Pension Risk News & Analysis : Pension Governance, LLC : Pension Risk & Investment

 New York Times reporter Alina Tugend ("Pick a Planner Who Can Spell ‘Fiduciary’," April 26, 2008) writes about the importance of doing proper homework when it comes to selecting an investment advisor, stockbroker or financial planner (consultant). Her rule? Ask someone you are thinking of hiring - Are you willing to wear the hat of fiduciary? Since not everyone is required by law to embrace the fiduciary mantle, and some do so only in exchange for additional compensation, the question is far from trivial. She quotes Sheryl Garrett, author of Personal Finance Workbook for Dummies (John Wiley & Sons, 2007) as urging individuals to document agreed-upon terms, including those that relate to the discharging of fiduciary duties such as care and loyalty. Fees and conflicts of interest are other considerations. For example, a compensation structure that includes commissions may encourage the sale of unsuitable securities to small investors.

As more employees migrate (by choice or force) to defined contribution plans, investment literacy is critical. Interested readers may want to check out the following resources:

•  "Final Report on Financial Planner Standards of Conduct" by the FPA Fiduciary task Force, June 1, 2007
• Investor Protection Trust library
• "SEC to continue assault on fiduciary protection in 2008" by Diahann W. Lassus (Investment News, January 7, 2008)
• "Can you trust your financial advisor?" by Liz Pulliam Weston (MSN Money, date not given) - Cites 2005 complaint count against advisors with almost 4,000 taking the form of "breach of fiduciary duty" 

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Several recent experiences inspire this post. On the positive side, two weeks ago, I had the pleasure of spending time with my step niece, a darling little girl of 3. After just 15 minutes, I realized that her favorite way of getting attention is to scream "excuse me" as many times as it takes until nearby adults acknowledge her. Cute at first, it annoys after a few shouts but Lilly certainly gets her way.

On the other end of the experiential spectrum, my Sunday foray to Starbuck's introduced me to "Miss Manners Not." Though I was first at the counter and obviously not yet finished paying for a handful of gift certificates, a lady customer thrice reached over me and then pushed me aside to order a cup of joe. Not being shy, I murmured "sorry to be in the way." To my shock, she replied "it's okay." Yes, my first response was to tilt my cup in her direction ("oops") but give me credit for being an adult who quickly cooed sotto voce, "let it go." (You've met folks like this gal, right? Gotta love 'em for their arrogance and cluelessness.)

Here's the connection to all things pension.

Everyday brings new headlines about the retirement crisis. Just a few days ago, New York Times reporter Mary Walsh cites a new study that shows that 2007 investment gains for America's giant pension funds are fast being erased by early 2008 market tumult. Likely to add to the funding gap and compelling a need for cash infusions is a strategic move away from equity. More disturbing is that jumbo plans, in distress, could "swamp the federal insurance system," already reeling from certain airline and manufacturing company woes. Piling on is the Fed's lowering of interest rates which pushes up the size of defined benefit plan liabilities, exacerbating things. Given tighter funding rules, courtesy of the Pension Protection Act of 2006, plan sponsors have much less latitude in riding out the storm, if even possible. (See "Market Turmoil Has Taken a Toll on Big Pension Funds" by Mary Walsh, April 17, 2008. Also read "2007 Gains Reversed in First Quarter of 2008" by John W. Ehrhardt and Paul C. Morgan, "Milliman 2008 Pension Funding Study," April 2008.)

In January 2008, the U.S. Government and Accountability Office ("GAO") released an alarm bell in the form of its report entitled "State and Local Government Retiree Benefits." They concluded that "58 percent of 65 large pension plans" had funding ratios of about 80 percent in 2006, a decline since 2000. By extension, this means that 42 percent are in bad shape. (There is continuing controversy over whether 80 percent is deemed "safe" or instead suggests a need to worry.)

