. Has the flurry of headlines in recent months, chronicling frozen pension plans, layoffs, wage concessions, rescinded health care benefits and varying levels of job satisfaction, made it hard to implement a smiley face approach to work?

2. Accepting the book's premise that happy companies are profitable companies (something that makes sense to me), are they also generous companies in terms of new and/or continued benefits?

3. Do employees favor benefits that promote self-empowerment or prefer a more traditional, and arguably parental, approach?

4. How often do HR professionals break bread with C-level executives in order to design the optimal benefits mix that maximizes the happiness quotient while controlling costs?

5. Are certain types of workers happy even when the company's culture is sad sack central? (For example, there is interesting research that people who get more sleep are happier in their jobs.)

6. Can a company cherry pick happy individuals during the hiring process and thereby save (make) money in the long run?

7. Will rapidly changing demographics alter the way companies hire, train and retain and what role will benefits play?

8. Do employees react to news of rescinded benefits more negatively than never having had them in the first place?

9. Is happiness a function of how executives get paid versus everyone else, absolute dollars paid to executives, both or neither?

10. Are companies in certain industries happier, and if so, why?

I just ordered my copy of what looks like a very interesting book. If you know of research that addresses any or all of these questions, please let us know.

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1. According to the U.S. Department of Labor website, "The first Labor Day holiday was celebrated on Tuesday, September 5, 1882, in New York City, in accordance with the plans of the Central Labor Union."

2. The Public Broadcasting Service (PBS) website provides some additional insight with a variety of articles about this U.S. federal holiday. "Conceived by America's labor unions as a testament to their cause, the legislation sanctioning the holiday was shepherded through Congress amid labor unrest and signed by President Grover Cleveland as a reluctant election-year compromise."

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In a riveting and timely article, senior Greenberg Traurig ERISA attorney Jeff Mamorsky provides a serious wake-up call to pension fiduciaries everywhere. (Click here to read "Is Today's Pension Plan Environment Cause for Concern?", CEO Magazine, August 2006.)

Mamorsky chronicles the parade of corporate horribles in the U.S. that eventually led to the Sarbanes-Oxley Act of 2002 (SOX). He points out the irony that "All this happened in the USA despite the fact that the federal pension law, the Employee Retirement Income Security Act of 1974 (ERISA), contains rules that require plan sponsors to establish internal control procedures to monitor compliance with the fiduciary responsibility requirements of ERISA."

In the spirit of the stick winning over the carrot, Mamorsky adds that "These rules were in some cases not followed since there were few real teeth in the law. It took SOX with its draconian certification penalties and ERISA's 'white collar' criminal penalty provisions to make plan sponsors take pension governance more seriously."

Emphasizing the nature of personal liability for pension fiduciaries, the article explains the critical, and undeniable, connection between SOX compliance and pension governance. In a rather ominous statement, Mamorsky warns "This liability has increased as the result of legislation such as SOX that requires a public company CEO, CFO or other responsible fiduciary to certify the establishment and adequacy of 'disclosure controls and procedures' relating to material items in the annual financial report. What companies sometimes overlook is that this SOX section 404 management assessment of the adequacy of internal control procedures requirement applies to pension and benefit expenses."

If you aren't scared at this point in the article, he goes on to describe SOX sanctions of money and jail - "$2m and up to ten years' imprisonment for non-wilful ($5m / up to 20 years' imprisonment for wilful) certification of any statement that does not comply with SOX requirements." Then there is the matter of heightened IRS scrutiny of pension plan governance (or lack thereof), a rise in litigation and general upset about the topics du jour, pension funding gaps, rescinded benefits and so on.

Mamorsky concludes that the rest of the world is starting to feel the pinch as the UK and other countries address governance as an important element of the "global pension world."

As an aside, our sister company, Pension Governance, LLC is soon to launch a pension litigation database, chock full of analyses and trends. We had planned to launch earlier but found many more cases than we originally anticipated.

A harbinger of days ahead in pension governance land?

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In my June 22, 2006 post entitled "Will the Real Pension Deficit Please Stand Up?", I made the case that measurement ambiguity is dangerous. It prevents anyone from addressing a financial funding problem in any meaningful way. While ERISA plan metrics have often been the focus, it turns out that municipal plan analysis may be similarly difficult to interpret. New York Times journalists Mary Williams Walsh and Michael Cooper report that the use of multiple valuation methods can result in completely different assessments. (See "On Tracking of Pensions, No Consensus", August 27, 2006.) Their interviews with several rating agency professionals suggest concern and the need to supplement reported numbers with additional metrics.

Actuarial methods are called into question as well, especially if they result in overly optimistic investment return projections and artificially smoothed expenses over time. Though clarification would be a welcome relief, the reporters write that "The Governmental Accounting Standards Board, which sets the rules, is in the initial stages of reviewing the 12-year-old standard governments use when reporting pension values. Any changes are likely to take years."

In contrast, note what an anonymous blog reader has to say (with some minor edits).

The NYT article talks about valuing the pension liability using the appropriate municipal bond yield. Because this rate is lower than the current GASB-mandated rate, the liability balloons.

But municipal bond yields are low because they are tax exempt. I'd make the case for the same-risk corporate bond yield. (If NYC has Aa credit, use the Aa corporate bond yield.) This approach would reflect the risk of the pension liability, but not the tax shield. Since pension distributions are subject to taxation, the tax-exempt municipal yield is inappropriate from the pensioner's perspective.

Some might argue that public pension obligations are close to guaranteed since municipalities can raise taxes to pay bills. This suggests they should be valued at a risk free rate. If so, I'd argue that it should be a Treasury rate, not a Aaa muni rate.

As an Accredited Valuation Analyst, I think it's safe to say that reasonable people can disagree about assumptions as long as each appraiser employs logic and can defend, and document, the basis of his or her assumptions. Competing methodologies are a different story altogether when they produce outrageously divergent outcomes that are hard to support.

Perhaps this is the beginning of a new specialist career - pension valuation translator.

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Hi everyone:

1. I'd like to take a few minutes to thank you for your terrific emails and comments. Please keep them coming. I may not always be able to respond right away but know that every email is read. The blog is a labor of love and it's been personally gratifying to be able to provide information that our 15,000+ visitors have found helpful. The list of blog topics is long and getting longer every day. There is so much to say!

2. We are migrating to a new blog home in about four to six weeks. The URL stays the same, www.pensionriskmatters.com. We'll have many more functions. The goal is to make the blog easier to navigate for our readers.

3. We are creating thought leadership in the form of research papers and webinars for the fall with a special emphasis on investment risk, pension finance, shareholder impact, valuation and alternatives (hedge funds, private equity funds, etc). If you would like to be a guest speaker or contributing author and/or want to submit ideas, please contact us. You can send an email to pension@bvallc.com or call 203-261-5519.

4. The biggest challenge is knowing whether to provide more technical information or instead offer big picture analyses or both.

5. Though the blog was only created a few months ago, we look forward to a continued conversation about employee benefits.

In appreciation of our readers,
Susan M. Mangiero, Ph.D., CFA, AIFA, FRM, AVA

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Once our blog is upgraded in four to six weeks, we'll be able to include permanent links to other blogs and websites. For now, here are a few places you may find worth a visit. As always, please decide for yourself. These comments are not meant to be official endorsements of any particular site. We cannot guarantee the accuracy of the content or appropriateness of policies.

Thanks to a reader, Harold, I learned about another website for seniors, @Prime! The site describes iteself as "one of the leading age 50+ webservices designed to serve the more than 77 million Americans with the largest purchasing power of any single group in America today". Its creator, Mr. David J. Tananbaum "has been closely associated with the pre-retirement and, retirement industry for more than 35 years, and, is currently President/CEO of National Retirement Programs, Inc." and "a founding member of the American Society of Pension Professional and Actuaries." A nice feature is the array of articles about financial empowerment.

And speaking of which, Mr. Rick Meigs agrees with the view that people are saving too little and are in for a rude awakening when they finally decide to retire. (I had opined in the August 29 post that an average 401(k) account balance of $102,000 seemed meager at best, especially considering longer life spans.) President of 401khelpcenter.com, LLC, Rick and I had a long conversation about possible pension litigation trends in the aftermath of the Pension Protection Act of 2006. (Our sister company, Pension Governance, LLC wil be launching a pension litigation database in early fall.) You can go to the home page to sign up for a free newsletter that is chock full of links to other websites and timely articles.

An interesting site that looks at the impact of health habits on age is www.RealAge.com. A "consumer-health media company and provider of personalized health information and management tools", RealAge, Inc. features a calculator to determine your "real age" versus your biological age. Their Scientific Advisory Board Members have written extensively on topics having to do with health. After all, expected life spans of employees have a direct bearing on a plan sponsor's financial obligations.

BenefitsLink.com is another good site. Geared to "the people who administer, give compliance advice about, design, make policy for, or otherwise are concerned with, employee benefit plans in the United States sponsored by either private or governmental employers", you can likewise subscribe to a complimentary newsletter about either welfare or retirement plans or both. A prominent feature is a benefits job center that seems rather comprehensive.

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Early August 2006 saw the launch of a new website, Eons.com. According to their press release, "Eons.com has interactive games to build brain strength, news on entertainment and hobbies for older people, a personalized longevity calculator and tips to live longer." A great idea from the founder of Monster.com, this networking community for the over fifty set boasts a section devoted to building a retirement dream list.(Thank you to the anonymous blog reader who sent us the URL. I later saw an article about this new site in Investment News.)

In stark contrast, a new study, courtesy of the Employee Benefit Research Institute (EBRI) and the Investment Company Institute (ICI), suggests that retirement dreams may be hard to achieve for the average person. In particular, Figure A6 paints a downright dreary picture, reporting an average 401(k) balance of only $102,000.

While some individual retirees will receive money from a defined benefit plan and/or Social Security, $102,000 is not much at all when you consider that large numbers of people are living well beyond fifty. While enjoying a short vacation in Arizona, I met several people who said they simply cannot afford to retire and are making adjustments. House-sharing, working more years and scaling back expectations are some of the options.

Eons' founder Jeff Taylor challenges seniors "to see how many friends and family you can inspire to live the biggest life possible. Be loud and be proud about your age." I hope people have the financial wherewithal to do what they dream, for as long as they can.

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Talking about defined benefit plans is a little like listening to the Beatles.

You say yes, I say no.
You say stop and I say go go go, oh no.
You say goodbye and I say hello
Hello hello
I don't know why you say goodbye, I say hello
Hello hello
I don't know why you say goodbye, I say hello.

While some advocate their use as a means to attract and retain employees, others intimate their inevitable demise. Either way, one thing is certain. More and more companies seem to favor plan freezes in order to cut costs.

Dow Jones Newswire reporter Steven D. Jones points out that the newly enacted Pension Protection Act of 2006 encourages freezes by compelling companies to fully fund their obligations within a prescribed period of time.

Whether a freeze is "soft" and shuts out new entrants or "hard" and also halts benefits from further accruing, current retirees are not typically impacted. On the other hand, people in the system could end up with less money when benefits are tied to time in the plan.

Even when companies are flush with cash, freezing may make sense. Retiree longevity comes with a hefty pricetag in terms of funded benefits. Moreover, forthcoming accounting rules will force disclosure of pension obligations onto the balance sheet, an unwelcome event for some, especially if it leads to loan covenant breach.

Even writing from a few sunny vacation days in Arizona, this author has to admit that the pension climate sometimes seems downright Arctic.

Jacket anyone?

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Gregory J. Volpe reports that New Jersey property taxpayers may be on the hook after all for state pension promises, despite efforts to cut costs by rescinding employee benefits.

In his August 24, 2006 article, Volpe writes that "The Office of Legislative Services, a nonpartisan agency comprising state workers, told the Joint Legislative Committee on Public Employee Benefits Reform on Wednesday that any law the Legislature passes to diminish retirement benefits for retired or active workers with more than five years in the system would be unconstitutional."

Despite disagreement about whether pension benefits can be cut to keep property taxes in check and otherwise enhance the state's financial position, legislators offered that health care benefits may be next on the chopping block.

As we'll discuss in future blog posts, if you think the pension issue makes you sick, health care benefits are going to take center stage in both the private and public arena in very short order.

More to come...

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In its newly released "Pension Insurance Data Book", the Pension Benefit Guaranty Corporation (PBGC) continues to show about a $23 billion deficit, adding that "typically, the plans trusteed by the PBGC are only about 50 percent funded on a termination basis. Very few of the claims against the agency (only 1.5 percent) come from plans that are at least 75 percent funded."

By way of background, the "PBGC is a federal corporation created by the Employee Retirement Income Security Act of 1974 to guarantee payment of basic pension benefits earned by workers. Its two insurance programs cover 44 million American workers and retirees participating in over 30,000 private-sector defined benefit pension plans, including some 1,600 multiemployer plans. The agency receives no funds from general tax revenues. Operations are financed largely by insurance premiums paid by companies that sponsor pension plans and by investment returns."

Could it get any worse?

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New York Times reporter Mary Walsh and Michael Cooper offer a grim assessment of New York City's pension finances in their August 20, 2006 article entitled "New York Gets Sobering Look at Its Pensions". Their research suggests a funding gap as large as $49 billion or "nearly the size of the city's entire annual budget and the equivalent of the city's publicly disclosed outstanding debt."

A key point of contention is how to properly measure the true economic value of the city's pension obligations. According to the article, New York City employs a unique method that sets the pension shortfall to zero. By doing so, it is never clear whether the plan is in deficit and to what extent. Apparently the method started at a time of bounty, with the aim of preventing a raid by officials.

As this author has repeatedly said, you must be able to properly measure the pension liability. Otherwise, how can one identify what corrective action to take, if any, to set the plan right? (Written for private plans, the same commentary applies in concept to public plans. Good information is everything. Click here to read "Will the Real Pension Deficit Please Stand Up?")

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A recent article caught this author's eye because it speaks to why the pension "problem" is likely to be with us for a long time.

The Associated Press reports that an official suggestion to cut back vacations in order to satisfy rising health care and pension costs has been soundly rejected by German workers. (See According to "Less Vacation? Germans Say 'Nein'", August 18, 2006). Apparently, Germans average twenty-four vacation days per year.

A related survey suggests that twenty-seven percent of more than 6,000 respondents take a vacation once a year while more than 1,400 persons claim to rest only once every two to five years.

Vacations provide a great way to recharge and return to work, refreshed, productive and happpy. However, five or six weeks of vacation is arguably generous by most standards and even more so, when funding gaps exist. (Of course, Americans are often accused of "living to work" versus "working to live" and there is certainly a lot to say about living a well-balanced life.)

The U.S. Social Security Administration reports less than ideal conditions.

Sluggish economic growth, high unemployment, and worsening demographics are burdening Germany's public pay-as-you-go pension system, which currently claims monthly government expenditures of about 15 billion Euros (US$19 billion). The Social Affairs Ministry estimates that the pension system will have a deficit this year of 1.5 billion Euros (US$1.9 billion). Continued economic performance next year could result in not only a benefit freeze but additional actions being taken to fill the funding gap that the government estimates will reach 3.5 billion Euros (US$4.5 billion) in 2006.

Without massive reform, there is no way around reduced benefits, higher taxes or both.

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Low birth rates, combined with large pension obligations, could spell trouble. That's why, according to several recent articles, many countries are now offering incentives to encourage natural parenting. Immigration reform is another approach.

Without change, countries such as Japan expect to cut pension benefits precipitously. Companies are worried too. A labor shortage could erode profitability in a big way.

