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

 

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."

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In his November 11, 2007 blog entry, New York Times reporter Floyd Norris describes an interesting tidbit of information, tucked inside the just filed 10-Q by Wachovia Corporation. On page 27, it reads "In the third quarter of 2007, we purchased and placed in our available for sale portfolion $1.1 billion of asset-backed commercial paper from Evergreen money market funds, which we manage. We recorded a $40 million valuation loss on this purchase, which is included in our market disruption-related losses." As Norris explains, while the regulatory filing adds that Wachovia is "not required by contract to purchase these or any other assets from the Evergreen funds" they manage, a loss of that magnitude would "break the buck." When the $1 Net Asset Value typically associated with a money market fund no longer prevails, Wachovia or any other financial institution in a similar position is arguably obliged to stem the financial tide or risk loss of investors or worse. Click here to access the 10Q report.

In today's article entitled "SEI, Rival Money Funds Go on Offense to Avoid 'Breaking the Buck'," Wall Street Journal reporters Diya Gullapalli and Tom Lauricella write that money manager SEI Investments has said "it would provide financial guarantees for some of the funds' holdings of SIVs." CEO Alfred West explains the rationale for voluntarily providing credit support, in the aftermath of a threatened downgrade of SIV Cheyne Finance, LLC paper. Held by several SEI funds, "managed for SEI by Columbia Management, the money-management arm of Bank of America Corp," the funds' rating could likewise be compromised. Click here to listen to the recorded November 12, 2007 presentation to SEI investors. 

A recent IMF presentation, entitled "Regional Economic Outlook - Europe" stresses the importance of improving "risk assessment models, market and liquidity risk management, due diligence, and transparency regarding the loan origination process and counterparty risk exposure."

Color me confused. Haven't many banks held themselves out to be leaders in the area of risk control? What about the fact that banks are highly regulated? Doesn't that contribute to good oversight? What is the role of Basel II, looming right around the corner and meant to reflect robust risk management activities on the part of banks in the U.S. and abroad?

For those banks with pension clients, what is the process in place to vet all recommended money market funds, including their own? Is the process conflict-free? Conversely, are pension funds directly (or through pension consultants) asking sufficient questions about the safety of recommended short-term capital pools?

As the mysteries unfold, don't be surprised what we learn about the importance of good fund selection and risk review process.

Note: Wikipedia defines a structured investment vehicle as "an evergreen credit arbitrage fund, similar to a CDO or Conduit. They are usually from around $1bn to $30bn in size and invest in a range of asset-backed securities, as well as some financial corporate bonds. An SIV is formed to make profits from the difference between the short term borrowing rate and long term returns." Click here for more information.

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The following is an excerpt from an article written by Dr. Susan M. Mangiero and published in Mann on Wall Street (August 2007 issue). If you would like to receive a copy of the full text article, click here to send an email request.

<<Despite a recent study that all is okay in corporate pension land, changes are taking place to indicate otherwise. Preparing for lots of pension buy-out business, investment banks hire actuaries in droves. Swap trading desks similarly staff, anticipating a surge in liability-driven investing. CPA firms scurry to find qualified professionals who can handle the alphabet soup of new accounting rules. Even those who breathed a sigh of relief with the final enactment of the Pension Protection Act of 2006 (“the suspense is over”) acknowledge the beginning of the end of “the way things were.” Board members, CEOs and CFOs wait for the other shoe to drop, assuming that the sequel to FAS 158 will compel wide swings in earnings. Congress and regulatory agencies busy themselves with a flurry of investigations. On top of everything else, longevity is forcing plan sponsors to rethink how to cut costs without alienating productive workers. The only constant is change. For traders who embrace volatility, life is good. For those in search of stability, hang onto your hats.

With all of this tumult underway, a little noticed trend seems to be emerging that could make pension clients high risk for service providers - asset managers, brokers, bankers, administrators, custodians, advisors, consultants, auditors and ERISA counsel. At its simplest, there is a real question as to who has investment fiduciary responsibilities other than the plan sponsor. Some organizations wear the hat of “fiduciary” but charge steep fees to compensate for added liability exposure. Others disavow the role, going so far as to include text to that effect in their engagement letter. However, real questions remain. Will judges uphold the legitimacy of this stance or instead classify a service provider as a functional fiduciary against their will, thereby opening the door to claims of breach? If that occurs, asset managers, consultants and other persons peripheral to a plan sponsor get the worst possible outcome – increased liability exposure without compensation.>>

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Alleging breach of fiduciary duty, plaintiff South Cherry Street, LLC cited failure of consulting firm Hennessee Group to do proper due diligence of the now defunct hedge fund, Bayou Group. In response, federal judge Colleen McMahon "granted a defense motion to dismiss the case, finding that Hennessee wasn't alone in being duped by Bayou." (Click here to read the August 3, 2007 Reuters article.)

As several related cases make their way through the courts, pay attention to how the judge rules. Some experts suggest that institutions could be asked to assume more responsibility for the investments they make, even after hiring a consultant.

If true, things are likely to change. After all, why hire someone else if ultimate responsibility stays with the plan sponsor? The import is considerable. Trustees and other internal fiduciaries who now look to outside experts will have to become more expert themselves. (We've long advocated for better fiduciary training and selection standards, whether an outside firm is employed or not. Click here to read a recent blog post on the topic.)

