Enterprise Risk Management, Board Governance and the Art of Cleaning Dirty Dishes

Old habits sometimes die hard. In my husband's case, he insists on soaking the dishes before putting them into the dishwasher. I prefer to scrub them with a sponge, rinse and put them aside until the current load is finished, the machine is emptied and there is room to add the next set. After twenty-two years of otherwise marital bliss, you would think that we would have the whole kitchen clean-up dance choreographed and down to a science. Yet, here we are on a Sunday night, talking about the best way to clean the dishes...again. The good news is that we have squeaky clean dishes. The less than good news is that it would be better in my view to discuss the issue thoroughly, agree on a process and then allocate work accordingly instead of each of us spending time on a basic task that should be easy enough to master without repeatedly going over the same thing.

Now if talking about cleaning dishes is the extent of disagreement in any relationship (marriage or otherwise), life is good. It does get you thinking however about interpersonal dynamics, leadership and how to accomplish a goal, especially when things are more complicated.

Managing enterprise risk management ("ERM") is a good example of a task that requires care and coordination and is arguably more complex than pulling out a scrub brush. According to a recent McKinsey & Company survey about improving board governance, others concur. In their August 2013 write-up of results, authors Chinta Bhagat, Martin Hirt and Conor Kehoe write that "...most boards need to devote more attention to risk than they currently do. One way to get started is by embedding structured risk discussions into management processes throughout the organization."

In "Risk Management and the Board of Directors" by Martin Lipton et al (Bank and Corporate Governance Law Reporter, February 2011), the role of oversight is distinguished from "day-to-day" risk management. The authors write "Through its oversight role, the board can send a message to the company's management and employees that comprehensive risk management is neither an impediment to the conduct of business nor a mere supplement to a firm's overall compliance program, but is instead an integral component of the firm's corporate strategy, culture and business operations."

According to a 2009 publication entitled "Effective Enterprise Risk Oversight: The Role of the Board of Directors" by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"), board oversight entails several important actions. These include the following:

  • Comprehend an organization's philosophy about risk and "concur with the entity's risk appetite," otherwise defined as its risk tolerance for alternative ways to create shareholder wealth;
  • Assess whether management has put effective risk management processes in place in order to identify, measure and manage key sources of uncertainty;
  • Regularly carry out a study of an organization's portfolio of risks in the context of stated risk tolerance goals; and
  • Evaluate whether management is "responding appropriately" to factors that could seriously erode enterprise value.

Hopefully, readers agree that the topic of risk management oversight should be important to pension plans and other types of institutional investors that invest in companies directly or by purchasing corporate stocks and bonds. Looking askance or ignoring the topic altogether is ill-advised.

In a recent conference call about vendor selection for a relatively large ERISA plan, I was surprised when one of the callers admitted to not having yet vetted the risk management controls in place for a candidate service provider. Worse yet, he thought doing so was a bad idea since "the numbers spoke for themselves."

Certainly insurance underwriters are taking a further look at their exposure. Professors David Pooser and Kathleen McCullough, on behalf of the Professional Liability Underwriting Society ("PLUS") Foundation, explain that more attention is being paid to the oversight role of directors in the aftermath of recent financial crises. In "How is Enterprise Risk Management Affecting the Directors' and Officers' Liability Exposure?" (September 1, 2013), they write that "Better governance control through ERM should make a firm a more appealing risk for D&O insurers to write. ERM becomes especially important if it signals that the corporation is less risky and better controlled than others, and therefore may be a useful tool to D&O insurers, regulators, and other monitors."

Understanding Directors and Officers ("D&O") oversight of a firm's enterprise risk management activities is not exactly the same thing as settling on how best to get the dishes clean. However, both activities are important, require that collaborative discussions take place and actions ensue.

Pension Plan Economics and Corporate Finance

Just published is an article I wrote about the urgent need for appraisers and deal-makers to make sure that they have adequately assessed the economics associated with defined benefit plan funding. Entitled "Pension Plans: The $20 Trillion Elephant in the (Valuation) Room" by Susan Mangiero (Business Valuation Update, July 2013), the objectives of this article are threefold: (1) shed light on the magnitude of the pension underfunding problem and the possible dire impact on enterprise value; (2) remind appraisers of the need to thoroughly understand and evaluate pension plan economics or engage someone to assist them; and (3) explain the adverse consequences on deal-making and corporate strategy when pension plan funding gaps are given short shrift. CEOs, Chief Financial Officers, private equity, venture capital, merger and acquisition and bank lending professionals will want to read this article as it showcases this timely and urgent topic.

Click to read my article about pension plan valuation.

