New is Not Necessarily Better and Could be Worse

Every now and then, my husband likes to remind me that older is better in terms of quality. His father's tools still get used, our washer and dryer from twenty years ago are in place and his 1989 Honda was only recently sold when I nudged him to buy a car with air bags. Incidentally, the CRV was sold with 400,000 miles to a neighbor who still drives it on a regular basis. I was reminded of his words when I read a New York Times article on the failure of "new math." More recently the concept that new can be counterproductive came to light when a meeting organizer insisted on using technology that was so "cutting edge" that a few of us could not join because we did not have the requisite equipment. As a result, we have to schedule anew, costing time that could have been avoided.

Applied to pensions, adding too much complexity by trying something untested and/or sold as "the next big thing" can spell trouble. As I wrote in "Investment Complexity Risk" (August 1, 2014), transactions that are hard to explain make it difficult for an investor to "appropriately identify the right benchmark to track performance." When that occurs, tasks such as portfolio rebalancing, assessment as to whether fees paid are "reasonable" and/or constructing an effective hedge strategy are difficult to achieve.

While "new" does not automatically mean "complex," the reality is that capital markets and service providers such as asset managers are increasingly dependent on one another. What happens with one organization can have a far-reaching impact on others. Consider Goldman Sachs Group Inc. ("Goldman"). Its plan to retract prime brokerage services to some hedge funds while increasing fees to those that remain as clients will impact the institutional investors that have exposures to asset managers that either need to look elsewhere for capital or will pay more money to Goldman. See "Goldman Sachs Cuts Roster of Hedge-Fund Clients" by Justin Baer and Juliet Chung (Wall Street Journal, August 4, 2014).

Some institutional investors are throwing their proverbial hands in the air when it comes to in-house management. Pensions & Investments reporter Douglas Appell describes a trend in seeking third party help as the result of "today's volatile markets." Refer to "Complexity of investments pushes funds to seek outsourcing help" (July 9, 2012). Asset managers are similarly outsourcing certain tasks such as performance measurement and attribution. According to "Managing complexity and change in a new landscape: Global survey on asset management investment operations" (Ernst and Young, 2014), partners Alex Birkin and Alan Fish write that "Firms are only beginning to realize the opportunity in outsourcing more complex processes."

Contracting others to augment one's core business is not bad or good on its face. Importantly, end-users must understand what they are buying and what may not be covered by the agreement. Based on my experience as a forensic economist and investment risk governance expert, disputes often arise when expectations - even those that are codified with a letter of engagement - differ. Ambiguous language is one culprit. In-house and external counsel as well as those tasked with dotting the due diligence "i's" can play a vital role in clarifying the terms of outsourcing. Similarly, attorneys can work with their institutional investor clients to ensure that a Request for Proposal ("RFP") questionnaire includes ample questions about the nature of the contracts in place between asset managers being considered and the vendors to said asset managers.

The principles of good contracting are tried and true. Some may sneer at old fashioned ideas but they have a place in one's investment risk governance toolbox. When the lights go out, a pencil has a lot more value than a computer that doesn't work.

Pension Governance Grill Lines

I am back from a health camp vacation in the Southwest and excited to blog anew. Besides walking unexpectedly into the path of a poisonous and large, scaly gila monster one night (a "what do I do now" moment I might add), I had a chance to attend a kitchen demo about how to grill seafood. In waxing poetic about equipment, the chef urged the audience to avoid pans that sit atop the stove and instead go for the real thing. He went on to say that substitutes for an outdoor barbeque were so inferior in his view that one might as well paint marks on the food.

Grins aside, applied to pension governance, truer words may never have been spoken. When I testified before the ERISA Advisory Council about hard to value investing, I described some of the best practices relating to governance, risk management and appraisals. My suggestion to those who took more of a hurried approach was to consider installing a comprehensive framework that would allow for checks and balances, appropriate delegation of duties and independent oversight. As I have said on numerous occasions, if that exists at your organization, take a bow. Communicate what that structure looks like. Interested parties will be glad to know.

The illusions of eating a faux grilled steak could dissipate with the first bite.

New GAO Study Addresses Performance Audit Reports

Courtesy of the U.S. Government Accountability Office, a new study looks at performance audits for different types of pension plans. The report is entitled "Oversight of the National Railroad Retirement Investment Trust" (May 2014) and responds to requests from members of the U.S. Congress for information about this $25 billion retirement plan. Based on countless interviews with regulators, private fiduciary experts (and yes, I did answer some questions about benchmarking) and pension fund executives, the authors put forth the idea that performance audits could be mandated to occur more often. Interestingly, GAO researchers point out that "the frequency with which the Trust has commissioned performance audits is comparable to or exceeds most state efforts," adding that "...nine state plans are audited at least once every 2 or 3 years" with interviewees from 19 states pointing out that retirement plans "were subject to audits at longer set intervals that varied from state to state or were not reviewed according to any established time frame."

Pension fund accounting and performance benchmarking is certainly getting its share of attention. U.S. Securities and Exchange Commissioner Daniel Gallagher recently decried what he believes is an under-reporting of "trillions of dollars in liabilities. In his May 29, 2014 speech before attendees of the Municipal Securities Rulemaking Board's 1st Annual Municipal Securities Regulator Summit, Commissioner Gallagher talks about pension and OPEB liabilities as a serious threat and warned that "...it is imperative that bondholders know with precision the size of the potential pension liabilities of the entities in which they are investing. And yet, they do not." He adds that the "threat has been hidden from investors." As Lisa Lambert and Lisa Shumaker describe, government officials say that these sharp remarks sting and will scare people into thinking that a systemic problem exists. Read "Pension groups strike back at SEC commissioner's criticism" (Reuters, June 16, 2014). In its Q1-2014 update, the National Association of State Retirement Administrators ("NASRA") show that public pension fund assets have grown to $3.66 trillion, up slightly from the year-end 2013 level of $3.65 trillion.

On the rule-making front, the Governmental Accounting Standards Board ("GASB") just published an update to its pension accounting standards and posted a pair of brand new proposals to "improve financial reporting by state and local governments of other post-employment benefits, such as retiree health insurance." See "GASB Publishes Proposed Accounting Standards for Government Post-Employment Benefits" by the editor of AccountingToday.com, Michael Cohn. You can download the three documents by visiting the GASB website. Click to access GASB's microsite about Other Postemployment Benefits ("OPEB").

The good news, as I have said all along, is that initiatives for heightened transparency are underway. For more difficult situations, don't be surprised if litigation about disclosures continues to occur. In case you missed the February 24, 2014 Practising Law Institute ("PLI") CLE webinar, you can purchase the slides and audio recording of "Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends." I co-presented with Orrick, Herrington & Sutcliffe LLP partner, Elaine Greenberg. My focus was on risk management, valuation, performance and investment decision-making.

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.

Deciding When to Tweak or Overhaul a Pension Plan

People in my family buy things to last. It doesn't always work out the way we want. For example, we can't watch internet movies through our television set because we have yet to upgrade to a newer box that has the technology to allow this to happen. However, sometimes it is better to upgrade, even if there is a short-term incremental cost to do so. I learned this lesson the hard way in recent weeks. Sick of an old laptop that constantly froze on pages with too many graphics and a printer that only worked when I cleaned the print head (and that became a frequent occurrence), I made a beeline to Staples. During my discussion with the technology salesperson, he agreed with me that the immediate outlay of buying new productivity tools would be a lot cheaper than upgrading with the purchase of a few parts. The speed, storage and ability to use newer versions of software were a few of the advantages we discussed.

Change can be a good thing or not. The concept of evaluating when to tweak plan design or asset allocation mix (or a host of other decisions), as compared to carrying out a complete overhaul, applies to retirement plans. Of course this assumes that it is even possible to modify. For a defined benefit plan that is grossly underfunded or a defined contribution plan that is set up to keep workers happy by offering a particular group of investments, reversing course could be problematic. On the flip side, a sponsor that can effect change that would be deemed advantageous by participants but does not take action could be accused of bad practices or worse. Keep in mind that lots of ERISA lawsuits allege actions that a fiduciary committee could have taken. The important thing is to be vigilant about what has to be done on an ongoing basis and respond accordingly,

At least some plan sponsors are taking heed of the need to review where things stand. According to a recent Aon Hewitt survey, 62 percent of polled 220 U.S. companies with traditional pension benefit offerings vowed to "adjust their plan's investments to better match the liabilities in the year ahead." Some respondents affirmed their intent to consider increased allocations to fixed income securities and hedging strategies, once their funding status improves. One out of eight companies queried are evaluating plan funding status as often as once per day. Click to download "2014 Hot Topics in Retirement: Building a Strategic Focus."

I have a t-shirt that reads "Change is good. You go first." It always makes me chuckle. Even when change is not warranted, it is important to demonstrate that at least someone has thought about risk factors and alternative ways to mitigate those identified uncertainties.Maybe the t-shirt should instead read "Assessing whether change makes sense is an important part of a fiduciary's responsibilities."

