Probing Pension Advisers For Possible Conflicts of Interest

 

In "New York Is Investigating Advisers to Pension Funds" (New York Times, November 5, 2013), Mary Williams Walsh writes that "state financial regulators have subpoenaed about 20 companies that help New York's pension trustees decide how to invest the billions of dollars under their control to determine whether any outside advice is clouded by undisclosed financial incentives or other conflicts of interest." 

Conflicts of interest are not new nor are they are likely to disappear overnight. In 2010, the U.S. Securities and Exchange Commission ("SEC") adopted measures to discourage bad acts. Three elements were cited in "SEC Adopts New Measures to Curtail Pay to Play Practices by Investment Advisers" (June 30, 2010) to include the following items:

  • Prohibition of "an investment adviser from providing advisory services for compensation — either directly or through a pooled investment vehicle — for two years, if the adviser or certain of its executives or employees make a political contribution to an elected official who is in a position to influence the selection of the adviser";
  • Prohibition of "an advisory firm and certain executives and employees from soliciting or coordinating campaign contributions from others — a practice referred to as "bundling" — for an elected official who is in a position to influence the selection of the adviser"; and
  • Prohibition of "an adviser from paying a third party, such as a solicitor or placement agent, to solicit a government client on behalf of the investment adviser, unless that third party is an SEC-registered investment adviser or broker-dealer subject to similar pay to play restrictions."

In the case of the New York State Common Retirement Fund, with nearly $161 billion in assets in Q1-2013, the single person trustee and New York State Comptroller, Thomas P. DiNapoli, describes numerous attempts to enhance transparency and avoid conflicts. From the official website, one can download files that include:

  • New York State Common Retirement Fund Placement Agent Disclosure Policies and Procedures of the Office of the State Comptroller," last updated on September 11, 2013;
  • "Transactions Compliance Review: New York Common Retirement Fund," dated February 22, 2010; and
  • An amended list, published on May 6, 2009 and disclosing "placement agents used during the administration of Alan Hevesi. The list was amended June 18, 2009 to reflect new information provided by the State Attorney General’s office."

While the published files are a good start, it would be nice to have even more information, especially with respect to the detailed due diligence process that was or is being employed by various advisers for recommended asset managers. My understanding is that the New York Financial Services Superintendent, Benjamin M. Lawsky, has requested pitch books as well as information about compensation levels, the nature of existing relationships between investment advisers and consultants and asset managers and how performance numbers are to be reported, including a description about the assessment of investments that do not trade in a public market. This makes sense given the growth in allocations to hard-to-value positions.

Letting the sunshine in is a good thing for plan participants and taxpayers alike. It would be hard these days for anyone to legitimately criticize attempts to avoid costly conflicts of interest, especially if misaligned objectives lead to grossly imprudent investment decisions.

In recognition of the importance of good pension governance, the National Association of State Retirement Administrators ("NASRA") adopted a resolution to expressly address ethics and disclosure requirements. Excerpting from Resolution 2011-02, it is stated that "Public fund fiduciaries should carefully review the trust and conflict of interest laws applicable to the system to ensure that the fiduciaries’ relationships with other parties are not incompatible with the duties to the system, and service providers to the system should divulge pertinent business activities, relationships and alliances including, among other things i) all services the firm, its principals, or any affiliates provide that generate revenue, ii) if the firm is owned in whole or in part by other firms or organizations, or if the firm owns other firms or organizations, that sell services to public pension systems, and iii) if the firm, its principals, or any affiliate has any strategic alliances with firms that sell services to public pension systems."

As headlines about underfunding and bankrupt cities continue and fiscal policy becomes even more entwined with the investment activity of $3 trillion in public pension coffers, I predict that state and federal investigations will likely go up in number, magnitude and frequency.