For individuals, new research cites the need for a long-term, relatively stable mix of stocks and bonds. In "Hitting or Missing the Retirement Target: Comparing Contribution and Asset Allocation Schemes of Simulated Portfolios," Professors Harold J. Schleef and Robert M. Eisinger argue that the likelihood of having enough money to retire comfortably is depressingly low. As New York Times contributor and money talking head, Mark Hulbert, points out, life-cycle or "target date" maturity funds may not perform "in line with their long-term averages." (Read "The Odds for a Retirement Nest Egg, Recalculated," New York Times, April 20, 2008.)

Of course, if Louis Lowenstein, author of The Investor's Dilemma: How Mutual Funds Are Betraying Your Trust and What to Do About It is right, fees and revenue-sharing arrangements will continue to erode retirement savings (meager for most), making it tougher to reach even a low savings goal. While employers shed their traditional benefit plans, they nevertheless have a vested stake in wanting their employees to be self-sufficient. Happy workers are typically productive workers who spin gold for shareholders and performance-compensated executives.

For the still clueless pension decision-makers, oblivious to the merits of effective asset-liability management (the equivalent of my coffee shop lady), hopefully the onslaught of economic and regulatory indicators will create a stir. If not, perhaps my young niece will take her "excuse me, excuse me, pay attention" show on the road.

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Despite colorful tales of medieval historians disputing its shape, most people then and now realize that the earth is not flat. We won't get to the end and fall off. Indeed, we're arguably more interconnected than ever before. So it's not surprising that a galaxy of international speakers convened in Sydney with many of the same problems, challenges and concerns as US peers. A recurring theme emerged for everyone in attendance at the Asset Allocation Summit 2008 - Investment management is all about risk. Identification, measurement and control are important,. regardless of plan design and country of origin. In fact, the similarities as to what keeps folks up at night are eerily striking, whether voiced by a plan sponsor from Europe, Asia, Australia or North America. Here are a few concerns that resonated with all in attendance.

1. How can investment fiduciaries minimize their liability exposure, especially when investment strategies are becoming more complex and diverse?

2. What is the responsibility to defined contribution plan participants, knowing that many will retire without ample means to maintain a particular lifestyle?

3. How can one avoid paying "excess fees" to managers?

4. What is the proper way to separate beta from alpha?

5. What is the role of infrastructure investing?

6. Should allocations to 130/30 strategies (and equivalents) come from equity or alternatives?

7. Will a recession be global in nature?

8. How much oversight is required by internal fiduciaries who delegate manager selection to consultants?

9. Is ESG (Environmental, Social, Corporate Governance) investing a plus or minus in terms of fiduciary duties?

10. How should derivatives be properly used and by whom (the plan, the money manager or both)?

Sound familiar? If so, perhaps we should be thinking about how to operate within a flat pension world. Credit Thomas Friedman for pointing out the oneness that pervades global thinking. In his best-selling "The World is Flat," he emphasizes the connections among seemingly disparate markets. Should we care about the governance of pension funds outside our borders? In a word, "yes." What is done elsewhere impacts an increasingly "flat" network of capital which in turn influences the investment opportunity set within our borders..

Isolationism is over for most everyone. What about you?

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Disappointing many, the Federal Reserve cut rates by a smaller amount than expected. Equity investors responded with a resounding hiss, sending the Dow Jones Industrial Average down nearly 300 points. Defined benefit plan managers can't be too happy either. After all, many of them have more money allocated to stocks than bonds. Then there is the matter of reported net unfunded liabilities rising as rates fall. What's an asset allocator to do?

This blog's author recently read survey results that suggest a significant migration to more complex securities. Not surprisingly, researchers describe a struggle on the part of investors and financial advisors who need higher returns but are not always comfortable that they understand the risks. (See "Financial Advisors to Embrace More Sophisticated Investment Products Over the Next Two Years, According to New Data from Cogent Research," Insurance Newscast, December 7, 2007.) 

I hate to say it folks but here goes. Why invest in something you don't understand? Isn't that part of the reason why the sub-prime debacle is starting to make the S&L crisis look like a walk in the park? Several incidents come to mind.

