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.

SIBOS 2008 in Vienna

I'll be blogging from Vienna, Austria shortly. I look forward to attending the SIBOS 2008 conference, billed as "the world's premier financial services event." I am honored to be speaking twice, once about regulation and a second time about pension issues. The theme is definitely global and the mood is serious. If you want more information, click here. The program is jam packed with terrific sessions and will no doubt offer interesting topics for www.pensionriskmatters.com.

I've included details about my participation below.

EVENT ONE: September 17 - "Will regulation help or hinder the investment funds industry?"

The funds industry is facing a tide of regulation, of which UCITS (Undertaking for Collective Investment in Transferable Securities) III and IV are the latest examples. In addition, the European regulator is demanding more transparency from the fund industry, especially around cross - border distribution (for example the Klinz report). How much impact will these initiatives have? What does the industry need to do to comply? Can initiatives such as the Fund Processing Passport provide an answer? And, most importantly, will the regulation help or hinder the industry going forward?

Speakers:

  • Mattias Bauer, Chairman, EFAMA
  • John G. (Jack) Gaine, Managed Funds Association
  • A.P. Kurian, Chairman, Association of Mutual Funds in India
  • Mick McAteer, EU Consumer Representative, Fin-Use
  • Susan Mangiero, CEO, Pension Governance LLC

Moderator:

  • Bob Currie, Editor, FSR Magazine

EVENT TWO: September 18 - "Where is my pension?"

The issue of pension shortfalls is a universal one, caused by a combination of longer life expectancy and inadequate planning. How does the financial services industry need to respond? In most markets, you need returns way above forecast beta. Does that mean that leveraged investment will become the norm? How should we fill the holes?

Speaker:

  • Robert Brown, CEO, Ausmaq
  • Glyn Edward, Funds, Custodian and Administrators, SWIFT
  • Susan Mangiero, CEO, Pension Governance LLC
  • Clive Witherington, Head of Business Development, Watson Wyatt

Dr. Susan Mangiero Will Give Hedge Fund Conference Keynote

Join me at the 6th Hedge Fund Accounting & Administration Forum 2008 on July 22, 2008 at the Harvard Club. I will be giving the second day keynote presentation entitled "Hedge Fund Risk Management and Valuation - No Time for Shrinking Violets."

More about this presentation is excerpted below.

"Explore key questions and challenges facing hedge fund professionals in these turbulent times. Join appraiser and risk manager, Susan Mangiero, for a topical discussion about the fast changing operating environment for buyers and sellers alike. Always important topics, portfolio valuation and operational controls are front and center as fund managers, and their service
providers, deal with new rules and regulations and the continuing fallout of credit-related problems. Dr. Mangiero will share her insights about:

  • Regulatory enforcement hot buttons
  •  Valuation and risk management litigation trends
  • Best practices for evaluating key risks and managing exposure
  • Institutional investor impact as pensions/endowments/foundations allocate more money to alternatives.

To learn more about this FRA, LLC sponsored two-day conference (July 21-22, 2008), download the flyer.

Doris Day, Scarlett O'Hara and Financial Market Tumult

Remember the 1939 epic classic "Gone with the Wind" wherein Scarlett O'Hara protests serious conversation? Interrupted by news of an imminent Civil War, this party gal (with the famous 17-inch waist) complains. "Fiddle-dee-dee. War, war, war: this war talk's spoiling all the fun at every party this spring. I get so bored I could scream." 

As I read "Why No Outrage" by James Grant (Wall Street Journal, July 19, 2008), I wonder if this southern belle might now be heard to say "Loss, loss, loss: this loss talk is spoiling all the fun..." About structural reforms (a 2007-2008 equivalent of losing Tara, the family homestead), Scarlett might encourage delayed action. "After all...tomorrow is another day." Why fuss now?

Well, as we all know, Main Street and Wall Street are inextricably linked. Unlike Las Vegas, what happens in the financial markets,  does not "stay here." (Read "Slogan's run" by Newt Briggs, Las Vegas Mercury, April 8, 2004.) When huge losses roil capital markets (not just in the U.S. but around the world), real people can get hurt:

  • Employees lose jobs
  • Shareholders see their portfolios plummet in value
  • Pension plans that allocate big money to equities and bonds scramble to improve funding
  • Retirees who depend on the financial health of plan sponsors pinch their pennies further
  • Vendors who do business with financial institutions tighten their belts and/or layoff staff
  • Businesses, seeking to grow, borrow at higher rates, if they can borrow at all...