Detroit Swaps, Counterparty Risk and Valuation

When I worked on several swaps and over-the-counter options trading desks, there was always a lot to do in order in order to properly set up a program with an end-user. Sometimes this involved in-person training of a board or asset-liability management committee or otherwise authorized persons who had made an organizational decision to employ derivatives. Credit limits had to be vetted, decisions about collateral had to be made and master agreements were negotiated and signed. Throughout the process, everyone was mindful that big money was at stake and that getting the preliminaries finished on time, with diligence and care, was both crucial and important. The key was (and still is) to plan ahead for a worst case scenario wherein a contractual counterparty cannot or will not perform. Should that occur, the remaining party would likely seek to unwind or offset a given position rather than allow a bad situation to linger. A valuation of the over-the-counter derivative instrument in question, such as an interest rate swap, would be determined and mutually agreed upon. Contractual terms such as the rate of swap exchange, time remaining and the quality and quantity of collateral posted by either or both counterparties would typically be used to determine the amount of money owed by the non-performing entity. An agreement as to when "non-performance" commenced would be yet another factor. In a dispute situation such as a lawsuit, damages might be part of the calculation.

Sounds straightforward, right? Well, things are seldom simple, especially when one counterparty is in financial distress. When a counterparty owes money but cannot pay on a given date or has insufficient monies to settle a swap as part of a buyout, the remaining counterparty has to look to the underlying collateral, consider litigation and/or negotiate for some type of remuneration. Legal decisions can complicate things. Consider the situation with Detroit.

On January 16, 2014, Judge Steven W. Rhodes, U.S. Bankruptcy Court for the Eastern District of Michigan, opined that a $165 million payment to UBS and Bank of America to end certain interest rate swaps was too much money to outlay right now. Refer to "Detroit bankruptcy judge rejects $165M swaps deal with banks" (Crain's Detroit Business, January 16, 2014).

By way of background, these over-the-counter derivative contracts were related to the issuance of pension obligation bonds. The objective at that time was to protect the Detroit issuer (and taxpayers by extension) from higher funding costs if interest rates climbed. By having a swaps overlay, the bank counterparties were to pay Detroit if rates increased above a specified level. Conversely, lower rates would obligate Detroit to make periodic swap payments to the banks involved.

Reporters Nathan Borney and Alisa Priddle describe a 2009 effort to collateralize the swaps with casino-related revenue in "Detroit bankruptcy judge denies proposal to pay off disastrous debt deal" (Detroit Free Press, January 16, 2014). They add that this move was aimed at avoiding "an immediate payment of $300 million to $400 million on the swaps, potentially violating the Gaming Act" since interest rates had not risen. According to "Detroit continues talks with banks after canceling swaps truce" (Bloomberg, February 7, 2014), the swaps have a monthly price tag of about $4 million, "have cost taxpayers more than $200 million since 2009" and are being questioned by the city with respect to their "legitimacy."

Numerous questions come to mind and will no doubt be raised as the banks and city officials continue to talk or the attorneys take over, should litigation ensue. The list includes, but is not limited to, the following:

  • Who had the authority to commit Detroit to the swaps trades? Click to view an interesting visual put together by the Detroit Free Press and entitled "Were The $1.44-Billion Pension Deal And The Pledge Of Casino Tax Revenue Legal?" (September 14, 2013).
  • Were any of the recommending swaps agents subject to a conflict of interest, as has been suggested by The Detroit News?
  • What was the due diligence carried out by city officials before the swaps were put in place?
  • How were the collateral-related terms decided and by whom?
  • How were swap interest rate triggers determined?
  • Was there an independent party in place to regularly review the quality and quantity of posted collateral?
  • What role did the internal and external auditors play with respect to oversight of the reporting of the swaps and related bond financing?
  • Was there an appreciation that rising rates would mean a payment by the swap banks to the city and that this inflow could have been used to offset the higher cost of variable rate debt?
  • Who undertook the analysis of the effectiveness of the swaps as a hedge against rising rates and was the hedge deemed likely to be protective?

There are lessons to be learned aplenty about swaps, contractual protection, collateral valuation, oversight, authority and much more. No doubt there will be much more to say in future posts.

Dodd-Frank, Swaps Clearing and Compliance for Pension Plan Asset Managers

According to the Bank for International Settlements, the notional amount outstanding, as of June 2013, of global over-the-counter derivatives exceeded $692 trillion. Interest rate swaps reflect the largest category at about $425.6 trillion. Given the jumbo size of this market, it is no surprise that regulators have demanded more transparency about the mechanics of the global swaps market, including reporting to regulators and the public dissemination of reported information. It is also no surprise that regulators have demanded what they deem to be risk-reducing measures such as the clearing of these instruments and collateral collection. With the promulgation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), numerous market participants are now required to clear their swaps. Click here to learn about the three categories of organizations that are required to adhere to swap clearing and trade execution requirements under Section 2(h) of the Commodity Exchange Act (“CEA”). Given the complexity of the prevailing swaps-related rules and regulations as well as the evolving nature of these mandates, any educational insights are welcome.

As an economic consultant, trainer and expert witness who regularly does work in the pension risk management arena and author of Risk Management for Pensions, Endowments and Foundations, I was delighted to have a chance to get comments about this important topic of swaps clearing and trade compliance from Davis Polk attorneys Lanny A. Schwartz and Gabriel D. Rosenberg. Mr. Schwartz is a partner, and Mr. Rosenberg is an associate in Davis Polk’s Trading and Markets practice. Besides the questions and answers provided below, and acknowledging that there is a lot to learn about swaps-related compliance, readers may want to download "Are You Ready? New Swap Trading Requirements For Pension Plan Asset Managers" (August 2013) by Attorneys Schwartz and Rosenberg, in conjunction with BNY Mellon.

Question: What is your motivation for writing about this topic as well as offering educational webinars?

Answer: We continue to receive numerous inquiries from swap market participants, many related to clearing. Swaps dealers were the first to have to demonstrate compliance with Dodd-Frank's swaps clearing mandate in March of last year. Most asset managers were required to clear specified types of interest rate swaps and credit default swaps as of June 2013. Other entities, including ERISA plans, had a deadline of September 2013.

Question: What areas have you identified as requiring more time and attention?

Answer: We are still mid-stream in terms of implementing a wide array of rules. Compliance is not a simple “check the box” exercise. Some swaps are now subject to mandatory clearing, but this is a relatively small part of the universe in terms of instruments traded in the market. Trading on a regulated futures exchange or swap execution facility is currently voluntary. Margin requirements are not yet final. Documentation requirements are similarly critical and require significant attention.

Question: What is a qualified independent representative and why is that important to an asset manager that has pension plan clients?

Answer: Before a swap dealer can act as an advisor to a pension plan regarding swaps, which in this context means making customized recommendations, the plan manager must verify that the pension plan has a qualified independent representative ("QIR") in place. A QIR is an agent of a Special Entity (such as a corporate or public pension plan) that is knowledgeable and independent of any swap dealer counterparty.

Question: It sounds like there is a large amount of due diligence that must be carried out by swaps dealers, asset managers and end-users such as pension plans, respectively. Would you elaborate?

Answer: You are correct that each category of swap market participant has a large amount of due diligence to carry out in order to ensure that they are compliant with Dodd-Frank's trading, clearing and other provisions. Swap dealers will generally require counterparties to adhere to one or more of the International Swaps and Derivatives Association (“ISDA”) protocols and other documentation as relevant to their activity. For example, suppose Big Bank X is a leading dealer of swaps and has been approached by Global Asset Management Firm Y to handle its trades on behalf of various end-users such as pension plans of Fortune 500 companies. Before Big Bank X will speak in detail about swaps with Global Asset Management Firm Y, it generally will need to make sure it has proper documentation in place. Unless Global Asset Management Firm Y can demonstrate adherence (or enters into alternative documentation developed by the swap dealer, Big Bank X will generally not transact with them.

Question: What are some of the action steps that a pension plan must take?

Answer: A pension plan, whether a corporate ERISA plan or government employee benefits plan, must have an account with a Futures Commission Merchant (“FCM”) in order to enter into swaps trades that are subject to clearing. This requires diligence and negotiation of important documentation about the clearing relationship. Pension plans should also consider the trade-offs between using swaps and nearly equivalent futures contracts.

Question: Are there areas of vulnerability that need to be better addressed?

Answer: A firm needs to have people in place who are experienced and knowledgeable about Dodd-Frank, operational processing, legal documentation and the use of technology for data inputting and report generation. None of these areas are trivial and require care and diligence. Additionally, since things are in flux as new rules are being adopted, it is critically important for any swap market participant to stay abreast of compliance mandates.

Question: Headlines are replete these days with news about regulatory investigations and lawsuits about how London Interbank Offer Rates (“LIBOR”) are determined by quoting banks. Inasmuch as the majority of swaps are tied to some type of LIBOR fix, how is swaps trading likely to be impacted?

Answer: The increased scrutiny about LIBOR could result in increased regulatory interest in other indexes that are referenced by swaps.

Question: What is the role of external counsel versus the internal General Counsel?

Answer: It is critical for asset managers to develop an educational program that allows front, middle and back office professionals to understand what rules, policies and procedures need to be established and followed. External counsel can add value by explaining the ISDA Protocols and other documentation and compliance requirements to clients. An end-user’s General Counsel should make sure that everything is in place in order to comply with Dodd-Frank. Plenty of clients say they don’t even know where to start and feel overwhelmed.