Following the 1987 market crash, equity put option writers sued their brokers, saying they did not understand the nearly unbounded downside, forcing some into bankruptcy. In the early 1980's, a handful of prominent institutional investors sued their bankers for putting them into complex, new fangled derivatives. One treasurer acknowledged the need to know more, exclaiming "Due to my inexperience, I placed a great deal of reliance on the advice of market professionals….. I wish I had more training in complex government securities."

Mark my words. The courts will be hearing a lot of cases that address who ultimately has responsibility for investment strategies gone awry. Pre-exemptively, pension funds must seek legal counsel to review their fiduciary duties. Nevertheless, as strategies become more complex, there will be sufficient numbers of investors who simply do not understand the risk and, absent good process, will lose money.

This gets back to a point made many times herein. Shouldn't pension decision makers (regardless of plan design) be required and/or encouraged to have a particular familiarity (experience, education) with investment and risk management?

The fact that no such certification requirement exists amazes and disturbs. 

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Check out the new online "ERISA Fiduciary Advisor." Designed to inform about who is a fiduciary and what duties they are obliged to carry out, the Advisor "was developed by the Employee Benefits Security Administration (EBSA) in its continuing effort to increase awareness and understanding about basic fiduciary responsibilities when operating a retirement plan."

Click here to learn more.

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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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In his pension blog, ERISA litigator Stephen Rosenberg recently wrote about the forthcoming legal battle between the San Diego County Employees Retirement Association ("SDCERA") and Amaranth Advisors, LLC. In response to an original complaint against the once mighty energy hedge fund, its high-power attorneys countered with a motion to dismiss. Claiming caveat emptor, defendants assert that the plan sponsor understood the risks and went ahead anyhow. Click here to read the original complaint and here to read the motion to dismiss.

How this case will be adjudicated is anyone's guess. Nevertheless, the outcome will be closely watched as it goes to the very heart of investment disputes by asking who bears responsibility.

In our kick-off of the Hedge Fund Toolbox^SM webinar series on June 14, 2007, we heard from former FBI agent Mr. Ken Springer (now president of Corporate Resolutions) and senior attorney and former regulator, Rick Slavin (now partner of law firm Cohen and Wolf P.C.). Both gentlemen vigorously urged pension investors to undertake a background investigation of key principals, check documents and never shy away from asking tough questions. Springer added that "material non-disclosure of critical events in one's career" represents a major concern, along with the need to do additional follow-up to explain discrepancies. Late payment of credit card bills or a faillure to pay child support suggest carelessness with other people's money.

In his overview of case precedent and enforcement actions, Slavin offered that sloppy, obtuse or incomplete paperwork is usually the beginning of trouble. He reiterated that the use of outside parties does not absolve plan sponsors of their fiduciary duties. Oversight obligations remain.

Springer told listeners that Bayou's problems, pre-meltdown, were evident had investors carefully reviewed available facts. "Blatant conflicts of interest, overstating of employees' accomplishments, suits by former employees, suits filed by investors and even suits filed by hedge fund managers" should have caught investors' attention before money changed hands. Slavin suggests that we're in for a bumpy ride. "There is every indication that more litigation and enforcement is on its way."

Rosenberg agrees. "We are currently watching the rise of a pension/401(k) investment plaintiffs bar, clearly modeled after the securities litigation class action bar, ready and waiting to sue pension advisors and anyone else in the line of fire for excessive fees, poor investment choices, and anything else that affects returns in the plans." He adds that, "If the hedge fund’s lawyers are right, then aren’t the plan’s fiduciaries and other advisors potentially liable for breaching their own obligations to the plan and its participants to properly select and monitor plan investments? And if so, then their best defense should the newly forming class action bar come after them for this mess would be that, contrary to what the hedge fund’s lawyers say, they actually did full and complete due diligence, and therefore lived up to their obligations and cannot themselves be liable for the fact that the investment went south."