There are so many questions. It's hard to know where to start.

1. Is it an invasion of privacy for national policy-makers to encourage individual lifestyle choices in order to preserve social benefits and promote "the greater good"?

2. Will working women respond to financial incentives to give birth or fret that it could deter them from climbing the corporate ladder?

3. Will child-free adults feel like social miscasts for not having children?

4. What should companies spend to create a "child friendly" work space and how will it impact shareholder value?

5. What is the nature of optimal immigration reform?

6. Should companies reach out to already retired workers and how could that affect the workplace dynamic between Generation X and Baby Boomers?

These, and a host of other queries, will keep politicians, sociologists and business professionals busy for months to come.

For background reading, try these articles.

1. "Cash Incentives Aren't Enough To Lift Fertility" by Mark Fritz, The Wall Street Journal, August 17, 2006

2. "Retiree benefits grow into 'monster'" by Dennis Cauchon, USA Today, May 24, 2006

3. "Low Japan birth rate may force pension cuts-report", Reuters, July 2, 2006

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It's back to school time and that includes this author. I'm attending a training program to earn the Accredited Investment Fiduciary Analyst (TM) designation.

As we await Presidential approval of the Pension Protection Act of 2006, two and a half days spent discussing investment issues in a fiduciary context will keep attendees very busy.

Click here to access Financial-Planning.com's article about financial designations.

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In "All risk and no reward?", Peter Davy describes the shift to a risk-based paradigm which, for some fiduciaries, is a brave new world. No longer likely to be encouraged to look at returns only, decision-makers will need to revisit "risk 101" fundamentals and then some. Enthusiasm about liability-driven investing is one good sign. Evaluating pension issues in the context of corporate strategy is thought to be another step in the right direction.

Somewhat surprisingly, a survey taken of mostly UK FTSE-listed firms by Mercer Human Resource Consulting and the Association of Corporate Treasurers ("ACT") indicates a low use of derivatives. ACT technical officer Martin O'Donovan suggests that trustees are dubious about "more complex strategies" and prefer avoiding what they don't understand. (Our survey results reflect a greater willingness to use derivatives.)

This blog's author is quoted as saying that "if the renewed emphasis on risk management means anything, it is that fiduciaries must be able to justify their investment decisions" and that "process is everything". The issue of a fiduciary duty to hedge is something worth pondering. (Click here for a nice piece by attorney Randall Borkus on the topic.) If pension fiduciaries are arbitrarily restricting use of any financial instrument without due consideration of the benefits and advantages, are they acting properly? (Readers are reminded to contact legal professionals for advice about what constitutes proper fiduciary duty discharge.)

One thing is certain. The next few years are going to mean breath-taking changes for retirement plan professionals.

Are you ready?

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Wikipedia describes the Rashomon Effect, named after the 1950 classic movie, as the proper way to describe any situation "wherein the truth of an event becomes difficult to verify due to the conflicting accounts of different witnesses."

And so one wonders if the Rashomon Effect pervades in pensionland. After all, it seems that every day brings new headlines with gloomy news about pension losses. Can it all be bad?

Whether a pension crisis is upon us is an excellent question. Solving a problem is impossible without acknowledging its existence.

These thoughts arose a few days ago when a blog reader sent the following anonymous note:

Government plans are not covered by ERISA for sound constitutional reasons, state sovereignty, the 10th Amendment, etc. Take a closer look and you will see that most plans are soundly managed. They are also subject to multiple levels of state oversight. Don't buy the hype.

Importantly, one might have penned something similar about ERISA funds regarding what we read and hear. The focus of the newly passed Pension Protection Act of 2006 in all of its 907 page glory, and now awaiting Presidential approval, company pension headlines are often negative, replete with references to losses, rescinded benefits and/or impact on employee morale.

The National Association of State Retirement Administrators ("NASRA") has written extensively in support of municipal pension plan management. To illustrate, in an August 2, 2006 letter to federal lawmakers, they and other signatories wrote about the misperceptions of public pension finance and the benefits of a study by the Government Accounting Office to set the record straight.

There are fundamental differences between governments and businesses that result in critical distinctions between plans in each sector and the way in which they are accounted for and measured. These distinctions are often unknown or misunderstood.

Public plans are in sound financial condition and State and local governments take seriously their responsibility for paying promised benefits to their employees and retirees. Comprehensive State and local laws, and significant public accountability and scrutiny, provide rigorous and transparent regulation of public plans and have resulted in strong funding rules and levels. Public plans are backed by the full faith and credit of State and local governments. Additionally, a public plan participant's accrued level of benefits and future accruals typically are protected by state constitutions, statutes, or case law that prohibits the elimination or diminution of a retirement benefit, providing far greater protections than what is provided by ERISA or PBGC.

State and local retirement plan assets are professionally-managed and provide valuable long-term capital for the nation's financial markets. The $2.8 trillion held in plan portfolios are an important source of stability for the marketplace and are designed to withstand short-term fluctuations while still providing optimal growth potential.

The bulk of public pension funding is not shouldered by taxpayers.

The vast majority of public plan funding comes from investment income.

This author concurs that shedding more light on the financial health of public plans is a great idea. Ditto for ERISA funds.

Finger pointing is futile. Taxpayers, shareholders and plan participants just want to know what impacts their wallets.

1. Can I afford to retire?

2. Will my benefits be limited or, worse yet, pulled away once I've retired?

3. Will my taxes go up?

4. Will my equity investment fall in value because of a company pension problem?

Reasonable people want answers now, not later on when it's too late to do anything to salvage their financial stake. As mentioned many times before, a real dilemma is information - old, incomplete and/or difficult to interpret. (Click here to read "Will the Real Pension Deficit Please Stand Up?")

How can we get closer to the truth and then use it productively?

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If you haven't read about what has been happening in San Diego with respect to its pension plan, a trip to SignOnSanDiego.com is well worth a visit. There you will find a slew of documents and articles about the many problems that have now led to indictments and a $1.4 billion estimated pension deficit, which in turn have led to restricted capital market access for what some consultants describe as "Enron-by the Sea". In the final audit report, made public just a few days ago, one of its authors, Arthur Levitt Jr., former SEC chairman, emphasized the need for fundamental reform.

Some of the reviewers' recommendations are listed below. Notice the item about financial statement certification, a la Sarbanes Oxley. Along these lines, this author suggests that decision-makers at least ponder the idea of a pension "financial expert", analogous to SOX audit committee rules. While an honest debate about what constitutes appropriate educational and experience requirements for such a position is a must, the hiring process could encourage objective and independent outsiders to join.

Optimists say that trouble begets reform and that lessons learned go a long way to help others avoid losses. That would be a good thing!

Excerpted Suggestions:

Creation of a permanent three-member Audit Committee empowered to retain the City's independent auditors and to inquire into all aspects of City governance and financial reporting, as well as establish and monitor "whistleblower" complaints.

Two members should be independent of the City and have significant financial expertise in accounting, auditing and financial reporting.

The appointment of a Monitor to oversee implementation of the remedial actions being recommended. The Monitor should make quarterly reports to the City's permanent Audit Committee and to the Division of Enforcement of the SEC. These reports should also be available to the citizens of San Diego.

Accountability for fiscal decision-making and disclosure must be built into the City's financial reporting system. To do this, the City must strengthen the role and accountability of the Chief Financial Officer who should be the individual primarily responsible and accountable for the accuracy and timeliness of the City's financial management, reporting and disclosure functions. Assisting the CFO should be a Comptroller, with experience in government accounting, and a Director of Financial Reporting, with specific responsibility for preparation of the City's financial statements. The CFO should also supervise a Director of Budget and Planning to be responsible for assisting the CFO in budget preparation and financial analysis. The Mayor and the CFO should annually include with the City's financial statements a statement of the City's responsibility for establishing and maintaining an effective system of internal control over financial reporting. Similarly, certain heads of each City unit, including its pension board, should be required to certify their stand-alone financial statements.

The City should provide increased pension system independence, accountability, and transparency, through, among other things, the reduction of the pension system board to nine members, five of whom should be mayoral appointees. The chairman of the pension board and its principal executive should be required to include a signed management report addressing accuracy of the Comprehensive Annual Financial Report, effectiveness of internal controls, and other relevant issues.

The City should support the Mayor's initiative to develop a five-year financial plan for City government. Each year the City Council should require a final budget that compares actual to budgeted performance, accompanied by written explanations by each department manager for variances.

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CNN senior writer Jeanne Sahadi describes increased limits, automatic enrollment (encouraged but not mandated) and greater flexibility with respect to selling company stock held in a 401(k) plan as only a few of the many elements of the Pension Protection Act of 2006 that bode well for the future of what the IRS describes as "the most popular type of retirement plan used today." (The Act still requires the President's sign-off.)

By way of background, a "401(k)" plan takes its name from a section of the Internal Revenue Code. According to the 401(k) Resource Guide, created and made available by the IRS:

A 401(k) plan is a qualified (i.e., meets the standards set forth in the Internal Revenue Code (IRC) for tax-favored status) profit-sharing, stock bonus, pre-ERISA money purchase pension, or a rural cooperative plan under which an employee can elect to have the employer contribute a portion of the employee's cash wages to the plan on a pre-tax basis. These deferred wages (elective deferrals) are not subject to federal income tax withholding at the time of deferral, and they are not reflected as taxable income on the employee's Form 1040, U.S. Individual Income Tax Return.

Since this blog deals with pension risk, it is worth mentioning that defined contribution programs such as 401(k) plans are not a risk-free alternative for employers. See Myth #4 of this author's article entitled "Pension Risk Management: Necessary and Desirable".

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How much does a plan participant really pay in retirement plan fees and what is the impact on economic investment performance?

A report from Bloomberg.com describes "behind the scenes" currency exchange fees as one culprit.

The class action complaint, filed August 2 in Canada, questions a bank's practice of charging foreign exchange fees on stock trades in retirement accounts, alleging secrecy, "in breach of the defendants' contractual and fiduciary duties."

Pundits predict a more intense focus on the issue of 401(k) fees stateside, and abroad, for 401(k) look-alike products.

Several reasons account for this. For one thing, financially strapped retirees seek to minimize costs for fear of having insufficient funds to pay for their golden years. Losses or sub-par performance will only add to their upset and fees could be a big component. Second, disciplined investors plan ahead by making certain assumptions about future returns. They need to incorporate all relevant costs. Third, the Pension Protection Act, likely to become U.S. law, increases the likelihood that financial firms will sell more customized (but often costlier) retirement products to defined contribution plan participants.

Not surprisingly, regulators have expressed concern about fees and urged disclosure. This may only be the beginning of a "fee frenzy".

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If her intent was to scare, New York Times journalist Mary Williams Walsh succeeds. Her August 8 front page story entitled "Public Pension Plans Face Billions in Shortages" cites a Barclays Global Investments calculation that "if America's state pension plans were required to use the same methods as corporations, the total value of the benefits they have promised would grow 22 percent, to $2.5 trillion" with only $1.7 trillion having been set aside to meet these obligations."

Importantly, municipal plans are not covered by the Pension Benefit Guaranty Corporation ("PBGC") nor does the Employee Retirement Income Security Act ("ERISA") apply. If a state, county or city government comes up short, taxpayers are on the hook.

At a time when many taxpayers are struggling to save for their own retirement, how happy will they be to get someone else's tab? We cautioned that taxpayer blues may soon be upon us. (Click here to read "Tea Party Redux: State Pensions in Turmoil", posted on July 27, 2006.)

Mary Walsh is right when she decries the absence of oversight and "comparable systems of checks and balances." This author finds it particularly appalling that Congressional lawmakers spent hours wrangling over the Pension Protection Act without word one about government plans.

What will it take for taxpayers to really "get it" and vote for fiscal prudence?

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As we prepared to pat ourselves on the back at having reached 10,000 visitors last week, things got a bit hectic and we were delayed. Since then, we've added 2,000 more visitors to PENSION RISK MATTERS (SM). Clearly, the topic of pension risk (and related issues) resonates with readers and for good reason. Changing accounting rules and regulations around the world mandate a focus on investment, operational and governance policies, procedures, strategies and lessons to be learned. Pension fiduciaries understand that they can be found liable on a professional and personal basis in the event of breach.

According to results from a survey co-sponsored by Pension Governance, the RiskMetrics Group and Ulysses Partners, seventy-seven percent of respondents said that they "feel that institutional investor fiduciaries are more vulnerable to being sued in the aftermath of recent corporate, government and non-profit scandals." (To view other results about external money managers, risk management, derivatives, governance and fees, see "Survey Shows That Institutional Investors Are Worried", July 28, 2006.)

Thank you so much for your continued support and suggestions. While our list of blog ideas is long and growing every day, we'd love to hear from you. Simply click here to send an email.

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What's inside your side pocket? The answer may shock you. That's the gist of a recent article about investments that are tucked away, not to see the light of day until the positions are sold or marked down in anticipation of bad news. In "Street Sleuth: 'Side-Pocket' Accounts of Hedge Funds Studied" Wall Street Journal, August 4, 2006, reporters Gregory Zuckerman and Scott Patterson write that funds have been known to place large chunks of their portfolio in side pockets. Any investor seeking to withdraw money may find it difficult, sometimes facing "limits on their ability to withdraw their money, terms that are put in place so a fund can avoid being forced to sell investments at a sizable loss if a number of investors suddenly want their money back."

They cite Securities and Exchange Commissioner Roel Campos who addressed side pockets as part of his remarks before the SIA Hedge Funds & Alternative Investments Conference on June 14, 2006.

Hedge funds may hide poor-performing assets in side pocket accounts to exclude such assets from the fund's valuation for purposes of calculating performance fees. Some hedge funds require leaving some of the investment in side pockets as a condition for redemption, even though the condition was not disclosed in the investment agreement. On the larger scale, there is the potential for excessive leverage, the concentration of positions, the dependence of valuations upon complex proprietary models, and operational risks for settlement and clearance systems. There is also the risk that hedge funds will all exit at the same time - as purportedly occurred in the 1997/8 Asia Financial Crisis. Performance fee structures give hedge funds an incentive to engage in risky strategies that may not be fully disclosed, and some advisers may not have sufficient risk management processes in place.

Complicating things is the fact that a hedge fund can have multiple side pockets. For a fund of funds manager, the situation could be daunting if he or she allocates money to a large number of funds, each with multiple side pockets.

Supporters of side pockets argue that valuing investments under less than ideal conditions is worse than putting them aside for awhile. They advocate the use of side pockets so that investments they describe as carefully selected have a chance to grow.

Nevertheless, there are things one can do. Even when formal valuations are not performed by an independent appraiser, the use of a qualitative risk driver matrix offers a relatively low-cost form of discipline to get investors thinking about scenarios that might spell trouble. The idea is to both identify factors that could depress value and think about the likelihood of occurrence. For example, the value of equity issued by a closely-held airline company that does not hedge will no doubt drop as oil prices rise. (This author is surprised by the number of investors who have not taken this rather simple step in assessing the risk elements of their portfolio.)

More and more pundits describe a blurring of the lines between hedge funds (some of them anyhow) and private equity funds. The Mid-Atlantic Hedge Fund Association is devoting an entire meeting to this topic on October 12. Founding member and chairman of the board of this educational organization, Dechert attorney Brian Vargo describes the three-hour program as a lively discussion that is sure to include valuation as one of several challenges associated with the trend towards convergence.