Question: There is so much more to discuss. Readers should stay tuned for further updates. At the client level, it sounds like you will both remain quite busy.

Answer: Susan, we appreciate the opportunity to share our insights with readers of your blog. We urge everyone with a stake in good governance to pay attention and do whatever is needed to comply with Dodd-Frank's swaps rules.

Longevity Derivatives Seem Poised For Further Growth

If this photo of senior ski fans is representative of the upward global trend in longevity, creators of derivatives could be on to something big. Deal count suggests that 2013 will be described as a banner year for banks and others types of financial companies as their respective corporate clients, in search of protection against the greying of their plan participants, took the plunge to get rid of risks they find difficult to manage. Financial News reports a December deal for 2.5 GBP between AstraZeneca and Deutsche Bank that "will cover the drug company against the risk that 10,000 of its former employees will live longer than expected." This follows a 1 billion GBP swap between Carillion and Deutsche Bank and a second transaction between BAE Systems and Legal & General, also in December 2013. See "A shot in the arm for longevity swaps" by Mark Cobley (January 6, 2014) for more details.

Certainly the topic is gaining importance in policy-making circles and at an international level. In December 2013, the Bank For International Settlements ("BIS") released an updated version of a study about longevity risk transfer markets. The product of the Joint Forum on longevity risk transfer ("LRT") markets, the report strongly encourages those with regulatory authority to carefully track the nature of deals being done and by which organizations as a way to gauge capacity to handle risks being transferred to the financial sector. Longevity risk exposures should be properly measured and attention should be paid to the extent to which "longevity swaps may expose the banking sector to longevity tail risk, possibly leading to risk transfer chain breakdowns." The study likewise notes the importance of supervisors to be able to evaluate whether those in possession of longevity risk have the "appropriate knowledge, skills, expertise and information to manage it."

These words of caution make sense, especially given the large amounts at stake. In its December 20, 2013 press release, the BIS cites estimates of the aggregate "global amount of annuity- and pension-related longevity risk exposure" as ranging between $15 and $25 trillion. Based on World Bank data, U.S. Gross Domestic Product for 2012 was $16.2 trillion. It was reported at $8.2 trillion for China and $5.9 trillion for Japan. The implication is clear. Get it wrong and it could mean big losses for a delicate global financial system that has had its share of risk management twists and turns. Click to access "Longevity risk transfer markets: market structure, growth drivers and impediments, and potential risks" (Basel Committee on Banking Supervision Joint Forum, December 2013).

As at least one major bank moves forward to develop a longevity derivative instrument that is meant to be traded, expect more news from insurance company and banking regulators about capacity, internal controls, assessment of risk, posting of capital and adequate disclosure about the transfer of large amount of longevity risks to financial intermediaries. Risk Magazine author, Tom Osborn, describes some of the impediments to a full-scale launch of the longevity transfer market, including limited disclosure about how transactions are priced, absence of a liquid index that would facilitate cost-effective hedging and avoid capital adequacy-related basis risk problems and questions about how exposures should be accurately modeled. Click to read "Longevity: Opportunity or flop?" (September 20, 2013).

Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends

Mark your calendars to attend "Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends."

At a time when unfunded pension and health care obligations are accelerating the budgetary crisis for some municipalities, experts fear that current problems are the tip of the iceberg. A new focus on accounting rules, the quality of disclosure to muni bond investors and the due diligence practices of underwriters, portfolio managers and advisers could mean heightened liability exposure for anyone involved in the nearly $4 trillion public finance marketplace. Add the history-making Detroit bankruptcy decision to the mix and attorneys have the makings of a perfect storm as they attempt to navigate these unchartered waters. The U.S. Securities and Exchange Commission has made no secret of its priority to sue fraudulent players in the public finance market. Insurance companies are reluctant to underwrite policies for high-risk government entities at the same time that municipal fiduciaries are more exposed to personal liability than ever before, especially as the protection of sovereign immunity is being challenged in court. Litigation that involves how much monitoring of risk factors took place is on the rise.

Public finance and securities litigation counsel, both in-house and external, can play a vital role in advising municipal bond market clients as to how best to mitigate litigation and enforcement risk or, in the event that an enforcement action has already been filed, how best to defend such litigation. Please join Orrick, Herrington & Sutcliffe LLP partner, Elaine C. Greenberg, and retirement plan fiduciary expert, Dr. Susan Mangiero, for an educational and pro-active program about the complex compliance and litigation landscape for municipal bond issuers, underwriters, asset managers and advisers. Topics of discussion include the following:

  • Description of the current regulatory environment and why we are likely to see much more emphasis on the disclosure activities of public finance issuers and the due diligence practices of underwriters and advisers;
  • Overview of hot button items that impact a bond issuer’s liability exposure, to include valuation of underlying collateral, rights to rescind benefit programs in bankruptcy and the use of derivatives as part of a financing transaction;
  • Explanation of GASB accounting rules for pension plans and likely impact on regulatory oversight of securities disclosure compliance and related enforcement exposures;
  • Discussion about trends in municipal bond litigation – who is getting sued and on what basis; and
  • Description of pro-active steps that governments and other market participants can take to mitigate their legal, economic and fiduciary risk exposures.

Featured Speakers:

Ms. Elaine C. Greenberg, a partner in Orrick, Herrington & Sutcliffe LLP’s Washington, D.C., office, is a member of the Securities Litigation & Regulatory Enforcement Group. Ms. Greenberg’s practice focuses on securities and regulatory enforcement actions, securities litigation, and public finance. Ms. Greenberg is nationally recognized for producing high-impact enforcement actions, bringing cases of first impression and negotiating precedent-setting settlements, she possesses deep institutional knowledge of SEC policies, practices, and procedures. Ms. Greenberg brings more than 25 years of securities law experience, and as a Senior Officer in the SEC's Enforcement Division, she served in dual roles as Associate Director and as National Chief of a Specialized Unit. As Associate Director of Enforcement for the SEC's Philadelphia Regional Office, she oversaw the SEC's enforcement program for the Mid-Atlantic region and provided overall management direction to her staff in the areas of investigation, litigation and internal controls. In 2010, she was appointed the first Chief of the Enforcement Division's Specialized Unit for Municipal Securities and Public Pensions, responsible for building and maintaining a nation-wide unit, and tasked with overseeing and managing the SEC's enforcement efforts in the U.S.’s $4 trillion municipal securities and $3 trillion public pension marketplaces. Ms. Greenberg recently gave a speech entitled “Address on Pension Reform” at The Bond Buyer’s California Public Finance Conference in Los Angeles on September 26, 2013.

Dr. Susan Mangiero is a CFA charterholder, certified Financial Risk Manager and Accredited Investment Fiduciary Analyst™. She offers independent risk management and valuation consulting and training. She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors. Dr. Mangiero has served as an expert witness as well as offering behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary on matters that include distressed debt, valuation, investment risk governance, financial risk management, financial statement disclosures and performance reporting. She has been actively researching and blogging about municipal issuer related retirement issues for the last decade. She has over twenty years of experience in capital markets, global treasury, asset-liability management, portfolio management, economic and investment analysis, derivatives, financial risk control and valuation, including work on trading desks for several global banks, in the areas of fixed income, foreign exchange, interest rate and currency swaps, futures and options. Dr. Mangiero has provided advice about risk management for a wide variety of consulting clients and employers including General Electric, PriceWaterhouseCoopers, Mesirow Financial, Bankers Trust, Bank of America, Chilean pension supervisory, World Bank, Pension Benefit Guaranty Corporation, RiskMetrics, U.S. Department of Labor, Northern Trust Company and the U.S. Securities and Exchange Commission. Dr. Mangiero is the author of Risk Management for Pensions, Endowments and Foundations  (John Wiley & Sons, 2005), a primer on risk and valuation issues, with an emphasis on fiduciary responsibility and best practices. Her articles have appeared in Expert Alert (American Bar Association, Section of Litigation), Hedge Fund Review, Investment Lawyer, Valuation Strategies, RISK Magazine, Financial Services Review, Journal of Indexes, Family Foundation Advisor, Hedgeco.net, Expert Evidence Report, Bankers Magazine and the Journal of Compensation and Benefits. Dr. Mangiero has written chapters for several books, including the Litigation Services Handbook and The Handbook of Interest Rate Risk Management.

De-Risking, HR Strategy and the Bottom Line

In case you missed our December 10, 2013 presentation about pension de-risking, sponsored by Continuing Legal Education ("CLE") provider, Strafford Publications, click to download slides for "Pension De-Risking for Employee Benefit Sponsors." It was a lively and informative discussion about the reasons to consider some type of pension risk management, considerations for doing a deal and the role of the independent fiduciary. The transaction and governance commentary was then followed with a detailed look at ERISA litigation that involves questions about Liability Driven Investing ("LDI"), lump sum distributions and annuity purchases.