In a related post, ERISA attorney Stephen D. Rosenberg wrote a commentary on his "Boston ERISA & Insurance Litigation Blog" (June 17, 2013) about why he believes that appraisers should not be designed as ERISA fiduciaries. He expresses doubt about whether imposing a fiduciary standard on appraisers will "improve the analysis provided to plan fiduciaries." He suggests that such a move by regulators could create a reluctance for valuation professionals to assume the liability associating with appraising a company with an ERISA plan.

For those who missed our program about appraiser liability, visit the Business Valuation Resources website to obtain a copy of "Valuation and ERISA Fiduciary Liability: Traps for the Unwary Appraiser." The program took place on May 14, 2013. Speakers included myself (Dr. Susan Mangiero), ERISA attorney James Cole with Groom Law Group and Mr. Robert Schlegel with the Houlihan Valuation Advisors.

Valuation and ERISA Fiduciary Liability: Traps for the Unwary Appraiser

An esteemed panel of experts will speak on May 14, 2013 from 1:00 PM EST to 2:40 PM EST as part of a webinar that is sponsored by Business Valuation Resources. Entitled "Valuation and ERISA Fiduciary Liability: Traps for the Unwary Appraiser," Dr. Susan Mangiero, CFA, FRM and Accredited Investment Fiduciary Analyst, will be joined by Mr. Robert Schlegel, ASA, MCBA and ERISA attorney James V. Cole II. Dr. Mangiero is a Managing Director with Fiduciary Leadership, LLC. Mr. Schlegel is a principal with Houlihan Valuation Advisors. Attorney Cole is a principal with Groom Law Group.

Why You Should Attend

As retirement, healthcare, and other employee benefits continue to grow, they are placing new stresses on firms of all sizes, whose commitments to these funds are beginning to outpace their revenues. Regulations and lawsuits are now challenging the defined responsibilities and liabilities of the financial professionals who create, manage, and even analyze these entities. This means that every appraiser now needs to assess risk, and the extent to which employee benefit plans impact enterprise value.

In this webinar, Dr. Susan Mangiero, Mr. Rob Schlegel, and ERISA attorney James Cole discuss existing, emerging, and proposed disclosure rules, an understanding of which are imperative to navigate the maze of actuarial, accounting, and regulatory numbers. Learn why estimating future expected cash requirements to service a plan(s) is imperative if an appraiser wants to opine whether a firm can realize its growth targets, and how benefit plan economics, such as withdrawal liabilities, change when derivatives or annuity transactions are in place. Appraisers need to understand emerging discussions now taking place at FASB and other regulatory agencies that will affect market participant activity relating to exchange value. Markets are waking up to this emerging area, and appraisers can no longer afford to remain asleep of these issues.

According to Mr. Blake Lyman, Professional Program Manager with Business Valuation Resources, LLC, "BVR is thrilled to be offering this program with Susan, Rob, and Jim. As the go-to resource for all professionals involved with business valuation, we always seek to present the most in-depth content on the most pressing issues for the many experts who rely on us. With Susan, Rob, and Jim's experience and expertise, this program is sure to surpass the high standards we set for ourselves and that our customers have come to expect."

To register, visit the Business Valuation Resources website.

Pensions and Corporate Finance: How to Avoid Buyer's Remorse

Ever since the PBGC’s 2007 opinion that a private equity fund with a controlling interest can be liable for a portfolio company’s pension problems, there is increased evidence that corporate transactions can go seriously awry if ERISA benefit plans are not properly addressed. Legal issues are not the only risk factor that could cause a merger, acquisition, spin-off or carve-out to fail to materialize. Low interest rates, investment lock-ups, participant longevity and complex vendor contracts are a few of the challenges that must be confronted by the legal and finance team in charge of due diligence. And with virtually every defined benefit plan facing funding issues in light of these circumstances, the PBGC is extremely proactive in seeking concessions to not interfere with corporate transactions yet hold parties who may have responsibility for unfunded liabilities accountable. Headlines are replete with articles about deals that were stalled or failed because ERISA due diligence was given short shrift. In 2010, the acquisition of a major chemical company took less than six months but coordinating the relationships with defined contribution managers took nearly two years to wrap up. Talks between a large manufacturing company and a potential target company are currently focused on how best to tackle the acquiree’s multi-billion dollar pension fund gap. In the aftermath of the settlement of a recent case, private equity firms and limited partners continue to be jittery about joint and several liability for pension plan funding gaps, making it harder to take a portfolio company public or sell. Taken together, the most important thing that a potential corporate buyer and its counsel can do is to acknowledge the importance of proper due diligence. These problems are not going away and arguably could get much worse.

