New GAO Study Addresses Performance Audit Reports

Courtesy of the U.S. Government Accountability Office, a new study looks at performance audits for different types of pension plans. The report is entitled "Oversight of the National Railroad Retirement Investment Trust" (May 2014) and responds to requests from members of the U.S. Congress for information about this $25 billion retirement plan. Based on countless interviews with regulators, private fiduciary experts (and yes, I did answer some questions about benchmarking) and pension fund executives, the authors put forth the idea that performance audits could be mandated to occur more often. Interestingly, GAO researchers point out that "the frequency with which the Trust has commissioned performance audits is comparable to or exceeds most state efforts," adding that "...nine state plans are audited at least once every 2 or 3 years" with interviewees from 19 states pointing out that retirement plans "were subject to audits at longer set intervals that varied from state to state or were not reviewed according to any established time frame."

Pension fund accounting and performance benchmarking is certainly getting its share of attention. U.S. Securities and Exchange Commissioner Daniel Gallagher recently decried what he believes is an under-reporting of "trillions of dollars in liabilities. In his May 29, 2014 speech before attendees of the Municipal Securities Rulemaking Board's 1st Annual Municipal Securities Regulator Summit, Commissioner Gallagher talks about pension and OPEB liabilities as a serious threat and warned that "...it is imperative that bondholders know with precision the size of the potential pension liabilities of the entities in which they are investing. And yet, they do not." He adds that the "threat has been hidden from investors." As Lisa Lambert and Lisa Shumaker describe, government officials say that these sharp remarks sting and will scare people into thinking that a systemic problem exists. Read "Pension groups strike back at SEC commissioner's criticism" (Reuters, June 16, 2014). In its Q1-2014 update, the National Association of State Retirement Administrators ("NASRA") show that public pension fund assets have grown to $3.66 trillion, up slightly from the year-end 2013 level of $3.65 trillion.

On the rule-making front, the Governmental Accounting Standards Board ("GASB") just published an update to its pension accounting standards and posted a pair of brand new proposals to "improve financial reporting by state and local governments of other post-employment benefits, such as retiree health insurance." See "GASB Publishes Proposed Accounting Standards for Government Post-Employment Benefits" by the editor of AccountingToday.com, Michael Cohn. You can download the three documents by visiting the GASB website. Click to access GASB's microsite about Other Postemployment Benefits ("OPEB").

The good news, as I have said all along, is that initiatives for heightened transparency are underway. For more difficult situations, don't be surprised if litigation about disclosures continues to occur. In case you missed the February 24, 2014 Practising Law Institute ("PLI") CLE webinar, you can purchase the slides and audio recording of "Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends." I co-presented with Orrick, Herrington & Sutcliffe LLP partner, Elaine Greenberg. My focus was on risk management, valuation, performance and investment decision-making.

Longevity Derivatives Seem Poised For Further Growth

If this photo of senior ski fans is representative of the upward global trend in longevity, creators of derivatives could be on to something big. Deal count suggests that 2013 will be described as a banner year for banks and others types of financial companies as their respective corporate clients, in search of protection against the greying of their plan participants, took the plunge to get rid of risks they find difficult to manage. Financial News reports a December deal for 2.5 GBP between AstraZeneca and Deutsche Bank that "will cover the drug company against the risk that 10,000 of its former employees will live longer than expected." This follows a 1 billion GBP swap between Carillion and Deutsche Bank and a second transaction between BAE Systems and Legal & General, also in December 2013. See "A shot in the arm for longevity swaps" by Mark Cobley (January 6, 2014) for more details.

Certainly the topic is gaining importance in policy-making circles and at an international level. In December 2013, the Bank For International Settlements ("BIS") released an updated version of a study about longevity risk transfer markets. The product of the Joint Forum on longevity risk transfer ("LRT") markets, the report strongly encourages those with regulatory authority to carefully track the nature of deals being done and by which organizations as a way to gauge capacity to handle risks being transferred to the financial sector. Longevity risk exposures should be properly measured and attention should be paid to the extent to which "longevity swaps may expose the banking sector to longevity tail risk, possibly leading to risk transfer chain breakdowns." The study likewise notes the importance of supervisors to be able to evaluate whether those in possession of longevity risk have the "appropriate knowledge, skills, expertise and information to manage it."

These words of caution make sense, especially given the large amounts at stake. In its December 20, 2013 press release, the BIS cites estimates of the aggregate "global amount of annuity- and pension-related longevity risk exposure" as ranging between $15 and $25 trillion. Based on World Bank data, U.S. Gross Domestic Product for 2012 was $16.2 trillion. It was reported at $8.2 trillion for China and $5.9 trillion for Japan. The implication is clear. Get it wrong and it could mean big losses for a delicate global financial system that has had its share of risk management twists and turns. Click to access "Longevity risk transfer markets: market structure, growth drivers and impediments, and potential risks" (Basel Committee on Banking Supervision Joint Forum, December 2013).

As at least one major bank moves forward to develop a longevity derivative instrument that is meant to be traded, expect more news from insurance company and banking regulators about capacity, internal controls, assessment of risk, posting of capital and adequate disclosure about the transfer of large amount of longevity risks to financial intermediaries. Risk Magazine author, Tom Osborn, describes some of the impediments to a full-scale launch of the longevity transfer market, including limited disclosure about how transactions are priced, absence of a liquid index that would facilitate cost-effective hedging and avoid capital adequacy-related basis risk problems and questions about how exposures should be accurately modeled. Click to read "Longevity: Opportunity or flop?" (September 20, 2013).

Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends

Mark your calendars to attend "Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends."

At a time when unfunded pension and health care obligations are accelerating the budgetary crisis for some municipalities, experts fear that current problems are the tip of the iceberg. A new focus on accounting rules, the quality of disclosure to muni bond investors and the due diligence practices of underwriters, portfolio managers and advisers could mean heightened liability exposure for anyone involved in the nearly $4 trillion public finance marketplace. Add the history-making Detroit bankruptcy decision to the mix and attorneys have the makings of a perfect storm as they attempt to navigate these unchartered waters. The U.S. Securities and Exchange Commission has made no secret of its priority to sue fraudulent players in the public finance market. Insurance companies are reluctant to underwrite policies for high-risk government entities at the same time that municipal fiduciaries are more exposed to personal liability than ever before, especially as the protection of sovereign immunity is being challenged in court. Litigation that involves how much monitoring of risk factors took place is on the rise.

Public finance and securities litigation counsel, both in-house and external, can play a vital role in advising municipal bond market clients as to how best to mitigate litigation and enforcement risk or, in the event that an enforcement action has already been filed, how best to defend such litigation. Please join Orrick, Herrington & Sutcliffe LLP partner, Elaine C. Greenberg, and retirement plan fiduciary expert, Dr. Susan Mangiero, for an educational and pro-active program about the complex compliance and litigation landscape for municipal bond issuers, underwriters, asset managers and advisers. Topics of discussion include the following:

  • Description of the current regulatory environment and why we are likely to see much more emphasis on the disclosure activities of public finance issuers and the due diligence practices of underwriters and advisers;
  • Overview of hot button items that impact a bond issuer’s liability exposure, to include valuation of underlying collateral, rights to rescind benefit programs in bankruptcy and the use of derivatives as part of a financing transaction;
  • Explanation of GASB accounting rules for pension plans and likely impact on regulatory oversight of securities disclosure compliance and related enforcement exposures;
  • Discussion about trends in municipal bond litigation – who is getting sued and on what basis; and
  • Description of pro-active steps that governments and other market participants can take to mitigate their legal, economic and fiduciary risk exposures.

Featured Speakers:

Ms. Elaine C. Greenberg, a partner in Orrick, Herrington & Sutcliffe LLP’s Washington, D.C., office, is a member of the Securities Litigation & Regulatory Enforcement Group. Ms. Greenberg’s practice focuses on securities and regulatory enforcement actions, securities litigation, and public finance. Ms. Greenberg is nationally recognized for producing high-impact enforcement actions, bringing cases of first impression and negotiating precedent-setting settlements, she possesses deep institutional knowledge of SEC policies, practices, and procedures. Ms. Greenberg brings more than 25 years of securities law experience, and as a Senior Officer in the SEC's Enforcement Division, she served in dual roles as Associate Director and as National Chief of a Specialized Unit. As Associate Director of Enforcement for the SEC's Philadelphia Regional Office, she oversaw the SEC's enforcement program for the Mid-Atlantic region and provided overall management direction to her staff in the areas of investigation, litigation and internal controls. In 2010, she was appointed the first Chief of the Enforcement Division's Specialized Unit for Municipal Securities and Public Pensions, responsible for building and maintaining a nation-wide unit, and tasked with overseeing and managing the SEC's enforcement efforts in the U.S.’s $4 trillion municipal securities and $3 trillion public pension marketplaces. Ms. Greenberg recently gave a speech entitled “Address on Pension Reform” at The Bond Buyer’s California Public Finance Conference in Los Angeles on September 26, 2013.

Dr. Susan Mangiero is a CFA charterholder, certified Financial Risk Manager and Accredited Investment Fiduciary Analyst™. She offers independent risk management and valuation consulting and training. She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors. Dr. Mangiero has served as an expert witness as well as offering behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary on matters that include distressed debt, valuation, investment risk governance, financial risk management, financial statement disclosures and performance reporting. She has been actively researching and blogging about municipal issuer related retirement issues for the last decade. She has over twenty years of experience in capital markets, global treasury, asset-liability management, portfolio management, economic and investment analysis, derivatives, financial risk control and valuation, including work on trading desks for several global banks, in the areas of fixed income, foreign exchange, interest rate and currency swaps, futures and options. Dr. Mangiero has provided advice about risk management for a wide variety of consulting clients and employers including General Electric, PriceWaterhouseCoopers, Mesirow Financial, Bankers Trust, Bank of America, Chilean pension supervisory, World Bank, Pension Benefit Guaranty Corporation, RiskMetrics, U.S. Department of Labor, Northern Trust Company and the U.S. Securities and Exchange Commission. Dr. Mangiero is the author of Risk Management for Pensions, Endowments and Foundations  (John Wiley & Sons, 2005), a primer on risk and valuation issues, with an emphasis on fiduciary responsibility and best practices. Her articles have appeared in Expert Alert (American Bar Association, Section of Litigation), Hedge Fund Review, Investment Lawyer, Valuation Strategies, RISK Magazine, Financial Services Review, Journal of Indexes, Family Foundation Advisor, Hedgeco.net, Expert Evidence Report, Bankers Magazine and the Journal of Compensation and Benefits. Dr. Mangiero has written chapters for several books, including the Litigation Services Handbook and The Handbook of Interest Rate Risk Management.

Private Equity Performance and Underfunded Pensions

Adopting a "half glass full" attitude, my co-author and I wrote about the business opportunities for private equity fund general partners ("GPs") with portfolio company problems. In "GPs Eye New Ruling" (Mergers & Acquisitions, December 2013 Issue) by ERISA attorney David Levine and Accredited Investment Fiduciary Analyst, Dr. Susan Mangiero, we talk about the aftermath of a recent legal decision that has the private equity world on high alert.

By way of background, in Sun Capital Partners v. New England Teamsters & Trucking Industry Pension Fund, the United States Court of Appeals for the First Circuit ruled that a private equity fund can be held liable for the pension obligations of a portfolio company. If left unchecked, private equity funds (and their limited partners such as pension plan investors) could see a diminution of performance for any number of reasons. For one thing, a GP may be unable to exit a position within a reasonable period of time if potential buyers get scared of being saddled with an expensive, underfunded retirement plan. In addition, cash that was otherwise earmarked to finance new growth projects may be used instead to comply with statutory contribution rules. Indeed, I have carried out financial analyses for prospective buyers on the basis of how much "extra" a pension problem is likely to cost.

