Pension Risk Matters : Pension Risk News & Analysis : Investment Governance, Inc. : Pension Risk & Investment

In reading "Earlier Retirement: Beating Back the High Fees" by Wall Street Journal reporter Eleanor Laise (March 6, 2010), I felt an immediate empathy for the subject of the article, Mr. Jeff Powelson. Apparently, this 401(k) plan participant lobbied his management hard to pay lower fees by replacing actively managed funds with index-tracking vehicles.

I am reminded by my own sorry experience with a "fully transparent" vendor a month ago, albeit a different product. Not having rented a car in many years, I okayed a $60+ per day fee to trek from a large Midwest airport to an important business meeting about 90 miles away. Our travel agent told me that it would cost $61 to rent a mid-size car for my colleague and me each day. I kept thinking how much we'd save by not having a van pick us up. Lo and behold when we arrived to sign the paperwork, quelle surprise! We were bombarded with hidden fees aplenty.

• If I paid with my company credit card, my colleague could not drive without me paying a surcharge of $21 per day.
• We could pre-pay for the gas at $2.98 per gallon or pay $7.98 per gallon the next day if we ran out of time to refuel before returning the car.
• Insurance would cost us about $80 per day.
• The use of a GPS device would be another $20 or $30.

A car that was supposed to cost less than $100 for our one-day excursion ended up costing about $220 with the various add-ons. More than the money, what upset me was that the car company would only let me view the numbers on an electronic screen and could not print out the contract and tally for me to review.

For those retirees (existing and prospective), fees deemed excessive, hidden and unfair are causing quite a stir. It's one thing to make a decision based on what you think is full information, only to discover that your wallet is being emptied quickly. 

More complete disclosure is one answer though, as Ms. Laise points out, what does that exactly mean? Should fees be decomposed by type of expense such as "investment management, plan administration, transaction costs and other items?"

A few basis points may not seem like much but, compounded over the years, it adds up. Looking under the hood sounds right but assumes that the latch quickly gives away. If money managers and plan sponsors alike are reluctant to provide details, it will be tough going for individual savers. Also smaller companies that want to provide generous benefits may not have the negotiating power to move away from "retail" pricing. That said, the issue of fees hits home. Companies are likely going to have to move towards enhanced reporting or risk upsetting their workers who could possibly make a bee line for the exit door. When skilled and productive workers are hard to find, that outcome is far from optimal.

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The following text is from an article I recently wrote for Mann on the Street (December 2009). As always, I welcome comments from readers. I am an avid believer in the notion that doing good means doing well. Click for the pdf version of "Investment Ethics: How to Make Money and Win Clients" by Dr. Susan Mangiero, CFA, FRM.

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According to Wall Street Journal reporter Pui-Wing Tam, hedge funds are not alone in reducing their fees to entice investors. As laid out in "Venture Funds Sweetening the Terms," fund-raising is down 65% from $58.2 billion in 2008 to $20.4 billion as of the beginning of November 2009. To offset a difficult economic environment, allay concerns about longer times to exit and diminished returns reported by some managers, performance-linked fees are being put on the table.

In a related article in the same paper, the Initial Public Offering ("IPO") thaw is described as imminent. According to "Issuers Look to 2010" by Lynn Cowan (November 23, 2009), underwriters prepare to help private businesses make their public debut. Notably, nearly 40 companies have "filed paperwork to start the IPO process, compared with eight during the same period of 2008."

It will be interesting to watch whether IPO-related liquidity leads to any retraction of performance-linked venture capital fees currently being offered to limited partners.

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ERISA legal expert and Ropes & Gray LLP partner, Attorney Andrew L. Oringer provides an interesting insight into a recent case about the investment of excess assets and prudence. The case he cites can be downloaded by clicking here. Note the court's opinion on page 5 wherein it writes that the plaintiff, seeking redress over a question of fees paid by the plan, cannot "bring suit because the plan's surplus was sufficiently large that the 'investment loss did not cause actual injury to plaintiff's interests in the Plan'."

Our thanks to Attorney Oringer for his contribution, provided below.

A Scary Halloween Gift from the Eighth Circuit?