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According to money management letter (April 9, 2007 issue), Rocaton Investment Advisors paid $2.75 million to the San Diego County Employees Retirement Association "for recommending Amaranth Advisors." The article also goes on to say that no information is forthcoming about whether Rocaton did anything wrong and whether this money is covered by professional liability insurance.

The reason for citing this article is not to put any one particular firm in the spotlight but rather to suggest that pension fiduciaries check with their appropriate counsel and do sufficient homework internally to make sure that everything that should be done is being done. This includes, but is not limited to, seeking answers to the following questions:

1. How much experience does a particular consultant and/or financial advisor under consideration have with respect to examining hedge funds or fund of funds?

2. Does the consultant and/or financial advisor have an adequate understanding of the hedge fund or fund of funds' use of leverage through short-selling and/or use of derivatives, if relevant? What is their systematic process for examination of leverage? How do they define leverage and does that comport with industry norms?

3. Has the consultant and/or financial advisor identified (and explained to plan sponsors) possible risk factors associated with a given hedge fund or fund of funds? Sector concentration, management style, specific ownership structure of the limited liability company or partnership, availability of risk analytics, stop loss triggers, primary and secondary plans for liquidation, valuation policy, redemption restrictions and use of side pockets are JUST the beginning.

We'll talk much more about the issue of investment risk review in coming days. Why? Plan sponsors are still on the hook for monitoring their monitors. It's simply not as easy as passing along a hot potato regarding due diligence to someone else.

P.S. There is a rumor that another pension consultant has offered recompense in conjunction with this hedge fund case. If true, could this be a trend in going after consultants and/or financial advisors in the event of losses?

 

 

 

 

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According to its May 12, 2006 press release, Fidelity Investments expands its offering to deliver "defined benefit plan sponsors increased investment flexibility and greater access to and control of plan data to help them identify and mitigate financial and fiduciary risks."

In today's Investment News, reporter Kathie O'Donnell writes that Fidelity Investments will replace its traditional pension plan for over 30,000 participants and instead offer them a "retiree health reimbursement plan and a beefed up profit-sharing plan." O'Donnell adds that Fidelity's in-house studies suggest the need to address the health care gap, the company match will increase to 7% from 5% and profit-sharing contributions will continue.

For some reason, today's headline stood out, causing me to wonder. Might it make sense to ask pension advisors, consultants and money managers what plan(s) they offer to their employees and why?

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News ReleaseContact:Kim McKeown
For Immediate ReleaseMarketing/PR Program Manager
March 22, 2007847-706-3528 (kmckeown@soa.org)

New Survey Looks at Pension Risk Management and Impact on Funding Gap

Pension Governance, LLC and the Society of Actuaries (SOA) are proud to join forces to research current pension risk management practices. In what is believed to be a unique large-scale assessment of this critical topic area since research was done in 1998, the jointly developed survey investigates the use of derivatives and related risk and valuation policies by pension funds and their external money managers. Questions address other topics such as the role of the pension consultant, involvement of the plan actuary, new pension rules and regulations and an increased emphasis on enterprise risk management.

Global growth in futures, options and swaps dwarfs all other financial markets. According to the Bank for International Settlements, over-the-counter and exchange-traded derivatives market activity in 2006 grew to more than $400 trillion. Public and private pension plans, a second giant force, control over $10 trillion in assets. Their risk management decisions affect millions of people around the world, compelling the need to understand pension risk management as never before.

Different than even a few years ago, markets are now more volatile, increased longevity is worsening the funding gap and pension fiduciaries seek higher returns in the form of hedge funds, private equity investments and portable alpha strategies, all of which frequently involve derivative instruments. Derivatives show up in countless liability-driven investing strategies as well, making it impossible to ignore their economic impact.

Adding to the complexity of the investment decision-making process, board members, policy-makers, taxpayers, shareholders, actuaries, fiduciary liability underwriters, debt rating analysts and plan participants need and want to understand what fiduciaries are doing in the area of pension risk management. Unfortunately, a dearth of information about plan sponsors and their money managers makes it extremely difficult to head off trouble before it starts. The primary goal of this survey is to make it easier for relevant parties to identify existing risk control practices and, by extension, encourage a long overdue discussion about best practices. While this survey emphasizes defined benefit plans, risk management applies to defined contribution plans as well. When financial controls are absent or implemented poorly, fiduciaries are unable to select appropriate 401(k) investments and evaluate service providers’ fees, possibly leaving themselves exposed to lawsuits.

Author of Risk Management for Pensions, Endowments and Foundations, Dr. Susan M. Mangiero, CFA, FRM, Accredited Valuation Analyst, Accredited Investment Fiduciary Analyst and her team are responsible for survey design and statistical analysis with ongoing input from an oversight group of pension professionals assembled by the SOA. According to SOA Research Actuary Steve Siegel, "we are all very excited about the prospect of providing our members invaluable insight about this important area.”

Invitations have been sent to nearly 6,000 pension fiduciaries in the United States and Canada. Interested plan sponsors who have not received an invitation are encouraged to participate by contacting either Dr. Susan M. Mangiero at 203-261-5519 or PG-Info@pensiongovernance.com or Steve Siegel at 847-706-3578 or ssiegel@soa.org.

Participation is limited to plan sponsors only. Preliminary results will be released to attendees of the SOA's Investment Symposium in New York, April 18-20.

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

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

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

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

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

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

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

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

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

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

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

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