Some of the issues I mentioned that are encouraging sponsors to quit their defined benefit plans in some way include, but are not limited to, the following:

  • Equity performance "catch up" from the credit crisis years and the related impact on funding levels, leading some plans to report a deficit;
  • Need for cash to make required contributions;
  • Low interest rates which, for some firms, has ballooned their IOUs;
  • Increased regulation;
  • Higher PBGC premiums;
  • Rise in ERISA fiduciary breach lawsuits;
  • Desire to avoid a failed merger, acquisition, spin-off, carve-out, security issuance or other type of corporate finance deal that, if not achieved, could lessen available cash that is needed to finance growth; and
  • Difficulty in fully managing longevity risk that is pushing benefit costs upward as people live longer.

While true that numerous executives have fiduciary fatigue and want to spend their time and energies on something other than benefits management, it is not always a given that restructuring or extinguishing a defined benefit plan is the right way to go. Indeed, some sponsors have reinstated their pension offerings in order to retain and attract talented individuals who select employers on the basis of what benefits are offered.

Given what some predict as a worrisome shortage of talented and skilled workers, the links among HR strategy, employee satisfaction and the bottom line cannot be ignored. For those companies that depend on highly trained employees to design, produce, market and distribute products, the potential costs of losing clients to better staffed competitors is a real problem. According to the "2013 Talent Shortage Survey," conducted by the Manpower Group, "Business performance is most likely to be impacted by talent shortages in terms of reduced client service capability and reduced competitiveness..." A report about the findings states that "Of the 38,618 employers who participated in the 2013 survey, more than one in three reported difficulty filling positions as a result of a lack of suitable candidates; the 35% who report shortages represents the highest proportion since 2007, just prior to the global recession."

As relates to the well-documented shift by companies and governments to a defined contribution plan(s), I recently spoke to a senior ERISA attorney who suggested a possible re-thinking of the DB-DC array, based on discussions with his clients. The conclusion is that a 401(k) plan is sometimes much more expensive to offer than anticipated. For employees who lost money in 2008 and beyond and cannot afford to retire, they will keep working. The longer they stay with their respective employer, the more money that employer has to pay in the form of administration, matching contributions, etc.

A plan sponsor has a lot to consider when deciding what benefits to offer, keep, substitute or augment. Dollars spent on benefits could reap rewards in the form of a productive and complete labor force. With full attribution to the seven fellas in Disney Studio's Snow White, will your employees be singing "Heigh-ho, heigh-ho, it's off to work we go" or will they instead bemoan their stingy boss and search for a new work home, with better economic lollipops, thereby leaving a business deprived of precious human capital?

Pension De-Risking For ERISA Plan Sponsors

I am delighted to join the speaker faculty for a December 10, 2013 webinar entitled "Pension De-Risking for Employee Benefit Sponsors: Minimizing Risks and Ensuring ERISA Compliance When Transferring Pension Obligations to Other Parties." If this topic is of interest to you, send me an email. I can make ten (10) guest passes available on a complimentary, first come, first served basis. Otherwise, you and your colleagues can register by visiting the Strafford Continuing Legal Education site. This topic is important and timely. I look forward to having you join us on December 10, 2013.

As U.S. pension plans face record deficits, options for transferring some or all of a sponsor's plan risk make sense for many companies. General Motors, NCR and Verizon are a few companies that have chosen de-risking options in 2012.

De-risking transactions take many forms, from transferring company obligations to third parties, to offering payouts to plan participants, to undertaking liability-driven investing and other strategies. Counsel and companies must tread carefully to avoid ERISA-based litigation or enforcement actions.

Prudent de-risking requires thorough financial analysis and clear demonstrations that ERISA fiduciary standards are met. Counsel should guide companies on how to establish the reasonableness of decisions and prepare to defend against possible court challenges.

Susan Mangiero, Managing Member at Fiduciary Leadership; Sam Myler at McDermott Will & Emery; Anthony A. Dreyspool, Senior Managing Director at Brock Fiduciary Services and David Hartman, General Counsel and Vice President at General Motors Asset Management, will provide benefits counsel with a review of pension de-risking approaches used by companies to reduce some of the risks involved with employee retirement benefits.  The panel will offer best practices for leveraging the precautions to prevent ERISA fiduciary law violations when making transfers.

The panel will review these and other key questions:

  • How can pension providers demonstrate they have met their ERISA standards of prudence, care and loyalty to plan participants?
  • What steps should be taken in preparation for termination of a pension plan?
  • What are the grounds for the various challenges to de-risking techniques and what are the techniques to avoid those challenges?

Following the speaker presentations, you'll have an opportunity to get answers to your specific questions during the interactive Q&A.

 

Fake Parakeets and Pension Risk Management

I was recently watching late night television when I did a double take. A commercial came on for fake parakeets. Yes, indeed, imitation budgies can now be had for $10 plus shipping and handling or $14.99 for a pair. Apparently the idea is that a featherless plastic bird that chirps and mechanically moves its head adds joy to the home without the mess and fuss of a dirty bird cage. I am not sure how many have been sold but the ad certainly gives one pause. After all, one of the typical reasons for buying a pet is the opportunity to connect with another living creature. (The Animal Planet website lists numerous reasons why someone gains from pet interaction. See "Top 5 Health Benefits of Owning a Pet" by Sarah Grace McCandless.) But hey, if someone is spending money to produce and promote a mechanical parakeet, there must be customers who see the light.

Sometimes though, a substitute for the real thing won't work. Take risk management for example. When scant attention is given to this vital area, unless a plan sponsor is lucky, chances are that a problem will ensue.

One of the biggest issues is to identify what risks must be mitigated. Not every risk is created equal. Some are more important than others because, left unchecked, they could wreak serious havoc with the financial survival of the plan or perhaps even the sponsor. For example, liquidity risk may be critically important for a mature plan or for a plan that is offered by a company with a deteriorating financial health. Once identified, the key is to measure an important risk factor(s) in a way that adequately captures its true nature. A third step is to evaluate the various ways that an identified and measured risk can be mitigated and decide what makes sense for the situation at hand. One solution might be a change in the asset allocation mix. Returning to the liquidity example, an illiquid asset or fund may be ill-advised for a plan in need of cash sooner than later.

The topic of risk management is broad and one that I have discussed numerous times in articles, speeches, my book entitled Risk Management for Pensions, Endowments and Foundations and chapters of books of edited readings. Plan sponsors and their participants are well served by focusing on the real thing when it comes to effective risk management and avoiding the mechanical parakeet version.

Fiduciary Management For Pension Plans

Besides being knowledgeable about medicine, nutrition and state-of-the-art health research, my doctor has a great sense of irony. He says things that make me laugh out loud. When I saw him recently, I mentioned how much I was enjoying reruns of some older television shows like Quincy, M.E. He replied, in typical clever fashion, "yea, but Sam did all the work and Quincy took the credit." It struck a chord because his statement is mostly true. In case you never watched the popular series about a coroner who helps the police solve crimes, veteran actor Jack Klugman (now deceased) applies Criminal Scene Investigation ("CSI") like smarts and tenacity in pursuit of justice. Sam Fujiyama (played wonderfully by actor Robert Ito) is likewise a medical doctor. He works alongside Dr. Quincy and is portrayed as an integral part of uncovering the truth.

In pension land, it is often the case that sponsors think they have hired someone to play the role of helpful Sam. The notion is that the advisor, consultant or fund of funds professional will be paid a fee to carry out a certain level of due diligence about action items such as setting up or revising an appropriate investment strategy, selecting or terminating an asset manager, redesigning a plan or evaluating pension transfer structures. Once the engagement letter is signed and a retainer fee is in place, the plan sponsor, like Dr. Quincy, can breathe a sigh of relief. Help is supposedly on the way - maybe. The safety net concept attached to bringing a third party on board, combined with what a colleague of mine describes as fiduciary fatigue, is reflected in the global growth of firms that describe themselves as fiduciary managers. While the retirement plan regulatory regime varies by country, the investment outsourcing model is gaining sway in the United States, the United Kingdom, the Netherlands and elsewhere. The undeniable trend to delegate merits discussion.

Before employers get too comfortable and think that their pension problems now belong to someone else, it is noteworthy to acknowledge that there are more than a few lawsuits that have been filed against third parties. Some of them allege breach on the basis of a failure to properly oversee and respond accordingly.

My observations come from firsthand experience. I have served as an economic analyst or testifying expert on disputes between an institutional investor such as a retirement plan, endowment, foundation or family trust. For other matters, I have provided due diligence training to fiduciaries and board members or reviewed the risk practices in place prior to a vendor being selected or as part of a later review of said vendor, once hired. As the founder of an educational start-up company a few years ago, I had a front row seat to the ongoing discussions between buyers and sellers of investment, risk and valuation services. Information in the form of repeated and in-depth surveys and numerous conversations about what pensions, endowments, foundations, family offices and other types of trust investors want and need from those who provide advice is telling. One issue that came up often from institutional investors was how to benchmark the quality of the work being provided by a delegate. This is a critical subject, especially for those outsourced professionals who are doing a terrific job and want their clients to be satisfied.

The topic of service provider due diligence is timely, important and the focus of my presentation on October 25, 2013 as part of the American Conference Institute's 6th Annual ERISA Litigation Conference. Interested readers are welcome to download my fiduciary due diligence slides.