So here's a question - you're managing an overfunded defined benefit plan (remember those) and you want to let your guard down. You want to roll the dice a bit or push the limit of what you can do with ancillary (non-investment) motivations, and you figure you can do so because you're playing with house money. At least, you want to play around just with some of the excess. Or maybe you're just a touch careless, albeit unintentionally so. What's the big deal?  After all, participants and beneficiaries are going to get their money, without government help, unless the whole overfunded thing goes to heck in a hand basket and turns radically south.

Now, you'd expect that you might be on the wrong end of this one, so, as your feet get colder, you poke around a bit. And what do you find? You find that you may indeed have a friend or two in the Eighth Circuit with an ever-so-slightly delayed Halloween present for you.  In McCullough v. AEGON USA, No. 08-1952 (8th Cir. Nov. 3, 2009), which follows its earlier decision in Minnesota Mining and Manufacturing, 284 F.3d 901 (8th Cir. 2002), the Eighth Circuit in effect seems to hold that one cannot violate the prudence rules with respect to the investment of excess assets.  (Note that the widely discussed 3M case may well be wrong on both of the issues considered there.)  Assuming AEGON is not reviewed en banc and reversed on rehearing, its confirmation of the 3M decision seems like a welcome development for those seeking to limit potential liability for investment decisions under a DB plan.

My advice, however, is to be careful, real careful, even in the Eighth Circuit. The reasoning of AEGON and 3M is so suspect that, outside the Eighth Circuit you would draw comfort from these cases at your own peril, and, even within the Eighth Circuit, I think you'd have to be at least a little concerned that any given case could be reversed by the nine old and young men and women in the black robes. Having said that, the cases are certainly nice precedent if you need to use them defensively

So: "Boo" or "Boo!" depending on your perspective.

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The plight of the hamster is simple. He is cute, furry and going nowhere fast. Sure he gets exercise but, measured in inches and miles, he's stuck in the same place, treading the same pattern over and over again.

Lest this sound like a zany rant from a busy blogger, might I suggest that the current spate of "pay to play" scandals reflects what some in the industry have been saying for years? Be scared, be very scared about the dsyfunction that is roiling financial markets. 

With respect to writer George Santayana, "Those who cannot learn from history are doomed to repeat it." With Enron, Worldcom and Bear Stearns far from a distant memory, why on earth are we still reading about bad players who end up costing taxpayers, shareholders and innocent bystanders gazillions of dollars? Worse yet, those individuals who wear the fiduciary hat proudly are being unfairly tainted by those who should know better and/or simply do not care about the lives they ruin with their bad acts.

Recent articles about California and New York pension problems only add fuel to the fire and leave most folks scratching their heads, asking legitimate questions, some of which are listed below:

• Given existing regulations, why are there so many scandals?
• Where is the board oversight that is supposed to prevent conflicts of interest or at least nip things in the bud before losses mount?
• How much are Sally and Joe "everyperson" supposed to tolerate in terms of broken trust on the part of those tasked with leadership?
• Why aren't major lessons being learned sooner than later?

As an ardent advocate of capitalism (and no, we do not have a pure capitalistic system in place anywhere, contrary to Michael Moore's movie lament), I find the current state of affairs impossible to defend.

Bad practices have got to stop. We need to be moving forward, not running around and around, making no progress and chasing our tails. Let me also add that I am not objective here. Our company (newly named Investment Governance, Inc.) has been busy at work for nearly a year, building investment "best practice" tools (to debut in short order). What has kept our team going lo these many months of 15 hour days are the repeated and strident cheers from all the good guys and gals who take their institutional fiduciary work seriously and want things to improve in a big way.

Bravo to those for whom trust is a sacred word! We seek to help you gain the recognition and support you so richly deserve. 

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In response to my post about the merger of Towers Perrin and Watson Wyatt ("Two Giants Merge - Que Pasa?" June 29, 2009), I wrote that generalists are finding it tough going in terms of assisting pension decision-makers, in large part because the issues that confront them are becoming more complex. Though my statement was not directed to any particular firm and reflected what I often hear from pension executives, one reader took me to task.

Mr. Alberto Dominguez writes that "The folks who work at Towers Perrin (disclosure: that would include me) and Watson Wyatt are hardly generalists. One argument in favor of the merger is that it will allow an even greater depth of talent and more specialization, enhancing the ability to assist clients with these increasingly specialized decisions." (Check out Alberto's blog on pension issues from an actuary's perspective, "What's An Actuary?". Also note that he has given me permission to reprint his comments but with the caveat that he is not rendering an official statement on behalf of Towers Perrin.)

