Foreign Corrupt Practices Act and Implications for Institutional Investors

For those who don't know, I am the lead contributor to an investment compliance blog known as Good Risk Governance Pays. I created this second blog as a way to showcase investment issues that had a wider reach than just the pension fund community. While I strive to publish different education-focused analyses on each blog, sometimes there are topics that I believe would be of interest to both sets of readers. A recent article that I co-wrote is one example. Entitled "Avoiding FCPA Liability by Tightening Internal Controls: Considerations for Institutional Investors and Corporate Counsel" (The Corporate Counselor, September 2014), Mr. H. David Kotz and Dr. Susan Mangiero explain the basics of the Foreign Corrupt Practice Act. Examples and links to reference materials are included, along with a discussion as to why this topic should be of critical importance to pension funds and other types of institutional investors. Click to download a text version of "Avoiding FCPA Liability by Tightening Internal Controls: Considerations for Institutional Investors and Corporate Counsel."

Brown M&Ms and Investment Service Provider Due Diligence

 

According to marketing guru Steve Jones, parties seeking to do business with one another can learn a lot from rock musician David Lee Roth. As explained in "No Brown M&M's: What Van Halen's Insane Contract Clause Teaches Entrepreneurs" (Entrepreneur Magazine, March 24, 2014), each of their agreements included a rider that was designed to force a promoter to pay attention to the band's true objective about ensuring safety. By adding what may have seemed like a silly provision about "melt in your mouth" candies being unwelcome, Van Halen was testing whether the promoter had read the contract in its entirety and was therefore more likely to install equipment properly. "If any brown M&M's were found backstage, the band could cancel the entire concert at the full expense of the promoter," leaving him or her with a possible loss in the millions of dollars.

In institutional investment land, there are intriguing parallels. For one thing, there is the safety issue. If a pension plan is poorly managed, beneficiaries may suffer. Second, if there is confusion or ambiguity about who is supposed to do what, when, how and at what price, there are likely to be disputes and economic consequences. There is a growing number of lawsuits and regulatory investigations that are scrutinizing service providers and/or the pension plan trustees who are tasked with diligently selecting them.

The developing market in outsourcing various services to a third party is yet another reason for paying close attention to the quality of engagement letters and vendor contracts. Earlier this year, the ERISA Advisory Council announced its plan to study "current contracting practices with respect to outsourced services, including provisions such as termination rights, indemnification, liability caps, service level agreements, etc. that might assist plan sponsors and other fiduciaries in negotiating service agreements."See "Outsourcing Employee Benefit Plan Services."

As someone who has done business intelligence research and trained investment fiduciaries and their advisors, I often hear the same frustration being expressed about a gap in expectations. Budget-strapped buyers want more for less. Consultants, asset managers and banks say they are searching for ways to satisfy their clients while still being able to earn a reasonable rate of return for their efforts. One solution is to streamline operations, to the extent possible, while acknowledging any fiduciary implications associated with prevailing law and governance standards. If cutting corners to preserve a profit margin ends up sacrificing requisite quality, trustees could be at risk of being investigated for anemic oversight of service providers. Vendors could be at risk for failing to deliver contractual services.

Based on my work for both defense and plaintiff counsel (depending on the matter and whether there is a counterclaim), a poorly worded agreement can be a potential trouble spot. Another hugely important issue is whether a service provider has self-identified as a fiduciary. An attorney or judge may categorize a particular service provider as a functional fiduciary even if a written contract is silent on that point. Trust counsel can play a critical role in assisting with negotiations before authorized persons sign on the dotted line.

ERISA attorneys David C. Kaleda and Theodore J. Sawicki address the issue of fiduciary status in a 2012 article for the National Society of Compliance Professionals. See "Should You Have a Formal ERISA Compliance Program?" In a recent discussion about the best practices for creating and adhering to service level agreements, ERISA attorney Howard Pianko expressed his strong view that there are numerous ways to ensure "plausibility" and still be able to hire affordable outside organizations to assist. He went on to describe the advantages of having a systematic mechanism in place such as the Six Sigma type model that his firm employs. Click to read about Seyfarth Lean. (Having earned a Green Belt in Six Sigma, I can attest firsthand to the upside of developing a process to control quality.) 

For those involved in the selection and oversight of service providers or the delivery of said services, ask yourself if you know as much about an existing or anticipated contract as you should.

Pension Usage of Swaps

I have been writing, training and consulting about the use of derivatives by pension plans for many years. There is no shortage of topics, especially in the aftermath of the Dodd-Frank Wall Street Reform and Consumer Protection ("Dodd-Frank") and the fact that pension investing and derivatives trading are significant elements of the capital markets. The OECD estimates the size of the private pension system in 2012 at $32.1 trillion. The Bank for International Settlements estimates the June 2013 global derivatives market size at $692.9 trillion.  

Given the importance of the topic of pension risk management and the evolving regulatory landscape, it was a pleasure to have a chance to recently speak with Patrick S. Menasco. A partner with Steptoe Johnson, Attorney Menasco assists plan investors, investment advisers and broker-dealers as they seek to navigate the laws relating to hedging, swaps clearing and much more. Here are a few of the take-away points from that discussion.

Question: Do the swaps provisions embedded in the Dodd-Frank legislation contradict the netting rules that are part of U.S. bankruptcy law?

Answer: No, the netting provisions of the Bankruptcy Code remain intact and should be taken into account in negotiating swap agreements. To the extent feasible, a performing counterparty wants to be able to net obligations in the event of a counterparty insolvency and default.

Question: Your firm obtained Advisory Opinion 2013-01A from the U.S. Department of Labor ("DOL") on February 7, 2013 regarding swaps clearing, plan assets and ERISA fiduciary duties. Explain the importance of identifying plan assets in the clearing context.

Answer: ERISA, including its prohibited transaction rules, governs "plan assets." Thus, it is critical to determine whether margin posted by a plan in connection with swaps clearing and the swap positions held in the plan's account are considered "plan assets" for ERISA purposes. Among other things, Advisory Opinion 2013-01A gives comfort that (1) margin posted by the investor to the clearing agent generally will not be considered a plan asset for ERISA purposes and (2) clearing agents will be able to unilaterally exercise agreed-upon close-out rights on the plan's default without being deemed a fiduciary to the plan, notwithstanding that the positions are plan assets.

Question: The headlines are replete with news articles about swap transactions with pension plans that could be potentially unwound in the event of bankruptcy. Detroit comes to mind. Should non-pension plan counterparties be worried about a possible unwinding in the event of pension plan counterparty distress?

Answer: Yes and no. The case in Detroit (which is currently on appeal) illustrates the risk that, notwithstanding state or local law to the contrary, federal bankruptcy judges may disregard the legal separation between municipal governments and the pension trusts they sponsor, treating those trusts as part of the estate. This may present certain credit and legal risks to the trusts' swap counterparties, although the Bankruptcy Code's swap netting provisions may mitigate some of those risks. I doubt that we will see anything similar to Detroit in the corporate pension plan arena because ERISA not only recognizes, as a matter of federal law, the separate legal existence of such plans, but also affirmatively prohibits the use of plan assets for the benefit of the sponsor. Separately, many broker-dealers negotiate rights to terminate existing swaps upon certain credit events, including the plan sponsor filing for bankruptcy or ceasing to make plan contributions.

Question: How does Dodd-Frank impact the transacting of swaps between an ERISA plan and non-pension plan counterparties such as banks, asset managers or insurance companies?

Answer: Dodd-Frank does a number of things. For one, it adds a layer of protection for ERISA and government plans (and others), through certain "External Business Conduct" standards. Generally, these standards seek to ensure the suitability of the swaps entered into by the investors. Invariably, swap dealers will comply by availing themselves of multiple safe harbors from "trading advisor" status, which triggers various obligations relating to ensuring suitability. Very generally, these safe harbors seek to ensure that the investor is represented by a qualified decision-maker that is independent of, and not reliant upon, the swap dealer. Under protocol documents developed by the International Swaps & Derivatives Association ("ISDA"), the safe harbors are largely ensured through representations and disclosures of the plan, decision-maker and swap dealer (as well as underlying policies and procedures).

Question: Dodd-Frank has a far reach. Would you comment on other relevant requirements?

Answer: Separately, Dodd-Frank imposes various execution and clearing requirements on certain swaps. These requirements raise a number of issues under the prohibited transaction rules of ERISA and Section 4975 of the Internal Revenue Code. Exemptions from those rules will be needed for (1) the swap itself (unless blind) (2) the execution and clearing services (3) the guarantee of the trade by the clearing agent and (4) close-out transactions in the event of a plan default. This last point presents perhaps the thorniest issue, particularly for ERISA plan investors that direct their own trade swaps and thus cannot avail themselves of the Qualified Professional Asset Manager ("QPAM"), In-House Asset Manager ("INHAM") or other "utility" or "investor-based" class exemptions. The DOL expressly blesses the use of the QPAM and INHAM exemptions in the aforementioned Advisory Opinion 2013-01A, under certain conditions. Senior U.S. Department of Labor staff members have informally confirmed that the DOL saw no need to discuss the other utility exemptions (including Prohibited Transaction Class Exemption ("PTCE") 90-1, 91-38 and 95-6) for close-out trades because they assumed they could apply, if their conditions were met.