It is therefore a mystery to the editor of Grant's Interest Rate Observer that relatively few bad players are taken to task "in the wake of the 'greatest failure of ratings and risk management ever,' to quote the considered judgment of the mortgage-research department of UBS." Grant conjectures that high gas prices and an election-focused Congress may be to blame or that "old populists" have hoisted themselves by their own petard, having pushed for paper money, federal insurance subsidization of higher risks and government intervention with respect to credit decision-making. From the tone of this long, yet fascinating, commentary, Grant rants about big government at the same time that, ironically, big government seeks to become even bigger in the form of new financial market regulations.

For my two cents as an advocate of free markets (not faux capitalism as exists around the world), a return to the gold standard merits serious consideration. Improperly priced federal insurance of bank deposits and pension liabilities (and much more) induces adverse selection and moral hazard. Riskier organizations get subsidized by more prudent market participants and have little incentive (arguably no incentive) to get their risk management house in order. Regarding government intervention as to how credit is allocated, plenty of empirical studies quantify the economic "bad" that results from information asymmetry. When buyers and sellers are not fully informed, supply and demand cannot intersect at the"correct" price of money or the optimal level of borrowing/lending.

Then there is the shame factor. In an era of reality shows, can we expect honor and accountability? Grant has few kind words for market behemoths (current and now extinct) who watch(ed) the Titanic sink "under the studiously averted gaze of the Street's risk managers." Will today's villains of excess rise, Phoenix-like, as have infamous names of yore, now reincarnated as media superstars? (Nick Leeson of Baring's fame has his own website and earns a living as a consultant and speaker. Henry Blodget pens "Internet Outsider" and e-newsletter, Silicon Alley Insider - a fun read for this bloggerette.)

Related to Grant's provocative piece, a recent article about voluntary standards caught my eye with its suggestion that industry attempts may be more show than reality. In its "agenda-setting column on business and financial topics," the Financial Times' Lex states that such guidelines receive little scrutiny and are put in place as a way to attract risk-averse institutional investors and/or to avoid the harsh spotlight of global regulators. (See ""Funds of hedge funds," Financial Times, July 17, 2008.) An easy way to check is simply ask each hedge fund manager about his/her reliance on published guidelines. Inquire how traders are compensated. Are they encouraged to take pure risks or are they instead benchmarked on the basis of risk-adjusted returns (with "risk" referring to the holistic assessment of uncertainties)? Don't stop with hedge funds. Ask any service provider or trader about their controls and how they monitor the quality of their processes.

The creation of an effective reward system and "best practices" are favorite topics of this blog. Our team (Pension Governance, LLC) and fiduciary community colleagues decry the status quo that makes it difficult to reward good players, at the same time that questionable practices are frequently left untouched. Poor quality disclosure is just one factor that inhibits the design of a better mousetrap.

Two hours into this post, I'm going to conclude with the notion that "freedom is not free" (anonymous). To enjoy flexibility and regulatory latitude, people of great courage must buck the existing system and both demand and assume accountability. At a minimum, interested parties (retirees, shareholders, taxpayers) want to better understand what went wrong and how internal controls will be strengthened post-haste as a result of introspection. Leaders at troubled institutions do a great service by informing the public about corrective actions underway.

For pension fiduciaries, a critical lesson learned is this. If you are not already doing so, waste no time in getting an operational review. This extends to tough and detailed interviews with your external money managers and service providers about all things risk management. Communicating your process to plan participants (for all types of plans) and shareholders/taxpayers gets you brownie points and helps to raise the "best practices" bar. 

Doris Day's sentiment may be great for meditation class but has no place in a discussion about financial system reform and governance of individual organizations, plan sponsors included. "What will be, will be" is the wrong answer (though "Que Sera, Sera" is a favorite tune).

The power of one keeps us in awe. Who will step up to the podium and say - "The buck stops here?"