In speaking to industry experts about the consulting industry in general, several trends appear to be taking hold. Anyone who wants to guest blog about this topic or offer their opinion (for attribution or not) is encouraged to email Pension Governance, Incorporated at PG-Info@pensiongovernance.com. 

This list (which is far from exhaustive) includes:

• Greater tilt towards specialization under one roof if seen by investment executives as being easier than contracting with multiple parties
• A desire to have a consultant wear the hat of fiduciary continues to have appeal if it is affordable, noting that most organizations will logically charge more for greater liability exposure
• Strident calls for transparency with respect to who is doing what, how and on what basis in terms of fees and buy-sell relationships.

Keep in mind that while consultants are being asked to do more, there are tremendous pressures to contain costs on the part of the organizations that write checks. There is no doubt that the investment consulting world is starting to change. As with any period of tumult, opportunities are there for those who know where to look.

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According to "Hedge Fund Power Shift Could Be A Good Thing," Securities Industry News reporter Carol Curtis (May 18, 2009) posits that hedge funds will benefit from a recent push to lower fees. Say what? Yes indeed. The thinking goes like this. As pensions push for lower fees and improved transparency from hedge fund and private equity fund managers alike, their win may thwart U.S. and global attempts to regulate alternatives. This in turn will put smiles on the faces of non-traditional fund managers, making for interesting bedfellows all the way round.

Speaking of full disclosures, I was interviewed for this article by Carol Curtis. I pointed out the nature of recent demands for concessions, adding that pensions, endowments and foundations should ask about the make up of both administrative and performance fees rather than relying on gross percentages.

Suppose an institutional investor is comparing Hedge Fund A against Hedge Fund B. The latter may spend more on operations because it licenses a sophisticated risk management system which in turn helps that fund monitor its holdings on a regular basis. Is the "cheaper" fund the better choice? It depends on a variety of issues. The point is that total fees charged may not tell the full story. Institutional investors will want to understand the nature of spending and the basis on which performance numbers are calculated, at a minimum.

Click to read this opinion piece. You may need a password to access the full article.

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According to "Investors warn private equity over cash calls" (March 26, 2009), Reuters reporter Simon Meads writes that private equity firms are facing "intense pressure" from limited partners (pensions, endowments and foundations). Cash strapped themselves, institutional investors are telling asset managers not to come knocking on cash infusion doors any time soon.

Does this phenomenon present a fiduciary conundrum? For one thing, might a limited partner be sued for a contractual breach if they refuse to pony up additional monies? Second, could a dearth of new cash making its way to private equity fund managers end up creating more financial pain for the limited partners? After all, if a private equity and/or venture capital fund finds itself short of the almighty dollar (or other currency), it may be unable to invest in new companies deemed to be high growth and/or be hamstrung from keeping current portfolio companies afloat. On the other hand, limited partners may be reeling from their own pain (whether Madoff induced, stemming from equity losses or something else) and figure that the cost of incremental disbursements outweighs the expense of abstaining.

One thing seems clear.

Institutional investors are demanding more for less. In "Calpers Tells Hedge Funds to Fix Terms -- or Else" (March 28, 2009), Wall Street Journal reporters Jenny Strasburg and Craig Karmin write that this large California giant is "demanding better terms from hedge funds, including lower prices and 'clawbacks' of fees if performance weakens." Said to have been sent to 26 hedge and 9 funds of funds, a March 11, 2009 memo outlines terms, with a proviso that counter terms will be considered.

In a March 6, 2009 article by the same two writers, the deputy chief investment officer for the Utah Retirement System echoes similar sentiments. In his "Summary of Preferred Hedge Fund Terms," Larry Powell calls for lower fees, adding that "management fees should be used to cover operating expenses only, and are not appropriate funding sources for staff bonuses, business reinvestment, strategy expansion, or wealth accumulation by partners." The 4-page letter urges a share structure that transfers "liquidity risk evenly among commingled investors" that could result in how gates, lock-ups and redemption terms apply to short and long-term investors, respectively. Regarding disclosures, Powell describes a minimum laundry list to include items such as:

• Annual audited financial statements
• Quarterly information about fees, operational costs, concentration of clients and soft dollar activity
• Monthly Net Asset Values, return attribution by strategy, geography and/or sector, largest long/short positions, leverage at the fund and strategy level
• Weekly return attributions and month-to-date estimates of return.