While the downside possibilities are real, Attorney Levine and I point out that "lessons learned" from the Sun Capital decision enable a GP to take action preemptively as a way to potentially "maximize value from portfolio companies while also mitigating future risk." Savvy asset managers can adapt their due diligence process to help avoid any issues that could preclude an exit within the typical three to seven year time period from an initial funding round. Some of the many steps that a GP can take include, but are not limited, to the following:

  • To the extent that a private equity fund is relying on the position that it is not a “trade of business” and is therefore not subject to liability for a portfolio company’s pension underfunding, it is wise to review the potential economic, fiduciary and legal risks should this position be challenged in court.
  • Review its holdings that are at least 80 percent owned by the private equity fund. Total equity exposure should include common stock, preferred stock and possibly economic rights associated with warrants and/or equity derivatives such as swaps. Although a core focus of any such review should be with respect to holdings subject to jurisdiction in the First Circuit (Maine, Massachusetts, New Hampshire, Puerto Rico, and Rhode Island), a broader review of holdings elsewhere might also be considered.
  • Review underfunded pension plans before and after each acquisition of a portfolio company in order to develop strategies for addressing the Pension Benefit Guaranty Corporation’s aggressive litigation positions that it has been taking lately. Failure to do so could result in unnecessary delays in connection with corporation transactions, including the sale of portfolio companies. Examine the collective bargaining agreements for any or all portfolio companies. Although the Sun Capital Partners case was about liability for pension funding obligations under a multiemployer pension plan (i.e., a pension plan maintained independent of an employer pursuant to collective bargaining), there is some concern that the logic of Sun Capital Partners might be extended to conclude that a private equity fund is conducting a “trade of business” under the Internal Revenue Code through its management and oversight of portfolio companies. A decision concluding that a fund is a trade or business for Internal Revenue Code purposes could impact a fund’s representations of its attempts to minimize its unrelated business income tax liability and/or its acceptance, pursuant to the Internal Revenue Code, as a trade or business.
  • Assess the economic, fiduciary and legal attractiveness of all employee benefit plans that are offered by private equity portfolio companies. This includes traditional defined benefit pension plan, 401(k) plans, and health and welfare arrangement. Individually and collectively, ERISA plans can carry significant liabilities that have the potential to (a) materially reduce overall business profitability (b) increase insurance premiums (c) lead to expensive litigation and/or regulatory enforcement (d) impede liquidity and (e) hamper capital raising. As a result, a general partner may never be able to realize the growth targets that motivated a particular investment in the first place. Just as significant, a private equity fund may find itself limited in its ability to exit a particular investment.
  • Meet with retirement-focused advisers, actuaries and counsel before investing in a new portfolio company. The due diligence analysis should be comprehensive. This means that a private equity fund will want to assess both the current and projected pension plan liabilities for a portfolio company as well as the riskiness of its investments in its pension and 401(k) plan. If a pension plan’s assets are illiquid or overly conservative, a deficit may occur or grow bigger. It is likewise important to understand whether the assumptions underlying actuarial calculations are overly optimistic. The objective is to understand the seriousness of a given situation in terms of economic, fiduciary and legal vulnerability.
  • Assess the accounting impact for any and all retirement plans. Be prepared to explain performance volatility to LPs as the result of an ERISA problem.
  • As the family of “de-risking” products continues to expand, consider restructuring a portfolio company’s ERISA plan if, by doing so, a private equity fund owner can improve the likelihood of an exit within its target time horizon. However, because ERISA’s fiduciary rules impose a duty of loyalty to participants and beneficiaries, decisions on de-risking should be evaluated under these standards.
  • Determine, in conjunction with ERISA counsel, whether to engage an “independent fiduciary” for purposes of evaluating an array of possible restructuring solutions. Buying annuities to settle pension liabilities or investing in employer securities or other “hard to value” assets are examples.
  • Recognize that the Sun Capital Partners decision could encourage further litigation and regulatory activities. Private equity funds might be well served to consider whether minor tweaks to their structure merit use, including the creation of additional services entities that are commonly used in operating company structures. Clarification of offering documents, careful monitoring of activities and/or comprehensive documentation of its involvement with portfolio companies can go a long way to help insulate a private equity fund from a finding that it is engaged in an Internal Revenue Code trade or business.

For further reading about this important legal decision and the economic and compliance imperatives, you can read earlier blog posts and link to various law firm memos on this topic. See "Pension Liability Price Tag For Private Equity Funds and Their Investors". Also see "More About Private Equity Funds and Pension IOUs."

Effective Investment Stewards Should Take a Bow

In case you missed it, check out the quirky indie film "In A World..." If you like movies as I do, you will enjoy this lighthearted comedy about the supposed rough and tumble world of voice-overs. The first few minutes are devoted to the memory of Don Lafontaine, the uber vocal artist of countless trailers and commercials who died at the age of 68 in 2008. The story then proceeds to chronicle the efforts of a character played by actress Lake Bell, Carol Solomon, in competing for gigs in a mostly male-dominated industry. (Kudos to Ms. Bell for writing, directing and producing this cinematic gem as well.) Various sub-plots involve the reinforcement of a shaky marriage, connecting anew with a less than supportive father and getting "used" by a female film executive who sees dollar signs in empowering women at the expense of boosting Carol's ego.

Aside from its entertainment value, the production stayed on my mind, hours after the popcorn was gone. Here is why. In a final scene, Carol decides to help young women with squeaky voices learn how to better present themselves. She asks "Are you ready to be heard?"

Applied to the pension world, the question is apt. In an era of rising enforcement and litigation activity, I have often wondered why more governance-focused plan sponsors are refusing to take a bow. In speaking to several of their representatives, the feedback I received is that visibility can be a two-edged sword. My understanding of what others have said to me is that affirmative "best practice" communications might be viewed as a defensive tactic to hopefully keep participants happy and therefore unlikely to sue. The danger is that those same statements could be seen as raising awareness of issues that will lead to questions and unwelcome attention to topics such as fees, risk management and vendor selection.

The subject of how much information to provide is certainly an important one to address. The president of retirement plan services at Lincoln Financial Group, Chuck Cornelio, writes that "The move away from process-focused messages, such as how to enroll, plan mechanics and investment selection, to conversations around the projected outcomes of a participant's savings behaviors and strategies, including future monthly retirement income, spending power and retirement lifestyle, will not happen overnight." Click to read "5 critical elements of retirement plan communication" (Benefits Pro, November 12, 2012).

A recent court action has shed light on the attorney-client privilege as relates to ERISA plan communications. Interested readers can download the presentation about the fiduciary exception rule by Attorney James P. McElligott (Partner, McGuireWoods) and Attorney Ronald S. Kravitz (Liner Grode Stein Yankelevitz Sunshine Regenstreif & Taylor). It is entitled "ERISA Counsel's Communications with Plan Fiduciaries and Attorney-Client Privilege" (Strafford Continuing Legal Education, April 3, 2013). Attorney McElligott adds that "Fiduciary communication is a critical area. The process starts with a well-written Summary Plan Description ("SPD") but requires constant thought and vigilance."

In its "Fiduciary Checklist," T. Rowe Price authors provide a long list of items that should be disclosed to participants. It is certainly a good start but I would add numerous sections to that list about the governance of any particular retirement plan.

This topic will receive more attention from this blogger, especially as different countries approach the issue of pension governance as a recognized problem, with some plans badly in need of a solution.

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.

Fiduciary Duty is More Than Numbers

As a published author, I am constantly assessing what has appeal to readers. I try to write about topics that are relevant and timely and welcome feedback. Click here to send an email with your suggestions. As a financial expert, I continuously seek to stay on top of what is being adjudicated. As a risk manager, I regularly evaluate what might have been done differently when things go seriously awry.

What I have noticed is that enumeration seems to offer comfort. Lists of this or that are common to many best-selling books and widely read articles. A trip to the Inc. Magazine website today illustrates the point. Consider this excerpted list of lists:

The popularity of laying out "to do" items extends to the retirement industry as well. For example, Attorney Mark E. Bokert provides insights in his article entitled "Top 10 ERISA Fiduciary Duty Exposures - And What to Do About Them" (Human Resources - Winter Edition, Thomson Publishing Group, 2007). His list of vulnerabilities - and prescriptive steps to try to avoid liability - includes the following:

  • Identify who is a fiduciary and making sure that they are properly trained;
  • Create a proper process by which investments are selected and monitored;
  • Monitor company stock in a 401(k) plan and consider whether to appoint an independent fiduciary;
  • Assess the reasonableness of "like" mutual funds versus existing plan choices;
  • Ensure that communications with plan participants are adequate;
  • Undertake a thorough assessment of vendors and review their performance thereafter;
  • Assess whether 401(k) deferrals and loan repayments are being made in a timely fashion;
  • Identify the extent to which service providers enjoy a float and whether they are entitled;
  • Understand what is allowed in terms of providing investment advice to participants and abide by the rules accordingly; and
  • Critically evaluate whether auto enrollment makes sense and the nature of any default investment selection.

One could easily break out each of the aforementioned items into sub-tasks and create appropriate benchmarks to ascertain whether fiduciaries are doing a good job. Indeed, ERISA attorneys are the first to invoke the mantra of "procedural process" as a cornerstone of this U.S. federal pension law. Importantly however, relying only on numbers is not sufficient. Increasingly legal professionals and regulators are asking that process be demonstrated and discussed. Expect more of the same in 2013. Analyses and expert reports may be deemed incomplete if they do not include a deep dive of the fiduciary decision-making process that took place (or not as the case may be).

U.S. Department of Labor Audits and ERISA Litigation

According to "Attorney, Official Discuss DOL Investigations, Give Recommendations on Avoiding Litigation," by Andrea L. Ben-Yosef (Pension & Benefits Daily, BNA Bloomberg, October 15, 2012), trouble may come in pairs. The same complaints from plan participants, leads from government authorities and/or news about a company's financial distress that trigger U.S. Department of Labor ("DOL") scrutiny could invite plaintiffs' counsel to file a contemporaneous lawsuit.
 
Speakers Mabel Capolongo, Director of Enforcement with the U.S. Department of Labor, Employee Benefits Security Administration ("EBSA") and Attorney R. Bradford Huss with Trucker Huss suggested that persons being examined for possible breach should familiarize themselves with the EBSA enforcement manual and notify their ERISA liability insurance carrier right away. Cited potential areas of investigation include:
  • Fiduciary breach;
  • Co-fiduciary liability;
  • Plan expenses;
  • Plan operations;
  • Plan investing;
  • Prohibited transactions;
  • Company securities in a plan, including Employee Stock Ownership Plan ("ESOP") issues;
  • Real estate holdings;
  • Bonding;
  • Reporting; and
  • Disclosure.

For regulatory information, click to access the EBSA Enforcement Manual.

In a related online interview for the Professional Liability Underwriting Society ("PLUS"), Chartis Executive Vice President Rhonda Prussack cites financial distress (including the filing for bankruptcy protection) as a significant concern for ERISA fiduciary liability. She adds that a troubled plan sponsor may see the value of company-issued securities plummet which in turn could trigger an ERISA "stock drop" case if such securities are part of the mix for a 401(k) or profit-sharing plan. A company seeking to save cash may switch from a defined benefit plan to a cash balance plan which in turn could pave the way for a lawsuit over allegations relating to the change in design. A company in trouble could shut down factories, instigate large-scale layoffs and/or cut back benefits, all of which lead to unhappy individuals who are more likely to sue. Ms. Prussack emphasizes that happy workers are less likely to sue. She further adds that plan participant actions are likely to take the form of putative class actions.

The bottom line is that there is a long list of potential risk exposures for ERISA fiduciaries and a continued need to mitigate liability.

Fiduciary Duty to Hedge

Who would have thunk that a discussion about pension governance and risk management would keep audience members in their seats for nearly three hours? Yet that is what occurred on January 24, 2012 as a panel convened to discuss such weighty issues as whether companies have a fiduciary duty to hedge and whether inaction can lead to litigation.

In his opening remarks as part of a January 24, 2012 event that was hosted by the Hartford CFA Society, ERISA attorney Martin Rosenburgh cautioned that fiduciaries could find themselves open to questions for not taking steps to mitigate risks. Attorney Gordon Eng, a former litigator and now general counsel and Chief Compliance Officer for a high yield bond fund, adds that any investment decision should be supported with ample documentation that reflects a careful and thorough deliberation of the issues at hand.

For more details about this lively, topical and informative event, read "Considering a Duty to Hedge" by Christopher Faille.