In case you missed it, the author wrote about the importance of getting independent opinions of value or having an outsider review the valuation process already in place on June 18, 2006. Click here to read the post.

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Judges continue to expel experts (and their reports) when they are unable to demonstrate relevant credentials and experience. In a July 2006 case involving the fair market value assessment of private company equity, the U.S. Tax Court wrote: "We are not obligated to pay any regard to an expert opinion that lacks credibility" and criticized the report for not adhering to the Uniform Standards of Professional Practice, otherwise known as USPAP.

Within the last few weeks, the IRS released valuation guidelines, a product of the Valuation Policy Council. "The VPC was established in 2001 to assist IRS leadership in setting direction for valuation policy that cuts across functional lines, and in identifying process improvements to improve compliance and better utilize resources." (Click here for a copy of the new guidelines and here for a credential comparison chart.)

As pension funds increase their exposure to private company stock, the valuation issues are profound. The last thing pension fiduciaries should want is to pay someone to render an opinion of value and have the court toss it out for lack of substance. Ditto for regulatory enforcement and arbitration proceedings.

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Wall Street Journal reporter, Eleanor Laise recently wrote that an increasing number of mutual funds are "venturing into the risky world of private-equity investments", "because of the prospects for higher returns." While SEC rules limit assets to no more than fifteen percent in illiquid holdings, Ms. Laise describes potential problems. Higher legal expenses for more complex deals, difficulty of unwinding a position and valuing private investments are far from trivial challenges. She cites one SEC investigation of a mutual fund that allegedly undervalued its private company positions to give the impression that it had not breached the fifteen percent limit. "The SEC also has charged funds with inflating the value of illiquid investments. Mutual-fund managers have an incentive to overestimate the value of these holdings because they collect fees that are calculated as a percentage of total assets in the fund." (See "Mutual Funds Delve Into Private Equity" by Eleanor Laise, Wall Street Journal, August 2, 2006.)

Applying a version of the transitive property from mathematics, the implication is clear. Some pension funds have increasing exposure to private equity investments that do not trade in a ready market.

1. Pension funds allocate money to mutual funds.

2. Mutual funds buy private equity.

3. Pension funds are exposed to private equity as an asset class. (This is in addition to any direct allocation by pension funds to private equity.)

The message is clear. For those pension funds investing more money in private equity (indirectly or directly), the valuation issues are real and cannot be overlooked.

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The term "operational risk" is typically defined as the risk that results from incomplete, poor or failed internal controls, people and/or systems. Sometimes the term is used as part of a discussion about business continuity.

Operational risk is often cited as a key element of the use of over-the-derivatives. For one thing, the growth in over-the-derivatives market continues to break records, with the Bank for International Settlements reporting global use, in terms of notional amounts, in excess of $284 trillion at year-end 2005. Interest rate contracts such as forward rate agreements, options and interest rate swaps dominate, with an estimated notional amount of approximately $215 trillion. Additionally, operational snafus account for several large derivatives-related losses. Check out the Wheel of Misfortune for some interesting case studies.

A July 2006 survey conducted by Investit Intelligence confirms continued interest in the topic, with investment company COOs citing most concern about technology and operational risk.

Others feel similarly. Timothy F Geithner, president and CEO of the Federal Reserve Bank of New York described improvements such as "greater dispersion of credit and market risk, the improvements in risk management, the size of the capital cushions, and the improvements in many parts of the payment and settlement infrastructure", while cautioning market participants to "make the investments necessary to improve the operational infrastructure that underpins the credit derivatives and broader OTC derivatives market."

Why is this important to pension funds? Given the giant size of the derivatives market and their prevalent use by mutual fund managers and hedge fund managers, pension fiduciaries should be asking tough questions about operational risk policies and procedures.

Of interest may be two articles on what this author refers to as the Five C Approach to Risk Management (SM). In the absence of a disciplined, and carefully crafted, organization-wide strategy, identifying, measuring and managing derivatives-related risk is difficult at best. (Click here to read "Pension Risk Management: The Importance of Oversight" and here to read "Five Keys to Risk and Risk Management.")

If used properly, financial derivatives can provide users with flexibility, the ability to transform risk and possibly even lower costs. Evaluating, and effectively dealing with, operational risk is a big part of prudent practice.

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Reuters reports that the Senate, with a vote of 93 to 5, has just passed a pension reform bill that now goes to President Bush. The Washington Post reminds readers that the U.S. House of Representatives approved this bill last week with a 279 to 131 vote.

Major elements of the Pension Protection Act of 2006 are listed below.

1. Sponsors will have to fully fund defined benefit plans within a seven year period, starting in 2008.

2. Airline companies get more time to satisfy obligations.

3. Hedge funds will find it easier to manage ERISA money before being subject to fiduciary requirements.

4. Financially weak plans will have to contribute additional amounts of cash.

5. Providing 401(k) plan investment advice by financial companies will be relaxed.

Comments and analysis will follow in the next few days.

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According to PENSION AND BENEFITS, a CCH Business & Corporate Compliance publication, "EBSA, the PBGC and the IRS have proposed revisions to the Form 5500 Annual Return/Report forms. The goal is to modernize the ERISA fund disclosure process. While mandated by law, the current reporting system is in need of major improvements, something this author has described in several articles elsewhere.

What are some of the problems with the current reports? There is a long lag time between when data is submitted to the U.S. Department of Labor and when the information becomes available for public consumption. To illustrate, this author did a quick search of Freeerisa.com for several large U.S. companies and found data up to and including 2004 but nothing for 2005. As investors and beneficiaries know all too well, things can go downhill pretty quickly in which case a stale Form 5500 would be of no use whatsoever.

Moreover, the Form 5500 (Schedule H for large plans) provides scant details about a plan's investments. Nothing is provided about valuation methodology nor is any information proffered about risk measurements or risk mitigation strategies.

A welcome change is the expansion of information about service provider compensation. CCH reports the following.

The DOL has determined that it is appropriate to modify the Schedule C reporting requirements to ensure that plan officials obtain the information they need to assess the reasonableness of compensation paid for services rendered to the plan. As proposed, Schedule C would consist of three parts. Part I of Schedule C would require the identification of each person who received, either directly or indirectly, $5,000 or more in total compensation (money or anything else of value) in connection with services rendered to the plan or their position with the plan during the last plan year. This requirement would no longer be limited to the 40 highest paid service providers.

Filers would also have to indicate, for all service providers, whether the service provider received any compensation attributable to the person's relationship with, or services provided to the plan, from a party other than the plan or plan sponsor. Thus, if a fiduciary or anyone on a list of service providers received, directly or indirectly, $5,000 or more in total compensation and also received more than $1,000 in compensation from a person other than the plan or plan sponsor, then the Schedule C would have to provide information identifying the payor of the compensation, the relationship or services provided to the plan by the payor, the amount paid, and the nature of the compensation.

For further information, check out these sites.

1. IRS Form 5500 Corner

2. U.S. DOL "Troubleshooter's Guide to Filing the ERISA Annual Report (Form 5500), Part I"

3. U.S. DOL "General Guidelines for Completing Form 5500 and Schedules A, C, D, G, H and I"

4. Freeerisa.com (You can register for no charge and then search over 270,000 new filings.)

5. Article entitled "Deciphering Risk Management Disclosures" (While the article does not address Form 5500, it describes some important transparency issues.)

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A provision in the pension bill just passed by the U.S. House of Representatives could permit hedge funds to increase Employee Retirement Income Security Act ("ERISA") holdings before having to wear the fiduciary hat (for those that don't voluntarily assume the role now). The current limit is twenty-five percent of a hedge fund's total assets. The precise way ERISA assets are calculated is likewise expected to change.

According to Greenberg Traurig hedge fund attorney Nir Yarden, "an ERISA fiduciary is tasked with many responsibilities not otherwise required, some of which could significantly impact hedge fund strategy, investment mix, fees and reporting."

As one can imagine, advocates and critics are plenty. A healthy debate is good. After all, a particular hedge fund may be perfect for one defined benefit plan but wholly inappropriate for another. (To date, hedge funds are typically not offered as a 401K investment choice.)

What is important is that hedge fund (or fund of funds) managers who become ERISA fiduciaries truly understand what that means.

For example, with respect to the use of derivatives, a U.S. Department of Labor guidance letter is pretty clear.

As with any investment made by a plan, plan fiduciaries with the authority for investing in derivatives are responsible for securing sufficient information to understand the investment prior to making the investment. For example, plan fiduciaries should secure from dealers and other sellers of derivatives, among other things, sufficient information to allow an independent analysis of the credit risk and market risk being undertaken by the plan in making the investment in the particular derivative. The market risks presented by the derivatives purchased by the plan should be understood and evaluated in terms of the effects that they will have on the relevant segments of the plan's portfolio as well as the portfolio's overall risk.

Plan fiduciaries have a duty to determine the appropriate methodology used to evaluate market risk and the information which must be collected to do so. Among other things, this would include, where appropriate, stress simulation models showing the projected performance of the derivatives and of the plan's portfolio under various market conditions. Stress simulations are particularly important because assumptions which may be valid for normal markets may not be valid in abnormal markets, resulting in significant losses. To the extent that there may be little pricing information available with respect to some derivatives, reliable price comparisons may be necessary. After entering into an investment, a plan fiduciary should be able to obtain timely information from the derivatives dealer regarding the plan's credit exposure and the current market value of its derivatives positions, and, where appropriate, should obtain such information from third parties to determine the current market value of the plan's derivatives positions, with a frequency that is appropriate to the nature and extent of these positions.

Valuation is another touchstone. Fiduciary duties require a thorough assessment of everything related to plan investments. In "Hedge Fund Valuation: What Pension Fiduciaries Need to Know", this author emphasized the need for an independent assessment of valuation and/or valuation processes, including, but not limited to a check of price data collection, accuracy of pricing models and existence of controls that are meant to separate the trading and payment functions. The central role that valuation plays is becoming all too apparent as regulators and auditors ask tough questions.

Valuation drives nearly every investment activity. It is impossible for hedge fund managers to make meaningful decisions about asset allocation, portfolio re-balancing, risk management, fee assessments and performance evaluation in the absence of good valuation numbers. It is equally difficult for the pension fund investor to evaluate managers, decide whether to redeem or subscribe, verify calculated incentive fees charged by the typical hedge fund and otherwise carry out their mandated fiduciary duties. (Click here for a copy of the article.)

Any hedge fund or fund of funds manager, seeking additional ERISA money, should think about creating a laundry list of MUST DO items required by law and reflecting best practices. This would necessarily include a process check of risk management and valuation policies, procedures, along with reporting methodology. (A sign of the times, we've been fielding a lot of inquiries of late on these topics.)

Fees are another issue altogether and deserving of an additional post or two. (Read what we wrote in May 2006.)

So Congress plays matchmaker. Whether hedge funds and ERISA plans will represent a marriage made in heaven or a relationship destined for divorce court critically depends on prudent process.

Two little words that mean oh so much!

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A recent legislative attempt in California has apparently caused quite a stir. Assembly Bill (AB) 2122 sought to preclude companies from paying dividends to shareholders before satisfying pension obligations and to "make directors and officers of a corporation jointly and severally liable for improper distributions" under certain circumstances.

Refer to the July 13, 2006 post entitled "Dividends, Pensions and California Chaos".

Blogger Jerry Kalish provides a novel suggestion.

The proposed bill - and the politics behind it - conveniently ignores the massive unfunded pension liabilities in California, e.g, the California State Teachers' Retirement System faces a $24 billion unfunded pension liability.

But we got them beat in my home state of Illinois which at $35 billion has the largest unfunded pension obligation in the country. The Fitch Rating service released a "negative outlook" for Illinois finances - one of only three negative outlooks issued by the rating service in its review of the states. The other two? Louisiana dealing with the aftermath of Hurricanes Katrina and Rita and Michigan dealing with massive problems in the automobile industry.

Um! Should there should be a law that no more salary increases occur for state legislators until pension liabilities are met?

So where does this attempt stand now?

According to the website that tracks California legislation, the bill failed passage on June 22, 2006 with "reconsideration granted".

While laudable to encourage prudent pension funding, there are a host of problems associated with this type of reform.

Is Milton Friedman right when he said that "the government solution to a problem is usually as bad as the problem" and that "there's no such thing as a free lunch?" Notwithstanding the law of unintended consequences, empirically validated time and time again, there are a variety of better, and arguably more efficient and cost-effective ways to solve the pension "crisis" than putting state legislators in charge of a company's capital structure.

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Pension risk is serious stuff so this author has been reluctant to post anything "cute" or "funny", instead opting to write about topics that resonate with our readers. From the feedback and tremendous growth in visits, we seem to be on the right track. In fact, the list of topics we want, and plan, to address is huge and continues to grow.

As a humble thank you to this blog's readers, please permit a bit of whimsey as a quick diversion. The inspiration? Almost everyone in pension land (hedge fund land too) seems to be insanely busy this summer. Instead of thoughts about languorous vacation days stretching into balmy nights, it's more about taking an expresso break as a way to get a few minutes in the sunshine, walking to and from the office.

So perhaps it is not surprising that quirky facts and bits of knowledge make for a welcome respite. Talking about the hot, muggy weather with a colleague, we spent several minutes debating the genesis of the expression "dog days of summer". In taking yet another minute or two to research (in lieu of that aforementioned expresso break), the conclusion was that more than a few popular idioms involve dogs.

Here are some examples.

1. We're going to the dogs.

2. This is a dog-eat-dog world.

3. You'll end up in the doghouse.

4. He is sick as a dog.

5. This investment is a dog.

6. He leads a dog's life.

7. I've been working like a dog.

8. It's raining cats and dogs.

9. Every dog has its day.

10. Her bark is worse than her bite.

11. Let sleeping dogs lie.

12. You can't teach an old dog new tricks.

To dog lovers everywhere, hang in there. We don't mean any harm. We're in search of a quick smile.

Now back to work ...

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Executive stock options continue to grab headlines. In late 2004, after a parade of protests, the Financial Accounting Standards Board issued the "Summary of Statement No. 123 (revised 2004): Share-Based Payment". Intending to promote transparency, FASB's rule requires public companies "to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award" and to recognize the cost "over the period during which an employee is required to provide service in exchange for the award-the requisite service period (usually the vesting period)."

Following suit, on July 26, 2006, the U.S. Securities and Exchange Commission announced news about additional (and arguably more comprehensive) disclosure rules for all sorts of executive compensation vehicles, including stock options. The SEC plans to provide "additional guidance regarding disclosure of company programs, plans and practices relating to the granting of options, including in particular the timing of option grants in coordination with the release of material nonpublic information and the selection of exercise prices that differ from the underlying stock's price on the grant date."

(Click here and here for recent posts on this topic.)

Now, backdating takes a bow. The Corporate Library describes this practice as "awarding stock options on one date, and then backdating the grant or award date to a time when the stock price was lower."

Experts say that backdating per se is not illegal. So why the hullabaloo? Several reasons account for the recent news flurry. For one thing, there may be tax consequences. CNNMoney.com reports that "companies and individuals could face hundreds of millions of dollars from civil penalties, unpaid taxes and interest payments if widespread wrongdoing is found." One law firm, McDermott Will & Emery writes that "failure to disclose this practice could possibly constitute securities fraud" and give rise to accounting misrepresentation as well.

Concerned about alleged misdeeds and an adverse impact on stock price, pension funds are lining up to bring suit. Institutional Shareholder Services writes that "an international group of 14 institutional investors led by the U.K.'s Universities Superannuation Scheme and the Australian Reward Investment Alliance asked the SEC to increase disclosure requirements for option grants. The group includes five U.S. state pension funds and institutions from Canada, Norway, and the Netherlands."