Financial Executives Address De-Risking and ERISA Benefit Programs

According to "Balancing Costs, Risks, and Rewards: The Retirement and Employee Benefits Landscape in 2013" (CFO Research and Prudential Financial, Inc. - July 2013), numerous changes are underway. The opinions of senior financial executive survey takers validate the continued twin interest in expanding defined contribution plan offerings and managing the liability risk of existing defined benefit ("DB") plans. The strategic import of benefits as a way to attract and retain talent is recognized by "nearly all respondents in this year's survey." Regarding the restructuring of traditional pension plans, this report states that nearly four out of every ten leaders have frozen one or more DB plans yet recognize the need to manage risk for those plans as well as for active plans. Liability-driven investing ("LDI") programs are being adopted by "many companies". Transfer solutions are being "seriously" considered by roughly forty percent of companies represented in the survey. Almost one half of respondents agree that a return to managing its core business could be enhanced by doing something to address pension risk.

None of these results are particularly surprising but it always helpful to take the pulse of corporate America with respect to ERISA and employee benefit programs. I have long maintained that the role of treasury staff will accelerate. There are numerous corporate finance implications associated with the offering of non-wage compensation. As I have added in various speeches and articles echoing what numerous ERISA attorneys cite (and I am not an attorney), plan sponsors must carefully weigh their fiduciary responsibilities to participants against those of shareholders in arriving at a particular decision.

For a copy of the study, click here.

Interested readers may also want to check out the reference items listed below:

If you have further comments or questions, click to email Dr. Susan Mangiero.

Audrey Hepburn, Gary Cooper and Pension Governance

Grab the popcorn. If you haven't seen the 1957 romantic film, "Love in the Afternoon," check it out. No nudity. No violence. No swear words. Just some clever banter, courtesy of Maurice Chevalier, Gary Cooper and Audrey Hepburn. I love these old-fashioned movies for their charm and ease of viewing. They remind viewers that there are some things that never get old. Yes, good ideas are fresh, sound and worth revisiting again and again.

Pension governance comes to mind.

When I created www.pensionriskmatters.com in 2006, my goal was (and still is) to provide educational information about process. Not only is procedural prudence a key element of various trust rules and regulations, it is the cornerstone of effective investment, risk and asset-liability management. Indeed, it is easy to show that bad process can be hugely expensive for plan sponsors and beneficiaries alike.

At the inception of this pension blog, there were few studies and surveys about the topic of pension governance. Things have changed since then. Always an important topic, it is good to know that this "old-fashioned" topic is receiving more attention and will hopefully gain even more visibility over time.

According to a July 23, 2013 press release, a survey of U.K. employers indicates awareness of the importance of pension governance. Sponsored by SEI Investments, the survey answers reflect a frustration that companies need to do more since "current governance structure [do] not allow them to easily take advantage of market conditions to improve their funding levels, with many trustees unable to make informed and timely decisions due to a lack of resources, including limitations of time and/or expertise." Consultant relationships was another queried topic. Nearly one third of respondents expressed a "perceived lack of transparency around the costs associated with traditional investment consultants who often charge separately for investment reviews, manager changes, and ongoing support, and who are not fully accountable to the scheme." Click to learn more about how to access the SEI UK survey.

Will pension governance remain a classic a la Gary Cooper? One certainly hopes so. Too much is at stake for good process to end up on the shelf.

Pension Risk Management For The CFO

As many of you know, I have been beating the drum for a long time about the importance of effective and comprehensive pension risk management. As this issue increasingly makes its way into the C-suite, programs that are specifically created with the Chief Financial Officer ("CFO") in mind are noteworthy. A June 18, 2013 program that is sponsored by Moody's Investor Services is one such educational offering. Join me, Dr. Susan Mangiero, and other speakers for this important event. There is no charge to attend. I look forward to seeing you there.

REGISTER TODAY
Pension Risk Management: Important Lessons for the Corporate CFO

NEW YORK
Tuesday, June 18, 2013
8:30AM - 11:30AM EST

Moody's Corporate Office
7 World Trade Center
250 Greenwich Street
New York, NY 10007

Please join us in New York for a breakfast seminar on pension risk management.  The seminar will include:

» Recent developments in the litigation arena including class action suits
» Best practices from a fiduciary/governance perspective
» Moody's Investors Service consideration of pensions within a corporate rating context
»  A discussion of pension risk from a Corporate ERM perspective, including an analysis of the impact of de-risking strategies on "grid implied" credit ratings

Who should attend: CFO’s, CIO's, senior finance professionals, and internal counsel of companies with significant pension operations. Advisors and asset managers will be welcomed on a limited basis, space permitting.

SPEAKERS
» Brian Ortelere, Partner at Morgan, Lewis & Bockius LLP
Brian is a partner in the New York and Philadelphia offices of Morgan Lewis, and is co-chair of the ERISA Litigation Practice at Morgan Lewis. His practice covers the full range of employee benefit defense litigation matters, including numerous ERISA class actions.


»
 Susan Mangiero, Managing Director of Fiduciary Leadership, LLC
Susan is an independent fiduciary expert, frequent industry speaker, and author of the popular blogs pensionriskmatters.com and goodriskgovernancepays.com.  She has given testimony before the ERISA Advisory Council and the OECD about pension governance.  She is the author of Risk Management for Pensions, Endowments and Foundations.

» Wesley Smyth, Vice President and Senior Accounting Analyst at Moody’s Investors Service
Wesley is an expert in corporate financial reporting and as Moody's subject matter expert on corporate pensions is a frequent author on pension related topics.  He focuses on corporate pension finance generally, as well as within the context of specific issuer credit ratings.

» David Pitts, Director at Moody’s Analytics
David is an experienced pension actuary and product specialist at Moody's Analytics, responsible for aligning MA's suite of pension risk models with emerging business requirements.  His recent work includes determining the impact of various de-risking strategies on "grid implied" credit ratings.

Breakfast will be provided at this event.

Note: There is no cost to attend this event. However a no-show fee will be charged to the credit card provided during registration.

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Contact Us:

Visit us online for a comprehensive list of Moody's Analytics events or contact Moody's Client Services & Support for more events information and all other inquiries.

 

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!

DOL Issues Advisory Opinion About Use of Swaps by ERISA Plans

ERISA plans have long relied on over-the-counter swaps to hedge or to enhance portfolio returns. Given the high level of attention being paid to de-risking solutions these days, the role of swaps is even more important since these derivative contracts are often used by insurance companies and banks to manage their own risks when an ERISA plan transfers assets and/or liabilities. Big dollars (and other currencies) are at stake. According to its 2012 semi-annual tally of global market size, the Bank for International Settlements ("BIS") estimates the interest rate swap market alone at $379 trillion. Click to access details about the size of the over-the-counter derivatives market as of June 2012. It is therefore noteworthy that regulatory feedback has now been provided with respect to the use of swaps by ERISA plans.

In its long awaited advisory opinion issued by the U.S. Department of Labor, Employee Benefits Security Administration ("EBSA"), ERISA plans can use swaps without fear of undue regulatory costs and diminished supply (due to brokers who do not want to trade if deemed a fiduciary).

In its rather lengthy February 7, 2013 communication with Steptoe & Johnson LLP attorney Melanie Franco Nussdorf (on behalf of the Securities Industry and Financial Markets Association), EBSA officials (Louis J. Campagna, Chief - Division of Fiduciary Interpretations, and Lyssa E. Hall, Director - Office of Exemption Determinations) made several important points about whether a swaps "clearing member" (a) has ERISA 3(21)(A)(i) fiduciary liability if a pension counterparty defaults and the clearing member liquidates its position (b) is a party in interest as described in section 3(14)(B) of ERISA with respect to the pension plan counterparty on the other side of a swaps trade and (c) will have created a prohibited transaction under section 406 of ERISA if it exercises its default rights. These include the following.

  • Margin held by a Futures Commission Merchant ("FCM") or a clearing organization as part of a swap trade with an ERISA plan will not be deemed a plan asset under Title 1 of ERISA. The plan's assets are the contractual rights to which both parties agree (in terms of financial exchanges) as well as any gains that the FCM or clearing member counterparty may realize as a result of its liquidation of a swap with an ERISA plan that has not performed.
  • An FCM or clearing organization should not be labeled a "party in interest" under ERISA as long as the swap agreement(s) with a plan is outside the realm of prohibited transaction rules.

There is much more to say on this topic and future posts will address issues relating to the use of derivatives by ERISA plans. In the meantime, links to this 2013 regulatory document and several worthwhile legal analyses are given below, as well as a link to my book on the topic of risk management. While it was published in late 2004 as a primer for fiduciaries, many of the issues relating to risk governance, risk metrics and risk responsibilities remain the same.