Question: Is there a solution for those ERISA plans that direct their own swap trading?

Answer: It is unclear. There are only two exemptions, at least currently, that could even conceivably apply: ERISA Section 408(b)(2) and Section 408(b)(17), also known as the Service Provider Exemption. The first covers only services, such as clearing, and the DOL has given no indication that it views close-out trades as so ancillary to the clearing function as to be covered under the exemption. In contrast, the Service Provider Exemption covers all transactions other than services. But it also requires that a fiduciary makes a good faith determination that the subject transaction is for "adequate consideration." If the close-out trades are viewed as the subject transaction, who is the fiduciary making that determination? The DOL's Advisory Opinion 2013-01A says that it isn't the clearing agent. Thus, to make the Service Provider Exemption work, you have to tie the close-out trades back to the original decision by the plan fiduciary to engage the clearing agent and exchange rights and obligations, including close-out rights. That argument has not been well received by the DOL, at least so far.

Many thanks to Patrick S. Menasco, a partner with Steptoe & Johnson LLP, for taking time to share his insights with PensionRiskMatters.com readers. If you would like more information about pension risk management, click to email Dr. Susan Mangiero.

Alternatives and Retail Retirement Account Owners

The prospect of being part of millions of retail retirement plans has some financial advisors and hedge fund managers giddy with excitement. The 401(k) market alone is huge. According to the Investment Company Institute, as of Q3-2012, these defined contribution plans held an estimated $3.5 trillion in assets. In 2011, over fifty million U.S. workers were "active 401(k) participants." This compares favorably to an approximate $2.66 trillion hedge fund market size in 2013, up from $2.3 trillion one year earlier. Private equity, real estate and infrastructure comprise the rest of the alternatives investment sector according to a press release issued by Preqin, a financial research company. See "Alternative Assets Industry Hits $6tn in AUM for First Time" (January 21, 2014).

CNBC contributor Shelly K. Schwartz explains that alternative investment strategies are appearing in the form of 400 plus mutual funds and exchange-traded funds ("ETFs") that employ "complex trading strategies" such as managed futures, long/short trading in stocks and multiple currency exposures. Allocating to leveraged loans, start-up ventures and global real estate are other ways that these relatively new funds seem to be mimicking the approach taken by hedge funds and private equity funds that traditionally have catered to institutional investors and high net worth individuals. Notwithstanding regulatory differences relating to diversification, percentage of "illiquid" investments, redemption, daily pricing and how much debt can be used to lever a portfolio, statistics suggest a growing interest on the part of smaller investors to get in on the action. See "Seeking safe havens? Analysts, advisors point to liquid alternative funds" (November 24, 2013). Also check out "Goldman pushes hedge funds for your 401(k)" (Fortune, May 22, 2013) in which reporter Stephen Gandel describes new funds being offered by various financial institutions, some of which invest in mutual funds that mimic hedge fund investing strategies and others that invest in hedge funds directly.

Not everyone is an ardent fan. In "FINRA warns investors on alternative mutual funds," Reuters reporter Trevor Hunnicutt (June 11, 2013) describes regulators' concerns that "not all advisers and investors understand the risks involved," especially with respect to whether a retail-oriented fund is truly liquid. In its "Alternative Funds Are Not Your Typical Mutual Fund" publication, the Financial Industry Regulatory Authority ("FINRA") cautions investors to assess investment structure, strategy risk, investment objectives, operating expenses, the background of a particular fund manager and performance history.

Given the ongoing search for the next big thing, we are likely to see a lot more activity in the alternative investments marketplace - for both institutional and high net worth clients as well as for individuals with modest wealth levels. PensionRiskMatters.com will return to this topic in future posts. There is much to write about with respect to fiduciary implications, risk management and valuation.

In the meantime, I want to thank ERISA attorney David C. Olstein with Skadden, Arps, Slate, Meagher & Flom LLP & Affiliates for apprising me of a 2012 U.S. Department of Labor grant of individual exemption for Renaissance Technologies, LLC ("Renaissance").  Described as a "private hedge fund investment company based in New York with over $15 billion under management" by HedgeCo.net (September 26, 2013), Renaissance holds a large number of equity positions in stocks issued by household name companies. Click to see a recent list of their transactions. The "Grant of Individual Exemption Involving Renaissance Technologies, LLC," published in the Federal Register on April 20, 2012 makes for interesting reading for several reasons. First, it describes policies relating to important topics such as valuation, redemption and disclosures for "privately offered collective investment vehicles managed by Renaissance, comprised almost exclusively of proprietary funds" and the impact on retirement accounts in the name of Renaissance employees, some of its owners and spouses of both employees and owners. Second, as far as I know, there are not a lot of publicly available documents about proprietary investment products that find their way into the retirement portfolios of asset management firm employees and shareholders. Third, as earlier described, there is evidence of a growing interest on the part of the financial community in bringing hedge funds or hedge fund "look alike" products to the retirement "masses."

Institutional Asset Allocation

My comments about institutional asset allocation, along with those made by Mr. Ron Ryan (CEO, Ryan ALM) and Lynn Connolly (Principal, Harbor Peak, LLC), were well received on January 8, 2014. Part of a joint program that was sponsored by the Quantitative Work Alliance for Applied Finance, Education and Wisdom ("QWAFAFEW") and the Professional Risk Managers' International Association ("PRMIA"), our audience of investment professionals added to the lively debate about topics such as strategic versus tactical asset allocation, fees, role of the pension consultant and the likely capital market impact due to the implementation of strategies such as liability-driven investing ("LDI") and/or pension risk transfers ("PRT"). 

With the size of the U.S. retirement market at $20 trillion and counting, big money is at stake. Bad asset allocation decisions can lead to a cascade of economic woes. It is no surprise that fiduciary breach allegations in the form of ERISA lawsuits are increasingly focused on questions about the appropriateness of a given asset allocation mix and whether an investment consultant or financial advisor has helped or hindered the way that pension monies are allocated. Noteworthy is that scrutiny about the efficacy of the asset allocation process and resulting money mix can, and has been, applied to both defined benefit and defined contribution plans. Keep in mind that asset allocation decisions are likewise central to assessing popular financially engineered products such as target date funds. Accounting issues and how changing rules influence asset allocation decisions are yet another topic that we will tackle in coming months.

Click to access Susan Mangiero's asset allocation slides, distributed to members of the January 8 audience, and meant to peturb a discussion about this always essential topic. Interested readers can check out "Frequently Asked Questions About Target Date or Lifecycle Funds" (Investment Company Institute) and "Annual Survey of Large Pension Funds and Public Pension Reserve Funds: Report on pension funds' long-term investments" (OECD, October 2013).

If you have a specific question about asset allocation and/or the procedural process associated with asset-liability management, send an email to me.

ERISA Assets: QPAM and INHAM Audit Legal Requirements and Best Practices

I am happy to announce that I will be joined by esteemed colleagues Howard Pianko, Esquire (Seyfarth Shaw) and Virginia Bartlett (Bartlett O'Neill Consulting) on September 10, 2013 from 1:00 to 2:30 pm EST to talk about QPAM and INHAM compliance audits. See below for more information. Click to register for this forthcoming educational event about ERISA requirements. (Note: I am given a few complimentary guest passes. Contact me if you are interested and they are still available.)

This CLE webinar will prepare counsel to advise asset manager clients regarding Qualified Professional Asset Manager (QPAM) and in-house asset manager (INHAM) audits as required by the Department of Labor. The panel will review the new exemption rules, who can conduct an audit, what the process entails, and how to showcase good practices with existing and prospective plan sponsors.

Continue Reading...

Pension Risk Governance Blog Celebrates Seventh Birthday

I am delighted to announce our seventh year as an educational resource for the $30+ trillion global retirement plan industry. With over a million visitors to www.pensionriskmatters.com, I appreciate the ongoing feedback and encouragement from financial and legal readers. This blog began as a labor of love and continues to be personally rewarding as a way to help guide the discussions about pension risk, governance and fiduciary duties.

Here is a link to the March 25, 2013 Business Wire press release about www.pensionriskmatters.com, an educational pension risk governance blog for ERISA, public and non-U.S. pension plan trustees and their advisors.

As always, your input is important. Click to send an email with your comments and suggestions.

Thank you!

House of Cards, Netflix and the Bottom Line

I spent hours this weekend glued to my computer screen. Curious to know if "House of Cards" would entertain as promised, I watched the first few episodes as a skeptic, only to be rewarded with solid acting, clever writing and a story line that kept on giving. This political thriller boasts a bevy of Hollywood talent, with Kevin Spacey at the helm. After losing a bid to be the next Secretary of State for a new president, this ethically challenged Congressman plots revenge and an alternative path to power. If you liked "The West Wing" and won't get discouraged by the seemingly realistic portrayal of what happens behind closed doors in Washington, you will enjoy the thirteen episodes of Season 1 and anxiously await the next baker's dozen.