To be clear, it is impossible to tackle the merits of any one situation without sufficient information to evaluate a problem, if one exists, and assess economic damages to anyone found to have been harmed by backdating.

However, even in the absence of case-specific information, a discussion about the valuation of executive stock options is nevertheless worthwhile. Saying that this topic is broad is like saying that Lake Michigan is a little body of water. That's why this topic will show up again in subsequent posts to www.pensionriskmatters.com and why it will continue to resurface as the topic du jour in court, regulatory proceedings, auditors' roundtables and board meetings everywhere.

To begin, pricing model choice and determination of inputs are integral to option valuation. While myriad factors contribute to a final assessment, one variable, volatility, is often described as dominant.

What exactly is volatility and how is it measured? Given different types of volatility, which one makes sense to use? Historical volatility is frequently measured as the standard deviation of returns for the underlying asset and can serve as a proxy for uncertain future asset price movement. This technique assumes that past price behavior is a bellwether for the future. Sometimes this is not an appropriate conclusion. An industry and its constituent members may have undergone radical change in the form of deregulation or technological innovation, completely changing the profitability landscape thereafter. In contrast, implied volatility is derived by examining market prices of an option (characterized by time to maturity, exercise price and other relevant factors) and backing into an estimate of investors' beliefs.

As demonstrated in "Model Risk and Valuation" by this blog's author, Dr. Susan M. Mangiero, the volatility number can have a dramatic impact on the computed value of an option. Moreover, the relationship between volatility and option value is not proportional. Consider that an increase of ten percent in volatility does not necessarily translate into a ten percent rise in the value of the option. (This is a simplistic statement since option value does not depend on volatility alone.)

Business Week reporters Jane Sasseen and Greg Hafkin correctly make the point that "options for volatile stocks carry higher expenses". Citing a report by Credit Suisse Group analyst David Zion, they describe a precipitous drop in the value of options granted by S&P 500 member companies, from "$104 billion in 2000 to $30 billion in 2005", adding that "implied numbers have been lower than the historical ones" but that "volatilities are heading up."

One thing is certain. Estimating volatility should amount to more than a mere number crunching exercise. The process should reflect an assessment of economic performance going forward. A mistake in volatility choice can be costly and lead to a slew of unwelcome events.

There is a lot (!) more to say on this topic.

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In a survey co-sponsored by Pension Governance, the RiskMetrics Group and Ulysses Partners, institutional investors expressed concern about a variety of issues, including:

1. Fiduciary breach litigation
2. Underfunding
3. Asset allocation mix
4. Investment return assumptions
5. Realized investment returns
6. Investment risk
7. Valuation
8. Regulation

In excess of fifty percent of respondents said they would like to know more about risk measurement and risk management. That makes sense, given survey results that point to beta, duration and, in the case of derivatives, notional principal amount, as favored ways to track position limits. As explained in great detail in Risk Management for Pensions, Endowments and Foundations, care must be taken to properly interpret these numbers, understand their strengths and limitations and undertake a comprehensive analysis of risk. Only twelve percent of respondents declared Value of Risk as a way to track position limits. Seventy-nine percent of respondents said that they do not currently use risk budgeting.

Interestingly, forty-six percent of respondents affirmed the use of more than ten money managers. No one answered "yes" to the question: "Do you use zero money managers?" The message? Institutional investors must make sure that the risk and valuation dialogue with external managers is comprehensive and clear. Outsourcing does not absolve fiduciaries of their oversight duties.

Seventy-five percent of respondents answered that the primary responsibility for making strategic risk management decisions rests with a committee. Only two percent answered that consultants or external money managers play this role. Arguably fiduciary education is critical for all committee members who collectively decide on all things risk. (As an aside, committee decisions should reflect analysis by all members rather than having some individuals passively accept the recommendations of one or two "leaders". The author is not an attorney. Fiduciaries should seek legal counsel for advice regarding relevant duties.)

Several results merit special comment.

More than ninety percent of institutional investors with assets in excess of $1 billion said that they know the amount of leverage being used by external money managers. At the same time, they expressed concern about risk management and admitted to using only a handful of risk measurements. Additional research is required to get behind these seemingly contradictory answers.

More than sixty percent of institutional investors with assets in excess of $5 billion cite the use of custodians as providers of "independent" valuation numbers. Only forty percent of investors with assets between $1 and $5 billion use custodians for this job. As institutions gravitate towards assets for which there is no ready public market or for which public market trading occurs infrequently, contacting qualified appraisers is worth investigating. Valuation disputes often end up in arbitration, litigation or regulatory enforcement actions and more than a few experts have been disqualified for lack of specialized training. Forty-eight percent of respondents claimed a concern about how hedge fund assets are valued.

For interested readers, click here to read "Hedge Fund Valuation: What Pension Fiduciaries Need to Know". Click here to read "Asset Valuation: Not a Trivial Pursuit."

Sixty-two percent of respondents confirmed that derivatives are permitted. Worry about the risk associated with derivative use, inadequate systems to monitor and manage risk and lack of familiarity or experience with derivatives showed up most often as the reasons for prohibiting their use. Seventy percent of users cited the use of equity and fixed income derivatives. When asked about instrument categories, sixty-three percent cited the use of futures contracts, fifty percent cited the use of interest rate swaps and forty some percent checked off credit derivatives and currency swaps. About thirty percent of respondents cited the use of options, both exchange-traded and over-the-counter.

Seventy-seven percent of people who completed the survey said that they "feel that institutional investor fiduciaries are more vulnerable to being sued in the aftermath of recent corporate, government and non-profit scandals."

This begs some important questions.

1. What are fiduciaries doing to better protect themselves from allegations of breach of duty?

2. Are investment committee members being recruited, retained and compensated on the basis of their investment knowledge and experience? If not, do they plan to introduce educational and experiential requirements soon? If not, why not?

3. Do fiduciaries respond best to the carrot or the stick approach? If the latter, will an increase in litigation result in better governance? If not, what will prompt organizations in need of improvement to do a better job?

4. How will pension reform and new accounting rules affect the investment risk strategies adopted by public and private funds? (The expectation is that derivatives and related risk management strategies will climb to the top of the MUST DO list in response to anticipated reforms and new rules.)

5. How are fiduciaries carrying out their duties with respect to properly analyzing non-traditional instruments and strategies?

The development of follow-up surveys is underway. Contact Dr. Susan M. Mangiero, CFA, Accredited Valuation Analyst and certified Financial Risk Manager (FRM) for more information.

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Is a modern Boston Tea Party soon to come? Will taxpayers say "enough" to what they perceive as generous municipal pensions while they struggle to save?

The Associated Press reports on July 21, 2006 that "Oregon's state pension board plans to ask about 1,900 retired government employees to repay an average of nearly $28,000 each. They are among 125,000 workers and retirees whose benefits will be cut as a result of a successful lawsuit filed by local governments who argued that the pension board put too much money in benefit accounts in 1999." Apparently, state employees will bear the brunt if retirees are loath to return the funds (though taxpayers ultimately finance salaries and benefits of existing and retired workers).

Moving east, a July 20, 2006 announcement from Albany has New York Governor George Pataki vetoing a bill "that would have allowed teachers and other government workers with 25 years of experience to retire at 55 with the benefits now available at 62", costing taxpayers more than $195 million over the next seventeen years.

Whether municipal benefits are excessive is hard to say. To be fair, many government workers accept lower than market salaries in exchange for better benefits. That being said, times are tough and it will become increasingly difficult for state, county and city employees to get much sympathy from individuals who have their own retirement crisis to solve.

Instigator of the now famous tea toss, Samuel Adams offered: "It does not require a majority to prevail, but rather an irate, tireless minority keen to set brush fires in people's minds." On the opposing side, British Admiral Montague countered: "You have got to pay the fiddler yet!"

Nothing is ever free. Someone, somewhere, somehow, pays the bill. How will politicians respond? After all, grumpy taxpayers tend to vote.

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A few thoughts come to mind regarding the new SEC executive compensation disclosure requirements.

1. Will it be hard for analysts to interpret information about executive pensions if they are reported on an accumulated benefit basis but FASB requires the use of a projected benefit approach?

2. How do company compensation committees determine who gets what and why? Understanding the process by having access to meeting notes would be particularly helpful.

3. What volatility numbers will be used to determine the value of executive stock options?

4. How are D&O insurance costs likely to change in response to disclosures about the timing of option grants to executives?

5. How are pensions determined for non-executives and does the Compensation Committee interface with the company's benefits team?

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SEC Chairman Christopher Cox announces new disclosure rules about executive compensation by stating that "With more than 20,000 comments, and counting, it is now official that no issue in the 72 years of the Commission's history has generated such interest." (Read the announcement online.)

Besides wages, options and other types of compensation, the investing public will now have access to a Pension Benefits Table which, among other things, will include "disclosure of the actuarial present value of each named executive officer's accumulated benefit under each pension plan, computed using the same assumptions (except for the normal retirement age) and measurement period as used for financial reporting purposes under generally accepted accounting principles".

This comes as good news, especially as Wall Street Journal reporters Ellen E. Schultz and Theo Francis highlighted the "hidden burden" for shareholders in the form of executive pensions. According to their June 23, 2006 article, "As Workers' Pensions Wither, Those for Executives Flourish", "Compensation committees often aim for a pension that replaces 60% to 100% of a top executive's compensation" versus "20% to 35% for lower-level employees." Their research revealed that "executive benefits are playing a large and hidden role in the declining health of America's pensions."

Talk about a morale buster for everyone below C-level!

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Global Pensions Magazine reports that the International Accounting Standards Board (IASB) has added pension accounting to its work plan. Smoothing and cash balance plans are two of the topics to make their way under the microscope. Executed in two stages, the goal is for IASB and Financial Accounting Standards Board (FASB) rules to converge by end of Phase Two.

According to its website, the International Accounting Standards Board is an "independent, privately-funded accounting standard-setter based in London, UK. The Board members come from nine countries and have a variety of functional backgrounds." Similarly, the FASB is self-described as "the designated organization in the private sector for establishing standards of financial accounting and reporting." (Click here to download Facts About FASB.)

Accounting harmonization is the wave of the future as more and more companies go global and investors seek ease of financial statement use. What will be interesting to know (and only time will tell) is whether:

1. The business community outside the U.S. is likely to push back

2. Disagreement will focus on the same issues (In the US, liability calculation methodology has taken center stage.)

3. Shareholders will demand the same level of transparency as in the U.S. (or more)

4. The extent to which common accounting standards will facilitate capital market development with respect to cost, availability and liquidity.

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The Star Ledger reports that New Jersey state officials "adopted a plan to shift billions of dollars in state pension money to private investment managers and set a course to reduce the funds' heavy reliance on the stock market." Journalist Dunstan McNichol describes a $16 billion reallocation from stock "in favor of larger holdings in toll roads, hedge funds and international stocks."

A harbinger of things to come?

Many experts agree that pending regulations and increased focus on pension obligations will move asset allocation to center stage, resulting in a variety of questions that demand good answers. (Asset allocation is oft-cited as the most important determinant of performance.)

1. How will an increased emphasis on alternative investments change the expected return-risk tradeoff of the pension portfolio (particularly as relates to estimating pairwise correlations of returns that vary over time)?

2. What are the liquidity implications of investing in public works projects, hedge funds, international stocks, commodities, private equities and so on?

3. How should pension plan decision-makers proceed in selecting alternative investment consultants (especially with respect to their ability to thoroughly analyze the impact of performance fees on net returns)?

4. How do alternative fund managers value their holdings, if at all?

5. How will overseers evaluate performance in the event of diminished transparency of returns and risk drivers that influence returns?

6. Will fiduciary liability change for funds that invest outside the traditional mix of equities and debt?

7. Do fiduciaries need additional training to feel comfortable asking the right questions about alternatives (and interpreting the answers with confidence)?

8. How should the Investment Policy Statement change to accommodate the use of alternatives?

Get ready pension fiduciaries! There is a lot of work to be done in moving the money around.

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The Independent reports that "British Airways is mulling the sale of its Air Miles customer loyalty scheme to help fill a pensions deficit that could be twice as big as first thought".

A novel concept, perhaps U.S. carriers will follow suit. How it will work specifically is not yet publicly known. It is reported that British Airways would receive up to 200 million British pounds "and provide flights in return" as part of a "complex transaction".

How the deal is priced will be of particular interest to many. Since airlines often employ discriminatory pricing, what exact flights should be bartered (in terms of revenue generation possibilities)? What are the tax implications? Is this the best way to finance the pension shortfall? What is the likely shareholder reaction? How will frequent fliers be impacted?

If it works for the airlines, what about the credit card companies and other industries that regularly employ reward programs to augment market share and plump up the bottom line?

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Haiku, a type of Japanese poetry, consists of three sentences, each one containing five, seven and five syllables, respectively. The goal is to convey a message in simple terms. Here are a few tries.

Pensions are crucial
People are not saving much
Will we always work?

Governance is key
Bad decisions cost money
Who will take the blame?

The point is this. Clear and simple communication is a precursor to change. Solving the retirement benefits problem is far from easy and a cacophony of dissident opinions, without some unifying end goal, spells disaster.

Wouldn't it be nice to simplify, clarify and streamline? Answering questions such as those shown below is a good start towards implementing meaningful reform.

1. What is the problem that needs to be solved?
2. Who currently bears the cost(s) of not having a solution in place?
3. What are the alternative solutions?
4. How do they compare/contrast in terms of costs and benefits?
5. Who should make the decisions about what benefits to offer?
6. How much responsibility should employees enjoy with respect to pensions?
7. Who currently "owns" the pension "problem"?
8. Who can effect change?
9. Who should be able to effect change?
10. What lessons can be learned from past mistakes with respect to pension funding?

We'd love to publish your poems, musings or anecdotes. Write to pension@bvallc.com

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Mr. Jerry Kalish provides a novel suggestion in response to a July 13, 2006 post about legislative attempts to curb dividend payouts for underfunded pension plans. (See "Dividends, Pensions and California Chaos".)

Creator of Retirement Plan Blog, Jerry writes the following:

"The proposed bill - and the politics behind it - conveniently ignores the massive unfunded pension liabilities in California, e.g, the California State Teachers' Retirement System faces a $24 billion unfunded pension liability.

But we got them beat in my home state of Illinois which at $35 billion has the largest unfunded pension obligation in the country. The Fitch Rating service released a "negative outlook" for Illinois finances - one of only three negative outlooks issued by the rating service in its review of the states. The other two? Louisiana dealing with the aftermath of Hurricanes Katrina and Rita and Michigan dealing with massive problems in the automobile industry.

Um! Should there should be a law that says no more salary increases for state legislators until pension liabilities are met?"

Give the man a bow for an astute observation.

Others have provided novel solutions to the ubiquitous problem of do as I say, not as I do. In 1993, then Michigan state representative Greg Kaza proposed that legislators' pensions be taxed at the state income tax rate, similar to what they required of others. The result? A few months later, the state ceased taxing private pensions. Greg continues to dazzle as executive director of the Arkansas Policy Foundation.

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According to Oscar Wilde, a cynic is "a man who knows the price of everything and the value of nothing." In today's world, that could be a label that some pension fiduciaries end up wearing with regret. At a time when pension funds are allocating more and more money to alternative investments, assessing their value and understanding why (and how) the value is likely to change is paramount.