Please email us with examples of pension and financial service leaders whom you believe inspire and lead the way in terms of governance. Let us know if we may attribute your comments or should post them anonymously.

 Editor's Notes:

Fiduciary Risk, Trading Controls and External Asset Manager Selection

Join us for our timely webinar about trading controls. At a time of unprecedented market volatility and repeated reports of larger than life losses, hear experts talk about  processes used to determine and monitor limits, vet authorized trading, review style drft and detect early warning signals. You can register today by clicking here. If you are unable to attend, a taped recording will be available for a nominal cost. Email us with questions or comments.

The event takes place on March 5, 2008 from 11:00 a.m. to 12:15 p.m. EST.

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

Who Should Attend:
Plan sponsors, plan administrators, pension consultants, board members with responsibilities for selection of investment fiduciary advisors, regulators, bankers, mutual fund and hedge fund managers with (or seeking to attract) pension fund investors

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

  • What Constitutes "Must Have" Elements of Effective Risk Management Systems
  • Ways to Detect Deviation from Management Style and/or Excess Position Concentration
  • Red Flags Regarding Possible Rogue Trading
  • Industry Best Practices for Trading Controls and Lessons Learned About What to Avoid

Speakers:
Dr. Susan M. Mangiero, AIFA, AVA, CFA, FRM - Moderator
President
Pension Governance, LLC

Mr. W. Anthony Turner - Speaker
Principal
Financial Tracking, LLC

Mr. Gavin W. Watson – Speaker
Business Manager for Asset Managers, Pensions and Insurance
RiskMetrics Group, Inc.

Fiduciary Risk, Trading Controls and External Asset Manager Selection - New Webinar

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

Join us on March 3, 2008 from 11 am to 12:15 pm EST for a lively discussion about ways to mitigate transaction risk.

Description: Fiduciary duties mandate oversight of external asset manager selection. This includes a proper vetting of trading-related controls and the process used to determine limits, authorized persons, style drift, early warning signals and liquidity traps.

Who Should Attend: Plan sponsors, plan administrators, pension consultants, board members with responsibilities for selection of investment fiduciary advisors, regulators, bankers, mutual fund and hedge fund managers with (or seeking to attract) pension fund investors

Learning Points: Topics covered during this 75 minute online and telephone event are shown below.

  • What Constitutes "Must Have" Elements of Effective Risk Management Systems
  • Ways to Detect Deviation from Management Style and/or Excess Position Concentration
  • Red Flags Regarding Possible Rogue Trading
  • Industry Best Practices for Trading Controls
  • Lessons Learned About What to Avoid

Speakers:

  • Dr. Susan M. Mangiero, AIFA, AVA, CFA, FRM - Moderator
    President
    Pension Governance, LLC
  • Mr. W. Anthony Turner - Speaker
    Principal
    Financial Tracking, LLC
  • Mr. Gavin W. Watson – Speaker
    Business Manager for Asset Managers, Pensions and Insurance
    RiskMetrics Group, Inc.

To register, click here. There is a modest charge of $125 per person. If you are interested in a discounted rate for multiple attendees, email PG-Info@pensiongovernance.com.

Webinar About Fiduciary Risk, Trading Controls and External Asset Manager Selection

Description:
Fiduciary duties mandate oversight of external asset manager selection. This includes a proper vetting of trading-related controls and the process used to determine limits, authorized persons, style drift early warning signals and liquidity traps.

Who Should Attend:
Plan sponsors, plan administrators, pension consultants, board members with responsibilities for selection of investment fiduciary advisors, regulators, fund of fund and hedge fund managers with (or seeking to attract) pension fund investors

Learning Points:
Persons who attend this 75-minute webinar will learn the following:
What Constitutes "Must Have" Elements of Effective Risk Management System

Ways to Detect Deviation from Management Style and/or Excess Position Concentration

Red Flags Regarding Possible Rogue Trading

Industry Best Practices for Trading Controls and Lessons Learned About What to Avoid

Speakers:
Dr. Susan M. Mangiero, AIFA, AVA, CFA, FRM - Moderator
President
Pension Governance, LLC

Mr. W. Anthony Turner - Speaker
Principal
Financial Tracking, LLC

Mr. Gavin W. Watson – Speaker
Business Manager for Asset Managers, Pensions and Insurance
RiskMetrics Group, Inc.