Here's the rub. You need to be an existing Netflix subscriber or sign up tout-suite. In a move that has Hollywood paying close attention, this self-described "leading Internet television network" laid out $100 million to a star cast of writers and actors to recreate a Yankee version of this popular UK theatrical offering.

Why would a company do this? Some assert that original content is where the money is. According to several recent studies, "Streaming videos online are becoming more popular as technology evolves and more content is created for the Internet." See "NPD study: More people watch Internet videos on TVs than computers." CBS News, September 26, 2012. If you hate the countless ads that now consume the first twenty minutes of any in-person showing, you will be glad to have an alternative to movie-watching.

For institutional investors, this push to garner new subscribers and hopefully add to the bottom line is noteworthy. According to the NASDAQ website, 86.85% of the $8+ billion capitalization for Netflix, Inc. (ticker is NFLX) is in the hands of institutional owners. Some of them may not be appeased, certainly those who have sued the company over financial statement disclosures. In April 2012, Judge Samuel Conti appointed the Arkansas Teacher Retirement System and State-Boston Retirement System as lead plaintiffs in this putative class action. Click to read the "Netflix Inc. Securities Litigation" court order.

Registered Investment Advisor (RIA) Fiduciary Liability Risk

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

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

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

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

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

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

Water With No Ice

My jaunts to a local coffee house have given me food for thought about how people listen and respond to ordinary requests. Let me explain.

A regular treat for me is a double expresso and a glass of water with no ice. Since I had adult braces removed a few years ago, it's tough to down frosty cold drinks so "straight from the freezer" is a no-no. Interestingly however, about ninety percent of the time, the person behind the counter hands me a tall H20 with (drumroll please) lots of ice. At first I thought it was carelessness on the part of one or two individuals but I started to notice that nearly everywhere I went, regardless of the type of dining venue, my pleas for room temperature liquid refreshment went unnoticed, unheeded or both. In the United States, drinking a cold beverage with lots of ice is standard fare. Maybe, as a result, servers are simply habituated to provide what they think most people want.

Does this tendency to hear what we want to hear and respond accordingly prevail elsewhere? If so, and applied to institutional investors, how does meaningful change come about? How do old habits make way for new and improved practices? My having to wait for the cubes to melt is a trivial event. When billions of dollars are at stake and people don't listen to reality or acknowledge what is needed, the consequences are material and potentially life-altering for plan participants who struggle financially because of bad fiduciary decisions.

I've noticed that discussions with some investors and asset managers since the recent market fallout bear bitter fruit. When asked if they are doing a great job addressing risk management, the answer is invariably "yes" but the reality is often quite different. Headlines aplenty in the last few years suggest that at least some decision-makers embrace the familiar (hear what they want to hear) by interpreting "risk" in the narrow context of standard deviation and correlations. Their take is that they are doing a top-notch job yet, in reality, have barely scratched the surface of what has to be done.

Investment professionals with fiduciary duties, functional or de facto, should understand that a new paradigm is upon us. As I wrote on January 1, 2009 in "History Repeating Itself or a New Start in 2009?" a "holistic risk management process must go well beyond benchmarking against point-in-time numbers alone." As I wrote in 2006, pension risks are both qualitative and quantitative in nature. Advisors, attorneys, asset managers and consultants can play a vital role in either perpetuating the myth that numbers tell the full story or bring fresh insights to the table with respect to a full and more complete assessment of where attention should be paid.

Imagine dressing up for a full course dinner and then being served a single stalk of celery. It's the same thing when a pension, endowment or foundation investment committee asks for help and then gets handed a bunch of performance reports that leave operational and business risks in the corner, unattended.

As we head into a new year, let's applaud the right-thinking investors who put risk management front and center.

Are Pension Performance Numbers Upside Down?

In a recent interview with Pittsburgh Tribune-Review journalist Debra Erdley, I pointed out the folly of relying solely on point in time actuarial numbers. As I state (below), no single metric is a substitute for a robust risk management process.

Susan Mangiero, CEO of Investment Governance, Inc., a group that advises pensions on best practices and risk management, said pension reports can be misleading - even when numbers are quoted accurately. "A one-point-in-time number is not very helpful. It says nothing about the riskiness of the investment portfolio. It says nothing about whether there is good due diligence in place - the vetting of the consultants, asset managers and investment managers. and it says little about the plan's ability to write checks every month," she said, adding that a pension plan with a high funding ratio could be heavily loaded with assets that are hard to convert to cash."

Others in the article (entitled "Onorato's boast about pension fund solvency raises eyebrows" - April 6, 2010) impugn politicians for their knowledge (or lack thereof) of arcane actuarial methodologies. Ouch!

I'm reminded of my finance teaching days when students were asked to rank capital projects by Net Present Value, Internal Rate of Return, Payback Period and so on. Consider Investment A with a calculated IRR of 50% and a NPV of $1,000 versus Investment B with expectations of 25% per annum and a dollar reward of $500,000. I'd rather have the cash than the cold comfort of a number that doesn't mean much.

Cash is king which is why an ongoing holistic risk management process is EVERYTHING!

Glass-Steagall Redux: A Gift to M&A Bankers?

 

There are few things in business that are outright bad for everyone. Usually someone, somewhere is a winner when the rules change. In the case of proposed new bank regulations, merger and acquisition ("M&A") deal makers may be about to enjoy a bonanza.

On January 21, 2010, the White House issued a press release entitled "President Obama Calls for New Restrictions on Size and Scope of Financial Institutions to Rein in Excesses and Protect Taxpayers" in which the 44th U.S. President proposes to limit banks from owning a hedge fund or a private equity fund or "proprietary trading operations unrelated to serving customers for its own profit." Additionally, unfettered deposit-taking growth would be strictly curtailed in order to avoid another federal bailout on the basis of "too big to fail." 

Another day, another mandate, another perverse outcome. 

  • Risk transfer requires a willing party to accept the uncertainty that is anathema to someone else. Companies cannot hedge unwanted price risk if there is no one on the other side of the equation. Restrictions on proprietary trading, otherwise referred to as Volcker's Rule, could arguably (and significantly) depress liquidity in numerous financial markets around the rule.
  • Lumping all hedge funds into one category is a mistake. Some hedge fund portfolios are highly liquid, with net asset values being reported to investors every day. Forcing a "one size fits all" solution to a financial market sector that varies in terms of strategy, scope and risk factors is a recipe for disaster.
  • Private equity funds tend to adopt a longer view than a trading operation. Is the suggested federal grab for power meant to discourage this source of  capital at the same time that bank credit is limited at best and cost-prohibitive at worst?
  • Why would Fannie Mae and Freddie Mac be exempt, especially given their stated track record in the area of risk-taking?

Not everyone is a sad sack. Think about all the equity carve outs and spin-offs that will result if banks are forced to shed their prop trading portfolios. This type of forced corporate restructuring will be a huge boon for investment banks, law firms and accountants who earn considerable fees for fairness opinions, buy-sell matchmaking and papering the deals.

Don't get me wrong. Excess in the trading room is bad news for everyone. Instead of binding limits introduced by regulators, why not encourage banks to increase capital reserves, evidence better risk management policies and procedures and let the market punish those organizations that get it wrong?

Perhaps not so coincidental, sales of Atlas Shrugged by Ayn Rand are skyrocketing. In its January 21, 2010 press release, the Ayn Rand Institute cites that more than seven million copies of this 1957 novel have been sold. The premise of this international best-selling book is that captains of industry who create wealth walk away from those who take, leaving the city of Gotham in the dark, unable to survive.

Will Wall Street Layoffs Hurt Service for Pension Clients?

According to "Pink slips on Wall Street" by TheDeal.com staff (February 23, 2009), there are going to be a lot of empty chairs in service provider land. The number of individuals being laid off, redirected or otherwise allocated to different duties is staggering. This begs some important questions.

  • Will those individuals who remain employed by banks, law firms, consultancies and so on be able to handle the work that erstwhile colleagues heretofore addressed?
  • Will the sell side feel even more pressure to close deals and will that in turn create heightened discomfort on the part of pension buyers?
  • Will the stress of imminent layoffs demoralize some professionals enough to discourage them from doing the best job possible (if they think they will be out of a job soon or unlikely to be rewarded for going the extra mile for clients)?
  • Will shrinking staffs (plan sponsors and service providers alike) cause people to take shortcuts? After all, we only get twenty-four of them every day. Time is a binding constraint, especially when "to do" lists are growing exponentially. New accounting rules and regulations only add to everyone's work.
  • If short cuts occur, isn't fiduciary liability exposure for everyone involved likely to rise because there is an increased probability that some risks will be ignored or improperly managed?
  • Could a nasty spiral ensue wherein untended risks create undue exposures, possibly leading to litigation and/or regulatory enforcement which in turn consumes time, money and energy, thereby reducing available hours to carry out prudent policies and procedures?

Things are really tough right now. However, the reality remains. Never a good idea to shirk from investment best practices, new challenges arguably demand even more of a commitment to problem-solving. How many people do you know who go home at 5 pm any more? Work is becoming a 24/7 commitment, especially as supporting resources become scarce.

Full Moon Influence - Will Financial Normalcy Return?