Join Dr. Susan Mangiero, CFA, certified Financial Risk Manager and Accredited Investment Fiduciary Analyst and senior ERISA attorney Lawrence K. Cagney to talk about ways to keep a deal from derailing and to avoid buyer’s remorse due to an incomplete assessment of pension plan economics on enterprise value.

Join us to hear speakers talk about critical steps and lessons learned from their experience, to include the following:

  • How to revise investment and/or hedging strategy and policy statement(s) when organizations merge;
  • Elements of an ERISA service provider due diligence analysis when plans are combined;
  • Red flags for an institutional investor to consider when seeking to allocate to private equity portfolios with “pension-heavy” companies that may be hard to exit without costly restructuring;
  • Assuring that participant communication is comprehensive;
  • Role of the corporate finance attorney versus ERISA counsel; and
  • Installing knowledgeable fiduciaries for the new and/or merged employee benefit arrangements

Click to register for "Pensions and Corporate Finance: How to Avoid Buyer's Remorse," sponsored by the Practising Law Institute on November 15, 2012 from 1:00 pm to 2:00 pm EDT.

Co-Leading Pension Risk Management Workshop in Orlando

I am off to Orlando to address the Florida Public Pension Trustees Association about pension risk management. I will be joined by an esteemed colleague, Dr. Michael Kraten, in a presentation about the fundamentals of enterprise risk management (including the famous COSO cube) and the role of the service provider in creating hedging programs and vetting asset managers who use derivatives. The workshop will include two case studies about foreign currency overlay programs and investing in hedge funds and private equity funds, respectively.

Having addressed the Florida Public Pension Trustees Association ("FPPTA") several times before about pension risk management, I am impressed with its commitment to fiduciary education about investment best practices.

Click here to review the FPPTA agenda for the 2011 summer conference.

Money Makes the World Go Around

It's not just Broadway that extols the virtues of money. "Money makes the world go around...that clinking clanking sound can make the world go 'round" (from Cabaret).

Any discussion about investments inevitably centers on how much was made or lost or is expected to be made or lost. That's not necessarily bad with a few caveats.

  • Performance standards must be uniform and therefore comparable across investors for a given asset class or fund.
  • Numbers alone do not necessarily reflect a robust risk management process. To the contrary, artificial performance numbers can lull investment decision-makers into false security. Contact me if you want training on the pitfalls of investment performance reporting and risk management gaps. Click here to send an email.
  • Historical numbers tell a story about what happened. Good risk management dictates the need to assess "what if" scenarios. Things change and sometimes materially so. Don't depend on historical numbers to predict the future.
  • More than a few asset returns exhibit non-normal behavior. In such cases, traditional statistical tests are limited tools for capturing extreme value behavior.

The good news is that every day offers a renewed chance to do better with respect to benchmarking and risk management. Think of existing problems as gifts. Meet the challenges head on and your organization potentially reaps significant rewards such as share price gains, capital-raising on more favorable terms, fiduciary liability reduction, reducing time and stress, keeping promises to beneficiaries and much more.

BP, Fat Tails and Risk Management

Many thanks to Ms. Marlys Appleton, governance expert and financial professional. Her comments are provided below. Click to read the original blog post entitled "BP Investments - The Role of Ethics and Risk Management" (June 19, 2010). The governance storm clouds are dark indeed.

<< I believe what happened in this case is connected to internal governance issues at BP. One only has to look at their safety violation record relative to peers such as Exxon and Conoco over the last few years (as reported recently by Bloomberg News) to see that BP accepted hundreds of safety violations as a "cost of doing business". Institutional investors' failure to pay attention to safety violation records at BP reflects their lack of understanding of the need to price in poor governance. BP's safety record was known for years and now the market is forced to acknowledge and price such behavior, with devastating results.

I also think of the Massey coal mine disaster - another company whose safety record was well know. Both boards need a paradigm shift to acknowledge past failures, but for one, it may be too late. Some damages cannot be remedied by compensation alone. The fund is a good start and may reduce the need for litigation though there are likely to be lawsuits. I believe such a devastating social and environmental disaster such as this event should not be mediated through the courts, but that's another topic. Add upon this, the additional layer of inept government regulation, another example of 'poor governance' as a contributing factor.

It is my hope that institutional investors, boards and executive management embark upon a real understanding of what can happen when governance and ethical behavior break down. In the world of emerging risks, acknowledgement of "fat tail" catatrophic events needs to be stepped up with the implementation of a good Enterprise Risk Management ("ERM") process. This information must then be socialized with boards, management, and investors. >>

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.