Fiduciary Management For Pension Plans

Besides being knowledgeable about medicine, nutrition and state-of-the-art health research, my doctor has a great sense of irony. He says things that make me laugh out loud. When I saw him recently, I mentioned how much I was enjoying reruns of some older television shows like Quincy, M.E. He replied, in typical clever fashion, "yea, but Sam did all the work and Quincy took the credit." It struck a chord because his statement is mostly true. In case you never watched the popular series about a coroner who helps the police solve crimes, veteran actor Jack Klugman (now deceased) applies Criminal Scene Investigation ("CSI") like smarts and tenacity in pursuit of justice. Sam Fujiyama (played wonderfully by actor Robert Ito) is likewise a medical doctor. He works alongside Dr. Quincy and is portrayed as an integral part of uncovering the truth.

In pension land, it is often the case that sponsors think they have hired someone to play the role of helpful Sam. The notion is that the advisor, consultant or fund of funds professional will be paid a fee to carry out a certain level of due diligence about action items such as setting up or revising an appropriate investment strategy, selecting or terminating an asset manager, redesigning a plan or evaluating pension transfer structures. Once the engagement letter is signed and a retainer fee is in place, the plan sponsor, like Dr. Quincy, can breathe a sigh of relief. Help is supposedly on the way - maybe. The safety net concept attached to bringing a third party on board, combined with what a colleague of mine describes as fiduciary fatigue, is reflected in the global growth of firms that describe themselves as fiduciary managers. While the retirement plan regulatory regime varies by country, the investment outsourcing model is gaining sway in the United States, the United Kingdom, the Netherlands and elsewhere. The undeniable trend to delegate merits discussion.

Before employers get too comfortable and think that their pension problems now belong to someone else, it is noteworthy to acknowledge that there are more than a few lawsuits that have been filed against third parties. Some of them allege breach on the basis of a failure to properly oversee and respond accordingly.

My observations come from firsthand experience. I have served as an economic analyst or testifying expert on disputes between an institutional investor such as a retirement plan, endowment, foundation or family trust. For other matters, I have provided due diligence training to fiduciaries and board members or reviewed the risk practices in place prior to a vendor being selected or as part of a later review of said vendor, once hired. As the founder of an educational start-up company a few years ago, I had a front row seat to the ongoing discussions between buyers and sellers of investment, risk and valuation services. Information in the form of repeated and in-depth surveys and numerous conversations about what pensions, endowments, foundations, family offices and other types of trust investors want and need from those who provide advice is telling. One issue that came up often from institutional investors was how to benchmark the quality of the work being provided by a delegate. This is a critical subject, especially for those outsourced professionals who are doing a terrific job and want their clients to be satisfied.

The topic of service provider due diligence is timely, important and the focus of my presentation on October 25, 2013 as part of the American Conference Institute's 6th Annual ERISA Litigation Conference. Interested readers are welcome to download my fiduciary due diligence slides.

Dr. Susan Mangiero Will Speak at ACI ERISA Litigation Conference

I am delighted to join the roster of multi-disciplinary speakers for this exciting October 24-25, 2013 New York City event. Designed for and by attorneys, the American Conference Institute's 6th National Forum on ERISA Litigation will include comments from renowned judges, in-house counsel, insurance experts, economic consultants and practicing litigators in the ERISA arena. According to the conference flyer, attendees will learn about the following:

  • Emerging trends in multiple facets of ERISA litigation;
  • Understanding new theories of liability arising from investment decisions, including alternative investments and the trend towards de-risking;
  • 401(k) fee case considerations and a discussion about evolving defense strategies, the issue of service providers and the viability of float claims;
  • ESOP litigation to include an overview of DOL investigations and settlements;
  • Benefits claims litigation
  • ERISA fiduciary litigation and ways to minimize liability exposure:
  • Class action update; and
  • Ethical issues that arise in ERISA litigation.

Having spoken and attended prior ERISA litigation conferences sponsored by the American Conference Institute, I always learned a lot. In particular, the discussions among jurists, the plaintiffs' bar and defense counsel makes for a collection of timely and lively debates. I hope you will be similarly satisfied if you decide to attend.