In case you were out and about today, there was a fantastic full moon that caught my eye and gave me pause. Okay, it didn't look quite like this lovely photograph, courtesy of The National Aeronautics and Space Administration ("NASA"), but it sure looked magnficent to this astronomy layman's eye. The superstitious say that a full moon encourages crazy behavior. Listening to the ongoing debates about the jumbo U.S. stimulus program of late makes me wonder if Washington isn't moonstruck. Talk about a runaway train. Yet free-spending Congressmen and women are not the only "luneatics." A Connecticut colleague says that people are doing illogical things now that he has never seen is his 40-year career as a corporate contracts attorney. According to "Some See a Rat in the Year of the Ox for Investors Seeking Advice," reporter Jonathan Cheng writes that wealthy clients are turning to feng shui as a way back to prosperity (Wall Street Journal, February 9, 2009). Well, best of luck to them. Maybe it couldn't hurt.

Editor's Note:

New Study Says Plan Sponsors Must Improve Fiduciary Practices

As I stated during my September 11, 2008 "hard-to-value asset" testimony before the ERISA Advisory Council, there are some stellar examples of pension risk management and there is everyone else. Given the dearth of publicly available information about pension financial best practices, one can only guess at the size of each of the two buckets, “great” and “not so great” except for occasional studies that offer empirical validation. In October 2008, Pension Governance, LLC (now Pension Governance, Inc.) released a unique study about the use of derivatives by plan sponsors. Sponsored by the Society of Actuaries, “Pension Risk Management: Derivatives, Fiduciary Duty and Process” found that the “everyone else” bucket is rather large, hinting at future problems if poor process is left unchecked. (Click to read my hard-to-value asset testimony. Click to download "Pension Risk Management: Derivatives, Fiduciary Duty and Process.")

 

Now, a new report offers additional and troublesome evidence that the “everyone else” bucket remains large. Hot off the press, the MetLife U.S. Pension Risk Behavior IndexSM (“PRBI”) considers investment, liability and business risk management among the largest U.S. defined benefit pension plan sponsors. (Pension Governance, Incorporated is proud to have assisted with what we think is path-breaking research.)

 

Designed to measure both the aptitude and attitude of employee benefit decision-makers, the research creates a base case gauge as to the current state of pension risk management. Not surprisingly, respondents ranked the following risk factors as “Most Important,” in part it is believed because they are the simplest to model and measure:

 

  • Asset Allocation
  • Meeting Return Goals
  • Underfunding of Liabilities
  • Asset and Liability Mismatch

Given radically changing demographic patterns and the related, oft material economic impact on plan sponsors, it is surprising that the following risk factors were identified as relatively unimportant (and in some cases ignored altogether):

 

  • Early Retirement Risk
  • Mortality Risk
  • Longevity Risk
  • Quality of Participant Data.

Also disturbing is what appears to be a disconnect between the importance attached to prudent process by plan sponsors and the regulatory and legal reality that PRUDENT PROCESS IS IMPORTANT. Not only can plan participants suffer untold harm in the absence of a good process or the presence of a bad process, fiduciaries are professionally and personally on the hook. (As this blog has urged many times before, questions about prudent process and fiduciary duty are best answered by plan counsel.)  

 

According to the MetLife press release, dated January 26, 3009, “While respondents ascribe a particularly high rating to the quality of their Plan Governance, they do not seem to carefully consider the effectiveness of their decision making methods or how to improve the way they make decisions. This suggests that many respondents don’t perceive decision making process as an integral element of plan governance, when recent ERISA litigation would suggest just the opposite. In addition, plan sponsors report that they routinely review liability valuations and understand the drivers that contribute to their plan's liabilities. However, at the same time, they indicate that they do not actively implement or regularly review procedures to manage either mortality, longevity or early retirement risk, which are major determinants of both the timing and level of future liabilities. These inconsistencies may indicate that plan sponsors tend not to systematically consider the interrelationships among risk items and plan their implementation of risk management measures to maximize effectiveness across all items. Over time, a lack of holistic risk management may have serious repercussions, including unnecessary volatility in earnings and/or cash flow or potential plan failure. “

 

Unlike other studies, this research sought to quantify attitudes and aptitudes, in essence creating a unique score card against which subsequent results can be compared. The news is not great. On a scale of 0 to 100%, the PRBI level is 76. Roughly translated, defined benefit managers earn an average grade of C with respect to how they manage defined benefit plan risk.

 

These results beg a hugely important question. Is “mediocre” performance acceptable or does the MetLife study sound a warning that someone needs to stay after school for extra help? This blogger thinks it is the latter and welcomes your suggestions about how to fix a wobbly system. (Email PG-Info@pensiongovernance.com with comments.)

 

As I’ve said many times, reward good process and make life difficult for those who do sub-par work. With trillions of dollars at stake, how can we accept anything less?

 

Editor's Note: Click to read the MetLife press release, dated January 26, 2009, about this new study. Click to download "MetLife U.S. Pension Risk Behavior IndexSM: Study of Risk Management Attitudes and Aptitude Among Defined Benefit Pension Plan Sponsors."

History Repeating Itself or a New Start in 2009?

Philosopher George Santayana once said that "Those who cannot remember the past are condemned to repeat it." If Nikolai Kondratiev were still alive, he might agree. An advocate of  long duration boom-bust periods, this Russian economist is credited for giving life to what is oft-described as a Kondratieff wave. His study of  American, English and French prices and interest rates from the 18th century led him to believe that an economic cycle is likely to repeat every 60 years, occuring as four distinct phases (inflationary growth, recessionary stagflation, mild growth and then depression). Click here and here for an interesting overview of Kondratieff's theories, applied to modern times.

As we launch into a new year, full of hope for a respite from what can only be described as a roller-coaster horrible, one wonders what lessons will be learned and acted upon. The Pension Governance team, not surprisingly, votes for a renewed (or for some organizations, a de novo) emphasis on enterprise risk management wherein plan sponsors hunker down to identify and properly measure the alphabet soup of nasties that can roil either a defined contribution or defined benefit plan. As I wrote several years ago, "Risk comes in many forms and ignoring it, while emphasizing returns, makes little sense." Click to read "Pension Risk Management: Necessary and Desirable" (Journal of Compensation Benefits, March/April 2006),

Importantly, a holistic risk management process must go well beyond benchmarking against point-in-time numbers alone. A June 9, 2008 article proves this point with respect to traditional pension plans. In "Surplus hits $111 billion," Pensions & Investments writer Rob Kozlowski chronicles a two-year rise in excess funding for the top 100 U.S. corporate schemes. Just six months later, Barrons reporter Dimitra Defotis cites a Credit Suisse report that has S&P 500 companies facing a "pension deficit of at least $200 billion," the "largest shortfall since 2002, when pension liabilities exceeded assets by a record-setting $218 billion in the aftermath of the dot-com bust." See "The Math Doesn't Add Up" (December 8, 2008). Owners of defined contribution plans are taking it on the chin as well. As USA Today reporter Christine Dugas lays out, more companies are dropping the 401(k) match at the same that plan participants have been hit with large negative returns. See "401(k) losses: Older investors' retirement funds hit hard" (October 31, 2008).

Questions abound, though not directed to any particular plan or organization. What could have been done differently to minimize the ill-effects of a systemic meltdown? What was the role of intermediaries in terms of advice-giving? Was there proper diversification? Was too much latitude given to asset managers? Was scant attention paid to risks relating to internal controls, valuation and restrictions on being able to liquidate particular holdings? Were investments in some cases not truly suitable for beneficiaries?

If New Year's Day marks an opportunity for a fresh look at life, why not make 2009 the year of the comprehensive pension risk manager?

Troubled Pensions - CNN Money Interview

Click here to view "Troubled Pensions," an interview I gave to CNN Money anchor Poppy Harlow on November 24, 2008. (The piece aired on November 26, 2008.) The roughly five minute discussion centered on four questions, including:

  • Is Congressional reform of the Pension Protection Act of 2006 needed or should plan sponsors be forced to top off underfunded plans?
  • Will the Pension Benefit Guaranty Corporation be able to handle traditional plans of ailing auto manufacturers?
  • Will plan sponsors be tempted to assume more investment risk in order to make up for current losses?
  • Is pension litigation on the rise?

LIBOR Manipulation - Comments from the Author

Given its global prevalence as a performance benchmark, the ongoing scrutiny about the economic accuracy of the London Interbank Offered Rate ("LIBOR"), is not surprising. In the text that follows, one of the authors of a recent paper about LIBOR rate-setting adds a few comments.

"Thank you, Susan, for your October 15, 2008 coverage of our "Libor Manipulation?" research manuscript. As always, you succeeded in 'cutting to the heart' of a rather complex topic in your customarily succinct, yet engaging style. When your readers download and peruse our work, I would encourage them to focus on the manner in which we extend and elaborate on the analysis done by the Wall Street Journal. For instance, we were able to detect two specific dates in time that reflect structural 'breaks' in data patterns. One occurred shortly after (and doubtlessly occurred in response to) the publication of the Journal's announcement of its investigation. However, the other event occurred over eight months before the appearance of this announcement, and appeared to coincide with the publication of three relevant external news events that affected the industry. Your readers will find more information in our manuscript. We welcome readers' comments."