Wise words to remind us of the importance of good process!

If you are interested in purchasing the recordings of any webinars that have already taken place, click here. (Webinars are listed in chronological order.) Click here to register for any or all of the forthcoming webinars in this exciting new series. Speakers will address the roles of financial advisor and consultant on June 26. Valuation is the topic of the June 28 event.

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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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In a May 16 interview with investment banker John Whitehead, Bloomberg journalist Christine Harper clearly pushed a button when she asked about Wall Street compensation. Said the former chairman of Goldman Sachs "I am appalled" and then described current levels as "shocking." Click here to read the interview.

On May 3, EFinancialCareers.com summarized an Alpha Magazine piece about the top twenty-five beneficiaries of the hedge fund boom, noting that disproportionate goodies that accrue to the fund's leaders encourage turnover. Hedge fund analysts have little incentive to remain beyond a few years, driving up costs and creating a drag on performance. Click here to read "Hedge Fund Compensation: Too Top-Heavy?"

From the pension fiduciary perspective, how does this news square in Peoria? Are investment committee members, trustees and/or board members on the hook for having selected money managers who are deemed to make "too much?"

Let me quickly add that what constitutes "too much" requires a systematic and thorough analysis of benefits netted against costs and that performance-linked pay is far from a bad thing under certain circumstances. For those fund professionals who are delivering "excess" returns (and that evaluation likewise requires care and diligence), current compensation may look like a bargain.

What's important is the process in determining how managers' compensation reconciles with projected risk-adjusted performance, at the outset when a selection is made and on an regular basis thereafter.

As a plan sponsor (regardless of plan type), how much attention do you give to this issue and how comfortable are you in explaining your decisions to plan beneficiaries?

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In his May 16 testimony to Congress, Mr. Douglas Lowenstein, head of the Private Equity Council, extolled the virtues of non-public investments. With over $110 billion invested in private equity by twenty large public pension funds, Lowenstein cites relatively higher historical returns that have helped plan sponsors pay the bills. Click here to read his testimony.

A few months earlier, a survey conducted by the State Street Bank describes escalating interest in hedge funds. At the same time, half of respondents expressed "a need for additional reporting and analysis on the part of hedge fund managers and more rigorous due diligence practices," adding that "they find it difficult to gain a portfolio-wide view of risk, and that aggregating risk statistics provided by all hedge funds in their portfolio was problematic. The same number also agreed that obtaining an accurate valuation of hedge fund holdings can be problematic." Click here to read the executive summary of the survey.

As with any investment, there is no "perfect" choice. Selection depends on a wide variety of factors.( A discussion about optimal asset allocation and security/fund selection is outside the scope of this blog post.) However, a few points are in order.

1. Risk management and valuation concerns are not created equal. They vary across type of asset and fund. Private equity funds tend to trade less frequently than hedge funds. Even within an asset class (assuming you agree that hedge funds constitute a separate asset class), the risk-return tradeoff varies by strategy, management and much more. For example, the use of derivatives by a market neutral hedge fund can differ dramatically from that of a macro oriented fund.

2. The use of a side pocket may reduce the need for frequent valuations. However, institutional investors need to understand if a side pocket is to be used, what will go inside the side pocket and the impact on reported performance as a result of its use.

3. Knowing that a manager employs derivatives is not enough. Understanding instrument and strategy choice is likewise important (though still not sufficient).

4. Valuation numbers provided by traders or anyone else who stands to benefit by reporting high numbers should be discarded and replaced with those provided by an independent party.

If you are interested in knowing about other red flags, email us in confidence.

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With all due respect to Gordon Gekko, replace the "d" (as in "Greed") with an "n" (as in "Green") and we end up with a way to both belately celebrate Earth Day and acknowlege an emerging trend in pension funds' allocation to Socially Responsible Investments (SRI).

Click here to access a nice primer from the UK. Checklists and case studies make it useful to anyone interested in knowing more about the topic. 