We've heard numerous institutional investors put a stake in the ground for what they perceive to be a more level playing field (their words). Just a few months ago, I led a workshop on risk management and "hard to value" investing red flags to a group of large public plan auditors. Many of the audience members described a "disclose" or "we'll walk" policy now in force with respect to alternative funds. (Hopefully it goes without saying that not every alternative fund is a "hard to value" fund.)

Several things come to mind. Could demands from institutional investors be potent enough, if met, to stave off new regulatory mandates, some of which are outlined in "Does More Financial Regulation Make Us Safer?" (March 29, 2009)? Second, might we see a flurry of alternative fund manager fee-related lawsuits, similar to 401(k) "excessive" allegations that are making their way through the court system?

The match is on - investor versus manager. Who will get the biggest slice of the pie going forward with respect to economic rights?

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Wall Street Journal reporters describe a trend that some believe was once only urban legend, namely hedge fund managers cutting their fees. In "Hedge Funds' Capital Idea: Fee Cuts" (September 9, 2008), Jenny Strasburg and Craig Karmin describe a new balance of power in which investors are being courted to stay the course rather than pull out their money in search of greener pastures. Replete with examples, the article suggests that jittery institutions may get a big discount on fees if they agree to lock-up periods or give the fund managers ample time to recover losses or improve on sub-par performance.

This makes sense from the hedge fund managers' perspective, especially those who face unprecedented redemption requests. From the pension investors' vantage point, things are not so clear. Yes, it's great to be able to pay lower fees but if the price of doing so is the realization of a mediocre risk-adjusted return profile, plan sponsors may be better off rethinking their allocation to that fund. As with everything else, it's seldom so simple. Unwinding a position may be expensive in terms of transaction costs alone. Then there is the issue of what should replace the hedge fund, if jettisoned from the pension portfolio.

What will be interesting to watch is whether other hedge funds feel pressured to follow suit in terms of dropping fees.

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In Fixing the 401(k): What Fiduciaries Must Know (And Do) To Help Employees Retire Successfully, author Joshua P. Itzoe suggests that the 401(k) industry is broken and in bad need of repair. As many employers migrate away from defined benefit plans to defined contribution plans, it is critical to understand any weaknesses in the current system and work vigorously to correct them.

Chapter 1 states conflicts of interest and opaque fee disclosures as two of the biggest issues faced by the 401(k) industry. Chapter 3 explains basic fiduciary duties as codified by U.S. pension law in the form of ERISA, co-fiduciary liability and how fiduciary types differ from one another. Subsequent chapters are rich with descriptions of relevant industry players (and there are many of them), inherent conflicts of interest and the generally accepted compensation arrangement for each category of service provider. Though there is an entire chapter devoted to types of fees, it would have been nice to sink one's teeth into some meaty math examples, along with some empirical data about magnitude and dispersion of fees across plans. 

Written for 401(k) fiduciaries, the basic nature of the book is both refreshing but worrisome. If current plan fiduciaries (the target market for the book) are unaware of their core duties, how have they been getting along so far? Far from being pedantic, Mr. Itzoe includes several chapters with concrete advice for improving 401(k) fiduciary practices. His provision of important questions at the end of each chapter is a nice touch, along with some helpful appendices such as a "Sample Fiduciary Audit File," "20 Steps to 404(c) Compliance" and a relatively long glossary. There is no index but a short bibliography is provided for interested readers.

For more information, check out http://www.fixingthe401k.com/. Click to read the author's bio. At $13 and change, I recommend this primer. Kudos to Mr. Itzoe, CFP and Accredited Investment Fiduciary, for putting forth a solid book on an important topic.

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A new study, published by Watson Wyatt, suggests that some pension funds are weary of expending higher investment costs. In "A fairer deal on fees," authors find that "pension funds around the world are paying on average 50% more in fees than they were five years ago" with costs now averaging north of 100 basis points. The study goes on to suggest that external asset managers and brokers get the lion's share, in exchange for promises of alpha but delivery of beta. As market conditions sour, pension decision-makers are going to feel even more pressure to justify the fees they pay to outsiders.