The Case of the Mistaken Jellybean and Pension Food for Thought

      
                                                                 

When I was a little girl, the spring holidays were a big deal. My sister and I would spend hours in search of hidden jellybeans and chocolate eggs. My favorite flavor was licorice and, once found, I would indulge. One year, to my delight, I found what I thought was a black jellybean. Luckily, upon closer inspection, I realized it was a gift from the cat (and of course I threw it away).

So what's the moral of the story for plan sponsors?

Look closely and act wisely.  What looks like a bonus could be a nasty surprise in disguise.

More specifically, sponsors who only look at the positive impact of short-term market conditions on funding status, without addressing long-term structural issues, miss the mark. What looks like a favored treat (relief from having to do anything now as long as nominal numbers "look good") could turn out to be just the opposite (a situation left untouched until it's too late to take corrective action in a cost-effective manner).

An examination of the short-term versus long-term also begs the question. Should the funding of benefit plans be considered strategic or tactical? Those organizations that address risk management on an enterprise basis are starting to more fully incorporate the cost and design of benefit programs as part of their planning. Unfortunately, there is evidence that things remain in disrepair.

"Corporate Directors May Not Be Providing Sufficiently Robust Enterprise Risk Oversight," published by the Conference Board in conjunction with the McKinsey & Company and KPMG's Audit Committee Institute, states that "Corporate directors could find themselves exposed to liability if they fail to keep pace with evolving best practices in enterprise risk management (ERM)." The study also found that "While 71.8% of directors believe they have the right risk metrics and methodologies in making strategic decisions, 47.6% of directors would like to see more data analysis related to the company's risk profile." Click here to read our prior blog post about Enterprise Risk Management entitled "Enterprise Risk Management in the Boardroom."

Enjoy what April has to offer but don't get lulled into false security.

Dividends, Pensions and California Chaos



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

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

Think about it.

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

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

The little bill that could ...

Enterprise Risk Management in the Boardroom


Thanks to Stephen Davis, editor of Global Proxy Watch, for highlighting a recent study about enterprise risk management. The three Conference Board authors - Carolyn Kay Brancato, Matteo Tonello, and Ellen Hexter -- suggest that board members may need to do a lot more work when it comes to (a) recognizing relevant risks and (b) managing them to avoid liability.

According to "Role of the U.S. Corporate Board of Directors in Enterprise Risk Management", there is a big gap between knowledge and action.

"The Conference Board study finds: Although 89.5% of directors say they fully understand the risk implications of the current strategy,

Only 77.4% of directors say they fully understand the risk/return tradeoffs underlying the current strategy.

Only 73.4% of directors say their companies fully manage risk.

Only 59.3% of directors fully understand how business segments interact in the company's overall risk portfolio.

Only 54.0% have clearly defined risk tolerance levels.

Only 47.6% of boards rank key risks.

Only 42% have formal practices and policies in place to address reputational risk.
Directors are, however, sensitive to the need for additional information:

While 71.8% of directors believe they have the right risk metrics and methodologies in making strategic decisions, 47.6% of directors would like to see more data analysis related to the company's risk profile."

So what does this have to with pension plans?

Simply put, a lot...

As more and more companies contemplate the financial and human capital impact of offering employee benefits, it's imperative to remember that pension management cannot be separated from corporate governance responsibilities, embedded in regulations such as the Sarbanes-Oxley Act of 2002 ("SOX").

Jeffrey D. Mamorsky, Employee Benefits Group Chairman with Greenberg Traurig, states: "What companies sometimes overlook is that this SOX Section 404 Management Assessment of the Adequacy of Internal Control Procedures requirement applies to pension and benefit expenses. This is an issue that cannot be overlooked since SOX includes draconian sanctions of $2 million and up to 10 years imprisonment for non-willful ($5 million/up to 20 years imprisonment for willful) certification of any statement that does not comply with SOX requirements." (See "Today's Retirement Plan Environment Leaves Much for Concern".)

In a speech to business editors, following the passage of SOX, U.S. Department of Labor Assistant Secretary Ann L. Combs sang its praises, adding that: "Some reports have criticized the Sarbanes-Oxley provisions as inadequate response to the problems brought to light by Enron and its progeny. The fact is, they are important provisions and will prevent future instances of corporate officers unloading their stock while workers are trapped in a sinking ship."

My own research in the areas of governance, compliance and litigation suggests an inextricable relationship between corporate and pension governance. Directors simply cannot ignore ERISA when making enterprise-oriented decisions. To do so could invite the possibility of financial loss, litigation, harm to reputation and/or regulatory action.

Author's Note: There are many articles that address the deficiences of SOX and regulation in general. Free marketeers advocate complete industry self-regulation or some variation thereof (and I have written elsewhere about the economic and philosophical merits of best practices versus regulation). However, whatever your opinion about regulations, including SOX, existing law is a reality.