Submitted by Professor Michael Kraten, PhD, CPA, Sawyer Business School, Suffolk University

Laboring Over LIBOR

Long accepted as a key rate benchmark, the London Interbank Offer Rate ("LIBOR") may be replaced by something else if a current deal is a trendsetter. According to Bloomberg reporter Cecile Gutscher, Electricite de France SA will repay interest on an 11 billion pound sterling loan - used to finance the acquisition of British Energy Group Plc - by first computing "an average of funding rates supplied by BNP Paribas SA, Deutsche Bank AG, Royal Bank of Scotland Group Pld, Banco Santander SA and Societe Generale SA." (See "EDF to Use Alternative to Libor on 11 Billion-Pound Buyout Loan," October 14, 2008)

This rate at which banks lend to each other in the global capital markets has had its ups and downs lately. Volatility, due in large part to the credit crisis and the resulting financial services industry fallout, has taken its toll. Borrowers, hedge fund investors and fixed-LIBOR interest rate swap counterparties represent just a few of the many organizations that are impacted by gyrating LIBOR rates.

According to a new research study, directional moves may not be the only concern about LIBOR. Authors Rosa Abrantes-Metz, Michael Kraten, Albert Metz and Gim Seow examine LIBOR rates relative to other short-term borrowing costs, along with an assessment of the "individual bank quotes that were submitted to the British Bankers Association." Seeking to dispel or validate the notion that LIBOR levels are artificially low (alleging that quoting banks do not want to be seen as needing money and therefore cite low rates), the authors conclude that manipulation is unlikely, noting some irregularities in the data. For more information, click to read "Abrantes-Metz, Rosa M., Kraten, Michael, Metz, Albert D. and Seow, "Gim, "LIBOR Manipulation?" (August 4, 2008).

This pension blog includes several posts about LIBOR and its varied applications: (a) derivative instrument trades such as swaps-linked LDI strategies (b) asset management performance analyses and (c) borrowing arrangements. See "Are Pension Investments Too Complicated?" (September 5, 2008) or "Lowballing LIBOR May Cost Pensions Plenty" (April 18, 2008).

New Study Addresses Pension Risk Management Gaps

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

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

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

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

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

Key findings include the following points:

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

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

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

SEC Short Selling Rules - Fallout for 130/30 and Hedge Funds?

Trading today may be wild as Wall Street back office staff and short sellers scramble to comply with new rules, imposed via emergency order by the U.S. Securities and Exchange Commission ("SEC"). By way of background, on July 15, 2008, the SEC issued "Securities Exchange Act of 1934, Release No. 58166/July 15, 2008," prohibiting naked short sales for 19 identified financial company stocks. (The company names and ticker symbols are shown below.)

The official stated goal is to avoid panic selling as a result of outright short trading and discourage false rumors. (A naked short contrasts with the situation whereby an individual borrows shares and then sells them at the prevailing market price. The short can be closed at a profit when the trader buys shares back at a lower price, assuming that prices do eventually fall).

Only a few days later, the SEC issued "Securities Exchange Act of 1934, Release No. 58190/July 18, 2008," amending its earlier emergency order and exempting certain parties such as "registered market makers, block positioners, or other market makers obligated to quote in the over-the-counter market, that are selling short as part of bona fide market making and hedging activities related directly to" the identified securities and related derivative instruments and exchange traded funds. The order is set to terminate at 11:59 p.m. EDT on July 29, 2008 "unless further extended by the Commission."

According to "SEC Short-Sale Rule Gets Negative Reviews," Wall Street Journal reporter Kara Scannell (July 19-20, 2008) reports that certain companies did not make the list but have nevertheless seen their stocks come under recent "selling pressure." Some firms complain that SEC list inclusion will add to jitters and thereby exacerbate woes for existing shareholders, big and small.

Important questions remain unanswered, notably the impact on non-exempted parties and their institutional investors. Take 130/30 managers. By their very nature, they short stocks they deem "over-valued." How will this SEC mandate impact quarterly 130/30 fund performance and beyond, especially if trading costs mount as a result of compliance? What about those pension plans that have allocated monies to 130/30 managers who are adversely impacted by the SEC order? Could their funding status be in jeopardy? The same concerns extend to hedge fund managers whose specified strategy requires short-selling in any or all of the SEC "specified" stocks. Additionally, will the regulatory effect be materially different if shorted shares already represent a large percentage of outstanding common equity?

Will the SEC emergency order solve one problem but create others?

Financial Services Firm Name (Ticker Symbols) Covered by the Order and Amendment:

  • BNP Paribas Securities Corp. (BNPQF or BNPQY)
  • Bank of America Corporation (BAC)
  • Barclays PLC (BCS)
  • Citigroup Inc. (C)
  • Credit Suisse Group (CS)
  • Daiwa Securities Group Inc. (DSECY)
  • Deutsche Bank Group AG (DB)
  • Allianz SE (AZ)
  • Goldman, Sachs Group Inc (GS)
  • Royal Bank ADS (RBS)
  • HSBC Holdings PLC ADS (HBC and HSI)
  • J. P. Morgan Chase & Co. (JPM)
  • Lehman Brothers Holdings Inc. (LEH)
  • Merrill Lynch & Co., Inc. (MER)
  • Mizuho Financial Group, Inc. (MFG)
  • Morgan Stanley (MS)
  • UBS AG (UBS)
  • Freddie Mac (FRE)
  • Fannie Mae (FNM)

Comments from Readers About Financial Tumult

In response to our July 19, 2008 post ("Doris Day, Scarlett O'Hara and Financial Market Tumult"), a reader with thefinance_section adds "Freedom certainly isn't free. I think you are only truly free once you can live off your passive income, i.e. income from investments."

In response to general market volatility, the chief actuary of a major retirement services firm writes the following:

"The market will continue to find instruments to dampen the losses from the large bubble of speculative loans created over the past three years. Government will also act to smooth the market. Congress & the Executive Branch cannot allow the full chaos that comes from destroying the equity of so many lenders by forcing them to write off the bad loans quickly. This is similar in scope to the issues of the S&L crisis of a prior generation, and the market should be watching closely to see how the industry and govt will follow the old pattern or try another approach.

In some respects, this crisis follows the prior bubble problem with tech stocks. A large number of people who get paid for activity (commissioned stockbrokers) were guilty of pushing "POS" investments in the late 90's. A large number of people (mortgage brokers and bank loan officers) were guilty of pushing more loans through the system in this decade. Both were speculative bubbles in the classic Holland Tulip style of the 1700's but both also had regulators to punish the truly criminal operators. Who will emerge as winners?

However, the sharper investment managers will try to find the higher performing assets of firms that are less exposed to the losses. Are there enough quality investments for those who are running to quality? Will this create another surge to buy from the banks least affected by the loan crisis? Who will seize the initiative? Who will be able to make timely value-style investment choices? The swift and the brightest will continue to prosper, and may even pick up some bargains along the way.

What will be the new "due diligence" rules for pension trustees?" 

Pension Fantasy Football - Any Takers?

I consider myself a relatively smart person, certainly (hopefully) smart enough to know when I don't know something. What falls in the category of "don't count on me?" Well, besides the fact that my husband begs me NOT to cook EVER again (my efforts being relatively inedible that is), I know very little about sports. Indeed, if ever asked to appear on Jeopardy, "sports" would be my Achilles' Heel. This doesn't mean that I disdain sports. To the contrary, I am learning to play golf, I take yoga classes (not quite a "sport") and I love to exercise. I hope to take up tennis when I have more free time.

That said, what does remain a complete mystery to me is the fascination with fantasy football (and equivalents for other sports). I know it's a popular pastime. My nephews and more than a few colleagues (mostly male) play for hours. WikiAnswersTM puts the number of worldwide players at 30 million. According to Fox Sports, "While only a select few extremely wealthy individuals have the privilege of owning a real NFL team, anyone can enjoy the thrill of owning a team of NFL players by playing fantasy football." Still, one wonders. Why not just watch football on television or in person or go out and play a game with friends? Doesn't the "real thing" offer a superior experience?

As I ruminated on the mysteries of fantasy football the other day (after the topic arose in conversation), it struck me that pension fiduciaries might learn a thing or two by simulating a "dream team" and watching their progress in moving the "ball" (effective pension governance) down the field. From his comments in "Pension funds get code of conduct from money manager group," it sounds like pension scholar Keith Ambachtsheer agrees that structural changes must be made to ensure proper pension governance. Pensions & Investments reporter Jennifer Byrd quotes this author of Pension Revolution: A Solution to the Pensions Crisis as saying "The truly best practice, and what pension funds need, is a corporate structure" that relies on knowledgeable professionals to run the plan with oversight from the board. This contrasts with "the current system of lay individuals being named trustees and then looking to outside experts for assistance."

(This blog will talk about the final Code of Conduct in a subsequent post.  For now, readers can download the document from the CFA Institute website.)

Fiduciary dysfunction is not a new topic but is nevertheless extremely important. Two years ago, pension professional Wayne Miller and Dr. Susan Mangiero wrote "Do Fiduciaries Need Better Incentives to Make the Retirement System Work?" (Executive Decision, January-February 2006). Here is an excerpt.