No surprise then that some pension funds are looking to indexing as a salvo. In "Pensions turn to passive management," Financial Times reporter Owen Walker (May 4, 2008) writes that assets being allocated to index-tracking funds are on the rise. John Davies of Standard & Poor's adds that financial service providers are fast developing products to appeal to thrifty fiduciaries.

Lest a pension fiduciary think that indexing (in whatever form) lets them off the hook, it's not that simple. If less money is apportioned to active managers, the ones who are selected (or kept) must do "extremely well" to offset any lower returns from the passive component of the overall portfolio. Assessing risk management policies of external managers remains a critical task.

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On April 16, 2008, members of the U.S. House Education and Labor Committee will mark up the proposed bill that, if adopted, will mandate additional disclosures as relates to retirement plan fees (1:00 p.m. in room 2175 Rayburn H.O.B.) As fee-related litigation soars (frequency and size of alleged economic damages) and individuals struggle to ready themselves for a long retirement haul (due to extended life spans), the import of any disclosure regulation is considerable.

To learn more, check out these resources. Note that the bill is renamed the "Fair Disclosure for Retirement Security Act of 2008."

• "Fair Disclosure for Retirement Security Act of 2007" introduced by Representative George Miller (D-California) and dated July 26, 2007 - full text
• "Fair Disclosure for Retirement Security Act of 2007" - summary dated July 2007
• U.S. House Education and Labor Committee hearings (H.R. 3185, the 401(k) Fair Disclosure for Retirement Security Act of 2007 - October 4, 2007)
• U.S. House Education and Labor Committee hearings ("Hidden 401k Fees Undermining Retirement Security?" - March 6, 2007)

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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.

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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?"

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In a June 22 article, Lipper HedgeWorld reporter Emma Trincal writes about the imminent debut of a hedge fund replication index product, courtesy of Barclays Capital. According to Managing Director and Head of Equity Derivatives, Hassan Houari cites research that "up to 80% of the performance of hedge fund indexes" can be explained by changes in the market. Houari further adds that Barclays seeks to offer a "cheaper, more liquid and more transparent alternative." Click here to read the article entitled "Barclays to Debut Hedge Fund Clone." (Registration is required.)

Clones are a popular topic these days. Last week, during Part Two of the Hedge Fund Toolbox^SM, sponsored by Pension Governance, LLC, Dr. Susan Mangiero, CFA and Accredited Valuation Analyst talked about increasing pressure for fiduciaries to justify fees. "Amid a flurry of 401(k) lawsuits alleging 'excessive' fees, it doesn't take a rocket scientist to know that hedge fund fees are next. If a plan sponsor can synthesize a signicant portion of expected returns for a particular hedge fund strategy, how can they justify paying for active management?"

Not everyone concurs that replication is possible. During the June 19 online event, co-founder of Bulldog Investors and the David who conquered Goliath SEC in the battle over regulation of hedge funds, Philip Goldstein challenged the notion that investors would be better off with a passive approach. "An Elvis impersonator is not Elvis." Ed Stavetski, CFA and Chief Investment Strategist for CMG Investment Advisors, LLC added that "Many hedge fund professionals work hard to identify value on behalf of their investors."

Emphasizing fiduciary duty, Ed Lynch, Senior Vice President and Investment Officer with Dietz & Lynch Financial Strategies Group of Wachovia Securities, LLC, reminded listeners that ERISA is clear on fiduciary duties that mandate a rigorous analysis of fees. Echoing the urgent need for discipline in the form of a systematic process to assess alternatives (in fact, any type of investment), Mangiero elaborated. "Fees drive performance and performance drives strategic asset allocation and re-balancing decisions. Plan sponsors need to get it right. Every trade costs money."

Click here to purchase the broadcast and slides for a nominal fee. (Past webinars are listed in chronological order.) Pension Governance subscribers enjoy webinar access for no additional charge. Click here to subscribe.