Bad Trading Controls Could Lead to Blow Ups


Recent hedge fund blow ups and mutual fund woes related to market timing and valuation may be a harbinger of things to come. Part of the problem has to do with trading controls that are either weak or non-existent. For institutional investors such as pension funds, this could spell disaster. According to President of Pension Governance, LLC, Dr. Susan M. Mangiero, CFA and Accredited Investment Fiduciary Analyst, "Pension funds have oversight responsibilities with respect to external money managers. They would be remiss not to review their service providers' trading controls. We have only to look at recent headlines for examples of how bad things can get when rogue individuals or computer problems are left unchecked."

The process used to determine limits, authorized persons, style drift early warning signals and liquidity traps are a few of the many topics to be discussed during an August 8, 2007 webinar (noon to 1:15 p.m. EST).

Entitled "Fiduciary Risk, Trading Controls and External Asset Manager Selection," the webinar boasts practitioners with trading desk and risk control experience, including moderator Dr. Susan M. Mangiero and expert guests - Mr. W. Anthony Turner, Principal, Financial Tracking, LLC and Mr. Gavin W. Watson, Business Manager for Asset Managers, Pensions and Insurance, RiskMetrics Group, Inc.

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

  • What Constitutes "Must Have" Elements of Effective Risk Management System
  • Ways to Detect Deviation from Management Style and/or Excess Position Concentration
  • Red Flags Regarding Possible Rogue Trading
  • Industry Best Practices for Trading Controls and Lessons Learned About What to Avoid

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

For more information about the webinar or to register for a modest fee, visit http://pensiongovernance.com/webinars.php?PageId=58&PageSubId=59.

Pension Governance, LLC Offers Webinars for Pension Fiduciaries about Hedge Fund Risk Management

Hedge funds are increasingly being used as part of a pension’s liability-driven investing (“LDI”) strategy or to potentially diversify a portfolio. At the same time, several recent hedge fund blow-ups, along with their prominent presence in corporate boardrooms via activist investing, has regulators and institutional investors more than a little concerned. Pension fiduciaries must demonstrate a rigorous due diligence in their selection process or risk breach of duty allegations. 

In an effort to assist plan sponsors, Pension Governance, LLC continues its Hedge Fund ToolboxSM series with two more online events this week. Join pension decision-makers for an engaging and timely discussion about the use of leverage, derivatives and financial risk controls (July 10, 2007) and operational risk (July 12, 2007).

According to series creator, Dr. Susan M. Mangiero, CFA, Accredited Valuation Analyst, Financial Risk Manager and Accredited Investment Fiduciary Analyst, "There is a sea change underway with respect to the use of hedge funds by pension plans. While increased monies to alternative fund managers may make perfect sense in some situations, a lack of understanding about financial and trading risks could spell disaster for retirement plans. We help plan sponsors interview a hedge fund’s risk manager as a more complete gauge of potential problems. If that function does not exist, that could be a red flag. However, the existence of a risk management function in and of itself does not mean that it is an effective safeguard against runaway losses. Personal and professional fiduciary liability exposure, duty to oversee and an increasingly complex investment landscape makes this a particularly challenging time for plan sponsors.” President of Pension Governance, LLC, Mangiero adds that "Our goal is to help fiduciaries with research, process checks and training to thwart trouble and help to promote best practices."

For more information, click here. Recordings of all six webinars are available for a modest fee to non-subscribers. To order past webinars, click here.

Pension Governance, LLC is registered with CFA Institute as an Approved Provider of professional development programs. Each program qualifies for 1.5 PD credits.

About Pension Governance, LLC:
Pension Governance, LLC (www.pensiongovernance.com) is an independent research, analysis, training and publishing company, emphasizing investment fiduciary risk management. Covered topics include fee structure, liability-driven investing, controls, valuation, alternatives and fiduciary best practices for board members, CFOs, treasurers and their attorneys, consultants and banks.