New Regulations About ERISA Plan Fee Disclosures

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

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

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

Public Pension Risk Management and Fiduciary Liability

A few weeks ago, Attorney Terren B. Magid and Dr. Susan Mangiero jointly presented on the topic of pension risk management and fiduciary liability with a particular emphasis on public plans. Attorney Magid's insights reflect a particularly unique perspective inasmuch as he served as executive director of the $17 billion Indiana Public Employees' Retirement Fund ("PERF"). Dr. Mangiero shares her views as an independent risk management and valuation consultant, author, trainer and expert witness.

Click to download the 25-page webinar transcript for public pension fiduciaries entitled "Are You Properly Mitigating Risk? Assess Your Fiduciary IQ" with Attorney Terren B. Magid (Bingham McHale LLP) and Dr. Susan Mangiero (Fiduciary Leadership, LLC). Comments about ERISA plans are provided when applicable.

Topics discussed include, but are not limited, to the following:

  • Public Pension Transparency Act
  • Discount Rate Choice
  • Dodd-Frank Wall Street Reform and Municipal Advisor Registration
  • Expanded Definition of ERISA Fiduciary
  • Fee Disclosure Under ERISA 408(b)(2)
  • Failure to Pay and Actuarially Required Contribution ("ARC")
  • Benefit Reductions
  • RFP Process
  • Fiduciary Audits
  • D&O Policy Review
  • Vendor Contract Examination
  • Qualitative and Quantitative "Investment Risk Alphabet Soup"
  • Interrelated Risk Factors
  • Key Person Risk
  • Hard to Value Investing
  • Model Risk
  • Stress Testing
  • Pension Litigation
  • Fiduciary Breach Vulnerability
  • Characteristics of a Good Model
  • Side Pockets and Investment Performance.

Comments are welcome.

Pension Funds and Performance Standards

David Spaulding, founder of the eponymous Spaulding Group, provokes readers with his suggestion that pension plans become "GIPS" compliant. Said differently, his thought is that users of information provided about retirement plan financial health would benefit if reported numbers reflect the Global Investment Performance Standards. Just an aside, www.gipsstandards.org states that "The GIPS standards are voluntary and are based on the fundamental principles of full disclosure and fair representation of investment performance results."

I have long maintained the need for more uniformity and clarity about how pension plan numbers are shared with the outside world. Absent fraud, there can be a huge discrepancy between what someone reads on the printed page and the true economic risks associated with any given scheme. Take a look at "The Plan That Didn't Bark: To solve the mystery of benefit plans, analysts must learn to think like detectives" by Susan Mangiero, CFA Magazine, March-April 2008.

I applaud Dave for reminding his blog readers that the standards exist "to provide an ethical framework for asset managers to provide their past performance to prospective clients." He adds that pension funds that expend time and money on a "GIPS" effort stand to "get their shop in order" by being forced to establish policies, procedures and controls. However, he adds that plan sponsors will still need to document how they are doing so I am a bit unclear as to the role of GIPS for pension plans and have asked Mr. Spaulding for further clarification about his ideas.In the meantime, click to read "Pension funds and GIPS" at Investment Performance Guy, April 20, 2011.

Pension Rate of Return Reality

According to its March 15, 2011 press release, the Board of Administration for the California Public Employees' Retirement System ("CalPERS") votes to maintain its current per annum discount rate assumption of 7.75 percent. Citing its actuary's take that maintaining the "discount rate at its current level is prudent and reasonable" and its long-term investment posture, this giant pension system justifies the status quo.

A few months ago, CalPERS "slightly decreased the allocation for traditional bonds and shifted the funds to inflation-protected bonds and commodities to reduce volatility risk." Its historical and projected analysis suggests an average gross (net) annual return of 7.95 (7.80) percent for the next several decades. Prior to 2004, CalPERS states that it had assumed an annual discount rate of 8.25 percent.

Not everyone agrees that defined benefit plan rates of returns should hover around the magic eight percent that has been long used for determining funding status. St. Petersburg Times reporter Sydney P. Freedberg describes the dilemma in "Experts say Florida overstates future pension returns" (March 21, 2011). If states assume a rate that is overly optimistic, reported IOUs will be smaller as a result on paper but not in reality. At some point, real money will be required to write checks to beneficiaries. On the flip side, the use of a more likely rate of return will balloon unfunded liabilities, forcing economic and political change right away.

The larger the funding gap (and assuming no changes in contributions), the more likely it is that traditional pension plan decision-makers will steer money towards higher risk investments, in anticipation of higher returns. This may be a valid strategy AS LONG AS new risks are properly identified, measured and managed. Otherwise, the situation could become even worse as out of control risk-taking leads to more and larger portfolio losses down the road.

As described in "Will the Real Pension Deficit Please Stand Up?" by Dr. Susan Mangiero, CFA, FRM (June 22, 2006), the American Academy of Actuaries writes in its July 2004 primer on pension fund accounting and funding 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."

The important issue continues to be how long it will take before plan participants, sponsors, shareholders and taxpayers get the real scoop on what is owed, when and by whom.

Big Baths and Pension Accounting

According to "Rewriting Pension History" by Michael Rapoport (Wall Street Journal, March 9, 2011, several large multinational corporations are changing the way they report retirement plan numbers. The goal is to stop smoothing losses and gains and instead have current year earnings reflect the full extent of what is owed (or available as a surplus).

Cynics might describe this strategy as a "big bath" approach. Report pain all at once and therefore be able to report higher earnings the following year. On a more benign note, companies may simply want to provide more transparency to their investors, especially at a time when lots of questions are being asked about the costs associated with providing retirement benefits to current and past employees.

Assuming good intentions, recognizing the pension deficit (surplus) in the year in which it occurred may still not provide accurate information about the true economic costs associated with servicing a traditional pension plan. There are many reasons why a comparison of the non-smoothed pension gain or loss for two or more companies could differ, sometimes dramatically. Consider the following.

  • Reported numbers that are based on accrual accounting do not necessarily reflect the actual cash flowing out (in) the door. Investors will still have to assess whether the sponsor can readily access cash to meet its pension obligations and at what cost.
  • Assumptions about factors such as wage hikes, cost of living adjustments, mortality, return on assets and risk exposure given a particular asset allocation mix can and do vary across companies. Unless a prospective or existing investor can assess whether underlying assumptions make sense, it is difficult to know if reported numbers are too low or too high, relative to economic reality.
  •  A year-by-year analysis of reported earnings is going to be hard to render without making some adjustments to past financial statements. Hopefully companies that use current accounting methodology for their 2010 books will provide sufficient information for investors to be able to compare "apples to apples."
  • Actuarial numbers used for compliance with the Pension Protection Act of 2006 could still vary, perhaps materially, from reported current year numbers, causing confusion for investors and creditors as to which number is "right."
  • For those companies that are infusing their defined benefit plans with massive amounts of cash, it would be helpful to understand how enterprise value is impacted as a result since that cash cannot be used for product development, dividend payments and so on.
  • For those executives who receive earnings-linked compensation, there are questions about how their respective bonuses will be computed in the year of the big bath versus the following years. The concern for investors is that executive compensation might be too "generous" later on due to this year's accounting decision versus a growth in operating earnings.

As described in "The Plan That Didn't Bark" by Susan Mangiero (CFA Magazine, March/April 2008), quantity is not the same thing as quality. Investors may be provided new and arguably more information about pensions and still be in the dark about the true encumbrance associated with an underfunded plan.

The same "clear as mud" dilemma that confronts investors of ERISA plan sponsors likewise applies to public pension and health care plans. According to Dr. Michael Kraten, an accounting professor with Providence College and president of Enterprise Management Corporation, "There are no requirements in the MD&A sections of the annual reports of the health plans to disclose and/or discuss detailed 'churn rates' of the subscriber base, 'turnover rates' of the provider base or the quality of care 'outcomes data' of the network itself."

More than a few individuals have called for a separate financial report for each retirement and health care benefit plan sponsored by a particular company or government. There are distinct advantages of that approach as long as uniform reporting standards are used and the accounting numbers are as close as possible to economic losses (gains). On the flip side, treating the benefit plans as separate and distinct makes it difficult, perhaps impossible, for a firm to manage risks across the enterprise.

That's a significant discussion for another day...

Congress Wants Public Plan Transparency

According to a press release dated February 9, 2011, U.S. Congressman Devin Nunes and U.S. Senator Richard Burr are about to force their peers to focus on public pension fund finances. While the House gets the Public Employees Pension Transparency Act this week, a version for the United States Senate is expected in a few days. The goals of this proposed legislation are several:

  • Provide one set of financial statements (and underlying assumptions) for state and municipal plans to the U.S. Secretary of the Treasury that are based on prevailing accounting methods, even if flawed.
  • Report a second set of financial statements that reflect the level of liabilities for each reporting entity as determined according to a uniform set of rules. "These guidelines will include more realistic discount rates, as well as controls to assure assets are counted using a reasonable estimate of fair market value."
  • Penalize non-compliant government units by withholding federal subsidies of state and local debt and nixing federal tax-exempt status for their bonds.

According to "US House Republicans Rule Out Federal Bailouts For States" by Andrew Ackerman (Wall Street Journal, February 9, 2011), today's Congressional discussion about the state of public employee benefit plans made it clear that states and/or municipalities seeking refuge from their funding problems will not get a federal bailout.

Unless struggling government plan sponsors rescind benefits and/or increase local tax revenue and/or take on a lot more investment risk, they are going to feel immense pain in the coming years. The bad news is not spread out equally. A table that describes the "Public Pension Crisis" and is based on "Public Pension Promises: How Big Are They and What Are They Worth" by Professors Robert Novy-Marx and Joshua D. Rauh projects that Oklahoma, Louisiana, Illinois, New Jersey, Connecticut, Arkansas, West Virginia, Kentucky, Hawaii and Indiana will exhaust their funding first.

The vicious cycle begins. If municipal bond investors view these issuers as higher risk, their respective cost of money will go up. More expensive debt service will exacerbate the overall problems, irregardless of which accounting rules are used for reporting. Taxpayers will get more upset and possibly vote with their feet, moving to what they perceive as fiscally sound cities, towns and states. Yet another falling domino, a shrinking tax base will mean fewer available dollars to pay bills, widening the money gap.

According to "Bond Rating Drop Ignites Pension Fight" by Lisa Fleisher and Jeannette Neumann (Wall Street Journal, February 9, 2011), the Garden State is now on the receiving end of a ratings downgrade and "is one of the seven lowest-rated states in the country." They report that New Jersey missed a $3.1 billion pension payment and could well have been a factor in the drop from AA to AA-.

I hate to say "I told you so" AGAIN but I wrote about the political impact of pension funding in the mid 2000's since it was obvious even then that there were large problems afoot. If you missed it, read "Tea Party Redux" State Pensions in Turmoil" by Susan Mangiero (July 27, 2006) and note that the term "tea party" has nothing to do with the party or movement of late.

Watch carefully as to how these plans change their asset allocations. Already there is a significant move towards investing in funds and instruments with an expectation of higher returns. That's not a problem as long as a robust risk management process in put in place or improved upon if it exists already. My forthcoming book on this topic will elaborate on the potential dangers of taking on too much risk.

Help With Form 5500 Reporting

For those in need of help, click to access the "Troubleshooter's Guide to Filing the ERISA Annual Report" (U.S. Department of Labor, October 2010). This 70-page publication includes a handy reference chart that relates to the Form 5500 and Form 5500-SF (for small firms), along with related attachments. Another helpful resource is "FAQs About The 2009 Form 5500 Schedule C."

School's still out regarding the extent to which plan sponsors will be able to comply with new rules. So far, Schedule C seems to be a sticking point with numerous questions being asked about how to properly report "indirect" versus "direct" compensation to service providers.

As more pension plans allocate monies to mutual funds, hedge funds, private equity funds and funds of funds, they will need to report details about fees paid to these organizations as they too are now deemed service providers.

Bad Disclosures - Recipe For Disaster?

According to "State workers face privatization" by Jason Stein (Milwaukee Journal Sentinel, January 6, 2011), over 300 Wisconsin State Department of Commerce employees may soon be classified differently. The stated goal is to better deploy its $183 million budget to try to create jobs. (Whether you believe that governments are the engine of jobs creation is a post for another day.)

Questions remain about the benefits for identified employees and whether they will be covered by the state's retirement system. A related question is whether the general public will have a true assessment of Wisconsin's retirement plan IOUs if these privatized workers are counted as "public" for some purposes but not for others. In reading the many comments posted for the aforementioned article, emotions are running high about the real costs associated with this decision. Clearly, more information would go a long way to quelling any concerns.