As a courtesy to readers of this blog, the American Conference Institute has activated a discount code of $200 for anyone who registers for the conference. Simply type "PRM200" when prompted. Click here to register. Click to download the agenda.

The Importance of Clear Communications

A funny thing happened the other day while having a snack in a Paris bakery. I am here for a few days, tagging along with my husband who is teaching for a month. Shortly after we sat down, a Japanese family arrived, went to the counter and asked in English for a sandwich to be heated before serving. As the woman at the cash register only spoke French, she did not respond right away. I think she was trying to understand what they wanted. The new arrivals asked again, in English and speaking a bit louder. Again, no reply. Then another customer, already seated and chatting with her friend, began speaking in Japanese to the family and subsequently translating into French for the bakery worker. As a result, the lady behind the counter was able to respond that they had no way to heat a sandwich and thereby allow the family to choose what they wanted to do as a result. Minutes later, four hungry customers were enjoying cold bread and hot beverages, with gratitude for the translator all the way around.

My take away points from observing this encounter is that the world is getting smaller. Speaking a second language is a plus. When you cannot speak the "right" language, access to someone who can translate is an advantage. When individuals are not communicating, opportunity loss occurs. Had the friendly passerby who spoke Japanese and French not played an active role, a family would have gone hungry for awhile and the bakery owner would have lost a sale.

Applied to the investment industry, similar lessons exist.

Investors often complain that contracts with managers, brokers, advisors, insurance companies and other service providers are too complex to understand. The ambiguity or absence of clarity as to who should be doing what and in what manner typically shows up as part of a dispute resolution. Something has gone awry and one party is bringing action against the other, based on facts and circumstances that include each party's interpretation of words.

Complexity of a product or service is another consideration. In "Don't Make Investing Too Complicated" by Matthew Luke (The Motley Fool website, May 10, 2013), readers are urged to focus on companies with simpler business models. Luke writes that "The more complicated an investment however, the more things can go wrong." While his statement may not apply to all investors, there is merit for everyone in being able to identify risk factors that can potentially destroy value.

As an independent risk governance and prudence expert, I am often in the position of having to ask service providers and investors alike to tell me what risk factors they deem most significant as potential destroyers of long-term value. We then talk about the likelihood of something going wrong and how risks are being mitigated. Those conversations cannot take place if information is overly complicated and/or unclear.

In other situations, a "translator" such as an informed consultant or advisor can assist both managers and investors in closing a sale and keeping a relationship alive. Like the bakery clerk and the hungry family, someone may need to intervene so that various parties are understood.

As new regulations are put into place, what investors will read likely reflects the need for the seller to comply. Compliance text is not necessarily the type of plain language that would better aid buyers in making an informed decision. This is not good. Investors need to understand what is at stake. Investment management service providers can benefit, sometimes materially so, by conveying concepts in plain language.

Registered Investment Advisor (RIA) Fiduciary Liability Risk

According to "Do plan advisers understand their risks?" by Rich Fachet (Investment News, October 8, 2012), some financial careerists may be woefully unaware of the risks they face as ERISA fiduciaries. The author, team leader with The Travelers Cos. Inc., goes on to say that the U.S. Department of Labor is serious about enforcement with $1.38 billion having been collected in 2011 "through prohibited-transaction corrections, restoration of plan benefits or the voluntary fiduciary-correction program." He adds that RIAs face both personal and professional liability. Whether tasked with discretionary authority over how to allocate an ERISA plan portfolio or giving advice with limited control over assets, these investment professionals have a lot to lose. Fachet lays out what kind of information should be gathered as a step towards mitigating fiduciary risk. The list includes, but is not limited to, the following tasks:

  • Assessment of the nature and magnitude of liability, taking new regulations such as ERISA 408(b)(2) into account and the potential cost of non-compliance;
  • "Lessons learned" from lawsuits that plaintiffs' counsel has won;
  • Determination of ERISA 404(c) "safe" versus "unsafe" harbors and how to counsel a plan sponsor as a result;
  • Review of "plan participant  options and models" as well as asset allocation percentages; and
  • Analysis of insurance gaps to include a review of adviser errors and omissions, professional liability, fiduciary liability and/or ERISA bond coverage.