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Today's post and the next few that follow focus on pension governance (the name of our new website and a term that is often used to describe fiduciary duties and best practices). For a discussion of what pension governance means, click here to read interviews with market leaders. It's such an important topic yet often overlooked. In fact, the U.S. Department of Labor created an educational program ("Getting It Right") in order to help individuals understand their duties. (The results of countless audits apparently left examiners nervous about the folks who did not properly self-identify as fiduciaries.)

"Hot off the press" is a set of standards devoted to the topic of pension governance. Newly published by the Stanford Law School, the so-called Clapman report urges pension funds, endowments and charitable funds to adopt principles that reflect prudence, ethics and transparency. Citing some big dollar "no-no's" on the part of institutional decision-makers, chief architect of the report, Peter Clapman,and others rightly point out that giant institutions must walk the walk if they admonish corporations to do the same. CEO of Governance for Owners USA and former chief investment counsel of TIAA-CREF, Clapman adds that “Bad governance also weakens funds by eroding public support for them." One element of the report calls for funds to provide clear (and make public) information about governance rules.

Yippee Yahoo!

A few of us sometimes feel as if we've been screaming in the wind about the urgent need to know who is in charge and how they are running the show. (I'm sure Clapman and others would agree.) To read how bad things are in terms of NOT being able to easily identify where the buck stops, check out "In Search of Hidden Treasure." More than a year ago, I wrote "that a systematic identification of who does what and why with respect to employee benefits is simply not a reality as things stand today. This makes it difficult (perhaps impossible) to effect change."

The Clapman Report suggests that funds hire "trustees who are competent in financial and accounting matters." Read "Practice What You Preach" for our list of basic questions about pension fiduciary selection, training and performance evaluation. Anecdotally, I've often queried trustees and  other types of fiduciaries - "How do you become and stay a fiduciary? Do you take a quiz? Do you possess a certain amount of relevant experience? Do you get paid what you're worth in terms of liability exposure and hours spent on plan-related tasks?"

Scary to say, selection is frequently a function of who is seen as having a few hours of free time. Unfortunately, being a plan fiduciary is arguably a full-time job. Moreover, with so many complex decisions to make, someone with a limited background in topics such as investing may truly struggle to understand basics, let alone nuances of evaluating risk-adjusted return expectations. Even when an external consultant is used, a fiduciary still retains oversight responsibilities (a topic deserving of its own separate post).

Another proffered recommendation from the Clapman Report is to "establish clear reporting authority between trustees and staff" and to "define appropriate responsibilities and delegation of duties among fund trustees, staff, and outside consultants." We couldn't agree more. Check out our earlier discussion about the importance of incentives in "Paper Clip Theory of Pension Governance."

One thing is clear. Pension governance is starting to attract attention. That's great news for the many fiduciaries already doing things the right way. (You deserve recognition.) For those who need to improve, perhaps the spotlight on practices, good and bad, will encourage change. That would be a huge plus for plan beneficiaries, taxpayers and shareholders.

Here are a few resources for interested readers.

1. Committee on Fund Governance: Best Practice Principles -"Clapman Report" (Stanford University)

2. Prudent Practices for Investment Stewards (Fiduciary 360, AICPA, Reish Luftman Reicher & Cohen)

3. Asset Manager Code of Professional Conduct (CFA institute)

4. Standards of Membership and Affiliation (The National Association of Personal Financial Advisors)

5. CFP Certification Standards (Financial Planning Standards Board)

6. Regular Member Code of Ethics (National Investor Relations Institute)

7. Code of Professional Responsibility (Society of Financial Service Professionals)

8. Also check the site for the Financial Planning Association. I understand that they are soon to release a new set of standards for financial advisors.

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Pension Governance, LLC is registered with CFA Institute as an Approved Provider of professional development programs. This program is eligible for 1.5 PD credit hours as granted by CFA Institute.

06/04/2007 : 12:00 pm to 1:15 pm EST

Description:
Join us for a lively discussion about 401(k) investment fiduciary issues in the aftermath of the Pension Protection Act of 2006, emphasizing economic and operational issues.