Pension De-Risking: Compliance and ERISA Litigation Considerations

On January 16, 2013, this blogger - Dr. Susan Mangiero - had the pleasure of speaking with (a) Attorney Anthony A. Dreyspool (Senior Managing Director, Brock Fiduciary Services) (b) Attorney David Hartman (General Counsel and Vice President, General Motors Asset Management) and (c) Attorney Sam Myler (McDermott Will & Emery) about compliance "must do" items and litigation vulnerabilities. Sponsored by Strafford Publications, "Pension De-Risking for Employee Benefit Sponsors" attracted a large audience of general counsel, outside ERISA counsel and financial professionals. In addition to numerous talking points shared by all of us presenting, we had lots of attendee questions about issues such as balance sheet impact, case law and annuity regulations.

Click to download the slides for "Pension De-Risking for Employee Benefit Sponsors."

In my opening comments, I described some of the factors that are being discussed as part of conversations relating to whether a plan sponsor should de-risk or not. These include, but are not limited to, the following:

  • Low interest rates;
  • Higher life expectancies;
  • Increased PBGC premiums;
  • Company's debt capacity;
  • Intent to go public or sell to an acquirer;
  • Available cash; and
  • Knowledge and experience of in-house ERISA fiduciaries.

Attorney Hartman urged anyone interested in de-risking to allow ample time of between six to eighteen months in order to file documents, research and create or modify policies and procedures as needed. He also advised companies to make sure that participants are fully apprised of their rights and to explain the merits of any particular transaction. For companies that may want to redesign a plan(s) for hourly workers, more time may be needed, especially if collective bargaining agreements are impacted.  His suggestion is to inform plan participants about state guarantees that apply in the event of an insurance company default. When retirees are emotionally attached to getting a check from their employer, care must be taken to allay any concerns that future monies will come from an outside third party. Keep in mind that the market may be moving at the same time that a deal is being put together. Regarding the transfer of assets, Attorney Hartman stated the importance of finding out early on what an insurance company is willing to accept. An independent appraiser may be required to determine the appropriate value of certain assets.

I talked about the various risks that can be mitigated via de-risking versus those that are introduced as the result of some type of defined benefit plan transfer or derivatives overlay strategy. The point was made that there is no perfect solution and that facts and circumstances must be taken into account. I added that litigation may arise if a plaintiff (or class of plaintiffs) question any or all of the following items:

  • Whether executives are unduly compensated as the result of an earnings or balance sheet boost due to de-risking;
  • Timing of a transaction and whether interest rates are "too low" at the time of a deal;
  • Completeness (or lack thereof) of information that is provided to participants;
  • Amount of fees paid to vendors;
  • Use of an independent fiduciary;
  • Level of asset valuations;
  • Use of an independent appraiser;
  • Extent to which due diligence was conducted on the structure of deal; and/or
  • Level of vetting of "safest available" annuity provider.
Continue Reading...

Pension De-Risking for Employee Benefit Sponsors: Minimizing Risks and Ensuring ERISA Compliance When Transferring Pension Obligations to Other Parties

Click to register for a January 16, 2013 webinar entitled "Pension De-Risking for Employee Benefit Sponsors: Minimizing Risks and Ensuring ERISA Compliance When Transferring Pension Obligations to Other Parties." Sponsored by Strafford Publications, this Continuing Legal Education ("CLE") webinar will provide benefits counsel with a review of pension de-risking approaches used by companies to reduce some of the risks involved with employee retirement benefits. The panel will offer best practices for leveraging the precautions to prevent ERISA fiduciary law violations when making transfers.

Description

As U.S. pension plans face record deficits, options for transferring some or all of a sponsor's plan risk make sense for many companies. General Motors, NCR and Verizon are a few companies that have chosen de-risking options in 2012.

De-risking transactions take many forms, from transferring company obligations to third parties, to offering payouts to plan participants, to undertaking liability-driven investing and other strategies. Counsel and companies must tread carefully to avoid ERISA-based litigation or enforcement actions.

Prudent de-risking requires thorough financial analysis and clear demonstrations that fiduciary standards under ERISA are met. Counsel should guide companies on how to establish the reasonableness of decisions and prepare to defend against possible court challenges.

Listen as our panel of experienced employee benefit practitioners provides guidance on precautions for companies undertaking transfers of pension plan obligations to third parties or other de-risking options. The panel will outline best practices for assembling a thorough financial review, complying with ERISA requirements, and responding to potential legal challenges from plan participants.

Outline

  1. De-risking overview
    1. Current trends
    2. Different approaches
      1. Transfers to third parties
      2. Lump sum payouts for participants
      3. Investment strategies
  2. Procedural prudence
    1. Financials
    2. Government filings and participant notifications
    3. Meeting ERISA fiduciary requirements
      1. Prudence
      2. Care
      3. Loyalty
  3. Potential challenges from plan participants
    1. Grounds for challenges
    2. Likelihood of success

Benefits

The panel will review these and other key questions:

  • What kind of financial reviews are needed to support a de-risking transaction?
  • How can pension providers demonstrate they have met their ERISA standards of prudence, care and loyalty to plan participants?
  • What steps should be taken in preparation for termination of a pension plan?

Following the speaker presentations, you'll have an opportunity to get answers to your specific questions during the interactive Q&A.

Faculty

Susan Mangiero, Managing Director
Fiduciary Leadership, LLC, New York Metropolitan Area
 

She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors as well as offered expert testimony and behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary for various investment governance, investment performance, fiduciary breach, prudence, risk and valuation matters.

Nancy G. Ross, Partner
McDermott Will & Emery, Chicago

She focuses her practice primarily on the area of employee benefits class action litigation and counseling under ERISA. She has extensive experience in counseling and representing employers, boards of directors, plan fiduciaries, and trustees in matters concerning pension and welfare benefit plans. Her experience includes representation of pension plans, ESOPs, trustees and employers.

Anthony A. Dreyspool, Senior Managing Director
Brock Fiduciary Services, New York

He specializes in the investment of assets of ERISA-covered employee benefit plans and all aspects of ERISA fiduciary law compliance.  He has more than 30 years of experience with respect to ERISA matters and has substantial knowledge in the structuring and formation of private real estate and equity funds for the institutional investment market.

CFO Magazine Article About Pension De-Risking

In case you missed the launch of "Applied to Pensions, Risk is a Four-Letter Word" by Dr. Susan Mangiero and ERISA attorney Nancy Ross (CFO Magazine, November 8, 2012), experts conclude that Chief Financial Officers need to do their homework before entering into a particular deal. "Beyond the obvious number-crunching needed to vet what's often a large dollar transaction, the decision to de-risk should minimally include:

  • A thorough evaluation of the financial, operational, and legal strength of the annuity provider as required by the U.S. Department of Labor Interpretative Bulletin 95-1.
  • Independent pricing of any hard-to-value assets that will be contributed as part of a de-risking deal.
  • Economic assessment of opportunity costs in a low interest rate environment and whether it is better to delay a transaction or close immediately.
  • Review of vendor and counterparty contracts that may need to be unwound in the event of a full transfer of pension assets and liabilities to a third party.
  • Review of direct and indirect fee amounts to be paid by a plan sponsor as the result of a de-risking transaction.
  • Assessment of litigation risk associated with plan participants asserting that they've been unfairly treated as the result of a pension de-risking arrangement.
  • Creation of a strategic communications action plan to ensure that plan participants, shareholders, and other relevant constituencies are provided with adequate information."

In a related commentary, ERISA Stephen Rosenberg describes the chaos in the defined benefit plan market that continues to give plan sponsors pause about staying with the status quo. Click to read "On Getting Out of the Pension Business."

De-Risking For Shareholders or Participants?

According to "De-Risking Focuses on Business Issues; Retirement Security a Concern, Critics Say" by BNA reporter Florence Olsen (Pension and Benefits Blog, November 2, 2012), the Pension Rights Center in Washington would like plan sponsors to catch their breath before partially or fully transferring its pension liabilities to third parties like insurance companies. Business Insurance editor-at-large Jerry Geisel writes that the Pension Rights Center wants the U.S. Congress to prohibit further pension de-risking transactions until legislators can assess the ramifications of giving some or all plan participants a choice to convert their future expected pension cash flows into a lump sum or having the employer contract with a group annuity provider to write checks instead of the original corporate sponsor. See "Pension Rights Center wants Congress to put moratorium on pension plan de-risking" (October 19, 2012).

In a forthcoming article for CFO Magazine, ERISA attorney Nancy Ross (with McDermott Will & Emery) and Dr. Susan Mangiero (with FTI Consulting) consider pension de-risking within the context of governance and the duty of loyalty to plan participants. They conclude that while there could be distinct advantages that accrue to retirees and workers when a sponsor enters into a pension de-risking transaction, ERISA fiduciary decision-makers may face personal and professional liability in the event that the economics of a deal mostly benefit shareholders.

In a recent announcement, one company that entered into a pension de-risking transaction cited the upside to include the following:

  • Enhancing the sponsor's long-term financial position;
  • Removing a "volatile" pension liability from the balance sheet;
  • Reducing cash flow and income statement volatility; and
  • Improving financial flexibility.

It is not known yet whether someone will challenge this kind of rationale as being too shareholder heavy or instead primarily in the best interest of plan participants who are impacted by a particular transaction. One might logically assert that a financially stronger plan sponsor means less risk for those participants who remain exposed to its credit risk and "ability to pay."