Gary J. Caine, FSA, with Multnomah Group, Inc. addresses the flip side, i.e. that ERISA fiduciaries must carefully vet investment advisers before they are hired and thereafter. In "Fiduciary Reliance on Registered Investment Advisors," he suggests that plan sponsors need to minimally ask about qualifications such as education, experience in assisting plans, professional designations and securities licenses. Conflicts of interest, liability insurance coverage and compensation arrangements are other areas to investigate.

Notwithstanding the need to carefully assess which registered investment advisers are appropriate partners for ERISA pension plans, merger and acquisition ("M&A") activity in this sector continues. According to a new study produced by Schwab Advisor Services, "year-to-date assets under management (AUM) for M&A deal activity reached $42.3 billion at the end of the third quarter, which nearly eclipses last year's AUM total of $43.9 billion.". See "New Clients Drive Steady Growth for Independent Advisors in Face of Uncertain Economic Environment, Say 2012 RIA Benchmarking Study From Charles Schwab" (July 17, 2012 press release).

With Retirement Savings Week just wrapped up on October 27, 2012, experts write that many individuals are still woefully unprepared for post-employment life. In "Retirement 'Savings Week' highlights savings gap," Market Watch reporter Elizabeth O'Brien describes a study from the Employee Benefit Research Institute ("EBRI") on October 22, 2012 that says that 44 percent of simulated "lifepaths" bolsters the reality of inadequate income for one's "golden years."

A glaring take-away from all of this is that registered investment advisers will have a large client base as long as people need help with retirement planning.

The Oops Factor and a Crackdown on Retirement Plan Advisors

In recent discussions with asset managers, pension trustees and consultants, investment fraud continues to attract attention. It is no surprise that people want to know more about what constitutes bad practice versus crossing the line, especially in the aftermath of a devastating few years of economic losses. New disclosure regulations are another catalyst for learning more about how to avoid trouble. Email your request if you want more information about what can be done to detect fraud and/or would like to receive research and thought leadership on the topic of investment fraud.

Impending changes to fiduciary standards and allegations of fiduciary breach likewise continue to create a stir.

In "The EBSA Cracks Down on Retirement Plan Advisors," AdvisorOne's Melanie Waddell (March 26, 2012) describes a material increase in enforcement actions brought by the U.S. Department of Labor ("DOL"), Employee Benefits Security Administration ("EBSA"). Besides effecting nearly 3,500 civil cases in 2011, EBSA closed 302 criminal cases with "129 individuals being indicted," "75 cases being closed with guilty pleas or convictions" and an excess of $1.3 billion in monetary damages collected. Quoting Andy Larson with the Retirement Learning Center, the article mentions fiduciary negligence as a key concern of regulation and a driving force behind a proposed expansion of ERISA fiduciary duties to numerous professionals who work with retirement plans in an advisory capacity.

ERISA Attorney David Pickle points out that fraud and embezzlement of 401(k) plan money have been investigated for years by the DOL and U.S. Department of Justice ("DOJ") but recent investigations are being done now as part of the formal Contributory Plans Criminal Project ("CPCP"). He observes that "the DOL is conducting an increasing number of investigations of financial service providers, including registered advisers, banks and trust companies (both as trustees or custodians but also as asset managers), and consultants. For other insights about ERISA pain points, read "An Excerpt From: K&L Global Government Solutions (R) 2012: Annual Outlook."