Who Should Attend:
Money managers, plan sponsors, plan administrators, custodians, pension consultants, pension attorneys or board members with responsibilities for selection of investment fiduciary advisors

Learning Points:
Persons who attend this 75-minute webinar will learn the following:

• Description of fiduciary duties under ERISA
• Discussion of procedural prudence as relates to 401(k) plan selection of fiduciary advisors
• Overview of safe harbor and selection of fiduciary advisor pursuant to the Pension Protection Act of 2006
• Litigation trends in the area of investment fiduciary breach as relates to plan sponsors and service providers such as consultants
• Fiduciary investment process for assessing 401(k) provider fees
• Role of fiduciary advisor in providing financial education
• Governance considerations with respect to selection of default investment 
• Structural changes in money management industry in response to material shift away from defined benefit plans
• Fiduciary advisor “red flag” practices such as soft dollar questions, revenue-sharing, limited disclosure
  

Speakers:

• Dr. Susan M. Mangiero, AIFA, AVA, CFA, FRM - Moderator (Pension Governance, LLC)
  
• Mr. Blaine F. Aikin, AIF®, CFA, CFP® - Speaker (Fiduciary36)
  
• Mr. David J. Bauer - Speaker (Casey, Quirk & Associates LLC)
• Mr. David Vriesenga - Speaker (Centre for Fiduciary Excellence, LLC)
  

Note: Subscribers to www.pensiongovernance.com receive free access to this webinar.

E-mail: PG-Webinars@pensiongovernance.com

Click here to register.

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Pension Governance, LLC is proud to sponsor a brand new section of the Social Science Research Network (SSRN). Part of SSRN's Financial Economics Network (FEN), Pension Risk Management publishes working and accepted paper abstracts covering a range of topics in the field. These include liability-driven investing, fiduciary assessment of hedge fund and private equity investments, organization and governance of defined benefit and defined contribution plans, selection of default investments such as target date funds, appropriateness of company stock for 401(k) plans, evaluation of money managers' fees, strategic asset allocation, fiduciary duty to hedge and use of derivatives.

Working with the SSRN team, co-editors Dr. Shantaram Hegde and Dr. Susan M. Mangiero encourage contributions in this exciting and critically important research area. At no other time has there arguably been such an urgent need to understand pension investment risk issues and competing solutions. 

Dr. Hegde is Professor of Finance at the University of Connecticut and author of many papers on derivatives, market microstructure and risk management. Click here to read his bio. Dr. Mangiero is author of Risk Management for Pensions, Endowments and Foundations. An Accredited Valuation Analyst and certified Financial Risk Manager, she is President and CEO of Pension Governance, LLC. Click here to read her bio.

Joining Dr. Hegde and Dr. Mangiero as part of the Pension Risk Management Abstracts Advisory Board is a team of experts in the areas of risk management, valuation and actuarial science:

Dr. Stephen Figlewski - Professor of Finance (New York University)

Allen Michel - Professor of Finance (Boston University)

Steven Siegel - Research Actuary (Society of Actuaries)

Gavin Watson - Business Manager for Asset Managers (RiskMetrics Group).

According to Dr. Mangiero,  "With many challenges facing pension fiduciaries, our goal is to help facilitate a conversation about pension finance, risk and valuation on behalf of investment stewards for millions of plan participants worldwide. The Pension Governance, LLC team is deeply grateful for the commitment of this top-notch team to promote good ideas in these areas. We look forward to making pension risk management the topic of choice for academic researchers and practitioners."

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On March 29, Reuters reported that  Judge David Herndon of the U.S. District Court for the Southern District of Illinois had given the green light for a 401(k) fee case to proceed. One of about a dozen lawsuits brought by St. Louis firm Schlicter, Bogard & Denton, plaintiffs allege that plan consultants were paid an "unreasonable" amount for record-keeping services rendered in 2004.

Coincidentally, on that same date, I listened to a lively discussion about fees, revenue-sharing and the state of 401(k) fee litigation. Moderated by Nell Hennessy, Fiduciary Counselors Inc. and sponsored by the American Bar Association, other speakers - Lynn Sarko (Keller Rohrbach LLP), Chris J. Rillo (Groom Law Group) and Kristen L. Zarenko (Office of Regulations and Interpretations, EBSA, US Department of Labor) - parried back and forth about procedural prudence, proper fee-related disclosure and new enforcement initiatives in the form of the Consultant/Advisor Program (CAP). Click here to read the program description. 

Always important, the topic of fee economics is arguably more so now since countless organizations are switching from traditional plans to defined contribution plans.