<< Imagine a time in the not too distant future. Retirement systems everywhere are in disarray. An outside specialist is asked to diagnose the problem and suggest a cure. A capitalist at heart, solutions-oriented and cognizant of a fiduciary imperative, she identifies the usual suspects—complex regulations, compelling demographics and overly optimistic economic assumptions.

Then, defying conventional wisdom, she asks the unthinkable. Has anyone looked at the role of fiduciary incentives? Do those in charge get rewarded for what they do well or penalized for what they fail to do? Who, if anyone, claims ownership of the retirement issue? Are these individuals empowered to effect meaningful change? How do we measure accountability for achieving plan goals? What alarm bells will ring in time to permit corrective action?

The room is quiet. No one knows what to say. The silence is deafening.

Sadly, current attempts at pension reform are likely to fail because they do not effectively address human behavior. People are motivated by rational self-interest and the promise of recompense for a job well done. This is not a bad thing. To the contrary, it is a cornerstone of a well-functioning market economy. Make it worthwhile and some clever person will figure out how to deliver a better mousetrap at a lower cost with the end result that we all benefit. >>

Click to read the full text of "Do Fiduciaries Need Better Incentives to Make the Retirement System Work?"

What do you think? Do we need a pension version of fantasy football or should organizations hunker down and create the real thing? I vote for the latter! (If your organization already has a pension dream team "for real," take a bow - and tell us more by email.)

LIBOR Gets a Licking - Why Pensions Care

According to "The Lowdown on LIBOR" (May 29, 2008) Businessweek reporters Ben Levisohn and Lauren Young write that $150 trillion is the "value of financial products with interest rates tied to" the London Interbank Offer Rate. In pensionland, this important benchmark rate shows up in a variety of ways.

A plan sponsor that employs swaps to manage interest rate risk often plays the role of Floating Rate Payor. As LIBOR rises, so too does its cash flow obligation as part of the periodic derivative trade settlement. Hedge funds may report a return that shows a shrinking basis point spread as LIBOR takes an upturn, challenging pension funds to explain "sub-par" performance to relevant constituencies. Equity values may be depressed if issuers in which a pension fund invests depend on short-term loans tied to LIBOR. Higher rates may force delinquincies for adjustable rate mortgage borrowers, impacting the price, liquidity and riskiness of some mortgage-backed securities, These are just a few of the LIBOR-related pain points for pension investors.

The saga doesn't end with volatility and escalating levels but rather continues with the process of rate-setting itself. Fearing reprisal from capital markets as credit conditions worsen, banks are thought to be quoting rates that are lower than where they are actually able to borrow from peers. In response, the British Bankers' Association undertook a thorough review of the group of banks that determine daily LIBOR levels, used in turn to price loans, settle derivative trades and/or value securities for an assortment of currencies. The following banks are used to determine U.S. dollar LIBOR:

  • Bank of America
  • Barclays Bank plc
  • Citibank NA
  • Credit Suisse
  • Deutsche Bank AG
  • HBOS
  • HSBC
  • JP Morgan Chase
  • Lloyds TSB Bank plc
  • Rabobank
  • Royal Bank of Canada
  • The Bank of Tokyo-Mitsubishi Ltd
  • The Norinchukin Bank
  • The Royal Bank of Scotland Group
  • USB AG
  • West LB AG.

According to a May 30, 2008 news release, a British Bankers' Association sponsored "FX and Money Markets Advisory Panel" has responsibilities to strengthen the oversight of BBA LIBOR. More details are expected shortly. Click to read "BBA Libor Panels."

Glitz and Glam or "Stodgy" Fundamental Investing?

When I was a young MBA pup (New York University), an investment professor asked students to purchase "Security Analysis" by Benjamin Graham and David Dodd. Not an unusual choice until one noticed the 1940 copyright. My reaction at the time was to think that this scholar needs to retire soon if he can't find a more modern text. Alas, the marvels of youthful ignorance, heh?

This flashback came to mind in reading the flurry of newspaper articles about the intended $23 billion purchase of Wm. Wrigley Jr. & Co. by private candy giant Mars Inc. Helping to finance things is no other than Warren Buffett who negotiated an approximate 10 percent of the deal for Berkshire Hathaway. With a stake in Sees Candy and the Coca-Cola Company, this uber value investor is familiar with beverages, salty snacks and sweets. (Note that Thomson Financial News, via Forbes.com, reports that Moody's Investors Service has put some of the Chicago gum giant's debt ratings under review as a result of the proposed structure.)

According to "Mars to Buy Wrigley’s for $23 Billion" by New York Times reporter Andrew Ross Sorkin (April 28, 2008), Wrigley's sales revenue just topped $5 billion. The National Confectioners Association reports that "gum sales continue to surge growing 9.3% over the latest fifty-two weeks" with the "key growth engine" being "seasonal confectionary products."

This news item is interesting but even more so after reading "Inside Citi, a Hedge-Fund Push Blows Up" wherein Wall Street Journal reporter David Enrich describes sales enthusiasm gone amuck. Having sold interests in "safe" fixed income hedge funds Falcon and ASTA/MAT to retail clients, global wealth management staffers are wrestling with a lawsuit, unhappy brokers and disgruntled investors. The article continues that Citi sold "only to clients with large, diversified portfolios." As litigation ensues (assuming it does), more will be known about sales practices and representations made to clients, existing and prospective.

Will an ordinary stick of gum pave the way for riches and leave certain "exotic" alternatives in the dust? One wonders - shades of the tortoise versus the hare? What are the lessons for retirement plans as billions of dollars are making their way into non-traditional securities?

Editor's Note: Here are a few fun facts about the confectionary industry.

Do You Have Your Own Fiduciary? If Not, Why Not?

 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:

Excuse Me! Excuse Me! Pension Fiduciaries - Heed the Call

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.

Investment Consultants and Time Perspective

 

I'm a big believer that we can learn from a variety of decision-makers. So it is with appreciation (and the proverbial hat tip) to Robert Elder for pointing out comments made by Frederick "Shad" Rowe, chairman of the Texas Pension Review Board. Robert pens an interesting Texas-centric blog called "Public Capital" and draws attention to Rowe's April 11, 2008 criticism of investment time travel that emphasizes past performance.

Recounting a Wayne Gretzky quote that "he skated not to where the puck was, but where it was going to be," Rowe excoriates investment consultants who "lead their clients not to where the puck is going to be or even where it is now, but instead to where it was three years ago." A 35-year investment veteran, Rowe further suggests that pension trustees are unwise to eschew long-term oriented investing in favor of strategies du jour such as (his words) "so-called 'alternative' investments, including private equity, where investment consultants are attempting to reduce what they call 'risk' and patching together a crazy quilt of 'uncorrelated' assets." Regarding commodities, he offers that the markets are too small to absorb the billions of dollars being thrown their way. Not a fan of international currency plays, Rowe thinks that pressure on the U.S. dollar will likely worsen economic conditions stateside. He urges pensions to think twice before investing in activism strategies that ignore company fundamentals.

Click to read Rowe's comments in their entirety. (In the spirit of encouraging productive debate, this blog welcomes comments from investment consultants about time orientation.)

Editor's Note: According to their website, the Texas Pension Review Board is "mandated to oversee all Texas public retirement systems, both state and local, in regard to their actuarial soundness and compliance with state law." Interestingly, there is a section about how the board is appointed. Worth reading, it is a rare example of documented experiential requirements. In this case, three of nine board members must have "experience in the field of securities investment, pension administration, or pension law." The board must also consist of an actuary, someone with "experience in governmental finance" and "a contributing member of a public retirement system."

Heels Pinch the Feet - Lessons for Pension Funds

As a big advocate of yoga pants and sneakers, wearing high heels is typically a "must do" versus a "want to do" item. I imagine that most men feel the same way about wearing ties. A recent article caught my eye wherein Wall Street Journal reporter Christina Binkley writes that "high-heeled pumps are the feminine equivalent of wingtips." Does that mean that penny loafers and ballet shoes put one on the slow track for promotions? (See "High and Mighty: Seeking Comfort in the Power Heel," April 10, 2008.)

So what does this have to do with pension funds? Allow me to explain.

In a literal battle of the fashionistas versus the style-challenged, my keynote presentation at Pension Bridge was followed by a public plan trustee who urged service providers to clearly explain investment concepts. Getting the audience to laugh about asset allocation and risk control is no small feat but that's what he did with his "plain folks" request. To paraphrase, "We say 'get out' as opposed to waxing poetic about contagion and geometric drift and so on.

Don't get me wrong. Math has its place for sure just as high heels add a note of perfection to that special outfit. However, do we want to start with number crunching and rocket science or focus first on fundamentals? I'd much rather start a discussion with plan sponsors that focuses on big picture risk drivers. Getting a feel for qualitatively what keeps people up at night is a great start to hunkering down to solve problems, improve practices and keep promises to participants.

What might service providers learn from Mr. Trustee's commentary? Here's a thought. Replace the fancy multi-colored slide decks (or at least augment) with some "101" conceptual illustrations BEFORE the quantitative heavy lifting begins. After all, if an investment decision-maker is uncomfortable with topics such as correlation, stochastic modeling and portable alpha, no sale is likely to occur and neither side brings closure to what could be a win-win.