The topic of financial disclosures may soon create real problems for public plans and, by extension, ERISA plans that are sponsored by companies that issue stocks and/or bonds. In today's New York Times, Mary Williams Walsh reports that the U.S. Securities and Exchange Commission ("SEC") may be investigating the large California pension plan known as CalPERS. It's premature and inappropriate to speculate but the inference is that bond buyers may have been in the dark about the "true" risks associated with this $200+ billion defined benefit plan. If true, California could pick up an even bigger than expected tab and municipal security investors could be in a position of having paid too much to own state debt. See "U.S. Inquiry Said to Focus on California Pension Fund."

As recently as 2009, then Special Advisor to California Governor Arnold Schwarzenegger, David Crane, referred to public pension plan reporting as "Alice-in-Wonderland" accounting. He added that "state and local governments are understating pension liabilities by $2.5 trillion, according to the Center for Retirement Research at Boston College." Since these are legal contracts that bind the state, city or municipal sponsor, they are on the hook for bad results, with large cash infusions likely.

It's not rocket science to conclude that other states and municipalities could face the same type of securities regulation inquiry. Indeed, even ERISA plans are vulnerable to allegations of fraud or sloppy reporting if their risk disclosures are incomplete, inaccurate, misleading or all of the above. See "Testimony for Securities and Exchange Commission Field Hearing re: Disclosure of Pension Liability" (September 21, 2010). Investors want to know whether they have a striped horse or a zebra in their stable. They need and deserve a solid understanding of investment risks to which they are exposing themselves. That can only occur if accurate and complete information is provided. To its credit, CalPERS seems to be emphasizing risk-adjusted performance as paramount. A December 13, 2010 press release describes the adoption of a "landmark" asset allocation that emphasizes "key drivers of risk and return."

Email Dr. Susan Mangiero, CFA and certified Financial Risk Manager if you would like information about what a risk disclosure assessment entails for your organization or on behalf of a client(s). You may likewise be interested in one of our workshops for directors, trustees and/or members of the investment committee about performance reporting within a fiduciary and financial risk management framework.

Free Educational Webinar About Fee Assessment, Form 5500 Reporting Compliance and Fiduciary Liability

Please join ERISA attorney Linda Ursin and Ms. Jamie Greenleaf, Senior Partner with Cafaro Greenleaf on June 29 from Noon to 1:00 PM EST to learn more about assessing management fees for reasonableness, new Form 5500 rules and fiduciary liability for failure of oversight of service providers. To register, visit https://www2.gotomeeting.com/register/671138658.

Fees, Form 5500 and Fiduciary Liability - The New F Words

Please join Investment Governance, Inc. CEO - Dr. Susan Mangiero - for a one hour discussion with ERISA attorney, Linda Ursin, and Ms. Jamie Greenleaf, Senior Partner with Cafaro Greenleaf on June 29 from Noon to 1:00 PM EST.

Attendees will learn more about:

1. Assessing management fees for reasonableness
2. Form 5500 compliance rules
3. Fiduciary liability for failiure of oversight of service providers

And much more!

Click here to register for this free educational webinar.

Pension Audit and Reporting Webinar Slides Now Available

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408(b)(2) Takes a Bold Step Forward

According to Attorney Fred  Reish, Managing Director at Reish & Reicher, the "word on the street" is that the new 408(b)(2) regulation - sent from the U.S. Department of Labor to the Office of Management and Budget on March 3 - will be an "interim final regulation and will have a delayed effective date." He adds that "effective" refers to the date on which people must begin complying with its terms. ERISA attorney Reish adds that:

My sense is that the delayed effective date will be somewhere between January 1, 2011 and 12 months after the regulation is issued. However, that is just a guess. That effective date would probably apply only to new plan clients. That is, there would probably be a transition period for existing  plan clients. Also, it is not yet clear whether the regulation will apply to individual retirement accounts, but it could."

For background on this important disclosure rule, see "The DOL's Proposed 408(b)(2) Regulation: Impact of the Mandated Disclosures on Registered Investment Advisers (RIAs)" by Fred Reish, Bruce Ashton and Debra Davis (February 2008).

Also see "Private Pensions: Additional Changes Could Improve Employee Benefit Plan Financial Reporting" (United States Government Accountability Office, December 2009).

I will post further information about fees paid to plan service providers in coming weeks.

Private Company Investing and Limited Financial Information

On March 1, 2010, Dr. Susan Mangiero, CEO of Investment Governance, Inc. sat down to talk to financial and strategy expert, Mr. Pascal Levensohn. In this second question of ten, read what this Investment Governance, Inc. Advisory Board member has to say about transparency or lack thereof when investing in a non-public company. Click here to read Mr. Levensohn's impressive bio.

SUSAN: Especially now, when transparency is so important, why is limited financial information available from a private company?

PASCAL:  Actually there is plenty of financial information available from private companies, but that does not mean that it is available to institutional investors as passive investors who are limited partners ("LPs") in venture capital or other private equity partnerships.

Putting that point aside, for a moment, what is absent is a quoted liquid market in their equity and debt securities, which means that the determination of the book value of those private companies is necessarily subjective. Institutional, or any other investors, for that matter, who choose to invest in illiquid securities, presumably do so because they expect to obtain superior returns from the illiquid securities at the end of the investment period than they would from liquid securities over the same period—otherwise it’s not worth giving up the liquidity and taking the risk of the longer holding period. To get to the core of your question, providing passive institutional investors with more financial information about illiquid securities isn’t going to make them more liquid.  They key is whether you can rest assured that the general partner who is responsible for managing your investment is honoring the trust that you have placed in that manager.

There has been a multi-year move among auditors, driven by demand for greater transparency in understanding the process behind the book valuation of private, illiquid investments, to bring more of a “mark to market” approach in the way the general partners of private equity partnerships value their portfolios.  Before I discuss this in more detail, I should fully answer your question:  the main reason why general partners, particularly in venture capital, should legitimately limit the amount of information they disclose to their investors about their private investments is (1) competitive considerations, particularly for disruptive emerging technologies where protecting intellectual property and market competition from large companies are defining elements in the company’s potential for success.

Having said that, if a sophisticated institutional investor insists on having the right to inspect the details about specific private investments, see business plans, and otherwise get details about the company, if they are prepared to sign a confidentiality agreement and have a good reason for wanting to see this information, it certainly exists and can be made available.

To address the broader point about accuracy in book valuation, I am concerned that the developing industry standard for venture capital is at risk of going too far while providing no real benefit to investors. I see the auditors forcing excessive quarterly compliance burdens on the general partners, and this trend has been developing since the institution of 409a valuations for common stock.  The reason I feel this burden is unnecessary is because, in my view, the additional information may be very precise without being accurate.

The fact remains that you don’t know the value of a private asset unless you actually intend to sell it.  And in venture capital, the second you become a forced seller of a company, you have given it the equivalent of the kiss of death.  For many emerging companies, the moment that you become a bona fide seller and are perceived to have to sell the asset, the value will be diminished—so you can imagine why the lack of an IPO market is the single greatest source of distress for venture capital in the U.S.  To conclude on this question, I’d like to emphasize that, in my view, for early stage companies with little or no revenue, valuation models driven by public equity or option inspired equity models simply make no sense.

Information Rights for Limited Partners Invested in Venture Capital

On March 1, 2010, Dr. Susan Mangiero, CEO of Investment Governance, Inc. sat down to talk to financial and strategy expert, Mr. Pascal Levensohn. In this first question of ten, read what this Investment Governance, Inc. Advisory Board member has to say about information rights. Click here to read Mr. Levensohn's impressive bio.

SUSAN: How much information are limited partners entitled to (pensions, endowments, foundations, etc) receive from a venture capital ("VC") fund?

PASCAL: Section 17-305 (b) of the Delaware Revised Uniform Limited Partnership Act, which governs LP information rights according to DE law, specifically allows the GP to withhold from LPs “any information the GP reasonably believes to be in the nature of trade secrets or other information the disclosure of which the GP in good faith believes is not in the best interest of the Fund or could damage the Fund or its business or which the Fund is required by law or by agreement with a third party to keep confidential.” This would include the GP’s fiduciary duties and confidentiality obligations with respect to not disclosing portfolio company information without the consent of such company. The Act provides for a specific list of information that LPs are entitled to, and funds historically disclose that same information to their LPs—the top law firms in Silicon Valley model their LP agreement forms to be pretty consistent with Delaware law.

Specifically, Section 17-305 of the Act provides for the following:

(a) Each limited partner has the right, subject to such reasonable standards (including standards governing what information and documents are to be furnished, at what time and location and at whose expense) as may be set forth in the partnership agreement or otherwise established by the general partners, to obtain from the general partners from time to time upon reasonable demand for any purpose reasonably related to the limited partner’s interest as a limited partner:

(1) True and full information regarding the status of the business and financial condition of the limited partnership;

(2) Promptly after becoming available, a copy of the limited partnership’s federal, state and local income tax returns for each year;

(3) A current list of the name and last known business, residence or mailing address of each partner;

(4) A copy of any written partnership agreement and certificate of limited partnership and all amendments thereto, together with executed copies of any written powers of attorney pursuant to which the partnership agreement and any certificate and all amendments thereto have been executed;

(5) True and full information regarding the amount of cash and a description and statement of the agreed value of any other property or services contributed by each partner and which each partner has agreed to contribute in the future and the date on which each became a partner; and

(6) Other information regarding the affairs of the limited partnership as is just and reasonable.

The current state of the art for Agreements of Limited Partnership in venture capital allows the GP to override the information rights LPs have pursuant to the Delaware Revised Uniform Limited Partnership Act (the “Act”) as permitted pursuant to the Act and allows the GP to “adjust” identifying information given to the LPs in order to protect the identity of the Fund’s portfolio companies, which often is an issue in the case of Freedom of Information Act (FOIA) LPs. In addition, the partnership agreement allows the GP to restrict / withhold information from LPs if “the General Partner reasonably determines [such LP] cannot or will not adequately protect against the [improper] disclosure of confidential information, the disclosure of such information to a non-Partner likely would have a material adverse effect upon the Partnership, a Partner, or a Portfolio Company.” Other elements of the well drafted agreement do provide the LP’s with disclosure rights to their advisors, equity holders, etc. and provide remedies and protections to the GP with respect to GP withholding rights and improper LP information disclosure.

Benchmarking the Investment Industry

 

In my September 11, 2008 testimony before the ERISA Advisory Council, I described two buckets of organizations - those which deserve a gold star and those who don't. I went on to explain that the size of the "everybody else" bucket might be very large but that current reporting requirements make it nearly impossible to know about red flags in advance. This is cold comfort for shareholders and taxpayers who would prefer to know about financial runaway trains beforehand.

Unfortunately, those who attempt to provide more sunlight about their activities are not always rewarded. In a recent conversation with the CEO of a major asset management firm, I was told that this firm had provided detailed information about its fee structure to institutional clients. Instead of being rewarded, and because there are wide variations with report to how asset managers present performance data, sunlight led to storm clouds. Endowments, foundations and pensions responded by asking why the fees were so high. The reality was that the costs were in fact lower than those of comparable traders but, since competitors were not providing more than basic feedback, their costs were interpreted as lower and therefore "better." It's no surprise that the executive with whom I spoke expressed frustration. Here they were trying to do what they thought was the right thing and come clean with a detailed decomposition of what they charged. Instead of a reward, they were kicked in the proverbial shins.

In "Type-A-Plus Students Chafe at Grade Deflation" (January 29, 2010), New York Times reporter Lisa W. Foderaro describes a similar phenomena in the university sector. Where Princeton sought to minimize grade inflation by limiting the number of A's, top quality students found it harder to compete for jobs when graduates from other schools flashed their scores. Never mind that Princeton arguably tried to impart higher integrity data.

Is the message that transparency is window dressing and that no one really wants to have the low down on "true" outcomes? Alternatively, should we conclude that heightened disclosure rules are inevitable but it is incumbent upon providers of information to educate their recipients, i.e. make sure that underlying assumptions are clearly explained? If that does not occur, might well-intended parties (those who provide more detail than necessary) be impugned instead of rewarded for their forthrightness? 