Could hedge fund regulation help to shed light on valuation practices? We may never know.

Just a few weeks ago, the D.C. Circuit Court of Appeals vacated a rule that required hedge fund managers to register, pursuant to the Investment Advisors Act of 1940. Wall Street Journal reporter Kara Scannell describes that, in the aftermath, "10 managers have filed papers to withdraw from registration." Whether this is good or bad depends on a host of factors. However, critics are likely to cite registration shyness as a step backward with respect to better understanding how hedge funds value their positions. While some funds report net asset values on a daily basis, others don't because they trade instruments for which there is no ready market or trading occurs infrequently.

As written before, this creates its own set of problems. (See the June 18, 2006 posting about hedge fund valuation.)

This blog's author, an Accredited Valuation Analyst, CFA charterholder and certified Financial Risk Manager, writes about the topic of hedge fund valuation, and the fiduciary implications, in two new articles.

Write to pension@bvallc.com if you would like a copy of either or both articles:

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

2. "a growing necessity for hedge fund valuation" (HFMWeek.com, June 29-July 5, 2006).

Incidentally, any concerns about transparency and valuation can rightfully be said to apply to private equity and venture capital funds as well. Future blog postings will look at these other types of alternatives.

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Take a five question quiz and see if others agree with you about the state of the pension system.

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Do you have happy workers? Productive workers? Loyal workers? So many news stories address the financial dimensions of THE pension issue. While important, ultimately the story is about the employees, isn't it? Ignoring tax considerations, companies provide benefits to protect human capital. Though this asset shows up nowhere on a company's balance sheet, it is nonetheless vital to profitability and growth. This is especially true for countries and industries where intellectual prowess determines success or failure.

According to a recent article in FORTUNE, the new paradigm urges managers to "hire passionate people". Citing research done by Christopher Bartlett of Harvard Business School, employees "want a sense of purpose". (See "Tearing Up the Jack Welch playbook" by Betsy Morris.)

In their best-selling book, First, Break All the Rules: What the World's Greatest Managers Do Differently, Marcus Buckingham and Curt Coffman regale the reader with countless suggestions as to how to manage people more effectively, including the need to keep people motivated.

Ironically, at a time when identifying and cultivating human potential is paramount, some leaders are still missing the mark. In today's Wall Street Journal, Erin White describes the disconnect between what companies say their performance reviews are supposed to measure versus what employees describe as their perceived opportunity set to advance and contribute. (See "For Relevance, Firms Revamp Worker Reviews".)

With so many companies shifting away from defined benefit plans, will there be a concomitant change in worker happiness? Do employees really choose a work situation based on benefits? Could plan sponsors be taking a short-term view without acknowledging long-term consequences? Do employees favor a parental approach or is individual empowerment the touchstone (in which case 401K and other choice-focused plans make perfect sense)?

There are no easy answers. People genuinely disagree about the role that benefits (quality, quantity, form) play in attracting and keeping good people.

One thing is certain, however. Corporations everywhere (U.S. and abroad) will be affected by changing demographics (recently described elsewhere in this blog). An oft-discussed dearth of skilled workers compels companies to think long and hard about the link between benefits and the bottom line.

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According to CFO.com, the State of California may soon prohibit a company from paying out dividends or buying back shares until all required defined benefit plan payments have been made. AB 2122, introduced by Democrat Johan Klehs, could impact corporate leaders individually as well since it "would make directors and officers of a corporation jointly and severally liable for improper distributions", even if they had no knowledge of the impropriety.

Needless to say that if this bill becomes law, other states would likely follow, creating a cascade of new challenges for chief financial officers everywhere.

Think about it.

Capital structure, securities issuance and debt rating assignments would necessarily change as a function of a company's mix of employee benefits. Modeling a defined benefit plan liability (and related liquidity obligations) would take center stage. Shareholders seeking current dividend income may get an unpleasant surprise if dividend payouts become more volatile, even if a company enjoys steady growth in economic earnings.

Then there is the philosophical issue about the role of government with respect to corporate management. Does the state have the right to micromanage this way? Would shareholders shy away from investing in companies with defined benefit plans, knowing that the state has the right to prevent dividend distributions? Would companies rush to shed defined benefit plans, possibly exacerbating an already pronounced trend towards defined contribution plans? Would companies lobby more aggressively for exemptions from the dividend rule? Would that worsen campaign finance problems? Would D&O insurance costs skyrocket as a result of increased liability exposure for board members? Would federal lawmakers seek to follow suit?

The little bill that could ...

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In a current National Law Journal article, Pamela A. MacLean provides a fascinating overview of unanswered questions regarding employee benefit-related promises. She points out that federal courts are being "pulled into the wrangling over how promises of lifetime benefits can be broken, or whether they existed at all", adding that "the courts have not been uniform in their answers". According to MacLean, there are three particular areas of contention that include:

1. Method and timing of benefit recission

2. Bankruptcy impact on the provision of post-retirement medical benefits

3. Health care benefits for individuals over 65 versus younger retirees

With the contemporaneous effort underway to reform pension accounting, any legal decisions that permit companies to expunge their retirement obligations without penalty may accelerate what many experts believe is the ultimate nail in the coffin for traditional offerings.

For additional reading, see "CPAs Debate FASB's Pension Draft", AccountingWeb.com and "FASB Pension Rule Could Spur Loan Woes" by David M. Katz, CFO.com.

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There is no doubt that hedge funds are here to stay, especially with respect to their increasing clout in the boardroom. According to editor and associate publisher of Directors & Boards, Jim Kristie, "Corporate America is owned by hedge funds". He points out that institutions, including hedge funds, own more than sixty percent of equity issued by top U.S. corporations. Moreover, he cites research that "the average institutional holding period is about 12 months" and possibly even shorter.

In the same issue, William G. McBride warns that activist hedge fund investors "rely on negative media to keep the pressure on boards of directors", highlighting bad practices, sluggish earnings and/or vague communication about strategy.

For some institutional investors, seeking redress by going to court as lead plaintiff is another type of activism. (See the recent post about this topic.) Given their significant ownership stake, is it possible therefore that hedge funds could displace pension funds as key players in litigation against company boards?

In a recent speech, U.S. SEC Commissioner Paul Atkins cites a concern about "complicity between short sellers, namely hedge funds, and plaintiff's lawyers". He adds: "As the story goes -- and I have personally seen instances of this before I came to the Commission -- the two groups can act in concert to systematically drive down the price of a company's stock, to their mutual gain and the company's and its shareholders' loss."

Institutional investors that use the legal system to ferret out wrong-doing serve society well. Their actions arguably help to promote capital market transparency and thereby facilitate economic growth.

Regarding activist hedge funds and their role in litigation as plaintiff, lead or otherwise, it is impossible to generalize anything from a few anecdotes. Moreover, the selection of lead plaintiff depends on many factors.

We welcome hearing about research that directly examines the role of hedge funds as lead plaintiffs and will keep you posted as our investigation ensues.

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Voltaire once wrote "No snowflake in an avalanche ever feels responsible". In the aftermath of some of the more "infamous" corporate scandals, one wonders if this is what the french philosopher had in mind. Unfortunately, for the directors seeking refuge in the opinions of others, hiding may become more difficult.

A recent article in Canadian Underwriter describes several trends that seem to be gaining ground: (a) plaintiffs' demand that directors personally contribute in the event of litigation-related payouts and (b) attempts by insurance underwriters to rescind Directors & Officers coverage "upon learning of fraudulently-reported financial statements".

At the same time, KPMG's Integrity Survey 2005-2006 suggest that things are improving. "Although the level of observed misconduct has remained constant, employees reported that
the conditions that facilitate management's ability to prevent, detect, and respond to fraud and misconduct have improved since 2000. For example, pressure to engage in misconduct is down, and confidence in reporting concerns to management is up."

In a related article, attendance at Directors College was way up this year, with a star-studded roster of speakers addressing many topics including several sessions about D&O insurance.

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Americans will celebrate Independence Day on July 4 with patriotic tributes, picnics and parades. Wouldn't it be wonderful if some time was spent ruminating about financial self-sufficiency as well?

According to the national debt clock website, U.S. IOUs are growing by roughly two billion dollars each day. (Keep hitting the Refresh key for the full effect.)

Personal debt levels are staggering. In a report to Congress, the Federal Reserve cites credit card outstandings in 2004 at $644.8 billion. UK statistics are no less sobering with an estimated fifty-two percent rise in indebtedness over the last five years.

Eilene Zimmerman describes the adverse impact of debt load for Workforce Management, stating that "debt problems cause stress and anxiety that sap workers' productivity, cause health problems and increase the likelihood they will leave a job in search of better pay". Moreover, employees may tap into their 401k accounts prematurely just to stay even with bills.

What role do employers play? Besides plan design, educating employees about retirement choices and personal finance overall can boost morale and enhance a company's return on benefits spending. However, doing so puts companies between Scylla and Charybdis. In its survey about corporate-sponsored financial education programs, Ernst & Young reports that some employers worry about the liability of providing financial education while those that abstain do so for the exact same reason, fear of increased liability.

According to the U.S. Department of Labor "Some plans, such as most 401(k) or profit-sharing plans, can be set up to give participants control over the investments in their accounts. For participants to have control, they must be given the opportunity to choose from a broad range of investment alternatives" and "must be given sufficient information to make informed decisions about the options offered under the plan."

Whether an employer provides broad-based financial training or not, employees still bear the responsibility of paying their bills on time and arguably planning for their own future.

So enjoy the fireworks and picnic today. The debt diet follows.

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Many experts agree with Betty Friedan that "Aging is not 'lost youth' but a new stage of opportunity and strength." Unprecendented advances in healthcare technology and amassed wealth make life a happy lot for countless seniors.

Gray power is here to stay.

According to a report from the National Institute of Aging, "the U.S. population age 65 and over is expected to double in size within the next 25 years. By 2030, almost 1-out-of-5 Americans - some 72 million people - will be 65 years or older. The age group 85 and older is now the fastest growing segment of the U.S. population."

The U.S. is not alone. The AARP website includes an Associated Press story that ranks Japan as the "most elderly" country, pushing Italy to second place, with the elderly making up "almost 27 million of Japan's total population of nearly 128 million". Brandchannel.com reports that UK seniors account for eighty percent of the nation's wealth and forty percent of consumer spending. The financial services industry is gearing up for the nearby demographic tidal wave of seniors in need of estate planning and retirement services.

On the jobs front, countless numbers of seniors are taking suits and briefcases out of the closet and returning to work. To help combat the ill-effects of the silver ceiling, the AARP has created a National Employer Team to bring together various companies and older workers in search of work.

It's easy to understand why hiring the 65-plus set has appeal. A company enjoys ready access to well-trained workers, offsetting an otherwise scarce supply of labor. Rehiring employees might also mean that millions of dollars of retirement benefit payments are deferred until a later date. State and federal governments realize higher tax revenues. Seniors who want to work avoid the pressure of being forced into an unwanted, premature retirement.

All in all, a good thing!

As writer Lisa Belkin aptly states in the July 2, 2006 New York Times: "The Best Part Comes in the Third Act".

So does this mean that sixty is the new thirty and that being fifty makes one a veritable youngster?



Note: The photo, taken by Jud Burkett with the Spectrum, accompanies a story about Senior Olympics.

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Thanks to Stephen Davis, editor of Global Proxy Watch, for highlighting a recent study about enterprise risk management. The three Conference Board authors - Carolyn Kay Brancato, Matteo Tonello, and Ellen Hexter -- suggest that board members may need to do a lot more work when it comes to (a) recognizing relevant risks and (b) managing them to avoid liability.

According to "Role of the U.S. Corporate Board of Directors in Enterprise Risk Management", there is a big gap between knowledge and action.

"The Conference Board study finds: Although 89.5% of directors say they fully understand the risk implications of the current strategy,

Only 77.4% of directors say they fully understand the risk/return tradeoffs underlying the current strategy.

Only 73.4% of directors say their companies fully manage risk.

Only 59.3% of directors fully understand how business segments interact in the company's overall risk portfolio.

Only 54.0% have clearly defined risk tolerance levels.

Only 47.6% of boards rank key risks.

Only 42% have formal practices and policies in place to address reputational risk.
Directors are, however, sensitive to the need for additional information:

While 71.8% of directors believe they have the right risk metrics and methodologies in making strategic decisions, 47.6% of directors would like to see more data analysis related to the company's risk profile."

So what does this have to with pension plans?

Simply put, a lot...

As more and more companies contemplate the financial and human capital impact of offering employee benefits, it's imperative to remember that pension management cannot be separated from corporate governance responsibilities, embedded in regulations such as the Sarbanes-Oxley Act of 2002 ("SOX").

Jeffrey D. Mamorsky, Employee Benefits Group Chairman with Greenberg Traurig, states: "What companies sometimes overlook is that this SOX Section 404 Management Assessment of the Adequacy of Internal Control Procedures requirement applies to pension and benefit expenses. This is an issue that cannot be overlooked since SOX includes draconian sanctions of $2 million and up to 10 years imprisonment for non-willful ($5 million/up to 20 years imprisonment for willful) certification of any statement that does not comply with SOX requirements." (See "Today's Retirement Plan Environment Leaves Much for Concern".)

In a speech to business editors, following the passage of SOX, U.S. Department of Labor Assistant Secretary Ann L. Combs sang its praises, adding that: "Some reports have criticized the Sarbanes-Oxley provisions as inadequate response to the problems brought to light by Enron and its progeny. The fact is, they are important provisions and will prevent future instances of corporate officers unloading their stock while workers are trapped in a sinking ship."

My own research in the areas of governance, compliance and litigation suggests an inextricable relationship between corporate and pension governance. Directors simply cannot ignore ERISA when making enterprise-oriented decisions. To do so could invite the possibility of financial loss, litigation, harm to reputation and/or regulatory action.

Author's Note: There are many articles that address the deficiences of SOX and regulation in general. Free marketeers advocate complete industry self-regulation or some variation thereof (and I have written elsewhere about the economic and philosophical merits of best practices versus regulation). However, whatever your opinion about regulations, including SOX, existing law is a reality.

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A flurry of activity is upon us in defined benefit land. The goal? Identify "high risk" plans early on. This, according to certain members of Congress, would be followed with additional funding by plan sponsors and thereby (hopefully) reduce the possibility of a government takeover. Critics counter that such a reform could make things worse, especially for already cash-strapped companies, struggling to stay in business. Moreover, they add that a risk classification based on unrealistic assumptions regarding early retirements at maximum benefit levels makes little sense.

The "Performance and Accountability Report: Fiscal Year 2005" shows a deficit of nearly $23 billion for the Pension Benefit Guaranty Corporation while estimating "future exposure to new probable terminations" at $108 billion, nearly four times the "damage".

In its primer on pension accounting and funding, the American Academy of Actuaries describes at least four types of numbers - service cost, accumulated benefit obligation, projected benefit obligation and present value of future benefits. They add that "Amounts calculated under pension funding rules are completely different than those calculated for pension accounting, and one must be careful not to mix the two topics."

Keep in mind that smoothing and credit balances are other considerations as we try to navigate our way through the maze of pension metrics. New rules that address (a) the treatment of a company's pre-funding of a plan and (b) whether a sponsor can continue to average a plan's value over several years could materially impact reported pension costs. (To the extent that capital market participants react to accounting numbers as inaccurate barometers of economic health, C-level executives could be busy with related financial tasks.)