The use of an independent fiduciary could help to allay any concerns about issues such as deal terms, fees paid, the selection of the "safest available" annuity provider and the fair market valuation of contributed assets that are deemed "hard to value." Outsourcing or delegating the investment management function to a financial institution - in lieu of a pension transfer - may be another approach to consider.

Only time will tell whether the plaintiff's bar sees a possible "two hat" fiduciary conflict as a reason to file an ERISA lawsuit against corporate officers and/or directors.

Risk Management for Financial Service Firms: Getting It Right

Join Dr. Susan Mangiero and other esteemed speakers in Seattle on October 5,2012 for an important conference entitled "Managing Risk in a Complex World." Part of the University of Washington Law, Business and Entrepreneurship Program, this event features speakers such as Mr. Bill Ayer, Chairman of the Alaska Air Group. Dr. Mangiero, a managing director with FTI Consulting's Forensic and Litigation Consulting practice, is a CFA charterholder, certified Financial Risk Manager, Accredited Investment Fiduciary Analyst and the author of Risk Management for Pensions, Endowments and Foundations (John Wiley & Sons). She will be joined on the podium by Steven Ramirez with the Loyola University Chicago School of Law, Matthew McBrady with Silver Creek Capital Management and Richard Painter with the University of Minnesota School of Law to discuss how banks, asset managers and other types of financial services firms are managing risks at a time of great regulatory and market uncertainty.

According to Dr. Mangiero, a financial expert in the areas of risk management, valuation, performance reporting, asset allocation, fees and investment fiduciary best practices, "Headlines are replete with bad news about organizations that did not take risk management seriously. Those banks, asset managers and other types of financial services firms that put internal controls in place and regularly measure and monitor their exposures are in a much better position to attract and retain new clients. With so much litigation and regulatory enforcement about risk management lapses, now is not the time to cut back on spending money for compliance."

Click to read more about this exciting University of Washington Law School event. Other sessions will address risk management in mergers & acquisitions, risk management for technology leaders and the role of risk management in fostering good corporate governance.
 

Pension Risk End Game

Are we there yet?

While traveling to New York City the other day on Metro North, I sat behind a little boy who kept asking his parents the same question that many in the pension field are pondering.

The issue of what end game applies is noteworthy, especially now that Congress has adopted pension reform.

In "Looking for Cash, Congress Finds Some in a Corporate Pension Rule Tweak," New York Times reporter Mary Williams Walsh (June 28, 2012) describes the parts of the just passed highway bill that could force costs upward for American businesses. For one thing, sponsors will be able to stretch out their cash outlays to buoy underfunded defined benefit plans over time. As a result, tax-deductible contributions will be smaller in the next few years, taxable income will be higher and federal tax coffers will go up by an estimated $9.4 billion over the next 10 years." In addition, insurance premiums that companies pay to the Pension Benefit Guaranty Corporation ("PBGC") will be higher to the tune of roughly $10 billion in the coming decade.

The news is troublesome for numerous reasons.

For one thing, employees, retirees, creditors and shareholders are going to find it even more challenging to assess the true cost to companies that offer benefit plans. As a result, they could be in for a nasty surprise later on if reported performance numbers are overly optimistic and mask a large liability that eventually will require cash. Second, the increased PBGC premiums are slated for general revenue which means that incremental dollars may never be available to pay participants of troubled sponsors because they have already been spent elsewhere. Third, using corporate pension plans as a national piggyback to pay for other programs goes against the nature of the trust arrangement that was put in place with the 1974 creation of the Employee Retirement Income Security Act ("ERISA"). Fourth, measuring pension risk and managing it effectively requires those in charge to have a good handle on the economic objectives they are seeking to satisfy. Chief financial officers ("CFO"s) and treasurers could be doing an excellent job of mitigating relevant uncertainties but not be rewarded if capital market participants emphasize accounting numbers that do not capture what is really going on.

Dr. Susan Mangiero, CFA charterholder, certified Financial Risk Manager, Accredited Investment Fiduciary Analyst and author of Pension Risk Management for Pensions, Endowments and Foundations will continue to write about pension risk management. There is a lot more to say.

CFO Liability and Pension Plan Governance and Risk Management

On October 16, 2012, thousands of CFOs,Treasurers, Vice Presidents of Finance and other corporate leaders will meet in Miami, Florida for a chance to attend timely and informative sessions as part of this year's annual conference of the Association for Financial Professionals ("AFP"). Dr. Susan Mangiero is proud to have been selected to speak at the Association for Financial Professionals' big event. She will be joined by senior ERISA litigation attorney Howard Shapiro with Proskauer Rose LLP to address the topic of CFO liability and pension plan governance and risk management. Click to access information about the Pension & Benefits educational session track that includes this important session and many others.

According to Dr. Susan Mangiero, a managing director with FTI Consulting's Forensic and Litigation Consulting practice and based in New York, financial professionals, board members and their advisors can learn numerous lessons by examining what went wrong elsewhere and, by extension, what to avoid. Mangiero emphasizes that "Litigation is a reality. Mitigating enforcement, regulatory, litigation and reputation risk is hugely important because of the expensive consequences of inaction. For enlightened companies both large and small, employee benefit plan governance is high on the priority list for officers and directors. When retirement plan problems exist, it could compromise a firm's ability to raise capital, finalize corporate finance transactions and/or add to enterprise value. Most importantly, it could mean that a company is unable to keep its promises to plan participants."

Dr. Mangiero is also the author of "Pension risk, governance and CFO liability" (Journal of Corporate Treasury Management, Henry Stewart Publications, Vol. 4, 4, 2012, pages 311 to 323). Click to read "Pension risk, governance and CFO liability."

Click to read "The Risk Manager" by Elliot A. Fuhr and Christine Wu McDonagh (FTI Journal, April 1, 2012) for a current discussion about the importance of having chief financial officers embrace and support enterprise risk mitigation.

Is Risk Management For Pension Funds Important?

As part of a panel this morning on pension risk management in San Francisco for The Pension Bridge 2012, I was happy to get feedback from lots of people who found the session helpful. While an hour is scant time to address such a critical topic, some of the observations from the session are noteworthy.

  • Everyone on the panel linked pension risk management to governance, adding that those in charge have to acknowledge the importance of identifying uncertainties and allocating resources accordingly before a robust process can begin.
  • An early morning speaker cited risk management as the most important topic being discussed by pension boards today. Yet few in the audience raised their hands when asked how many pension funds had risk management policies and procedures in place.
  • Trying to explain the disconnect between perception and reality is tough. Some panelists suggested that the difficulty in trying to define risk is part of the reason why discussions have not yet led to actions.
  • I commented that operational risks are not going to be picked up by standard financial metrics yet cannot be ignored.
  • My suggestion to the pension fund trustees in the audience was to meet with plan counsel in order to understand their duties and obligations. Inviting a fiduciary liability insurance professional to that same meeting might be helpful in identifying risk governance gaps that could cost a plan more money in premiums. Even better yet would be the hiring of an independent third party to conduct a fiduciary audit of the pension plan's investment processes to discern where internal controls should be improved.
  • I disagree with comments made by one of my fellow panelists about the role of the Chief Investment Officer in leading the risk management function. An industry best practice touted by many experts is to have a separate Chief Risk Officer who reports to the Board and who is given sufficient latitude to say "no" to the investment team when they start to take on too much uncompensated risk.

The take away for me from the risk management session today is that many organizations still do not embrace the urgent need to properly identify, measure and manage a large number of financial, operational and fiduciary risks. This is not a good thing. Talking about risk management and the related governance process is a step in the right direction but not enough by far.

Pension Risk, Governance and CFO Liability

My November 2011 presentation about pension risk, governance and liability to financial executives struck a chord. Part of a Chief Financial Officer ("CFO") conference held at the New York Stock Exchange, attendees alternatively listened with interest while adding their insights from the front lines here and there. It is no wonder.

With ERISA litigation on the rise and 401(k) and defined benefit plan decisions often driving enterprise value in a material way, CFOs and treasurers have accepted the obvious. Corporate governance and pension governance are inextricably linked. Make a bad decision about an employee benefit plan and participants and shareholders alike may suffer. As a result, the CFO is exposed to fiduciary liability, career risk and the economic consequences of an outcome with broad impact.

Rather than rely on luck, there is no better time to apply discipline and rigor to employee benefit plan management for those companies that have not already done so. With trillions of dollars at stake, properly identifying, measuring and mitigating pension risks continues to be a critical element of fiduciary governance.

The complexity and ongoing nature of the risk management process is sometimes overlooked as less important than realizing a particular rate of return. Recent market volatility, large funding deficits and pressures from creditors, shareholders, rating agencies and plan participants make it harder for pension fiduciaries to avoid the adoption of some type of pro-active risk control strategy that effectively integrates asset and liability economics.

In "Pension risk, governance and CFO liability" by Susan Mangiero (Journal of Corporate Treasury Management, Henry Stewart Publications, Vol 4, 4, 2012, pages 311 to 323), the issues relating to a panoply of risks such as actuarial, fiduciary, investment, legal, operational and valuation uncertainties are discussed within a corporate treasury framework. Article sections include:

  • Enterprise risk management, employee benefit plans and the role of the CFO;
  • Conflicts of interest and pension plan management;
  • Risk management principles and 401(k) plans;
  • Pension liability and mergers, acquisitions and spinoffs;
  • Prudent process;
  • Pension risks; and
  • Benchmarking success.