Editor's Note: Click to read "Testimony by Dr. Susan Mangiero to ERISA Advisory Council Working Group on Hard to Value Assets," September 11, 2008. (Note that Pension Governance, LLC is now part of Investment Governance, Inc.)

Information Economics

I sometimes forget that not everyone is familiar with my favorite idioms. For example, in speaking to one of our legal research consultants today, I told her that I would be "out of pocket" for a few days around the holidays. When she queried as to what I meant, I explained to her my use of the term and then, being curious, took two minutes to search the web as to where the expression originated. According to a blog entitled "the hubbub: Language, behavior, technology," this term had once only referred to tax deductible expenses but has morphed into meaning that an individual is unavailable. Indeed, in its October 7, 2006 blog post entitled "Office Talk: 'Out of Pocket'," the authors suggest that something more sinister may be afoot. Not only unavailable, "out of pocket" is a possible diss, a warning not to bother ... "you can use email, phone, IM, SMS, carrier pidgeon -  there's nothing you can do to reach me at that time."

This got me to thinking about the implications overall for investment professionals for whom information is arguably the lifeblood of money flows.

  • Can we be over exposed to individuals or is there always room for more?
  • Is there such a thing as too much information?
  • How should we be sorting "good" information from "bad?"

In 1997, I published a doctoral dissertation about the information economics associated with high frequency trading. Entitled "Are Institutional Investors and Analysts Informed Traders? An Empirical Examination," I investigated trading volume and costs for "visible" exchange-traded stocks on one end of the spectrum in terms of institutional ownership and analyst following and "neglected" equity securities at the other extreme. As expected, I was able to document informational inefficiencies, leading to the conclusion that there might be "gold in them thar hills" if one is to pay close attention to micro data trends.

Expect more from me on the topic of information arbitrage. It is both mysterious and puzzling but certainly worth further investigation.

New Study Addresses Pension Risk Management Gaps

 At a time of great market turmoil, plan participants, shareholders and taxpayers want to know whether their retirement plans are in good hands. Risk is truly a four-letter word unless plan sponsors can demonstrate that a comprehensive pension risk management program is in place. Unfortunately, there is little information that details if, and to what extent, plan sponsors are doing a credible and pro-active job of identifying, measuring and mitigating a variety of risks. The risk alphabet includes, but is not limited to, asset, operational, fiduciary, legal, accounting, longevity and service provider uncertainties.

While no one could have predicted the extreme volatility that characterizes the current state of global capital markets, it has always been known that poor risk management can make the difference between economic survival and failure. Applied to pension schemes, ineffective risk management could prevent individuals from retiring at a certain age and/or leaving the work force with much less than anticipated. Others pay the price too. Taxpayers worry about rate hikes that may be inevitable for grossly underfunded public plans. Shareholders could find themselves on the hook for corporate promises or experience depressed stock prices due to post-employment benefit obligations.

In an attempt to shed some light on this critical topic area, Pension Governance, LLC is pleased to make available a new research report that explores current pension risk management practices. In what is believed to be a unique large-scale assessment of pension risk practices since the publication of a 1998 study by Levich et al, this survey of 162 U.S. and Canadian plan sponsors seeks to: (1) understand why and how pension plans employ derivative instruments, if they are used at all (2) identify what plan sponsors are doing to address investment risk in the context of fiduciary responsibilities and (3) assess if and how plan sponsors vet the way in which their external money managers handle investment risk, including the valuation of instruments which do not trade in a ready market. The report was written by Dr. Susan Mangiero, AIFA, AVA, CFA, FRM, with funding from the Society of Actuaries.

Each survey-taker was asked to self-identify as a USER if he/she works for a plan that trades derivatives in its own name. A NON-USER works for a plan that does not trade derivatives directly but may nevertheless be exposed indirectly if any of the plan's asset managers trade derivatives.

In answering broad questions, a large number of surveyed plan sponsors describe themselves as doing all the right things to manage investment, fiduciary and liability risks. However, answers to subsequent questions - those that query further about risk procedures and policies at a detailed level - do not support the notion that pension risk management is being addressed on a comprehensive basis by all plans represented in the survey sample.

Key findings include the following points:

  • Plan size seems to be one factor that distinguishes USERS from NON-USERS, with 39% of USERS managing plans in excess of $5 billion versus 14% of NON-USERS associated with plans larger than $5 billion.
  • Pension decision-making appears to vary considerably by job function, with 48% (37%) of USERS (NON-USERS) choosing "Other" rather than selecting from given titles such as Actuary, Benefits Committee Member, CFO or Human Resources Officer.
  • Time allocation varies considerably with 64% (40%) of USERS (NON-USERS) saying they devote 75 to 100 percent of their work week on pension issues. In contrast, 37% of NON-USERS say they spend 0 to 24% of their work week on pension issues.
  • A majority of USERS (64%) and NON-USERS (48%) have had discussions about the concept of a fiduciary duty to hedge asset-related risks. A smaller number say they have discussed the concept of a fiduciary duty to hedge liability-related risks.
  • Few plans currently embrace an enterprise risk management approach with 59% (57%) of USERS (NON-USERS) responding that their organization does not use a risk budget. When asked if their organization has or is planning to hire a Chief Risk Officer, 57% (64%) of USERS (NON-USERS) answered "No."
  • NON-USERS cite numerous reasons for not using derivatives directly, including, but not limited to, "Lack of Fiduciary Understanding" (25%), "Perception of Excess Risk" (31%), "Considered Too Complex" (23%), "Prohibition Against Possible Leverage" (19%) and/or "Defined Benefit Plan Risk Not Considered Significant" (28%).
  • A query about whether survey-takers review external money managers' risk management policies results in 70% (58%) of USERS (NON-USERS) responding "Yes." Fifty-two percent (57%) of USERS (NON-USERS) say they review external money managers' valuation policies. This survey did not drill down with respect to the rigor of questions being asked.
  • Survey respondents seem to rely mainly on elementary tools to measure risk. Eighty-three percent (64%) of USERS (NON-USERS) rank Standard Deviation first in importance. Seventy-nine percent (63%) of USERS (NON-USERS) rank Correlation second. Only one-third (38%) of NON-USERS cite Stress Testing (Simulation). Four out of 10 USERS cite Value at Risk in contrast to 23% of NON-USERS who do the same.
  • Survey respondents worry about the future with 58% (60%) of USERS (NON-USERS) ranking "Accounting Impact" as a concern. Other concerns were also noted to include "Regulation," "Longevity of Plan Participants" and "Fiduciary Pressure."

Click to download the 69-page study, entitled "Pension Risk Management: Derivatives, Fiduciary Duty and Process" by Susan Mangiero. Given the large file size, readers are encouraged to (a) first save the file (right mouse click) and then (b) open the file from wherever you have saved the file. Otherwise, you may receive an error message, depending on your computer configuration. 

The study is also available by visiting www.pensiongovernance.com. Send an email to PG-Info@pensiongovernance.com if you experience any difficulty in downloading the pdf file and/or want to comment about the study.

Reader's Comment About Transparency

Wendy Fried writes the following in response to the September 26, 2008 post entitled "Would Better Disclosure Have Helped WaMu Shareholders?"

"It's pretty hard to say without knowing what really pushed WaMu over the edge. If it was a run on the bank by ordinary depositors acting out of fear, as has been reported, it's hard to see how more disclosure would have helped. More likely, what was called for was was smarter regulatory oversight and less faith in self-serving risk models."

Wendy is creator of an interesting and colorful blog called Proxyland.

Would Better Disclosure Have Helped WaMu Shareholders?

According to a September 25, 2008 press release from the U.S. Securities and Exchange Commission ("SEC Seeks More Transparent Disclosure for Investors"), pundits will gather in Washington, D.C. on October 8 to wax poetic about transparency. Two panels will convene to address "data, technology, and processes that companies and other filers use in satisfying their SEC disclosure obligations" as well as "how the SEC could better organize and operate its disclosure system so that companies enjoy efficiencies and investors have better access to high-quality information."

While I am in favor of "sufficient" disclosure to inform shareholders, plan participants and other interested parties, a critical question remains. What exact type of disclosure can really make a difference? I vote for information about process and accountability. Otherwise, financial statement users end up with snapshot assessments of mandated metrics. While these numbers could be potentially helpful, they are made less so without an understanding as to how they are derived, why they change and the extent to which an organization is exposed to economic danger. A few of the countless questions on the minds of inquiring individuals are shown below. (This is by no means an exhaustive list.)

  • Who has the authority to effect change for all things financial management?
  • Who oversees authorized persons and the latitude they enjoy to make decisions?
  • How are risk drivers identified, measured and managed on an ongoing basis?
  • What creates "stop loss" threshholds?
  • How are functional risk managers compensated?

As reported by CNN.com, JP Morgan Chase has just purchased $307 billion in assets from Washington Mutual (ticker symbol WM) in what is described as "the biggest bank failure in history." Serious stuff indeed but would more detailed financials have helped? We know that the large thrift ushered in a new chief risk officer ("WaMu replaces its chief risk officer," April 29, 2008) to "help steer the nation's largest savings and loan through the fallout of the mortgage and credit crises."

The 2007 Annual Report on Form 10-K/A for Washington Mutual, Inc. is rich with information about risk management, credit risk management, liquidity risk and capital management, market risk management, operational risk management and "Factors That May Affect Future Results." Page 5 of said document states that an evaluation of the Company's disclosure controls and procedures allows the "Company's Chief Executive Officer and Chief Financial Officer" to conclude that, "as of the end of such period, the Company's disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company..."

A company press release dated July 22, 2008 informs the public of actions taken by the Company to build up its reserves and mitigate risk. See "WaMu Reports Significant Build-Up of Reserves Contributing to Second Quarter Net Loss of $3.3 Billion." The bank's website provides a slide presentation about credit risk management also dated July 22, 2008. It details all sorts of information about the loan portfolio, including allowances for loan losses.

According to Wall Street Journal reporters Robin Sidel, David Enrich and Dan Fitzpatrick, a flood of deposit withdrawals forced the demise of this Seattle based financial house. (See "WaMu is Seized, Sold Off to J.P. Morgan In Largest Failure in U.S. Banking History," September 26, 2008).

Question of the Day: What disclosures could have helped shareholders (including pension plans) to know how bad it could get and in what time?

Risk Management Adventures

Thanks to financial planner David Boczar for sending along a thought-provoking quote from famed commodities trader Ed Seykota. Described as someone who turned $5,000 into $15 million over a dozen years, this uber trend follower Seykota cautions: "Surrender to the reality that volatility exists, or volatility will introduce you to the reality that surrender exists."

As I've written many times, risk management is not the same thing as risk minimization. Risk is neither inherently "good" or "bad" but rather a reality, with potentially crushing economic impact if ignored or given short shrift. As we've seen in recent days, some attempts to tame the risk lion have resulted in serious casualties.

It is no surprise then that pundits and reporters are asking about the whereabouts of risk managers, part of the frenzied blame game afoot. (Is there a "Where's Waldo" equivalent here?) New York Times blogger Saul Hansell pressed a lot of hot buttons with his September 18, 2008 post entitled "How Wall Street Lied to Its Competitors." My response, now one of more than 100 posted responses, is shown below.

<< I concur with much of this article. Effective risk management is much more than quantitative analysis. Many individuals are lulled into false security when given a bunch of computer printouts, accepting numbers as gospel truth. Like the fictional Detective Columbo, decision-makers must search for “hidden” information, not reflected in computer printouts. I recently testified before the ERISA Advisory Council about “hard to value” assets. Click here to read my comments. http://www.pensionriskmatters.com/2008/09/articles/valuation/testimony-of-dr-susan-mangiero-about-hard-to-value-assets/

P.S. Some of the quants sat on boards of financial institutions. It would be helpful to know more about their role as relates to oversight of risk management activities. >>

To my last point (above), it should be noted that litigation risk could be a deterrent for prospective directors with risk management experience. For example, Ms. Leslie Rahl (who is quoted in Hansell's blog post about the perils of underestimating risk of complex mortgage backed-securities) is, according to the Financial Post, named in a lawsuit filed against Canadian Imperial Bank of Commerce (CIBC), along with others such as the former Chief Risk Officer and the current Chief Risk Officer. Journalist Jim Middlemiss quotes the bank as denying allegations and expressing confidence that their conduct was appropriate. (See "CIBC hit by suit over subprime lending," July 24, 2008.) Additionally Rahl, a former Citibank derivatives division head, is listed on the Fannie Mae website as a "Fannie Mae director since February 2004."