Okay, we get it. There are lots of ways to measure pension deficits but which one tells us what we really want to know?

What is the truth?

Will the real pension deficit please stand up?

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The San Jose Mercury News reports a litigation backlash against thirteen Silicon Valley firms in connection with questions about their stock option programs. While arguably newsworthy, what is perhaps more telling is the role played by U.S. and foreign pensions.

Since the Private Securities Litigation Reform Act became federal law in 1995, the clout of these moneyed giants has not gone unnoticed. (There is even a blog by the name of The PSLRA Nugget.)

Several studies have tried to reconcile the intent of the law (i.e. to cede more clout to the investor tied to the largest financial stake) with outcomes in terms of fees, settlements, cases filed and so on.*

In their 2005 paper, Stephen J. Choi and colleagues write: "We find no systematic evidence that private institutional lead plaintiffs are associated with larger class recoveries. Public pension funds, on the other hand, are correlated with higher class recoveries as a fraction of the potential damage award in the post-PSLRA period. Our results are, however, consistent with the possibility that public pensions 'cherry pick' the actions in which they seek to become lead plaintiff, selecting only the cases with the largest potential damages and the strongest evidence of fraud. Further analysis is necessary to evaluate this possibility." (See "Institutions Matter The Impact of the Lead Plaintiff Provision of the Private Securities Litigation Reform Act" by Choi, Stephen J., Fisch, Jill E. and Pritchard, Adam C. April 15, 2005, NYU, Law and Economics Research Paper No. 04-08.)

According to the New York Stock Exchange Fact Book, U.S. pension funds now own about twenty-two cents of every dollar of issued corporate equity. Institutional investors (including pensions) own roughly fifty cents or one-half.

What does this mean?

Here's my humble take. As stated several times before, pension fiduciaries are in the spotlight as never before. Any investment-related loss is likely to trigger some type of response. Will it be surprising if it takes the form of litigation to recoup losses? Not really. Will it be a bad thing? Maybe. Maybe not. This is a complex question, one that cannot possibly be answered here.

More to come...


* To prevent a flood of cases migrating from federal to state courts as a result of the PSLRA, the Securities Litigation Uniform Standards Act of 1998 barred certain lawsuits from being filed in state courts. (Please be reminded that the author is not an attorney and urges readers to always seek counsel with respect to any legal question.)

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As earlier stated, asset valuation is the cornerstone of investing. (See "Do You Really Know the Value of Your Portfolio?")

The absence of good valuation numbers makes it virtually impossible to execute vital tasks:

1. Asset allocation

2. Risk management

3. Performance evaluation

4. Selection and comparison of managers ...

(The discussion of what constitutes "good" numbers is left for another posting.)

Regulators and politicos are hardly alone in urging more prudence with respect to the valuation of certain positions. Industry groups have jumped into the fray, and some assert, it's none too soon. The Private Equity Industry Guidelines Group posted valuation guidelines a few years ago. Its mission: "To promote increased reporting consistency and transparency while at the same time improving operating efficiency in the transfer of information among market participants by establishing a set of standard guidelines for the content, formatting and delivery of information." The "MFA's 2005 Sound Practices for Hedge Fund Managers" has a lot to say about valuation policies and procedures and is well worth a read.

So why is this important to pension fiduciaries? For one thing, countless fiduciaries are allocating monies to hedge funds. Second, a recent article offers that hedge funds could have as much as fifty percent of their money tied up in relatively illiquid assets, in part (some argue) to avoid having to register their managers.

According to U.S. SEC Commissioner Roel C. Campos, "To avoid dilution and unfairness, valuation numbers must be accurate and unbiased. A key element of monitoring the risk of hedge funds is to understand the valuation used by said funds and counterparties to the funds."

Hiring an independent appraiser can go a long way to aiding this process, especially when accreditation itself entails satisfying rigorous education and experiential requirements. In fact, courts and regulatory bodies are increasingly turning away experts on valuation matters unless their credentials include specialized valuation training. (Note: As an Accredited Valuation Analyst and someone who has completed course and exam requirements for two other specialized valuation designations, I can attest to the rigor.)

With so much at stake, pension fiduciaries should be asking tough questions of their hedge fund managers (and/or consultants who recommend hedge fund managers).

1. Does the hedge fund rely on independent appraisers to provide assessments of fair market value?

2. Has a hedge fund established a proper valuation process?

3. How often are the valuations updated? *

4. Is each opinion of value well documented?

5. Are all terms and conditions of a particular economic interest specified and analyzed accordingly?

6. Does the hedge fund manager acknowledge how much of its portfolio is not valued on a regular basis, thereby affecting reported portfolio performance?

The list is long. One thing is certain. Hedge fund valuation is the topic "du jour". Can a pension fiduciary afford to invest in a hedge fund, fund of funds, private equity fund, venture capital fund, commodity pool, derivatives fund and so on, without understanding whether, and to what extent, managers have considered various valuation issues?



* Not discussed here, there are those that assert that some positions should not be valued and that doing so would jeopardize the asset allocation decision that led to investing in relatively illiquid holdings in the first place. I welcome your comments regarding this point.

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We're up to 6300 visitors since late March 2006 and look forward to making even more new friends.

Today we welcome readers from Albourne Village , Hedge Fund Manager and RiskCenter, respectively.

Albourne Village "is a free and unique internet-based knowledge economy for the Alternative Investment community. The site has been designed as an ideal environment for evolving hedge-fund news, intellectual property, content and debates on current issues, as well as a valuable source of commercial contacts."

"HFM Week and hfmweek.com are produced exclusively for the international hedge fund community. Hedge Fund Manager was launched in September 2002, and is now published weekly. It is now read by over 5,500 alternative fund managers - predominantly CFO's and managing partners - and their key advisors across the globe."

Risk Center "is the first Web-based syndicated news service devoted exclusively to providing financial risk professionals with the inside scoop on breaking economic, political and financial stories, as well as the risk strategies required to measure and manage these risks. Acting as the eyes and ears for risk professionals, RiskCenter provides an information filter so that viewers do not have to search through a myriad of sources to find the key news that has been researched and written from the point of view of a risk manager."

Let us know what you think. We'd love to hear from you.

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Results of a new survey from executive search firm, Risk Talent Associates, provide good news for financial rocket scientists everywhere. Total compensation for chief risk officers in 2005 rose by eighteen percent to nearly $800,000 on average, with hedge funds and funds of funds paying larger bonuses to draw "top risk managers away from traditional investment banks". Not to be outdone, president Michael Woodrow warns that alternative investment managers will soon be competing with "capital markets' firms" and asset managers who acknowledge the importance of analytics and risk management knowledge and experience.

On the pension risk front, I recently wrote about the difficulty of getting good people at the same time that talent is required to navigate some rather choppy investment waters. (See "Pension Fund Hiring - Start of a New Trend?")

I have long held the view that effective investment management is not possible in the absence of what I refer to as the "risk troika" - identification, measurement and management.

Are higher salaries for risk professionals a reflection of their importance to an organization's financial well-being? As I wrote a few years ago, risk professionals should be both knowledgeable and experienced about a wide variety of topics - market mechanisms, statistics, systems and data quality, internal controls, deal structure, to name a few. Moreover, they need to be able to (a) describe the relationship between various risk drivers and portfolio loss potential in plain language (b) work well with a cadre of people in diverse functional areas and (c) say no to new ideas that may induce unwarranted risk under certain market scenarios.

Not too many people can fill those shoes!

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Global Investor Magazine cites survey results from J.P. Morgan Asset Management that show a surge of interest in liability-driven investing (LDI). An impressive forty-eight percent of respondents admit to using, or planning to use, an LDI strategy. Four countries lead the way: the Netherlands, Denmark, Sweden and the UK. The common theme - regulations that "push pension schemes to value their liabilities with market rates".

Interestingly, more than seventy percent of respondents cited the need for an LDI approach, even for plans in surplus.

Some take-aways for US plans?

1. The use of derivatives by retirement plan sponsors is likely to increase as interest in LDI rises stateside.

2. Regulation and accounting standards that encourage liability management will be the likely catalysts for change.

3. Managers, consultants and plan trustees will need (and hopefully want) to become more savvy in the areas of derivative instrument valuation, risk measurement and controls.

4. Traditional asset allocation models may have to give way to a new paradigm that emphasizes portfolio splitting into separate return and liability-managed components.

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Fiduciary liability is serious stuff. As earlier discussed, ERISA litigation statistics suggest a precipitous increase, especially with respect to issues of fiduciary breach. (See "Pension Lawsuits".)

According to Reish Luftman Reicher & Cohen attorney Joe Faucher, ERISA fiduciary liability can apply "when the plan expressly designates a person as a fiduciary, generally as the plan administrator, plan trustee, or member of an administrative committee". It is also relevant when "a manager performs a function that ERISA deems a fiduciary function". Examples include the following:

1. Influence or control "over the management of the plan or any authority or control over management or disposition of the plan assets"
2. Provision of investment advice in exchange for a fee
3. Discretionary authority as regards plan administration

On June 13, Greenberg Traurig attorney and Chairman of the Employee Benefits Group, Jeffrey D. Mamorsky, will be joined by Rhonda Prussack, Fiduciary Liability Product Manager for the National Union Fire Insurance Company and IRS Senior Employee Plans Examiner and Large Case Reviewer, Randy G. Sammons.

The topics?

1. Trends in Litigation
2. Regulatory Environment
3. IRS Audit Initiatives
4. Prescriptive Techniques to Avoid Litigation

Is a new wave of trouble about to crash around us?

With an increased focus on compliance, governance and best practices, we're likely to hear much more about fiduciary breach. Keep in mind that even service providers such as CPAs, money managers and consultants are vulnerable, personally and professionally. (The author is neither an attorney nor CPA. Readers are urged to seek advice from appropriate professionals as to whether they are fiduciaries to a plan and what that entails.)

Though not a panacea for eliminating oversight duties, outsourcing is gaining in popularity. Independent Fiduciary Services CEO Samuel (Skip) Halpern provides some compelling reasons as to why and when to seek help in the form of an independent fiduciary.

Look for much more on this topic in coming months!

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With so much talk about actuarial assumptions and related shortfalls, little is said about absolute dollars (or pounds or pesos and so on). This is a mistake. Retirees can't pay their bills with paper returns. They need cold, hard cash. Even with defined contribution plans, there is the issue of a "pseudo" liability. Should 401k plan sponsors better track employee demographics and pick investment choices accordingly? (Some experts offer that lifestyle funds are a step in the right direction. That's a topic for another day.)

A new retirement index from the Center for Retirement Research at Boston College suggests that time may be nigh to reinvigorate the debate.

Returns or cash flow? That is the question.

On a rather bleak note, the Center reports that "nearly 45% of U.S. households are at risk of being unable to maintain their standard of living in retirement".

Scary stuff, beneficiaries are not the only ones affected. Investment and risk managers alike face new challenges when the goal is to match liabilities versus beating a benchmark.

1. Which part of the portfolio should be allocated to liability matching versus return enhancement?

2. What strategies make sense?

3. What is the role of mean-variance optimization when a portfolio is split?

4. Is it feasible to regularly evaluate demographics to reflect worker mobility when asset allocation changes are expensive or otherwise difficult to make?

5. What are the ancillary issues associated with liability matching techniques such as the use of derivatives?

The list of MUST ADDRESS questions is long. Risk control critically depends on the objective at hand.

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In a recent Washington Times article entitled "Derivatives: Global roulette wheel", editor-at-large Arnaud de Borchgrave describes a global market now topping $300 trillion as reason to "fasten your seat belt". It's not clear what precipitated his dire warnings about systemic risk and classification of risk management talk as "gobbledygook to the layman". (Take a look at our March 2006 posting about derivatives.)

It's true that the use of derivatives introduces incremental risk such as the possibility of counterparty non-performance or problems with settlement. (Arguably netting and collateralization help to reduce some of the transaction-specific risk.) At the same time, derivatives used properly (and this is an important qualifier) can mitigate financial risk, transform cash flows, transfer risk, enhance asset performance or otherwise synthesize exposure to a particular risk-return position. How else could the market have grown to its giant size had it not been for a large number of participants who were (and are) willing to trade with each other?

At the risk of dating myself, I did an analysis about fifteen years ago that showed that derivatives-related losses were a fraction of disappearing dollars due to fixed income security defaults for the time period in question. It would be interesting to update the analysis and gauge whether derivatives are indeed the equivalent of a financial hurricane, wreaking damage far and wide.

One key issue (among many) is the measurement of risk. Consider a fixed-to-floating interest rate swap with a $20 million notional principal amount or "face value". Depending on the particular counterparties and deal structure, this popular size measure fails to convey meaningful information about potential loss. The incremental exposure for a counterparty that hedges its short-term commercial paper costs by entering into a swap as a fixed rate payor is not the same as a counterparty that receives floating in anticipation of higher rates.

Derivatives are not necessarily for the faint of heart nor should they be shunned as the proverbial bad boy of finance.

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According to its website, the Canadian Pension Plan Investment Board is in a hiring mode. Responsible for investing funds received from the Canada Pension Plan, the now C$98 billion fund is seeking several dozen qualified people in the areas of investment and risk management.

A few months ago, a major UK newspaper cited the dearth of qualified pension investment and risk management professionals at the same time that expertise is urgently needed. Is this the start of a hiring trend? Are pension experts suddenly in demand? If so, why? Some likely reasons include:

1. New retirement plan regulations

2. Changed accounting rules

3. More complex investment strategies

4. Recognition that investment and risk management go hand in hand

5. Notion that hiring seasoned staff can minimize fiduciary breach exposure

6. Explosive growth in pension litigation

We may be in for a bumpy road. If true that there are insufficient experts available who can connect the pension risk dots, it will be difficult to make meaningful changes in a cost-effective manner.

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According to a recent story in HedgeWeek, hedge fund liability insurance may merit some serious consideration. Regulatory enforcement actions and investor lawsuits are on the rise, in the U.S. and elsewhere. Hedge fund directors are arguably more vulnerable than ever before, especially in areas such as valuation and trading controls.

Bigger and more frequent claims make for unhappy insurance underwriters. The logical result? Higher premiums, reduced coverage and larger deductibles.

For pension fiduciaries with hedge funds on the shopping list, now might be the time to ask managers even more questions about their policies and procedures - content, frequency of review and revision, oversight and metrics for determining "errors".

After all, pension fiduciaries themselves are under more scrutiny and are unlikely to want to invest in a hedge fund or fund of fund with few or no documented policies and procedures.

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Thank you everyone for helping to make the debut of PENSION RISK MATTERS a success. We've had more than 5000 visitors to our site in just two months. Our goal is to make the blog as user-friendly as possible. We welcome your ideas and comments.

What pension risk topics are of interest to you? Email pension@bvallc.com.

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Taking time for some weekend reading, I was struck by several headlines that focus on a topic I predict we'll hear more about (much more) in coming months, namely how to best allocate assets to meet liability objectives. Here are a few examples.

"Big pension fund too equity-heavy, says consultant"

"Pension Fund to Expand Stock Buying"

"DB plan sponsors hedging their bets on hedge funds: Pension plans expected to invest $300 billion"

While a discussion of optimal asset allocation and portfolio re-balancing is left for another time and venue, a few questions and comments come to mind.

1. As new accounting rules encourage a focus on liability-driven investing, how will plan fiduciaries decide on a portfolio split between matching liabilities and generating excess return?