According to the ERISA enforcement manual, civil violations include:

  • Failure to operate a plan prudently and for the exclusive benefit of participants
  • Use of plan assets to benefit the plan administrator, sponsor and other related parties
  • Failure to properly value plan assets at the current fair market value
  • Failure to adhere to the terms of a plan (assuming that those terms are compatible with ERISA)
  • Failure to properly select and monitor service providers
  • Unlawfully taking action against a plan participant who seeks to exercise his or her rights.

Criminal violations include:

  • Embezzlement of monies
  • Accepting kickbacks
  • Making false statements.

The "oops - I didn't know" strategy is unlikely to serve those who work with or for pension plans. The spotlight continues to focus on ways to improve the management of $17+ trillion U.S. retirement system and rightly so. There is so much at stake for millions of people.

George Washington said that "In executing the duties of my present important station, I can promise nothing but purity of intentions, and, in carrying these into effect, fidelity and diligence.

ERISA and public pension trustees are likewise tasked to be faithful and diligent, among other things. For those who choose a different path, the outcome can be dire indeed. Jail time and stiff penalties as well as legal costs are a few of the potential costs associated with a fraud conviction, not to mention shame and the loss of income.

Advisor Service Agreements: The Weak Link

Today's blog post is provided, courtesy of Mr. Phil Chiricotti, President of the Center for Due Diligence. Since the topic of contract review as an important element of proper due diligence is one which I have addressed elsewhere on www.pensionriskmatters.com and in my articles and speeches, I asked Phil for permission to reprint his article and he kindly agreed.         

                                          Advisor Service Agreements: The Weak Link

Enormous attention has been centered on retirement plan fees in recent years, including the new 408(b)(2)disclosure requirements. The liability has also increased for those who fail to comply. Lost in this shuffle is the fact that fees are only one piece of the puzzle.

While a well drafted, reviewed and understood service agreement can help preclude errors and claims, the service agreement is also the primary defense against liability caused by service provider mistakes and negligence. In spite of this important role, many plan sponsors - particularly small plan sponsors - sign standard service agreements without adequate review or counsel.

In addition to agreeing to vague service agreements, some sponsors engage advisors without a service agreement or verification of insurance coverage and bonding. As noted many times, most small plan sponsors also lack first party fiduciary liability insurance. A combination of the aforementioned is nothing less than a nuclear accident waiting to happen.

The DOL's new regulations provide an increase in both fee disclosure and clarity for comparative shopping, but 408(b)(2) does not preclude the need for an equitable service agreement. In our minds, the service agreement remains a weak link in the advisor vetting process, particularly in the small plan market. Indeed, the service agreement may not even reflect what was discussed and/or negotiated during the vetting process.

As noted by many attorneys, ERISA's primary focus has been on regulating the relationship between plan sponsors and participants. Beyond prohibited transactions and prior to the DOL's new disclosure regulations, little guidance was provided on how to manage the relationship between sponsors and service providers, including those assuming a fiduciary role.

The courts have not spoken uniformly about recourse between the plan and outside fiduciaries, but the plan sponsor's supervisory role, or the lack of it, has come under intense scrutiny in recent years. Because errors and disputes are a fact of life, it is long past time for the service agreement to become an integral part of the advisor vetting process from the beginning.

 

U.S. SEC Significantly Steps Up Enforcement

In case you missed it, the U.S. Securities and Exchange Commission announced significant enforcement initiatives on January 13, 2010. These include a focus on due diligence and valuation issues with a particular emphasis on due diligence, investment advisors, investment companies, performance and valuation.

Read "SEC Names New Specialized Unit Chiefs and Head of New Office of Market Intelligence" (U.S. Securities and Exchange Commission, January 13, 2010).

This follows on the heels of our January 7, 2009 blog post wherein we reported that the FBI is hiring over 2,000 professionals with backgrounds in accounting and finance. See "FBI Hiring Spree - More Financial Fraud Expected?" and "Wanted by the FBI: Talented Professionals to Serve the Nation."