For interested readers who want to follow the mounting litigation related to sub-prime activities, check out attorney Kevin LaCroix's blog entitled The D&O Diary. Be forewarned that Kevin posts volumes about Director and Officer (D&O) liability. Should we be disturbed that he has so much news about which to write?

What does this mean for institutional shareholders? Run, don't walk, to the closest risk management analysts who can help you decipher whether a company is doing a "good" job of identifying, measuring and managing a panoply of financial and operational pain points. Send us an email if you want some help.

On the topic of models, my article entitled "Asset Valuation: Not a Trivial Pursuit" (FSA Times, The Institute of Internal Auditors, 2004) still rings true. Check out the 10 prescriptives discussed therein. (This is by no means an exhaustive list.)

  1. Gain an intuitive understanding of the model.
  2. Ask questions of the model builders.
  3. Determine whether or not a model meets regulatory requirements.
  4. Inquire whether or not different models are being used for tax reporting versus financial statement presentation.
  5. Understand the data issues.
  6. Ask about model access.
  7. Evaluate the asset portfolio mix.
  8. Ascertain the extent to which a model incorporates embedded derivatives.
  9. Determine the simulation approach used to value path-dependent securities.
  10. Enlist senior management to assign someone from the finance team to work closely with the auditing team.

New Pension Investment Disclosure Rules a Reality

Unhappy auditors and plan sponsors may be roaring in response to the outcome of yesterday's FASB board meeting. In case you missed it, Norwalk-based accounting rulemakers opine in favor of enhanced asset risk disclosures. Despite industry arguments to the counter, FASB concludes that benefits outweigh costs, citing credit-related large losses as a factor in their decision to enhance plan transparency.

As stated in our July 15, 2008 post ("FASB Meets to Unlock Pension Investment Risk Information"), critics offer that FAS 132(R) compliance entails time-consuming data collection and analysis, across asset categories and fund managers and, in some cases, for multiple corporate entities. According to CFO.com reporter Marie Leone, FASB chairman Bob Herz (himself a former pension fiduciary) favors layers of information. A plan that allocates four out of every ten dollars to equities would be asked to disclose industry and sector concentrations as follows:

  • 40% in equities
  • 25% of that 40% in pharma
  • 50% of that 25% in high-growth pharma stocks.

Leone adds that FASB board members unanimously dismissed the need for a materiality guidance rule, also concluding that "drilling down to the underlying assets that make up mutual funds, trusts, and fund of funds was not necessary" as long as qualitative text is provided to financial statement users. Click to read "One Step Forward on Pension Disclosures" by Marie Leone (CFO.com, July 16, 2008).

Click to access the FASB audio file for "Disclosures about plan assets" (July 16, 2008 FASB board meeting). Noteworthy is the discussion about what constitutes an "optimal" level of granularity, while acknowledging that some fund managers are VERY reluctant to say too much about how they invest.

Call me circumspect but one wonders whether point in time qualitative information would be better replaced with a description (even if somewhat broad) of risk management and valuation policies and procedures for (a) the plan sponsor and (b) external money managers, respectively.

Process is extremely important. An investment may not return much over a given period(s). However, if financial statement users know that a plan sponsor (and/or asset managers, in the case of outsourcing the investment function) is regularly measuring and managing risk, there may be less angst on the part of nervous beneficiaries and shareholders.

What an interested party does not know (and can't control or influence as a result) is a sure way to lose sleep.

FASB Meets to Unlock Pension Investment Risk Information

The Financial Accounting Standards Board ("FASB") meets on July 16, 2008 to discuss how much investment-related information pension plans should disclose to the public. Following the "exposure" of Statement 132(R) on March 18, 2008, industry participants weigh in about the feasibility of compliance. In its 17-page summary of comment letters, FASB notes disagreement among respondents with respect to the need for asset categorization. Some suggest the use of Form 5500 as a guide to the proper delineation of asset investment risks. (As mentioned elsewhere in this blog, we take issue with the Form 5500 as a meaningful guide for economic risk assessment purposes.) 

Surprising to this blogger, only one other organization (Eli Lilly) besides Pension Governance, LLC comment on the need to better understand a reporting entity's process. In our May 2, 2008 letter, we suggest  that accounting rules "require plan sponsors to describe how it decided on a particular concentration, who monitors the concentrations, what triggers a breach, and what happens when a concentration is exceeded."

Regarding fair value, several companies aver that such disclosures would "provide little information to users because annual postretirement benefit cost is based on the expected return on plan assets rather than the actual return." In stark contrast, note that the U.S. Department of Labor is holding hearings today about "hard to value" assets held by ERISA plans.

More than a few respondents claim that the costs of gathering, and then analyzing, requisite information will outweigh the benefits, especially for those companies with geographically dispersed benefit plans. Others cite problems related to assets held by "multiple trustees in pooled asset accounts" whereby the "look through" process cannot be done by a "trustee with partial information, and the employer may not have the skills or proper information to do so."

A key question remains - If something like FAS 132(R) is not adopted, what do critics propose in its place? At a time when more and more plans allocate monies to complex securities and/or funds with less than full transparency, is it sufficient for fiduciaries to simply say "trust me" and assume that disclosure of investment risk is unwarranted? That may be a lot to ask of plan participants who are already nervous about their financial futures.

Editor's Notes: Click to read "Postretirement Benefit Plan Asset Disclosures - Comment Letter Summary" (FASB). Click to access comment letters submitted by various organizations (including Pension Governance, LLC) about "Employers' Disclosures about Postretirement Benefit Plan Assets."

FASB Releases New Pension Accounting Rules for Comment

In an effort to unlock the mystery about pension investment risk-taking (something we've discussed at length in previous posts), the Financial Accounting Standards Board recently released FASB Staff Position FAS 132r-a (Employers' Disclosures about Postretirement Benefit Plan Assets) for public comment. This author is preparing a response on behalf of Pension Governance, LLC (having also been invited to informally speak with FASB last summer about risk metrics and disclosure pitfalls). If adopted, it will combine elements of FASB Statement No. 157, Fair Value Measurements, and FAS 133/161, the latter being focused on accounting for derivative instruments. 

Critics are already sharpening the proverbial knives, asserting that the proposed rule addresses the asset side only, leaving interested parties in the dark with respect to the economic impact of integrated asset-liability management strategies. Others suggest that a requirement for plan sponsors to separately disclose the fair value of each "significant" category of plan assets will be lots of work with limited benefit to financial statement users. Having worked with FAS 133 compliance (sometimes referred to as the "consultants' full employment act"), I believe that FAS 132r will encourage plan sponsors to hire outsiders to assist with fair valuation and valuation process checks. (We offer this service as do others.) For some plans, the cost of engaging an independent third party might be cost-prohibitive, putting fiduciaries in a difficult spot as to what to do instead, especially if staff members are ill-equipped to do the work on their own. On the positive side, a comprehensive review (if done properly) can aid plan sponsors by pointing out compliance and economic gaps.

Click to read the draft of the FASB proposed pension accounting rules. Public comments will be accepted until May 2, 2008.

The Plan That Didn't Bark

This blog's author is proud to have been asked by CFA Magazine to author a short piece about employee benefit plan disclosure rules and the likely impact on share price. As I've written many times before, what we know about risks being taken by plan sponsors could fill a thimble. In "The Plan That Didn't Bark" (March/April 2008 issue), I suggest that "to solve the mystery of benefit plans," analysts must play the role of investigator. This remains a truism despite recent attempts to enhance reporting guidelines about economic risks of benefit plans, including healthcare offerings.

Even clever analysts who know their disclosure standards cold must nevertheless look beyond reported numbers. "Financial analysts really have no choice but to become forensic detectives. They cannot rely solely on published numbers but instead must ask lots of pointed questions about how plan sponsors identify, measure, and manage myriad types of risk. Knowledge of accounting rules is only a beginning, and a humble one at that. Economic, fiduciary, and regulatory factors count too."

Click to "The Plan That Didn't Bark" by Dr. Susan Mangiero, AIFA, AVA, CFA, FRM (CFA Magazine, March/April 2008).

Warren Buffett on Pensions - Crazy Assumptions?

In case you missed it, the Oracle of Omaha, Mr. Warren Buffett opined on the less than sanguine state of pension reporting. In his 2007 Letter to the Shareholders, this famed CEO of Berkshire Hathaway Inc. made the following comments about corporate and public pension finance. His comments echo our concern (a repeated favorite topic of this blog) about the black box we currently call pension reporting is going to rear its ugly head in a horribly painful way. What we don't know is going to really hurt. Shareholders, beneficiaries and taxpayers, are on the hook at the same time that Medicare and Social Security (and international equivalents) are in deep trouble.

We concur Sir!

For more than a few plans, the sky is falling. Unfortunately, we don't have a way to gauge when and by how much. Is this anyway to run things?

Excerpted from "Warren Buffett's Letters To Berkshire Shareholders
Updated February 29, 2008" - 2007 Letter:

<< Fanciful Figures – How Public Companies Juice Earnings
Former Senator Alan Simpson famously said: “Those who travel the high road in Washington
need not fear heavy traffic.” If he had sought truly deserted streets, however, the Senator should have looked to Corporate America’s accounting.

An important referendum on which road businesses prefer occurred in 1994. America’s CEOs had just strong-armed the U.S. Senate into ordering the Financial Accounting Standards Board to shut up, by a vote that was 88-9. Before that rebuke the FASB had shown the audacity – by unanimous agreement, no less – to tell corporate chieftains that the stock options they were being awarded represented a form of compensation and that their value should be recorded as an expense.

After the senators voted, the FASB – now educated on accounting principles by the Senate’s 88 closet CPAs – decreed that companies could choose between two methods of reporting on options. The preferred treatment would be to expense their value, but it would also be allowable for companies to ignore the expense as long as their options were issued at market value.

A moment of truth had now arrived for America’s CEOs, and their reaction was not a pretty sight. During the next six years, exactly two of the 500 companies in the S&P chose the preferred route. CEOs of the rest opted for the low road, thereby ignoring a large and obvious expense in order to report higher “earnings.” I’m sure some of them also felt that if they opted for expensing, their directors might in future years think twice before approving the mega-grants the managers longed for.

It turned out that for many CEOs even the low road wasn’t good enough. Under the weakened rule, there remained earnings consequences if options were issued with a strike price below market value. No problem. To avoid that bothersome rule, a number of companies surreptitiously backdated options to falsely indicate that they were granted at current market prices, when in fact they were dished out at prices well below market. 

Decades of option-accounting nonsense have now been put to rest, but other accounting choices remain – important among these the investment-return assumption a company uses in calculating pension expense. It will come as no surprise that many companies continue to choose an assumption that allows them to report less-than-solid “earnings.” For the 363 companies in the S&P that have pension plans, this assumption in 2006 averaged 8%. Let’s look at the chances of that being achieved. 

The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss. This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been.

How realistic is this expectation? Let’s revisit some data I mentioned two years ago: During the
20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century.

Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow – recently below 13,000 – would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last.

It’s amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands, such as 14,000 or 15,000. If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome?

Dividends continue to run about 2%. Even if stocks were to average the 5.3% annual appreciation of the 1900s, the equity portion of plan assets – allowing for expenses of .5% – would produce no more than 7% or so. And .5% may well understate costs, given the presence of layers of consultants and highpriced managers (“helpers”).

Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.

I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about doubledigit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.

Some companies have pension plans in Europe as well as in the U.S. and, in their accounting,
almost all assume that the U.S. plans will earn more than the non-U.S. plans. This discrepancy is puzzling: Why should these companies not put their U.S. managers in charge of the non-U.S. pension assets and let them work their magic on these assets as well? I’ve never seen this puzzle explained. But the auditors and actuaries who are charged with vetting the return assumptions seem to have no problem with it.

What is no puzzle, however, is why CEOs opt for a high investment assumption: It lets them
report higher earnings. And if they are wrong, as I believe they are, the chickens won’t come home to roost until long after they retire. After decades of pushing the envelope – or worse – in its attempt to report the highest number possible for current earnings, Corporate America should ease up. It should listen to my partner, Charlie: “If you’ve hit three balls out of bounds to the left, aim a little to the right on the next swing.”