Media Sponsors:
Pension Governance, LLC is proud to have Albourne Village, Hedgeco.net, Lipper Hedge World, and the National Association of Certified Valuation Analysts as media sponsors.

Is Your Pension Plan Operationally Sound?



If you don't have a stress ball on your desk, now might be the time to splurge. Pension fiduciaries have a lot on their plate and it seems that every day brings new challenges, operational risk management included. According to a recent Advanced Micro Devices (AMD) white paper, written in conjunction with Toomre Capital Markets, "internal processes, people and systems periodically fail" and could possibly threaten a firm's survival. The authors describe "fat finger loss" wherein "incorrect keys were pressed with no malicious intent" to illustrate the importance of controls. Being able to catch data errors before they get out of hand is the lifeblood of a well-run organization.

Rogue trading likewise illustrates operations-related vulnerability. Think back ten years. Barings Bank, a venerable global financial institution, was literally driven out of business due to the actions of a single derivatives trader. Where was the proper oversight? It's an amazing story that some still find hard to believe.

I saw this firsthand while getting my Ph.D. and teaching finance. Not a fan of showing videos in class, I made an exception for the risk management students and asked them to view the HBO movie about Barings. At the end of the film, you could hear a pin drop. Finally, a student asked if I thought such a debacle could occur again. My response? Absolutely. Any time people are part of the process (and they always are), there is room for error. That's why effective operational risk management policies and procedures are so important.

Click here to read the AMD paper. It includes a nice summary of "Ten Sound Practices for the Management and Supervision of Operational Risk" as provided by the Bank for International Settlements (BIS). Click here to access the full version of the BIS document.

Technology is a critical component of operational risk. Without the ability to capture and analyze data, it is virtually impossible to create and monitor limits, check for odd exposures or even detect fraud. Even with a good system, it is far from easy.

Interested readers can click here to read "The Five Keys to Risk and Risk Management" or read the several chapters in my book about operational risk, technology and modeling.

Pension Consultants and Hedge Funds

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

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

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

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

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

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

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

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

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

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

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

ERISA and Derivatives

During a September 26, 2006 panel discussion about the use of derivatives by pensions, mention was made of a U.S. Department of Labor letter. Several people asked for more information. (The Pensions & Investments conference focused on liability-driven investing.)

Click here to read the letter. Excerpts are provided below. Several items are noteworthy, especially since liability-driven investing strategies often rely on the use of derivatives.

1. There is a clear focus on process.

2. Regulators cite the need to identify operational and legal risks.

3. Passing the baton to a money manager does not absolve plan decision-makers of oversight duties with respect to the use of derivatives by outside firms.

4. Methods used to assess market risk should be appropriate and could include stress testing and simulation.

<< Investments in derivatives are subject to the fiduciary responsibility rules in the same manner as are any other plan investments. Thus, plan fiduciaries must determine that an investment in derivatives is, among other things, prudent and made solely in the interest of the plan's participants and beneficiaries.

In determining whether to invest in a particular derivative, plan fiduciaries are required to engage in the same general procedures and undertake the same type of analysis that they would in making any other investment decision. This would include, but not be limited to, a consideration of how the investment fits within the plan's investment policy, what role the particular derivative plays in the plan's portfolio, and the plan's potential exposure to losses. While derivatives may be a useful tool for managing a variety of risks and for broadening investment alternatives in a plan's portfolio, investments in certain derivatives, such as structured notes and collateralized mortgage obligations, may require a higher degree of sophistication and understanding on the part of plan fiduciaries than other investments. Characteristics of such derivatives may include extreme price volatility, a high degree of leverage, limited testing by markets, and difficulty in determining the market value of the derivative due to illiquid market conditions.

As with any investment made by a plan, plan fiduciaries with the authority for investing in derivatives are responsible for securing sufficient information to understand the investment prior to making the investment. For example, plan fiduciaries should secure from dealers and other sellers of derivatives, among other things, sufficient information to allow an independent analysis of the credit risk and market risk being undertaken by the plan in making the investment in the particular derivative. The market risks presented by the derivatives purchased by the plan should be understood and evaluated in terms of the effects that they will have on the relevant segments of the plan's portfolio as well as the portfolio's overall risk.