2. How can and should derivatives be used to transform assets and liabilities?

3. What role should alternatives play?

4. What will cause a shift away from the traditional equity-fixed income mix for defined benefit plans?

5. How should the equity risk premium be evaluated with respect to managing goals, knowing that greater reliance on fixed income is likely to widen a plan's pension deficit if equities outperform?

6. How should fiduciaries be evaluated and compensated if they focus on risk control in lieu of exceeding return targets?

7. Are decision-makers sufficiently trained to deal with surplus volatility, fat tailed distributions, side pockets and other financial delights?

8. What is the likely impact on capital markets as long-term pension investors begin to favor a radically different asset allocation mix?

As accounting rules, regulatory mandates, changing demographics and economic reality join hands, it's clear that a paradigm shift in asset allocation strategies and tactics is on its way. Are we ready?

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According to economist John Maynard Keynes, "In the long run, we're all dead." That may be but the long run is getting longer. The Centers for Disease Control and Prevention report that "life expectancy for Americans has reached an all-time high" with women expected to live to 79.9 years and men giving way around 74.5 years. The good news is not unique to the U.S. More than a dozen countries have a life expectancy at birth of more than 80 years. What accounts for the female factor? Researchers Daniel Kruger and Randolph Nesse offer that men take more risks than women, exposing themselves to danger, especially in their twenties. (The gap seems to narrow over time.)

Living longer could be a blessing or a curse. Liz Pulliam Weston makes a compelling case that women are in retirement crisis mode. She warns that the fairer sex is likely to experience job discontinuity (and related income diminuition), earn less on average, outlive a spouse and save too little. Then there's a marriage penalty since "Single women are four times more likely than couples to live in poverty."

In pension land, longevity spells trouble. Plan sponsors find themselves in the unhappy position of having to fund benefits for an additional period. A KPMG study estimates a 2005 pricetag for British companies of "an additional 20 billion pounds in pension liabilities".

Longevity derivatives offer some hope. One form, annuity bonds, pay coupons that are linked to a pre-specfied survivorship index. From an investor's perspective, a low correlation with traditional offerings has appeal. Mortality bonds are another possibility. According to Kevin Dowd, one bond paid principal based on an international mortality index with a "generous floating coupon payment in return for accepting the risk of a reduced principal payment in the event of a catastrohic mortality deterioration". Yet another variation, still in its infancy, is the longevity swap. The outlook is mixed. In "The Grave Problem with Longevity Risk", professor Dowd describes advantages and disadvantages of this emerging market.

If actuarial predictions prevail, financial engineers could be extremely busy. Companies and governments will need help in managing pension and post-retirement healthcare benefits that are growing with kudzu-like speed.

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The evidence that something is awry in global pension land is everywhere. While Rome burns, reform proceeds at a snail's pace. BenefitNews.com reports uncertainty about when Congressional action will occur in the U.S. Abroad, the pace of reform is different, depending on the country.

Is delay good or bad?

In his May 24 posting, American Enterprise Institute resident scholar Norman J. Ornstein makes a compelling case for acting now to reform what most people describe as a broken system. He advocates a national infrastructure that would give employees solid investment choices along with portability. While having the right to take your accumulated retirement monies from job to job makes perfect sense for today's mobile work force, we're haunted by the inevitable question about investor readiness.

Are employees willing and able to take full responsibility for making good investment choices? What role should employers play with respect to providing investment education and possibly exposing themselves to liability for offering "bad advice"? (These questions apply to defined contribution plans of any sort.) Other issues prevail.

Who picks up the tab for large unfunded liabilities that get either frozen or outright terminated? How do we best transition from point A to point B without exacerbating the situation for already troubled companies? One proposal, requiring immediate funding of high risk plans, might push sponsors into bankruptcy, thereby creating a host of unwelcome problems. States are not immune and are starting to enact legislation to do likewise. Whether these pension stabilization funds solve the problem or simply pass the buck to the taxpayer is debatable.

Finally, it's not a foregone conclusion that all reform is good. In fact, as columnist Rob Norton so nicely describes, there is a bounty of research that documents the law of unintendend consequences. Simply stated, the idea is that regulation is likely to change behavior in such a way that new (and more acute) problems arise as a result.

An alternative is industry self-regulation. While the economic merits of a free market approach are significant, it would probably be difficult to get politicos onboard.

Changes must occur. Let's just hope that regulators consider the opportunity costs and all potential outcomes for the $10 trillion retirement benefits market before speeding along the wrong path.

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Two motivations account for the existence of www.pensionriskmatters.com: a desire to inform and facilitate a meaningful dialogue about pension risk and governance issues, especially at a time when so many changes are taking place around the world. Based on the insightful and encouraging comments we've received from blog readers, we seem to be on the right track. Thank you everyone!

We'd like to make the blog more interactive and are therefore inviting readers to comment. We'll publish the comments at least once a month and hopefully more often.

Here are a few suggested topics. We'll add more along the way.

If you are so inclined, simply send your comments to pension@bvallc.com. If you prefer to remain anonymous, please state such so we know not to publish your name. If you want others to contact you, please include an email address in your comments.(We reserve the right to edit but we will try to preserve the essence of your comments.)

1. What do you think is the difference between asset-liability management and liability-driven investing and why do you think so few pension funds are employing these techniques (though the trend points towards increased use)?

2. Do fiduciaries have a duty to hedge market risk?

3. Should fiduciaries be required to have X number of years of investment education and experience in order to serve?

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I love my Easy Button. Designed by some clever person at office supply company Staples, I press it every few days to remind myself that solving a particular problem is possible.

You might be thinking that this all sounds silly. It's certainly not rocket science but even the most capable among us sometime need a low-cost and humorous reminder that things are not as bad as they seem, that we can achieve an end goal if we take a breath, regroup and map out a step-by-step approach. If a problem is perceived as too complex, difficult to reconcile and too hard to tackle, how can anyone possibly move forward?

Apropos to pension governance, there is an urgent need for simplification and reassurance that the process of effectively discharging fiduciary duties is possible, practical and unlikley to break the bank (in terms of time, money, energy, stress, reputation).

Fear is a big factor that can both overwhelm and paralyze. At a time when pension liabilities are mounting, sweeping regulations are on their way and millions of employees are about to retire on what they think is their guaranteed nest egg, we can ill-afford to have fiduciaries look the other way because things are too hard.

To the contrary, we need people with courage and leadership skills to stand up and be counted. This is often a Herculean task with respect to anything having to do with pension risk. Why? Good people often cower at the mention of tools and techniques such as Value at Risk, Enterprise Risk Management, Derivatives, Risk Budgeting, Liability-Driven Investing, Stress Testing, Fat Tails, Model Risk and so on. For those fiduciaries with a limited background in finance, let alone investing, the fear factor is significant.

Is there hope? Absolutely. For one thing, fear can be managed as long as it is first recognized. According to the author of "One Small Step Can Change Your Life : The Kaizen Way" and pioneer in the area of success research, Dr. Robert Maurer asserts that fear can be a powerful tool to prepare us "for action", adding that "fear is nature's gift to awaken us to the possibilities". Then it's up to us to take one small step at a time to effect change.

Certainly a move in the right direction is an acknowledgement of those in charge that fiduciary education is a sine qua non of pension governance. To that end, this author will continue her efforts to inform and empower by trying to make complex concepts more understandable. (While the list of future topics is long, suggestions and comments are always encouraged. Email pension@bvallc.com.)

As Confucius once said, "A journey of a thousand miles begins with a single step."

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Proper asset valuation is a cornerstone of the investment management process. Without good numbers, it is virtually impossible to make meaningful decisions about asset allocation, portfolio re-balancing, risk control, and manager evaluation. The challenge is especially relevant as endowment, foundation and pension fiduciaries commit billions of dollars to hard-to-value instruments at the same time that regulators are asking tough questions about methodology and process.

Anyone with fiduciary responsibilities needs to have a solid grasp of valuation fundamentals AND understand what happens in the absence of good numbers. The consequences are dire.

Duties extend to assessing external money managers on the basis of their respective valuation processes. (If you get a blank stare, worry.)

1. Do they use independent appraisers or do traders provide their own marks at the same time that they are compensated for reported performance?

2. What valuation models are used?

3. Are they recognized as standard models?

4. Are the models tested?

5. Where does the model input data come from?

6. What systems are used to value individual positions and portfolios?

7. Is model risk well understood and analyzed on a periodic basis?

The list goes on. If a plan sponsor is uncomfortable with evaluating a manager's policies and procedures, hire someone to help. Oversight is a core responsibility and cannot be outsourced away.

There is a lot to say about this subject. I'll be speaking about valuation as part of the (a) Asset Allocation & Risk Management Strategies for Institutional Investors (AARMS) conference in Boston on May 18 (b) National Association of Certified Valuation Analysts (NACVA) annual conference on June 2 and (c) Hedge Funds 101 & 102 conference for FRA, LLC in New York on June 23.

If you are interested in presentations and/or articles on the topic of valuation and model risk, contact me . I'd like to know what keeps you up at night with respect to everything valuation.

Without doubt, there is increasing emphasis on the topic of valuation with respect to both process and outcome.

Valuation is in the news!

"Understand how a fund's assets are valued. Funds of hedge funds and hedge funds may invest in highly illiquid securities that may be difficult to value. Moreover, many hedge funds give themselves significant discretion in valuing securities. You should understand a fund's valuation process and know the extent to which a fund's securities are valued by independent sources." (Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds, U.S. Securities and Exchange Commission)

"According to a survey conducted by the Alternative Investment Management Association (AIMA) in Q4 2004, 20% of the assets held by hedge funds are hard-to-value securities. But many of these hard to value assets are concentrated within specific strategies such as distressed debt, emerging markets and mortgage backed-securities. Investors in a non diversified hedge fund may therefore have up to 100% exposure to hard-to-value securities. A combination of assets with poor market liquidity, leveraged structures and their non-stable correlation with other related assets mean valuations can exhibit considerable volatility within a short period of time." (Hedge Funds: Are their returns plausible? Speech by Dan Waters, Sector Leader Asset Management, Financial Services Authority - UK, March 16, 2006)

"The more unusual the instrument or the greater the degree to which the asset payoffs are determined by a tiny fraction of the economic states the harder is the instrument to value and assess the risk." (The Growth of Derivative Securities speech by Chester S. Spatt, Chief Economist and Director of the Office of Economic Analysis, U.S. Securities and Exchange Commission, December 8, 2005)

"Diligence, prudence and caution should be applied when valuing private companies, and in particular when considering the valuation write-ups of early-stage companies, in the absence of market-based financing events." (Industry Group Releases Clarification Valuation Guidelines Endorsed By ILPA press release, October 2004) - Note: ILPA = Institutional Limited Partners Association

"Preliminary results from a survey on the pricing of hedge fund portfolio assets suggest that considerably more than one-third of managers mark hard-to-price securities in equity and fixed-income portfolios according to their own models, rather than using dealer's prices." (Model-Driven Pricing Common for Illiquid Securities, HedgeWorld.com, February 3, 2004)

"Investment Adviser Defrauded Hedge Funds, SEC Suit Alleges" (Derivatives Litigation Reporter, January 15, 2001)

"Ambiguity clouds valuation methods" (Financial Times, February 25, 2002)

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I do a lot of public speaking. I enjoy it, especially when the audience participates by providing commentary, war stories and lessons learned. As part of a recent presentation about pension governance and hidden risks, I asked what I thought was a rhetorical question.

Why would anyone want to be a fiduciary?

Often the pay is bad and the hours are long. (Individuals seldom receive any additional compensation at the same time that they are asked to assume significant responsibilities that put them directly in the "line of fiduciary fire".) One might say it's like being asked to constantly eat your peas without any hope of ever getting dessert.

Not surprisingly, several members in the audience answered: "We can't figure out why anyone would want to be a plan fiduciary."

Keep in mind that most people don't get a choice in their current position. If what they are tasked to do meets the functional definition of a fiduciary, bingo!

I'll be the first person to say that it's a good thing that people are willing to serve as fiduciaries. Assuming they are capable, knowledgeable and conflict-free, their service can make a world of difference.

Therein lies part of the problem. As I've described in other postings, pension work may not be a person's primary job and it becomes an issue of squeezing time out of an already hectic day to carry out fiduciary duties. Others may feel ill-equipped to tackle multi-million dollar decisions.

Perhaps the supply-demand dilemma for qualified fiduciaries accounts for what can only be described as a heightened interest in the notion of hiring an independent fiduciary. In his May 2006 paper on this topic, Mr. Samuel W. Halpern (former U.S. Department of Labor attorney and president of Independent Fiduciary Services, Inc.) describes some of the situations that lend themselves to hiring an independent fiduciary. These include:

"1. managing employer stock

2. tender offer

3. in-kind contribution

4. unpaid contributions

5. sale-leaseback

6. securities class action regarding employer stock

7. retiree medical plan

8. union sale to pension fund

9. merger of mutual funds

10. transaction between two investment vehicles sponsored by a single investment firm."

Echoing these sentiments about conflict and the need for independence, law professor Paul Secunda wrote that "it is not generally a good idea to represent a company or individual corporate officers in both their corporate and fiduciary capacities" and that non-lawyers should seek independent counsel for the ERISA plan and not "rely on existing corporate counsel to also represent them in their fiduciary capacity". (You may want to contact Professor Secunda for a copy of his paper entitled "Inherent Attorney Conflicts of Interest Under ERISA: Using the Model Rules of Professional Conduct to Discourage Joint Representation of Dual Role Fiduciaries".)

Is this the beginning of a new and better paradigm?

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That a relationship between investment performance and fees exists is hardly news. Fees matter. However, it's not quite as simple as it may seem. Fees vary by amount, timing and form. A two percent fee, charged upfront, hurts more than a two percent fee that is levied on the back end. A no-load fund that charges higher annual expenses might cost an investor more than a fund with an upfront charge but lower annual expenses. For mutual funds and exchange-traded funds, the U.S. Securities and Exchange Commission provides a handy calculator with the qualifier that "the results should be compared for several funds or different classes of a single fund".

Importantly, lower may not necessarily mean better. Consider performance fees such as those charged by numerous hedge funds. If an investor understands and willingly acknowledges likely risks, a performance fee may be an acceptable price to pay for participating in returns that exceed a pre-specified benchmark.

However, good decision-making cannot take place in the dark. As described below and in a GAO report about mutual fund disclosure, transparency is not always easy to come by.

1. Database vendors typically provide returns on a gross basis because that is how they are reported by participating money managers. Evaluating a large number of funds requires manual adjustments to facilitate an "apples to apples" basis. This is time consuming to say the least and sometimes difficult to do.

2. Fees vary by type of fund, strategy and timing. Care must be exercised to take into account relevant factors.

3. Fees change over time. Past fees may not be a bellwether of future fees.

4. Reported performance may not reflect all elements of a portfolio as would be the case with side pockets or similar mechanisms. Refer to Barry Schachter's hedge fund blog for comments about side pockets.

5. Mutual fund expenses may not be reflected in published performance reports, forcing one to review the Statement of Additional Information.

6. Institutions and retail clients do not bear the same costs so fee analysis must incorporate any differences.

According to BenefitNews.com, New York Attorney General Eliot Spitzer announced plans to "examine how 401(k) investments are allocated and whether fund managers are exacting higher fees than participants believe they are paying".

What this portends is anyone's guess. Investigations have the potential to shed light on the important topic of investment fees. Of course, institutional investors should be asking lots of tough questions before they commit dollar one to any particular manager. In fact, it's their duty to behave prudently and proper inquiries, during the RFP process and in-person interviews, are a perfect time to dig deep.