2007 looks to be an active year in terms of court-watching!

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

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

Process is everything!

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

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

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

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

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

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

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

Here are a few excerpts:

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

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

Select investment alternatives that are prudent and adequately diversified

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

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

More to come...

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

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

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

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

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

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

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

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

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

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

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

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That a relationship between investment performance and fees exists is hardly news. Fees matter. However, it's not quite as simple as it may seem. Fees vary by amount, timing and form. A two percent fee, charged upfront, hurts more than a two percent fee that is levied on the back end. A no-load fund that charges higher annual expenses might cost an investor more than a fund with an upfront charge but lower annual expenses. For mutual funds and exchange-traded funds, the U.S. Securities and Exchange Commission provides a handy calculator with the qualifier that "the results should be compared for several funds or different classes of a single fund".

Importantly, lower may not necessarily mean better. Consider performance fees such as those charged by numerous hedge funds. If an investor understands and willingly acknowledges likely risks, a performance fee may be an acceptable price to pay for participating in returns that exceed a pre-specified benchmark.

However, good decision-making cannot take place in the dark. As described below and in a GAO report about mutual fund disclosure, transparency is not always easy to come by.

1. Database vendors typically provide returns on a gross basis because that is how they are reported by participating money managers. Evaluating a large number of funds requires manual adjustments to facilitate an "apples to apples" basis. This is time consuming to say the least and sometimes difficult to do.

2. Fees vary by type of fund, strategy and timing. Care must be exercised to take into account relevant factors.

3. Fees change over time. Past fees may not be a bellwether of future fees.

4. Reported performance may not reflect all elements of a portfolio as would be the case with side pockets or similar mechanisms. Refer to Barry Schachter's hedge fund blog for comments about side pockets.

5. Mutual fund expenses may not be reflected in published performance reports, forcing one to review the Statement of Additional Information.

6. Institutions and retail clients do not bear the same costs so fee analysis must incorporate any differences.

According to BenefitNews.com, New York Attorney General Eliot Spitzer announced plans to "examine how 401(k) investments are allocated and whether fund managers are exacting higher fees than participants believe they are paying".

What this portends is anyone's guess. Investigations have the potential to shed light on the important topic of investment fees. Of course, institutional investors should be asking lots of tough questions before they commit dollar one to any particular manager. In fact, it's their duty to behave prudently and proper inquiries, during the RFP process and in-person interviews, are a perfect time to dig deep.

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Sir Francis Bacon said it all when he declared "knowledge is power". The more we know, the better equipped we are to make good decisions. This is why I am such a big advocate of better disclosure when it comes to all things financial (See the April 11, 2006 posting entitled "Practice What You Preach".)

So it was with great delight that I read Gretchen Morgenson's New York Times article this morning, in which she describes the opaque nature of fund manager compensation. Her point is a good one. The absence of information is made more acute by the fact that most of the large fund companies are private and therefore outside the reach of statutory requirements to tell all. Pulitzer Prize winner Morgenson references a recent letter from investment legend John C. Bogle. He writes about the urgent need to require mutual funds "to disclose the aggregate dollar amount of direct and indirect compensation paid to the five highest-paid executives of their manager and distributor".

Why is compensation disclosure important?

A lot of money is at stake. Managed funds are an integral part of the retirement planning process. According to the Investment Company Institute, retirement assets invested in mutual funds in 2004 approximated $3.07 trillion, with $1.6 trillion finding a home in defined contribution plans. Anything that impacts performance necessarily affects the financial security of employees and retirees. This includes fees which should reflect, among other things, the costs of operating a fund. How and why an individual manager is compensated speaks volumes about the expected return pattern of a particular fund. (Some of the other factors that determine returns include strategy, portfolio mix, risk management procedures, internal controls and market conditions.)

When actual returns deviate from forecasted returns (and initial asset selections have been made on the basis of expectations), an investor may find herself in the unhappy situation of not having enough money to satisfy an objective. Individual or institution, the end result is a funding gap in need of a solution.

John C. Bogle is not alone in asking questions about manager compensation. In May 2005, the U.S. Department of Labor and SEC published Selecting and Monitoring Pension Consultants - Tips for Plan Fiduciaries.

A broad and important topic, manager compensation and the relationship with pension consultants, is left for another day...

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