Whatever pension-cost surprises are in store for shareholders down the road, these jolts will be surpassed many times over by those experienced by taxpayers. Public pension promises are huge and, in many cases, funding is woefully inadequate. Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed. Promises involving very early retirement – sometimes to those in their low 40s – and generous cost-of-living adjustments are easy for these officials to make. In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep. >>

FASB Unveils Proposal to Require More Pension Disclosure

In what should be seen as a giant step forward for anyone interested in pension fund financial health, the Financial Accounting Standards Board (FASB) just approved a proposal that could force additional disclosures about investments. The rationale should be obvious. Defined benefit plans are allocating billions of dollars to alternative investments. When these capital pools invest in "hard to value" assets, trying to gauge pension risk is like catching jello. It's a near impossible task.

According to the Board Meeting Handout for February 13, 2008, few plan sponsors have gone beyond what is required of them by FAS 132(R), essentially reporting asset class categories "without further disaggregation." Additionally, the Board decided in November 2007 that FASB Statement No. 157 (fair value rule) would not apply to pension plans. In the absence of other mandates and voluntary disclosure (something free market economists favor, myself included), retirees and shareholders are nearly clueless when trying to gauge potential fallout from "risky" investing. If approved as an amendment of Statement 132(R), the new rule would "include a principle for disaggration of plan assets and a list of required asset categories" and "require further disclosure of categories or subcategories for concentratons of risk."

This blog's author has written ad nauseum about the critical information void with respect to pension investment risk. In fact, I literally just submitted a provocative piece on this topic for CFA Magazine. It will be part of the March/April 2008 issue.

Here are some initial thoughts. (I could write a book on this topic of pension risk disclosure.)

  • Could disaggregation veil true risk exposure in much the same way that single asset performance is not the same as portfolio performance?
  • Will there be a universal consensus about how to properly measure risk?
  • Will certain risk metrics be accepted as superior for a particular asset class (an approach I advocate)?
  • Will increased disclosures discourage some plan sponsors from dipping their toes into alternative investment waters?
  • Will pensions be encouraged to hire Chief Risk Officers as pension risk management takes its rightful place on stage?
  • Will some instruments such as derivatives be decomposed as standalone versus embedded?
  • Will alternative managers push back from pension clients when asked to open their trading books to more scrutiny? (Remember the response when several endowments asked alternative fund managers for more information as part of the Freedom of Information Act a few years back? They were  shut out of deals.)

The U.S. Government Accountability Office is soon to release its study about pension fund investments in hedge funds. It will be interesting to compare their recommendations with those from the folks in Norwalk, home of FASB.

It's 10 PM. Do You Know Where Your Pension Plan Is?

In "Trying to Clear Fog From Pension Plans" (February 3, 2008), New York Times uber pension reporter Mary Walsh describes a website that provides information about company plans. By going to www.AtPrime.com, one can set up a free account and then click on the "Pension Inspector" to input criteria such as company name. I did so for General Electric Company and up popped four plans, each with its own ID number and plan name. Ditto for Pitney Bowes with a result of 9 plans displayed, including the 401(k) plan.

A cursory review of information found at the site suggests a good start but hardly sufficient to gain a meaningful understanding of economic risk. One can find data about employer contributions, accountant name, plan administrator, funded status (for defined benefit plans), end of year "Current Value of Assets", "Interest Rate Utilized" and so on. However, detailed information about various plans remains a mystery. For example, Schedule H (Form 5500) should give some comfort as a snapshot of plan assets and liabilities. However, the granularity is so far from helpful (there is seldom any detail provided), one wonders why the US government requires the form at all. (Some plans do report detailed holdings at year-end though I could not find such in my investigation of this online tool.

Opacity is certainly not the fault of www.AtPrime.com. The fundamental shortcomings of pension reporting is something we've long anguished about. On April 17, 2006, this blog pointed out the near impossibility of identifying those in charge of a particular plan's investment decisions. Searching for a needle in a haystack may be easier by far. Other than the name of the plan administrator (mandated by law), good luck in identifying relevant persons from public records. Click here to read "Searching for Hidden Treasure."

In "Pension Investment Risk Disclosure - What Don't You Know?" (September 6, 2007), this blog's author compared a partially submerged truck to knowledge about pension risk transparency, asking "Are you seeing only half the truth or are you completely unaware of investment risks lurking in your plan's portfolio?" This goes for 401(k) plans too. What you choose as a "low-risk" investment may be anything but "safe." A read of recent headlines goes to this point. 

Kudos to www.AtPrime.com and sites such as www.FreeErisa.com. Until disclosure rules change, something is better than nothing. Still, for a worried employee, retiree or shareholder, wouldn't it be nice to have a better idea about what's going on in pensionland?

Is Disclosure Really That Hard?


Investment risk disclosure continues to take center stage. In "Clearing the Financial Fog - Emily Barrett ponders the virtues of transparency" (Wall Street Journal, MarketBeat Blog, September 14, 2007, posted by Tim Annett), the point is made that full disclosure is fraught with problems.

"The trouble with transparency is, there’s just something terribly obscure about it."

"In some ways, banks are already engaged in the clarification process, as more are forced to take back on their books funds previously buried out of regulators’ reach. This includes loans lying around in banks’ warehouses waiting to be chopped up and sold to raise money for private-equity takeovers. A number of bank sponsors of hedge funds have also been forced either to cut credit lines, or, as in the case of Bear Stearns Asset Management, to commit financing to shore them up. But there are limits to how clear banks can be. The complexity of structured finance, which deals in layered bundles of debt, doesn’t lend itself to easy analysis."

“The problem is exposures get buried in different structures,” said Jim Caron, rates strategist at Morgan Stanley. “I don’t think it’s a lack of willingness to get things out to regulators, there’s just a natural lack of transparency in these structures.”

Click here to read the aforementioned post in full.

To be sure, deciding on what and how to provide information is not an easy task. Nevertheless, access to sufficient and meaninful information is vital to good decision-making on the part of institutional investors such as pension funds. Here is the comment I posted.

<< As I’ve written many times (www.pensionriskmatters.com), pension fiduciaries have an obligation to make informed investing decisions. Whether pensions are counterparties to a derivative-related trade (mostly with banks on the other side) or they invest in funds (mutual/hedge/etc) that invest in derivatives, the information they currently get from their trading partners is limited at best. A plan sponsor must understand enough about risk controls and risk drivers for a particular investment/counterparty/asset manager so the investment committee can answer a fundamental question - Are we likely assuming too much risk for the expected payout if we transact with this bank/asset manager? In my view, financial institutions have a golden opportunity to disclose meaningful information about their risk exposures with institutional investor clients, going beyond mandatory requirements. Besides building goodwill, they may be able to attract (and retain) additional assets to manage by fully acknowledging the pension plan’s pain points (need for solid risk information). This does not necessarily translate into providing more information but rather providing “better” information that directly addresses economic risk-taking, and related controls. A joint interview with the portfolio manager and risk manager is one option. Providing the pension plan investor with the bank or asset manager’s risk management policy or statement of risk-taking is another positive gesture. Working with an independent third party to vet risk management process on behalf of the pension plan investor is another possibility. Comment by Susan M. Mangiero - September 18, 2007 at 1:10 pm >>

New IRS Form Mandates Governance Disclosures for Non Profits - What About Pensions?

Little noticed inside the pension community is a provision of the Pension Protection Act of 2006 that directly impacts reporting by tax-exempt organizations. What's interesting is that required changes mandate important governance disclosures for churches and foundations and other non-profits. According to Guidestar.org, "Form 990-T was considered a tax return and was not open to public inspection. The Pension Protection Act of 2006, however, mandates that any IRS Form 990-T filed by a 501(c)(3) organization after August 17, 2006, is now a public document. The exception is a Form 990-T filed solely to request a refund of the telephone excise tax."

Too bad the same disclosures are out of reach for anyone interested in understanding the nature of fiduciary risk attached to pension plans. As we pointed out in "Searching for Hidden Treasure" (April 17, 2006), even seemingly "mundane" information such as who makes primary decisions about defined benefit and defined contribution plans is often out of reach. As I wrote then, other than the names of the plan sponsor and plan administrator (found on Form 5500), no one knows much about who is in charge. (Some databases provide this information for a fee and various plan sponsors voluntarily provide this information online or in writing.)

Wouldn't it be grand to know more about who is making critical decisions regarding the $10 trillion pension industry? After all, how can we reward "good players" and hold "bad" or "careless" fiduciaries accountable if they operate in the shadows?

At a time when the SEC is asking for additional information (executive compensation decisions, audit committees, etc) and FASB wants to know more (having just announced plans to promote pension investment risk disclosure) where is the upset about pension fiduciaries - who they are, how they are selected and whether they are qualified for the tasks put upon them?

Editor's Note:

Part III questions of the newly revised form 990 are shown below. The IRS website provides detailed instructions and commentary.

  • Enter the number of members of the governing body
  • Did the organization make any significant changes to its organizing or governing documents?
  • Does the organization have a written conflict of interest policy?
  • Does the organization have a written whistleblower policy?
  • Does the organization contemporaneously document the meetings of the governing body and related committees through the preparation of minutes or other similar documentation?
  • Enter the number of independent members of the governing body
  • If “Yes,” how many transactions did the organization review under this policy and related
    procedures during the year?
  • Does the organization have a written document retention and destruction policy?
  • Does the organization have local chapters, branches or affiliates?
  • If yes, does the organization have written policies and procedures governing the activities of such chapters, affiliates and branches to ensure their operations are consistent with the organization’s?
  • Does an officer, director, trustee, employee or volunteer prepare the organization’s financial statements?
  • Does the organization have an audit committee?
  • How do you make the following available to the public?

Pension Investment Risk Disclosure - What Don't You Know?

Do you feel comfortable about the amount of risk in your pension plan? Like the partially submerged truck, are you seeing only half the truth or are you completely unaware of investment risks lurking in your plan's portfolio?

If you're like the typical participant or shareholder (investing in a company with a defined benefit plan), the outlook is grim. A dearth of information makes it nearly impossible for an interested party to understand when a pension fund is taking on too much risk. That also means that one can never be quite sure about how a pension plan manages asset-liability risk, if at all. Scary stuff indeed!

FASB to the rescue? Perhaps.

At its August 29, 2007 meeting, the staff announced its plan to address three areas, including "disclosures about risks in plan assets, for example use of derivatives." The scuttlebutt is that disclosure about hedge fund investments and other alternatives may be a separate initiative.

This blog's author has long been an advocate of increased transparency, while noting that more disclosure does not necessarily mean better disclosure. Click here to read some past posts on this topic. Though no investment can be said to be absolutely "good" or "bad" (facts and circumstances are key), it is noteworthy that so little is known about such a large and important segment of the capital markets - the $10 trillion pension investor market.

When invited to speak with FASB pension team members on the topic of disclosure, I laid out what I thought would be "problem areas" in terms of disclosure and interpretation. Here are a few thoughts.

  • There are multiple ways to measure leverage. Which one is best?
  • How do you get people to look beyond traditional (and arguably limited-use) metrics?
  • What rules discourage "gaming" of the system and instead focus attention on economic risk analysis (rather than accounting compliance)?
  • Is there a chance of information misuse?
  • Will periodic statements be sufficient to ward off potential problems (an oft-cited criticism of Form 5500 reports)?
  • Could reporting requirements backfire and discourage plan sponsors to "play it too safe?" (Risk-taking is not necessarily a wrong move but certainly uninformed risk-taking spells trouble. Ditto for being "too" cautious if it means that a plan falls further behind in its ability to meet its obligations.)

On the disclosure front, reporter Diya Gullapalli writes that mutual fund managers are voluntarily providing information about their exposures, in hopes of minimizing investor angst. "Among the rare disclosures are precise percentages of mortgage-related holdings and lengthy explanations of losses." (See "Fund Firms Draw Back the Curtain, Wall Street Journal, September 6, 2007.)

Related to this notion of "need to know" is the SEC's announcement that three hunded letters are on their way to various companies, seeking details about executive compensation levels and the underlying rationale for alleged largesse.

A discernible trend towards increased disclosure is upon us. The critical question is whether the marketplace is ready. 