Stateside, Mercer Consulting's survey of U.S. pension funds about SRI suggests continued growth. Click here to access the survey.

By the way, it's not just Ayn Rand who rejects altruism. Institutional investors say that opportunities to reduce risk, enhance returns or better align economic interests with socially-oriented values are key drivers behind their decision to invest in SRI funds.

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Continuing to exhibit meteoric growth, the global derivatives market is now estimated at around $400 trillion. That's a lot of zeros - $400,000,000,000,000. In contrast, the CIA World Fact Book estimates 2006 Gross World Product at $65 trillion. Said another way, aggregate economic production for the entire world has an approximate dollar value of only 1/6th the estimated market size for futures, options, swaps and various combinations.

Is it any wonder then that regulators  are asking questions about who does what in the world of derivatives? One false move and the intricate web of financial institutions which dominate derivatives trading could fall apart. Increased volatility for the market as a whole or an exogenous shock to a particular sector potentially spells trouble.

In her April 4, 2007 article, Wall Street Journal reporter Eleanor Laise writes that "automated trading of derivatives and increased use by fast-growing hedge funds have helped make the market more accessible to mutual funds" and that "mutual funds aim to stand out in a crowded field." She further points out that identifying the use of derivatives by portfolio managers requires a hard look at the fund's prospectus. I'd emphatically add that reading what is available is seldom sufficient. To the contrary, a pension fiduciary needs to ask a myriad of questions of and about the mutual fund manager. Here are a few suggestions from a long list. (Email me if you want additional information.)

1. Who determines the type of permitted derivative instruments and strategies, and on what basis?

2. Does the fund or family of funds have a risk manager? If so, does he or she have the authority to make meaningful decisions about risk controls? Who does that person report to?

3. How are mutual fund traders compensated with respect to return, risk and risk-adjusted return?

4. Is there a risk management policy (and related procedures) that can be reviewed before investing? If considered proprietary, is it possible to meet with the portfolio manager and/or risk manager to discuss?

5. What types of risk metrics are employed by the mutual fund?

6. Who authorizes derivatives-related trading limits, and on what basis?

7. Are the fund's auditors comfortable with how the derivative instruments are marked-to-market?

8. Does the portfolio manager rely on an external system to analyze and monitor risk? If a proprietary system is used instead, is there an independent party who validates the models and integrity of the data feed?

9. How is liquidity measured? What is the portfolio manager's plan for liquidating various positions if necessary?

10. Does the portfolio manager have the latitude to switch gears with respect to derivatives-related trading and not have to fully disclose to investors? (In other words, is there a chance that the mutual fund's use of derivatives in a risk-return sense could differ materially from the stated scope?)

American author Mark Twain once said - “There are two times in a man's life when he should not speculate: when he can't afford it, and when he can.” While clever, the fact remains. Financial engineering and derivatives are here to stay. Any pension fiduciary not yet familiar with the D-word needs to remedy that situation right away.

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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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Before I realized the importance of being a fiduciary, work was fun. I have a fondness for the good old days when I had more financial freedom. That was before the failure of our high risk portfolio. What folly! Now the lawyers tell me our strategy is not a good fit, our process is feeble and breach may be a felony with personal liability not far behind. I wish I could flee! >>

Perhaps a bit too gimmicky, my goal was to get the audience to think about the ultimate F word - FIDUCIARY - and the related consequences associated with a job poorly done. My contention? We're all risk managers now.

Think about what's happened in the last few days. Volatility is up. Assets that typically move inversely with one another are moving in the same direction - down, more than a few investors are liquidating positions to meet margin calls, credit problems are rearing their ugly head in the form of sub-prime loan losses and there is overall nervousness about how risk is priced.

Is this the tipping point that compels pension fiduciaries to examine their risk management policies and procedures - and those of their appointed money managers - or do they instead shrug off bad times as short-term and likely to reverse? If not market turbulence, what will get fiduciaries to focus on risk-adjusted return in a more meaningful way?