Plan fiduciaries have a duty to determine the appropriate methodology used to evaluate market risk and the information which must be collected to do so. Among other things, this would include, where appropriate, stress simulation models showing the projected performance of the derivatives and of the plan's portfolio under various market conditions. Stress simulations are particularly important because assumptions which may be valid for normal markets may not be valid in abnormal markets, resulting in significant losses. To the extent that there may be little pricing information available with respect to some derivatives, reliable price comparisons may be necessary. After entering into an investment, a plan fiduciary should be able to obtain timely information from the derivatives dealer regarding the plan's credit exposure and the current market value of its derivatives positions, and, where appropriate, should obtain such information from third parties to determine the current market value of the plan's derivatives positions, with a frequency that is appropriate to the nature and extent of these positions.

If the plan is investing in a pooled fund which is managed by a party other than the plan fiduciary who has chosen the fund, then that plan fiduciary should obtain, among other things, sufficient information to determine the pooled fund's strategy with respect to use of derivatives in its portfolio, the extent of investment by the fund in derivatives, and such other information as would be appropriate under the circumstances.

As part of its evaluation of the investment, a fiduciary must analyze the operational risks being undertaken in making the investment. Among other things, the fiduciary should determine whether it possesses the requisite expertise, knowledge, and information to understand and analyze the nature of the risks and potential returns involved in a particular derivative investment. In particular, the fiduciary must determine whether the plan has adequate information and risk management systems in place given the nature, size and complexity of the plan's derivatives activity, and whether the plan fiduciary has personnel who are competent to manage these systems. If the investments are made by outside investment managers hired by the plan fiduciary, that fiduciary should consider whether the investment managers have such personnel and controls and whether the plan fiduciary has personnel who are competent to monitor the derivatives activities of the investment managers.

Plan fiduciaries have a duty to evaluate the legal risk related to the investment. This would include assuring proper documentation of the derivative transaction and, where the transaction is pursuant to a contract, assuring written documentation of the contract before entering into the contract.Also, as with any other investment, plan fiduciaries have a duty to properly monitor their investments in derivatives to determine whether they are still appropriately fulfilling their role in the portfolio. The frequency and degree of the monitoring will, of course, depend on the nature of such investments and their role in the plan's portfolio. >>

Operational Risk and Over-the-Counter Derivatives


The term "operational risk" is typically defined as the risk that results from incomplete, poor or failed internal controls, people and/or systems. Sometimes the term is used as part of a discussion about business continuity.

Operational risk is often cited as a key element of the use of over-the-derivatives. For one thing, the growth in over-the-derivatives market continues to break records, with the Bank for International Settlements reporting global use, in terms of notional amounts, in excess of $284 trillion at year-end 2005. Interest rate contracts such as forward rate agreements, options and interest rate swaps dominate, with an estimated notional amount of approximately $215 trillion. Additionally, operational snafus account for several large derivatives-related losses. Check out the Wheel of Misfortune for some interesting case studies.

A July 2006 survey conducted by Investit Intelligence confirms continued interest in the topic, with investment company COOs citing most concern about technology and operational risk.

Others feel similarly. Timothy F Geithner, president and CEO of the Federal Reserve Bank of New York described improvements such as "greater dispersion of credit and market risk, the improvements in risk management, the size of the capital cushions, and the improvements in many parts of the payment and settlement infrastructure", while cautioning market participants to "make the investments necessary to improve the operational infrastructure that underpins the credit derivatives and broader OTC derivatives market."

Why is this important to pension funds? Given the giant size of the derivatives market and their prevalent use by mutual fund managers and hedge fund managers, pension fiduciaries should be asking tough questions about operational risk policies and procedures.

Of interest may be two articles on what this author refers to as the Five C Approach to Risk Management (SM). In the absence of a disciplined, and carefully crafted, organization-wide strategy, identifying, measuring and managing derivatives-related risk is difficult at best. (Click here to read "Pension Risk Management: The Importance of Oversight" and here to read "Five Keys to Risk and Risk Management.")

If used properly, financial derivatives can provide users with flexibility, the ability to transform risk and possibly even lower costs. Evaluating, and effectively dealing with, operational risk is a big part of prudent practice.