There is a lot to be said for comfort and practicality some of the time.

Emotions, Trading Risk and the Twinkie Defense

Following on the heels of our March 15 post about emotions and retirement planning, another just published article addresses the role of the brain with respect to risk proclivity. In "The Science of Risk-Taking," TIME reporter Kate Stinchfield writes that thrill-seeking has a chemical payoff. Research suggests that higher risk tolerance relates to the reabsorption of dopamine, a neurotransmitter. Serotonin is a factor as well. Normal levels prevent erratic behavior. Testosterone is yet another consideration, with lower (higher) amounts linked to risk aversion (taking). Stinchfield quotes Professor Marvin Zuckerman (University of Delaware) as saying that "high-sensation seekers tend to underestimate the risk."

So does this mean that current excesses of financial risk-taking are tied to unusual brain activity? Can "bad" body chemistry interfere with the prudent process of implementing and monitoring risk controls?

"Sorry your honor, my chemical levels made me take wild, zany risks with other people's money." This sounds like the financial equivalent of the Twinkie Defense.

Pensions and Liquidity Squeeze

More than a few people have declared the beginning of the end. A reference to halcyon market conditions, it looks like they are right (at least for now). A flurry of headlines address what this blog author has been saying all along. Watch the collateral, assess liquidity risk and take stress testing seriously. Where does one begin?

1. On March 5, a Pension Governance sponsored webinar (Fiduciary Risk, Trading Controls and External Asset Manager Selection) emphasized to need to be wary of the risks you don't know and manage the ones you can measure. In his remarks about global bank and pension regulation, Mr. Gavin Watson (Institutional Business Strategy Head, RiskMetrics Group) correctly pointed out that risk management is no longer a luxury. Basel II seeks to better link capital reserves with banks' economic risks. UCITS III (Undertakings for Collective Investments in Transferable Securities) requires asset managers to have a daily risk monitoring program that is easy to understand. Pension plans are not immune from new rules. Risk forecasting is a statutory reality for Dutch plans. UK plans must take underfunding risk into account or pay a punitive levy. The Pension Protection Act of 2006 in the US imposes a variety of rules that relate to fiduciary risk mitigation, including the selection of a proper advisor for 401(k) plan investment selection. Mr. Anthony Turner (Principal - Financial Tracking Technologies) talked about the need to examine managers' holdings and track deviations from approved limits.

2. In a separate webinar on March 6, I urged audience members to pay attention to the quality, quantity, price behavior and transferability restrictions attached to pledged collateral. Part of "Liquidity Risk Managemenft," hosted by Knowledge Congress and co-sponsored by Pension Governance, LLC, my presentation addressed liquidity red flags, including but not limited to the following:

• Undue Concentration in a Few Number of Holdings
• Low Trading Volume
• Infrequent Trading
• Limited Number of Market Participants
• Contractual Limitations on Whether, How and When Withdrawals Can be Made
• Volatile Market
• Form of Withdrawals, if Permitted
• Correlation Changes
• Contagion 

3. In today's paper, famed New York Times reporter Gretchen Morgenson refers to investors as guests in Hotel California since "they have checked into an investment they can never leave." Referring to auction rate notes (debt instruments with long or no maturities that reset weekly), author of "As Good as Cash Until It's Not" describes how this market has screeched to a halt in recent days. Finding few bidders, mostly municipal issuers worry about growing budget gaps. Investors, on the other hand, are left holding the bag after investing in what they perceived to be relatively "low risk" securities.

4. In "Hedge Funds Frozen Shut," Business Week journalist Matthew Goldstein reports that "Since November at least 24 hedge funds have barred or limited investors from taking their money out, tying up tens of billions of dollars for an indefinite period. Among them: GPS Partners, a $1 billion fund that bets mainly on natural gas pipelines; Pursuit Capital Partners, a $650 million portfolio with troubled debt; and Alcentra European Credit, a $500 million fund that owns slumping loans used to finance private equity buyouts. For those institutional investors who failed to read the fine print allowing managerial discretion, these lock-outs are bad news. Arguably, hedge funds want to prevent a mass exodus of their investors for several reasons. First, a drain on assets makes it harder to recover losses (if possible at all). Second, fees drop as the size of their portfolio falls due to redemptions and sub-par performance. Making matters worse, prime brokers are turning off the money tap, create illiquidity problems for hedge fund managers at the precise moment when they need cash to stay in the game. Goldstein suggests that redemption restrictions may be postponing an inevitable collapse for some hedge funds.

I'd say "take two aspirin and revisit the situation in the morning" but that solution fars short of what looks to be rough times ahead.

Pension World is Flat

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?

The Cow Theory of Pension Investing



Free market advocate and famed author Ayn Rand is said to have explained communism with the use of an old Russian tale. It goes like this.

  • In a liberalized environment, Farmer A gets a new cow. Farmer B admires his neighbor's addition and works hard to buy a cow of his own.
  • In a state-run society, Farmer A gets a new cow. Farmer B realizes that he must work to pay taxes to feed Farmer A's cow. With a fixed wealth pie, levies diminish Farmer B's money pot, thereby giving Farmer B an incentive to destroy what he must support. He plots to get rid of Ms. Moo, making Farmer A worse off and arguably costing Farmer B time and money to pursue his wicked ways.

Friction is inevitable when players are encouraged to abide by a "you win, I lose" mentality. Reward silo decision-making and don't be surprised that people behave accordingly.

If the "me generation" characterizes your place of work, look out. Risk management is going to be a tough challenge. Effective enterprise wealth creation requires fluid communication and seamless operations. One hand must know what the other is doing in order to properly identify how various determinants of economic value either offset (hedge) or accelerate loss (leverage, correlation, lack of diversification).

Given its historic, just announced, write-down of $16+ billion, Merrill Lynch is taking the cow tale to heart. When asked by the Wall Street Journal to address "what shocked" the new CEO the most when he took the reins, John Thain replied - "Two things. One was the lack of understanding of the risk in these positions, and the lack of balance-sheet control. The balance sheet really got out of control, and traders were able to put on positions that were way too big, and I don't (think) there was a good understanding of what the risk was." He also added that "Merrill had a risk committee" but that "It just didn't function." (See "Merrill's Risk Manager" by Susane Craig and Randall Smith, January 18, 2008.)

Thain's response? Don't kill the cow. Encourage people to work together. In the same interview, Thain describes a newly mandated weekly meeting with the respective heads of fixed income, equity and risk. The goal is to avoid undue risk-taking that could bring down the house, not just for one group but for everyone - employees, shareholders and so on.

Pension fund managers can learn a few things from the Parable of the Bovine and Merrill's painful progress in managing large losses.

  • Acknowledge the value of working across divisions and job functions. Don't make investment or plan design decisions in a vacuum.
  • Don't empower one or more players to "run away" on their own. Internal controls are imperative. That includes a proper assessment of how external asset managers, custodians, consultants and the like manage their own financial process. If they are exposed to potential trouble spots, so are you.
  • Understand that a buy-in of good risk management practices by you and your peers raises the bar for everyone. Good team players should be rewarded by how the organization fares, not a particular division.

The Cow Theory may not push the Dow Theory off the investment map but it should be heeded nevertheless.

Private Equity Returns Appeal to Pensions

According to Global Pensions (January 10, 2008), Canadian, US and UK public pension fund investors are satisfied private equity investors. Surveying 108 institutions, Private Equity Intelligence Ltd (Preqin) found that "private equity out-performed for these pension plans in 82% of cases." In another survey, Preqin found that "95% of these investors predicted their private equity investments would out perform public market returns from a 2% advantge to over 4% in coming years."

Acknowledging the huge amount of money making its way into private equity, this blog's author wrote about the 4P's on December 31, 2007 - Pensions, Private Equity, Performance and Placement. We urged readers to study the risks, alongside the expected benefits, adding that valuation of private company economic interests can be challenging.

In response, Mr. Doug Miles, CEO of Globalprivatequity.com, Inc. wrote that life has surely changed when it comes to estimating value. We hope you find his commentary interesting. We welcome guest bloggers on any topic related to pension investing and risk management (which importantly includes the topic of valuation). Drop us a line if you want to share your thoughts with our fast-growing audience.

Wall Street Bonuses - A Reason to be Thankful

Bloomberg reporter Christine Harper reports an average Wall Street bonus of just over $200,000, from a wealth pie of $38 billion, spread out over 180,000+ individuals. In stark contrast, she adds that "Shareholders in the securities industry are having their worst year since 2002, losing $74 billion of their equity." About this same time last year, USA Today reported an average investment banking bonus of $137,580. (Read "It's a Wall Street bonus bonanza, December 20, 2006.)

With approximately 45 percent more in year-end goodies to take to the bank, financial professionals will be in fine mettle to celebrate Thanksgiving on November 22 this year. Yippee!