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How do we need you? Let us count the ways.
We need you from the depth and breadth and height
Our portfolio statements will allow
We need you to the level of everyday's
Most urgent wants, for food and shelter

With apologies to Elizabeth Barrett Browning, it's true that pension fiduciaries often stand between a comfortable retirement and a financial struggle. Their job, if done properly, can make a real difference in the lives of individuals, still working or now retired.

This blog primarily addresses pension financial risk issues from a fiduciary perspective. Yet we've received more than a few emails from persons seeking assistance to recover lost or diminished pensions. Descriptions of tough economic times are poignant. They serve as a constant reminder that what pension fiduciaries decide has consequences.

Happy Valentine's Day!

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In speaking to a colleague about managerial excesses the other day, I relayed the story of something that took place years ago. I was in college and worked as a bank teller in the afternoons and opened new accounts on Saturdays. The woman assigned to provide on-the-job training (long retired I'm sure) chided me for tossing a paperclip. "I'm a shareholder of this bank and every penny counts. We just don't throw away paperclips."

At the time, she struck me as old-fashioned and picky. Of course, when you're twenty, I suppose everyone seems un-cool.

What continues to amaze me is that I recall that event as clearly as if it had just happened. Her comment was an epiphany of sorts. This woman was not an executive. She wasn't even a bank officer. She was a secretary (administrative assistant in today's parlance). She wasn't responsible for the budget. No one counted supplies. Certainly one abandoned clip couldn't mean much. Yet her words resonate still. With skin in the game, she had a compelling motivation to be thrifty and encourage others to follow suit.

The relevance to pension governance is striking. When fiduciaries do not have a vested interest in adhering to best practices, will they be tempted instead to follow the path of least resistance? What motivates an individual to be a good steward of other people's money? Is it an increasing awareness of personal and professional liability that moves people to act or a concern that doing the right thing counts most?

A few days ago, I asked several financial advisors why they thought so many lawsuits focus on 401(k) fees rather than defined benefit plan fees. One response speaks volumes. "It's the company's money with DB plans but when employees pay, there is less managerial concern." Cynical or a reflection of the existing risk-reward system? Fiduciary responsibilities apply to both DB and DC plans. Yet decision-makers tend to feel pain faster and more fully when DB plan assets underperform and their compensation is tied to share price, cash flow or budget variance.

Experts agree that pension governance is AWOL at more than a few companies and statehouses. Why is that? As I wrote in Executive Decision last year, incentives are everything. Reward people for good behavior and you get what you pay for. The converse is true as well.

For those already in the vanguard with respect to effective investment fiduciary practices, kudos and keep up the great work. For those doing the equivalent of the pension paperclip toss, a good New Year's resolution is to stop.

P.S. Click here if you'd like to read "Do Fiduciaries Need Better Incentives to Make the Retirement System Work?"

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

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

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

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

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

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

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

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

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

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

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

In case you missed my earlier two posts on the topic of information and economic value, click here and here. No investment is "good" or "bad" on its face. An investor must carry out a careful analysis of characteristics that are thought to contribute to the expected risk-return tradeoff. Moreover, an investor must consider its objectives and constraints.

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

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

4. Some fund managers can choose to provide limited information to potential investors, to the extent permitted by prevailing law. ERISA fiduciaries may be subsequently forced to look at other funds that provide whatever information is deemed necessary to discharge their duties. The Pension Protection Act of 2006 sheds arguably more light on what a fiduciary must do with respect to proper investment decision-making. However, it is not a standalone document and references opinions that will ultimately have to come from the U.S. Department of Labor and elsewhere.

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

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

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

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

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

1. Identifying Liability-Driven Objectives and Alternative Solutions

2. Derivative Instrument Strategies

3. Modeling and Valuation Issues

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

"Hedge Fund Valuation is a Big Deal for Pension Fiduciaries"

"Do You Really Know the Value of Your Portfolio?"

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

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

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

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

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

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