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Institutional investor clients such as pensions, endowments and foundations have always had unique needs because of their size and breadth of asset mix. Regulations, accounting and economic considerations are likewise important, especially now. Fiduciary accountability has taken on a new urgency as headlines about big losses motivate shareholders and taxpayers to demand reform. Integral to the process is the proper identification, measurement and management of risk.

Join Dr. Susan M. Mangiero, CFA, FRM and Accredited Valuation Analyst for an update about investment performance pitfalls, sources of hidden risk, risk control gaps and valuation challenges that directly impact the way institutions invest and what advisors can do to assist them.

Addressing the topic that "Risk is More Than a Four Letter Word", Dr. Susan M. Mangiero joins an impressive group of speakers as part of the FI 360 Annual Conference about fiduciary risk and responsibilities.

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A three legged stool is often used to describe retirement planning: private savings, pension benefits from employers and Social Security. The problem is that each leg is becoming increasingly wobbly. We already know that the national savings rate in the U.S. and elsewhere is anemic at best. Pension plans are either non-existent at countless companies or undergoing radical transformation in the form of rescinded benefits, transfer of risk to employees (via a defined contribution plan) or complete termination.

Making matters worse, Social Security trustees have just rung the alarm bell on what many thought was a safe bet. According to the recently issued trustees' report for 2006, "the fundamentals of the financial status of Social Security and Medicare remain problematic under the intermediate economic and demographic assumptions. Social Security's current annual surpluses of tax income over expenditures will soon begin to decline, and will be followed by deficits that begin to grow rapidly toward the end of the next decade as the baby-boom generation retires."

The trustees acknowledge that the program passes a "short-range test of financial adequacy" but "continues to fail our long-range test of close actuarial balance by a wide margin. Projected OASDI tax income will begin to fall short of outlays in 2017, and will be sufficient to finance only 74 percent of scheduled annual benefits in 2040, when the combined OASDI trust fund is projected to be exhausted."

How much worse can it get?

The year 2040 may seem an eternity away but not when you take into account the miracle of technology and its effect on longevity. Living longer is arguably a gift but what happens when people who live for another twenty to thirty years past retirement run out of money? (Check out a May 9, 2006 conference about aging and the impact on financial markets, sponsored by the North American Securities Administration Association.)

Far from trivial, people may simply not have enough money to get by. Working longer or exiting retirement to work again are possible solutions. In fact, some seniors find that they prefer to work. However, what if employers resist hiring older workers? What if some jobs require physical stamina that may not exist as one's body ages? According to a new survey released by the Metropolitan Life Insurance Company, working past sixty may be driven more by financial necessity than desire.

One thing is clear. Things have got to change. Otherwise, be prepared for a tumble as one or more of the stool legs break.

Note: OASDI stands for "Old-Age, Survivors, and Disability Insurance".

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The Administrative Office of the U.S. Courts reports an increase in new Employee Retirement Income Security Act ("ERISA") case filings from 9,167 cases in 2000 to 11,499 cases in 2004. According to a March 2006 American Bar Association publication, about fifty stock-related lawsuits have been filed in the last two years, alleging employee benefit fiduciary violations and adding to a growing number of what some describe as "stock drop" actions.

The basic idea is this. Company stock is included as an investment choice for defined contribution plan participants. The stock falls in value. Employees suffer losses. Fiduciaries are asked to address whether: (a) their inclusion of company stock as an investment choice was appropriate (b) they conveyed accurate information about the company (c) they had put employees first or were influenced by conflicts of interest.

What has groups such as the Professional Liability Underwriting Society alarmed about the "startling" increase in these ERISA fiduciary breach cases? First, the amounts at stake are huge. Second, some experts suggest that it may be easier to bring suits on the basis of ERISA violations instead of securities fraud. (There is a lot written on this topic, including the requirements to become a lead plaintiff under the auspices of the Private Securities Litigation Reform Act of 1995, "PSLRA"). Third, various employee benefit reforms, expected out soon, could lead to financial restatements and unhappy investors.

Legal experts suggest that we're in for a bumpy ride. Negative headlines, excessive executive compensation (perceived or real), market volatility, a dramatic shift away from defined benefit to defined contribution plans and regulatory reform that could force write-downs are some of the many factors that will continue to put fiduciaries in the spotlight.

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In a recent speech to the National Association for Business Economists, Bradley D. Belt laid out some cold, hard facts. Executive Director of the Pension Benefit Guaranty Corporation (PBGC) for a few more weeks, Belt described employee compensation as potentially "a rich source of profits" when companies book expected returns that exceed realized returns on invested assets. He points out that pension funds are assuming more risk at the same time that the practice of smoothing allows companies to stretch out pension losses over time.

Who will pay for existing, and accepted, practices that widen the gap between economic and accounting reality?

1. Taxpayers in the event of a bailout of PBGC?

2. Investors who see the value of their portfolio fall due to pension problems?

3. Employees who may lose benefits or even their jobs?

So if things are so bad, why isn't there more screaming in the streets?

Part of the seemingly benign response to one headline after another about the loss of pensions and other retirement benefits is that ownership of the issue is so diffuse.

Who is responsible for setting things right?

1. CEO's and CFO's who want as little as possible involvement regarding benefit-related decisions?

2. Attorneys who rally for damages in a court of law?

3. Congressional legislators who are often accused of doing too much too late?

4. Regulators who face limited resources and competing jurisdictions?

5. Employees who seldom feel they can make a difference?

6. Plan fiduciaries who may not even acknowledge themselves as such, let alone show that they carry out their duties willingly and effectively?

7. Auditors, actuaries, consultants?

Until true "owners" of the pension issue are identified and someone steps up to the plate (or they are forced to do so), the hot coals are likely to be passed from one party to the next.

Not a happy thought!

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Derivatives have long been the proverbial "black sheep" of finance. A few highly publicized losses and it's off to the races with bad headlines galore. Don't get me wrong. I'm neither an advocate nor a critic. Like many others, I believe that the decision to use derivative instruments (type, strategy, application) depends on a multitude of factors, starting with an organization's objectives and constraints.

There is no perfect investment or financial technique. Something that works for one company or government may be wholly inappropriate for another. That's why a recent article about hedge funds and derivatives has me puzzled. While I agree that more and better disclosure is paramount, I'm not sure anyone is better off by being scared in the absence of evidence.

Here are a few things to ponder.

1. A $270 trillion derivatives market did not grow by leaps and bounds because these instruments are considered dangerous by all market participants. Someone has to think there are benefits associated with their use.

2. It's possible to create examples that show how the identical derivative instrument and/or strategy can reduce risk in one situation while inducing risk in a second situation. Context is everything.

3. Not all hedge funds hedge. Indeed, some of them employ derivatives in a speculative fashion as a way to try to enhance return. Others use derivatives to reduce interest rate, currency, equity and/or commodity risk.

4. Investors should not plunk down hard-earned money without doing their homework. This applies to institutional investors as well. Pension funds commit billions of dollars to hedge funds every year. Beneficiaries and regulators want to assure themselves that pension investment fiduciaries are doing what is needed to make a well-informed decision about hedge funds, whether they use derivatives or not.

5. Fraud is a tragic reality. Both buyers and sellers need to work together to preserve financial market integrity and make it as hard as possible for bad players to ruin things for everyone else. If this were easy, it would have been done by now. Industry associations and providers of fiduciary education can help.

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I agree with Professor Paul Secunda, author of WorkPlace Blog. People have to start getting more serious about retirement planning. Relying on one source of capital is ill-advised. In its newly published "Reimagining America: AARP's Blueprint for the Future", a cogent argument is made in favor of supplementing traditional sources with income from continued employment. This opens a Pandora's box of issues for individuals, companies and governments.

1. Will people want to work late into their 60's and beyond?

2. Will individuals need retraining to maintain a competitive edge in an ever increasingly sophisticated world of technology and global pressures?

3. Who should provide resources to retool and retrain?

4. What industries are likely to welcome older workers?

5. How will taxpayers be affected by changing demographics and work patterns?

6. Will productivity be impacted by career mobility?

7. What are the policy implications for people who cannot work past a certain age?

These and many other important questions will soon climb to the top of the priority list for corporate leaders and policy-makers alike.

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As retirement plan losses mount, the inevitable finger pointing ensues. In a recent survey of visitors to this blog, an overwhelming 96 percent of people agree that a pension crisis looms large. What's interesting is that multiple parties are getting the blame, with the lion's share going to U.S. Congress, plan fiduciaries, pension consultants, governors, regulators and board members.

Here are the results so far.

"Assuming you think there is a pension crisis, who do you think is responsible?" (Respondents were allowed to pick more than one answer.)

Attorneys: 10 percent
Auditors: 14 percent
Board Members: 31 percent
Chief Executive Officers: 24 percent
Employees: 17 percent
Governors and Other State Officials: 31 percent
Money Managers: 10 percent
Pension Consultants: 34 percent
Plan Fiduciaries: 45 percent
Regulators: 38 percent
Retirees: 7 percent
Shareholders: 3 percent
Taxpayers: 7 percent
U.S. Congress: 41 percent
Honorable Mention: IRS, Unions, Actuaries

When asked who can fix things, U.S. Congress, board members, plan fiduciaries and regulators took the lead. Interestingly, while pension consultants and state legislators are cited as part of the problem, they are not given much credit for being part of the solution. Only 21 (18) percent of respondents pick pension consultants (state politicians) as likely rescuers. Perhaps this stems from a feeling that the "pension crisis" must be addressed at the top in terms of tax, financial and accounting incentives and constraints.

Regarding Social Security, 76 percent worry about a current crisis.

An eye-popping 96 percent of respondents agree that "most people are ill-equipped to invest their own money for retirement planning purposes". The sorry state of financial literacy has been discussed in several posts and countless articles elsewhere by investment pundits. Regulators are clearly concerned too. On April 11, IMF Director Hausler emphasized the exposure of retail investors to a wide array of complex risks, adding that a "low level of financial literacy, combined with extensive risk taking, is politically an explosive brew."

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I've spent the last few weeks trying to uncover information about the retirement plan decision-makers at various companies. I'm willing to pay money for this information. Why?

Simply put, I want to know who has responsibility for making multi-million dollar decisions that affect thousands of employees and retirees. Once identified, I'd like to read their bios, understand how they were selected, read about how they are evaluated and identify to whom they report.

Unfortunately, my quest has provided scant results. Here is a summary of what I know. (I welcome comments about possible data sources.)

1. There is no universally accepted organizational structure to determine who is in charge of recommending and deciding on what retirement benefits to offer those outside the executive suite.

2. When a retirement benefits committee exists, it goes by different names, some of which are listed below.

(a) Master Retirement Committee
(b) Trust Selection Committee
(c) Saving and Investment Plan Committee
(d) Pension Committee
(e) Retirement Board
(f) Fiduciary Committee
(g) Benefits Committee
(h) Deferred Compensation Board
(i) Compensation and Employee Benefits Committee

3. Titles of benefits-related decision-makers vary. Some examples follow.

(a) 401K Board Chairperson
(b) Benefits Director
(c) Benefits and Compensation Director
(d) Benefits Administrator
(e) Head of Human Resources
(f) Compensation Committee Chairperson

4. The SEC has proposed a significant overhaul of reporting rules as relates to executive compensation and compensation committees. It appears to be silent with respect to the compensation decision-making process for employees below C-level.

5. Page 1 of Form 5500 requires the identification of the plan sponsor and plan administrator, respectively. Schedule P to Form 5500 requires the signature of a fiduciary and the name of a trustee or custodian. (According to the U.S. Department of Labor website: "Each year, pension and welfare benefit plans generally are required to file an annual return/report regarding their financial condition, investments, and operations. The annual reporting requirement is generally satisfied by filing the Form 5500 Annual Return/Report of Employee Benefit Plan and any required attachments.")

6. ERISA mandates the distribution of a Summary Plan Description (SPD) to each plan participant and beneficiary currently receiving benefits. Required information includes "the name, title and address of the principal place of business of each trustee of the plan". Education and experience are not mandatory disclosure items.

The bottom line is that a systematic identification of who does what and why with respect to employee benefits is simply not a reality as things stand today. This makes it difficult (perhaps impossible) to effect change.

Hunting for treasure shouldn't be this hard!

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Diversify, diversify, diversify! No smart investor should do otherwise, right? Well suppose individuals are not even saving enough, let alone investing wisely. What then?

Sad to say, financial illiteracy is reaching crisis proportion. In a recent release, the Bureau of Economic Analysis (part of the U.S. Department of Commerce), reported a continued negative savings rate. This means that individuals are spending more than they earn. Not surprisingly, personal bankruptcies are climbing higher. According to the Administrative Office of the U.S. Courts, "bankruptcies filed in the twelve-month period ending December 31, 2005, totaled 2,078,415, up from the 1,597,462 petitions filed in the 12-month period ending December 31, 2004", reflecting a whopping 30 percent increase. Similarly significant, they report that "this was the largest number of bankruptcy petitions ever filed in any 12-month period in the history of the federal courts".

A faint glimmer of hope comes in the form of a new study from the Jump$tart Coalition for Personal Financial Literacy. High school students showed a tiny improvement in their understanding of topics such as budgeting and credit cards. Survey designer Dr. Lew Mandell acknowledges the gain but stresses the need for much more work in the area of pecuniary preparedness.

Couple these alarm bells with pension safety nets that are in serious disrepair around the world and the fact that many employers are rescinding or reducing benefits, if offered at all, and we are about ready to enter a maelstrom of unprecedented proportion.

What do you think? Crisis or not? Take this five-question survey and see what others think.

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Sir Francis Bacon said it all when he declared "knowledge is power". The more we know, the better equipped we are to make good decisions. This is why I am such a big advocate of better disclosure when it comes to all things financial (See the April 11, 2006 posting entitled "Practice What You Preach".)

So it was with great delight that I read Gretchen Morgenson's New York Times article this morning, in which she describes the opaque nature of fund manager compensation. Her point is a good one. The absence of information is made more acute by the fact that most of the large fund companies are private and therefore outside the reach of statutory requirements to tell all. Pulitzer Prize winner Morgenson references a recent letter from investment legend John C. Bogle. He writes about the urgent need to require mutual funds "to disclose the aggregate dollar amount of direct and indirect compensation paid to the five highest-paid executives of their manager and distributor".

Why is compensation disclosure important?

A lot of money is at stake. Managed funds are an integral part of the retirement planning process. According to the Investment Company Institute, retirement assets invested in mutual funds in 2004 approximated $3.07 trillion, with $1.6 trillion finding a home in defined contribution plans. Anything that impacts performance necessarily affects the financial security of employees and retirees. This includes fees which should reflect, among other things, the costs of operating a fund. How and why an individual manager is compensated speaks volumes about the expected return pattern of a particular fund. (Some of the other factors that determine returns include strategy, portfolio mix, risk management procedures, internal controls and market conditions.)

When actual returns deviate from forecasted returns (and initial asset selections have been made on the basis of expectations), an investor may find herself in the unhappy situation of not having enough money to satisfy an objective. Individual or institution, the end result is a funding gap in need of a solution.

John C. Bogle is not alone in asking questions about manager compensation. In May 2005, the U.S. Department of Labor and SEC published Selecting and Monitoring Pension Consultants - Tips for Plan Fiduciaries.

A broad and important topic, manager compensation and the relationship with pension consultants, is left for another day...

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