How Much Does Your Investment Banker or Asset Manager Make?

According to "Pay at Investment Banks Eclipses All Private Jobs" (September 1, 2007), New York Times reporter David Cay Johnston tells the tale of two cities. There is Investment Banker Land where the typical weekly pay exceeds $8,300 and then there is Everyone Else Land. (In Fairfield County, Connecticut - home to many corporations and hedge funds -  the mean pay, as reported by the Bureau of Labor Statistics, was $23,846 a week.) Click here for a copy of this government report, with a breakdown in average pay by various geographic areas.

This blog's author is the first to say "hooray for capitalism." If financial institutions pay individuals the big bucks because they can spin flax into gold for shareholders, arguably a happy marriage between supply and demand has taken place. However, and notwithstanding the fact that we can vigorously debate the "reasonableness" of salaries all day long, plan sponsors face a dilemma.

1. How do pension fiduciaries deal with the gap between what they can afford to pay financial experts and what the big banks pay, especially at a time when skilled analysts and risk managers are desperately needed by pension plans, regardless of plan type?

2. If any particular fund manager is reporting losses or sub-par performance, how do pension fiduciaries justify a decision to retain a manager and/or investment bank that treats itself well in the compensation department? In other words, how does manager pay get factored into the short-term versus long-term retention decision?

3. How do pension fiduciaries assess "acceptable" compensation paid to asset managers and bankers? Do more complex strategies require the installation of smarter and more experienced personnel who should charge more as a result?

4. How much detail should be provided to plan beneficiaries with respect to compensation of asset managers and/or investment bankers who work with the  plan?

Rather than tell you what I think, email your feedback about investment banking and money management compensation. Let us know if we have permission to post your response.

Pension Risk - Did You Miss the Man in the Gorilla Suit?

While on a "sort of" vacation at a health spa in Arizona, this blog's author has treated herself to some "fun" reading, in between exercise classes and tending to business. As such, I came across an article in the Science Times section of the New York Times that I would have ordinarily set aside. Written about perception and reality, it seems to perfectly capture current happenings in pension land. Coincidentally, its August 21 publication date was the same day I fielded an invitation from CNBC to address whether pensions are taking on too much investment risk, where one goes to unearth information about pension investments and whether there is anything a plan participant or shareholder/taxpayer can do about "excess" pension risk. Unable to coordinate schedules, I will not appear on August 22. However, I encourage readers to download the Squawk Box video of the segment about pension risk. It promises to be interesting and timely.

Let me connect a few dots.

According to George Johnson, author of the aforementioned article, "Sleights of Mind," magicians succeed by exploiting what are described as cognitive illusions - "disguising one action as another, implying data that isn't there, taking advantage of how the brain fills in gaps." According to The Amazing Randi, this means that assumptions are often mistaken for facts.  Courtesy of the Visual Cognition Laboratory at the University of Illinois, a short video illustrates that observation skills are mixed. Only a few audience members who watch a film of basketball players - and then count how many times a particular team (categorized by shirt color) scores - ever notice the man in a gorilla suit walking on stage. (By the way, did you know that there is such a thing as National Gorilla Suit Day? Click here to learn more.)  

How this relates to pension risk is as follows. We know that billions of pension dollars are moving into derivatives, hedge funds, private equity funds, commodity pools, infrastructure, real estate investment trusts and so on. We know that some of these funds invest in economic interests that are "hard to value." We know that not every fund has a solid risk management policy. (Current newspaper headlines make that point abundantly clear.) We know that not every pension fiduciary has a finance background, let alone investment expertise. We know that finding out about a pension fund's holdings and liability risk drivers is often difficult. Form 5500 reports filed by ERISA funds are stale and overly general. Public funds might provide some information online or in response to the Freedom of Information Act but likely not on a frequent enough basis. Even financial footnotes are notorious for what they don't say about pension risk (on both the asset and liability side). It's rare if we even know who is making multi-million decisions about employee benefit plans, let alone be able to review their resume to gauge "suitable" knowledge and experience. We've blogged many times about meaningful disclosure, or more precisely, lack thereof. Click here to access past posts on this topic.

In a soon-to-be released survey about pension risk (co-developed by Pension Governance, LLC and the Society of Actuaries), there is clear evidence that pension fiduciaries perceive that they are doing a great job of vetting external managers with respect to risk management at the same time that the questions they profess to ask are overly simplistic. (Look for the executive summary to be released in mid-September.) Our forthcoming www.pensionlitigationdata.com clearly indicates a surge in allegations of breach on the part of the investment fiduciary(ies).  Coincidence? Maybe not.

If the Fed and international central bankers are unable to quell investors' fears, we move into a recession and/or different asset classes get hit hard in terms of price volatility, life is going to be very tough for plan sponsors. Poor practices will likely come to light as large losses occur. Risk is truly a four-letter word. Absence of a rigorous risk identification, measurement and management system (policies, procedures, operations) will leave little room for defense.

 We are going to write much more on this topic in coming months. It's too important to ignore.

P.S. The nice photo comes to readers from the National Zoo.

Man or Machine - Do Pension Trustees Know?

The war between man and machine is no longer science fiction. As market turmoil continues, some experts suggest that "quant" funds may be making things worse. In "Blind to Trend, 'Quant' Funds Pay Heavy Price" (August 9, 2007), Wall Street Journal reporters Henny Sender and Kate Kelly describe the inadequacy of statistical models to accurately estimate "how risky the market environment had become." Losses by more than a few hedge funds are one result of automated trading.

In today's paper, New York Times reporter Landon Thomas Jr. adds that banks are starting to feel the pain as well and not just because of questionable credit issues in the sub-prime market. "Strategies employed tend to be not only duplicable but broadly followed — the result being a packlike tendency that has helped increase market volatility."

Investors seeking to withdraw funds has exacerbated liquidity concerns. Leverage is another stated worry. By definition, borrowing money allows a trader to take a bigger position than would otherwise be possible. Short selling and derivatives are oft-cited as other leverage-inducing techniques. When times are good, leverage can magnify positive returns. The flip side is that leverage results in bigger losses when things deteriorate.

Leverage is not per se "good" or "bad." However, investors must understand the extent to which a fund levers its trading and therein lies the rub. There are multiple ways to measure leverage and its impact on reported performance is not  well understood. (There is no universal consensus about how returns should reflect the "L" word.) Click here to see some examples recently added to the CFA Institute's site about Global Investment Performance Standards. (Choose Leverage/Derivatives from the pull-down menu.)

This blog's author adds "There is so much more work to be done in the area of disclosure and transparency. The amount of information that outsiders are missing is staggering. Even insiders may not have the full picture unless they know what questions to ask." Email us if you want a copy of "Deciphering Risk Management Disclosures" by Dr. Susan M. Mangiero, AIFA, AVA, CFA, FRM.

If pension fiduciaries thought that interviewing traders and portfolio managers was tough, try asking questions of R2D2.

Disclosure and Fiduciary Implications - Big Problem?

Disclosure is fast becoming the proverbial four letter word in pension fiduciary land. Critical questions abound.

  • How much information do pension fiduciaries need in order to make an "informed" decision?
  • Who should provide that information, how often and in what form?
  • Is there a danger of having "too much" information?
  • What does the law currently require?
  • What information is currently available and to whom?
  • Is there an industry consensus about what constitutes "good quality" information?
  • What are the consequences of "incomplete" disclosure and are they equally unpleasant for plan participants, shareholders, taxpayers and plan sponsors?
  • What current roadblocks stand in the way of "better" disclosure (once that term is defined)?

 The topic of disclosure and transparency is as broad as it is critical to good plan governance. We've written extensively about this topic as applied to investment risk and will continue to do so. Click here if you would like to receive copies of some of our many articles. After hours of work, our research librarians are completing an Ebook on the topic of pension information resources. Click here if you want to be notified of its publication.

With a copyright date of July 4, 2007 (symbolic perhaps?), independent fiduciary Matthew D. Hutcheson addresses the topic of 401(k) plan information in "Retirement Plan Disclosure: A Declaration of Ethical Principles and Legal Obligations." Not known for being shy about his point of view, Hutcheson makes a compelling case for additional, complete and user-friendly disclosure about fees and related compensation arrangements.

“The Department (Department of Labor) emphasizes that it expects a fiduciary, prior to entering into a performance based compensation arrangement, to fully understand the compensation formula and the risks associated with this manner of compensation, following disclosure by the investment manager of all relevant information pertaining to the proposed arrangement. [Advisory Opinion Letter 1989 WL 435076 (ERISA)]

Thus, for a fiduciary to know all relevant information ahead of time, service providers must disclose all relevant information prior to entering into an engagement. The failure to disclose all relevant information effectively forces fiduciaries to violate the law unknowingly. The SEC has taken action against various service providers of 401(k) plans because of hidden compensation arrangements which obscured relevant information to fiduciaries. "

Hutcheson provides solid legal and regulatory evidence in support of full disclosure of all types of fees and related non-fee agreements. In addition, he reminds readers that fees impact economic performance and are therefore integral to any kind of investment decision-making. Would we buy a car or get surgery without enough information to gauge potential risk and rewards? 

His message comes at an opportune moment to begin a national "no holds barred" conversation about fees, fiduciary duty and protection of plan participants.  Countless companies are switching from defined benefit plans to defined contribution structures. In loco parentis NOT.  While employers transfer more responsibility to employees, research suggests that individuals are saving much less than is minimally needed to secure a reasonable lifestyle in retirement. Add to that an uncertain outlook for the long-term viability of Social Security and Medicare (and international equivalents to the U.S. post-employment safety net) and policy-makers are starting to take notice. Not a day too soon for many folks. If you think a train is about to crash, why wait to seek preventative measures?

Hutcheson concludes that "industry and regulators must either: (a) Return to the model originally contemplated under ERISA, in which recognized fiduciaries would make all decisions regarding trust assets; or (b) Empower participants to make their own individual decisions with respect to the assets in their personal tax-deferred 401(k) accounts. If the chosen course is to return to the original intent of ERISA, then fiduciaries of 401(k) plans must be armed with all relevant information necessary to construct a low-cost prudent portfolio for the benefit of the participants. Alternatively, if the chosen course is to enable those holding tax-deferred investments to, in essence, serve as their own mini-fiduciaries, then they must be afforded the information necessary to construct the same sort of prudent, low cost personal portfolio."

Those who advocate individual responsibility, and therefore favor the idea of choice at the employee level, get push-back from some that Sally or Joe "Every Worker" is unlikely to delve deep with respect to investment issues. Yet people make decisions for themselves every day - choosing a doctor, buying a car, voting, changing jobs and so on. But, for argument's sake, let's agree that a "mini fiduciarization" of the workforce is impractical, infeasible or otherwise unappealing. What then?

If only plan sponsors are to decide on all things 401(k), should we not be seriously engaged in identifying what makes for a "top quality" fiduciary? Besides access to good and complete information about fees and other pecuniary arrangements, we've long advocated a requirement for "suitable" qualifications (education and experience) before someone makes multi-million decisions with other people's money. To be clear, the use of the term "require" here refers to that which is self-imposed by plan sponsors, perhaps with the help of various industry and fiduciary organizations. Mandatory requirements would be problemmatic and could exacerbate the situation. (Our firm, Pension Governance, LLC provides fiduciary training, process checks and research in the areas of investment risk and valuation. Part of a growing industry to help fiduciaries do a better job, we complement work done by our partners but always with the same message. Good process is everything!)

On the topic of information, the more voices the better as long as it gets us to an enlightened place. This means that "good" disclosure would be seen as a value-enhancing tool for all concerned parties, not another costly, "go nowhere" exercise.

To read the full text of Hutcheson's article, click here. You will be taken to the Social Science Research Network site. Pension Governance, LLC is a proud sponsor of four SSRN sections. Click here to learn more about our sponsorship of a pension risk management section (created just for us) and a research section about mutual funds and hedge funds. Click here to learn more about our sponsorship of a research section about employment law and litigation and a research section about corporate governance.

For further reading, click on the title of each item listed below:

"Who Wants to be a Fiduciary Anyhow?"

"Do You Know the True Cost of Your Retirement Plan?"

"Searching for Hidden Treasure"

"Do We Need an Easy Button for Fiduciaries?"

"401(k) Fee Analysis - Who Benefits?"