Even folks like Freddie Mac CEO's Richard F. Syron must be happy in the piggybank department. According to the Washington Post, their accounting of 2006 rewards ("Top 100 Executives by Total Compensation") lists his take as a mere $1.1 million in salary but $15.5 million in aggregate. Never mind that a November 20, 2007 press release reports a third quarter loss of $2.0 billion, reflecting "a higher provision for credit losses and losses on mark-to-market items" and "total GAAP mark-to-market losses of $3.6 billion," including $1.5 billion in "interest-rate related items."  (Read "FREDDIE MAC REPORTS THIRD QUARTER 2007 NET LOSS OF $2.0 BILLION OR $3.29 PER DILUTED SHARE: Core Business Growth Offset by Credit and Valuation Losses.")

Even if you believe in the power of free markets to determine performance-linked compensation (and further acknowledge that some Wall Streeters contributed to shareholder wealth), these big numbers don't play well in Peoria. They especially don't go over well in pensionland.

At a time of strained state budgets and company layoffs, enticing qualified persons to work on pension issues is not a walk in the park. As we've discussed MANY times, it's tough to attract experienced, knowledgeable persons to sign on as fiduciaries. The payoffs are asymmetric at best. Do a great job and the reward is small. Do a bad job and the liability is great.

How will they express gratitude when the discussion turns to pecuniary rewards?

Pension Buyouts - Banks Are Gearing Up

In discussing his relationship with service providers, a plan sponsor recently told me that he feels like a juicy steak to a hungry lion. Everyone wants his business and he struggles to keep up with the many requests for meetings with consultants, actuaries and asset managers. According to "Pensions may be outsourced : Banks look to take the plans and their assets off the hands of employers" (October 31, 2007), that fiduciary may be even busier now, fending off requests to assume his company's defined benefit plan(s).  As Los Angeles Times reporter Jonathan Peterson describes, Citigroup has just received an okay from the Federal Reserve to "take over" a $400 million retirement plan, sponsored by Thomson Regional Newspapers.

If a harbinger of things to come (and banks are definitely gearing up for this business), risk management acumen and internal controls should be front and center. After all, if a liability is transferred from the original plan sponsor to a large bank, it will be discomfort indeed if that bank struggles with keeping its own house in order. The stakes are too high. Lest you think that big always means better, keep in mind that we've just gone through a rollercoaster summer with a handful of financial giants reporting losses.

As regulators examine the efficacy of pension buyouts by banks in the U.S. and elsewhere, this blog's author recommends that a bank's pension-related risk control abilities be made publicly available for analysis and review. The last thing we need is a concentration of pension assets in a few shaky hands. Better that everyone is comfortable upfront with the buyers' abilities in the areas of risk management, operational processing and good pension governance.

 

Can Changing Investment Strategy be a Fiduciary Breach?

Click here to check out attorney Stephen Rosenberg's response to our October 27, 2007 post about 130/30 funds. His comments are thought-provoking.

Are 130/30 Programs Appropriate for Pension Funds?

After recently speaking to a group of public pension funds, I sat down to listen to other speakers, one of whom gave an eloquent talk about "130/30" strategies. Somewhat new on the investment scene, the goal of these "enhanced equity" strategies is to relax portfolio weight constraints that otherwise preclude a portfolio manager from expresssing a serious "thumbs down" for a particular stock. In addition, fund professionals are given latitude to emphasize favored stocks.

The mechanics are relatively straightforward. A 130/30 portfolio manager invests $1.00 in Stock X and sells $0.30 in Stock Y.  Proceeds from the short sale are used to purchase an additional $0.30 of Stock X.

Advocates assert that 130/30 funds (or variations thereof) are transparent, can be classified as equity, can be easily benchmarked and offer a possible way to increase returns. Critics counter that higher fees, frequent trading (and related costs) and relatively short track records give one pause. In addition, many of the funds employ quantitative models to drive investment decisions. In the last few months, amidst a credit crisis, more than a few quants found themselves selling off long positions while buying other stock to cover short positions. A tumble in returns and increased volatility was the unhappy result.

After the speaker concluded, I asked him how a plan sponsor is able to justify investing in 130/30 funds if its Investment Policy Statement specifically precludes short-selling, whether by design or, in the case of some public plans, short-selling is expressly prohibited. His response that pension plans are modifying their Investment Policy Statements to accommodate did not sit well with me. If trustees or other types of fiduciaries have made a conscientious decision to avoid short-selling, why change mid-stream? Mind you, this blogger is not saying that 130/30 strategies are bad or good but simply pointing out that prudent process would suggest the need for a thorough vetting of the attendant risks associated with this type of short-selling.

I asked ERISA attorney Stephen Rosenberg for his thoughts. With permission, comments from this McCormack Firm, LLC partner and fellow blogger are shown below. (Click here to read his fine blog.)

<< The fiduciary exposure - or at least the potential exposure - for the plans really runs to the rationale and due diligence, or lack thereof, in changing the pre-existing policy to allow the plan to instead invest using this strategy. The fiduciary’s obligation is one of prudence, and presumably there was a rational, intelligent reason for precluding such investment strategies for the plan’s investments. If the plan switches its policy to allow for such investing, the plan needs to be able to show an equally rational and defensible reason for the change. Otherwise, the plan and its fiduciaries open themselves up to claims, in the event the investment declines in value, that the original policy forbidding such investments was correct and the change was neither prudent nor well though out, and thus represents a breach of fiduciary duty. It may or may not be the case that such investment strategies should be part of the pension plan’s investment mix, but what is necessary to ward off fiduciary duty claims, and to satisfy fiduciary obligations, is a well thought out investigation, prior to making the change, by knowledgeable parties, into whether changing the plan’s investment policies in this regard is appropriate. The best defense to claims that such a change violated fiduciary obligations is competent third party advice from someone with nothing to gain from the change, i.e. advice on this issue from someone other than the bank seeking the investment. >>

Notable is his emphasis on getting INDEPENDENT feedback about the efficacy of a 130/30 strategy. Moreover, his comments about process make perfect sense. Before committing millions of dollars to a 130/30 type strategy, a plan sponsor should be able to thoroughly explain a change of heart about its stance on short-selling. Hopefully, for those plans for which there is an outright regulatory restriction (by virtue of state law let's say), they understand the compliance implications.

As the "short enabled" market grows, it will be interesting to track which pension plans participate and why.

Is There Fiduciary Liability Attached to Divestment?




According to Wall Street Journal reporter Craig Karmin, some legislators want public pension funds to shun companies that invest in terrorist countries such as Iran. Citing efforts by Missouri State Treasurer, Sarah Steelman, Karmin lays out the pros and cons of forced liquidation. (See "Missouri Treasurer's Demand: 'Terror-Free' Pension Funds," June 14, 2007.)

As part of a June 14 interview with CNBC's Maria Bartiromo, I offer four considerations (as much as I could say in a short on-air appearance). First, selling stocks because of statehouse mandates could cost taxpayers and plan participants in the form of "unexpected" transaction costs. This would in turn exacerbate funding problems for any states already in the red. Second, trustees would have to decide how to invest the proceeds of disposed equities, possibly earning less than before. Third, there could be a conflict for fiduciaries in terms of duty. Do they follow new rules that require divestiture, even if it forces them to violate state trust laws that demand careful analysis before deciding on an "appropriate" strategic asset allocation? Fourth, plan fiduciaries will likely need to spend considerable time and money in order to identify which companies offend, now and regularly thereafter.

No one supports terrorism but this "solution" might invite more problems. There is never a free lunch. Someone, somewhere pays.

Click here to watch the interview.

Pension Governance, LLC Sponsors Pension Risk Management Research Site



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."

Information and Pension Investing



Having read more than a few blog posts about a company called Monitor110, I decided to spend some time at their website. While I know nothing about the company other than what I read, their graphic of the "New Information Dissemination Cycle" fascinates. If true that blog content, local news and other types of non-traditional venues offer a competitive edge to investors, capital markets could be turned upside down.

Just in the last ten or so years, rocket speed transmission of data - aided in part by advanced technology developments and cross-border deregulation - has improved efficiencies, thereby reducing costs and shrinking diversification potential. Some posit this is a good thing. Others complain that it makes it difficult to "beat" the market by accessing and analyzing information not widely known by others. This is a topic that is near and dear to my heart, having spent several years writing a doctoral dissertation about market microstructure. (I looked at information economics in the form of bid-ask spreads for NYSE-traded stocks across levels of institutional investor ownership and analyst following. Send an email if you would like a copy.)

According to their website, Monitor110 envisions revolutionizing "financial services by enabling Institutional Investors to turn Internet information into alpha generation." At a time when countless pensions, endowments and foundations are scrambling for returns, potential wins have great appeal. (This is not an endorsement of any particular company or strategy. Readers are responsible for their own analysis.)

The role of information in making investment decisions is a topic of great interest to us all. Debating the economic value of information deserves far more space than can be provided here. However, the notion that blogs - and other "non main stream" sources of information - contain pearls of wisdom not yet assimilated by the market certainly merits discussion. One question that arises. Do blogs lead or lag major news announcements? Journalist Chris Nolan has an interesting take on the power of blogs in an article for EWeek.com, writing that, beyond politics, "their value as forums for collective knowledge is becoming known in other areas as well."

What did people do before the Internet came along?