Click to download "Pension risk, governance and CFO liability" by Dr. Susan Mangiero, CFA, FRM.

Fiduciary Duty to Hedge

Who would have thunk that a discussion about pension governance and risk management would keep audience members in their seats for nearly three hours? Yet that is what occurred on January 24, 2012 as a panel convened to discuss such weighty issues as whether companies have a fiduciary duty to hedge and whether inaction can lead to litigation.

In his opening remarks as part of a January 24, 2012 event that was hosted by the Hartford CFA Society, ERISA attorney Martin Rosenburgh cautioned that fiduciaries could find themselves open to questions for not taking steps to mitigate risks. Attorney Gordon Eng, a former litigator and now general counsel and Chief Compliance Officer for a high yield bond fund, adds that any investment decision should be supported with ample documentation that reflects a careful and thorough deliberation of the issues at hand.

For more details about this lively, topical and informative event, read "Considering a Duty to Hedge" by Christopher Faille.

Pension Risk Management and Governance: Challenges and Opportunities in a New Era

 

Please join me and fellow panelists on January 24, 2012 fro. 4 to 6 pm for a topical discussion about pension risk management and governance. Given that the last few years have posed unprecedented challenges for plan sponsors, both corporate and public, as well as their asset managers and consultants, life in employee benefit land will never be the same again. Market volatility, low interest rates, increased scrutiny about carrying out fiduciary duties, calls for better disclosure and greater complexity keep pension decision-makers busy.

Hear what legal and financial professionals have to say about what keeps plan sponsors and their advisors and asset managers up at night and how they can implement best practices for pension risk management within a fiduciary framework.

The roster of speakers who will address both defined benefit and defined contribution plan best practices and concerns include:

  • Mr. William Carey, President, F-Squared Retirement Solutions
  • Attorney Gordon Eng, General Counsel and Chief Compliance Officer, SKY Harbor Capital Management, LLC
  • Dr. Susan Mangiero, CFA, FRM, Risk and Valuation Consultant and Expert Witness
  • Attorney Martin J. Rosenburgh, CFA
Continue Reading...

Prioritizing Risk Management

Since I launched my second blog in early 2011 to discuss risk management and investment best practices for a wider institutional audience beyond pension plans alone, I've seldom posted items in both places. Instead, I've tried to provide unique insights for employee benefit plan decision-makers on www.PensionRiskMatters.com and address broader regulatory, litigation and compliance issues on www.GoodRiskGovernancePays.com.

Today is an exception. I am reprinting my comments about risk management on both blogs because I believe so strongly in the importance of effective risk management as an integral component of investment governance. I hope you enjoy reading my comments, originally published on The Glass Hammer website. For those who are not familiar with the group, check out www.TheGlassHammer.com to learn about this award-winning blog and online community created for women executives in finance, law, technology and big business. See below or click on "Thought Leaders: Prioritizing Risk Management" to read the full text of this commentary about the benefits of risk mitigation well done and the costly consequences of inattention or sloppy practices.

Full Text:

Thought Leaders: Prioritizing Risk Management, July 14, 2011, 1:00 pm

Contributed by Susan Mangiero, PhD, Investment Risk Governance Consultant and Author

For those financial institutions which have yet to grasp the importance of identifying, measuring, managing, and monitoring risks on a comprehensive basis, time may not be on their side. Regulators and litigators alike are forcing change.

There are countless individuals who want better information from their service providers about risk and are prepared to vote with their feet if they don’t get good answers. After all, these institutional investors themselves are confronted with a bevy of new mandates that require transparency. The good news is that change opens the door to business opportunities. Enlightened organizations that have good processes in place and have nothing to hide can differentiate themselves from competitors. Providing clients with education and data tools offers yet another way for asset managers, consultants, banks, and advisors to forge stronger relationships with their pension, endowment, foundation and family office clients. On the flip side, those who are reluctant to explain how they manage their financial, operational and legal risks may lose clients or worse yet, could end up as defendants in a lawsuit.

Pay to play conflicts, questions about hidden fees, state and federal legislation and new accounting rules are a few of the forces at work to ensure that trillions of institutional dollars are in good hands. Effective investment stewardship is no longer a luxury. Recent surveys confirm that buy side decision-makers continue to emphasize governance and risk management for their organizations as well as providers of products and services. Institutional investors can ill afford to lose money after a tumultuous few years. Investment committee members who give short shrift to fiduciary duties could end up being investigated by regulators or sued. According to federal court data, the number of ERISA lawsuits is going up. Factor in investment arbitrations, enforcement actions and “piggyback” securities litigation allegations and it is clear that unhappy investors are not going to accept the status quo.

1. Fiduciary Focus

Besides efforts underway by the U.S. Securities and Exchange Commission (SEC), the U.S. Department of Labor (DOL) has proposed an expanded definition of who should serve as a fiduciary to ERISA employee benefit plans. If adopted, countless more professionals will be tasked with demonstrating procedural prudence when it comes to the investment of over $30 trillion in money from corporate retirement plan sponsors. States are likewise seeking change in the form of trust law reforms that tighten accountability for the investment of monies held by endowments, foundations and charities. The questions now being addressed by judges and arbitration panels relate to “excessive” risk-taking, insufficient diversification, absence of independent assessments of hard-to-value instruments and oversight failures that have led to large losses that might have been highly preventable.

One asset management firm recently settled with the SEC for $242 million over a mistake with one of its risk management models. Another firm just settled with the SEC for $200 million due to problems in the way subprime securities were marked. A few years ago, a Northeast pension plan was sanctioned by the DOL for not having thoroughly vetted valuation numbers provided by one of its hedge fund managers.

When I testified before the ERISA Advisory Council in 2008, I emphasized that having good valuation policies and procedures is essential because it impacts so many decisions having to do with asset allocation, hedging and fees paid.

Continue Reading...

Co-Leading Pension Risk Management Workshop in Orlando

I am off to Orlando to address the Florida Public Pension Trustees Association about pension risk management. I will be joined by an esteemed colleague, Dr. Michael Kraten, in a presentation about the fundamentals of enterprise risk management (including the famous COSO cube) and the role of the service provider in creating hedging programs and vetting asset managers who use derivatives. The workshop will include two case studies about foreign currency overlay programs and investing in hedge funds and private equity funds, respectively.

Having addressed the Florida Public Pension Trustees Association ("FPPTA") several times before about pension risk management, I am impressed with its commitment to fiduciary education about investment best practices.

Click here to review the FPPTA agenda for the 2011 summer conference.

Financial Model Mistakes Can Cost Millions of Dollars

 

It's been awhile since I've blogged. Work has been busy and then I took off ten days to visit Paris. The City of Lights is amazing indeed. Now that I'm back, I will try to blog more frequently. There is certainly no shortage of topics about risk, governance, litigation, valuation and so on.

For those who don't know, I created a sister blog a few months ago. See GoodRiskGovernancePays.com. Nearly all of the time, the posts on each blog are different. However, I decided to reprint a post from GoodRiskGovernancePays.com here since the topic is hugely important. After all, for those defined benefit and defined contribution plans that are exposed to "hard-to-value" investments, leverage and perhaps higher than expected volatility, model risk could be the hidden alligator that bites if left unchecked. As always, I welcome your comments at contact@fiduciaryleadership.com.

Here is the post that was originally posted on June 2, 2011 by Dr. Susan Mangiero.

In a recently published article about financial models entitled "Financial Model Mistakes Can Cost Millions of Dollars" (American Bar Association, Section of Litigation, Expert Witnesses, May 31, 2011), Dr. Susan Mangiero defines model risk and explains why it is so important. Referencing the recent $242 million enforcement action by the U.S. Securities and Exchange Commission as a result of model mistakes made by a well-known asset management firm, this financial expert cites the heightened regulatory and litigation imperatives with respect to risk and valuation models. She concludes the article by listing some of the ways to mitigate risk. These include, but are not limited to the following:

  • Hire knowledgeable programmers with capital market experience;
  • Create and follow a set of policies and procedures that govern how and who will validate financial models over time and what will trigger revisions in a model(s);
  • Avoid conflicts of interest that would reward managers for ignoring problems and would potentially preclude an independent and objective assessment of problems and related corrective action(s);
  • Test assumptions for validity in stable markets as well as extreme circumstances;
  • Stress a model using a sufficient number of economic scenarios to gauge its predictive power and whether results can be relied upon in both good or bad times;
  • Educate personnel about how a particular model is supposed to work;
  • Establish a response strategy should a problem occur and investors need to be informed before things get out hand;
  • Scrap models that are overly complex and expensive to replicate;
  • Don't be afraid to ask questions about inputs, data quality, results, and concerns; and
  • Invite informed outsiders to offer an independent and regular critique on a confidential basis.

 

"Death" Derivatives and Longevity Related Pension Risks

As seniors continue to live hopefully fulfilling lives, plan sponsors grapple with how to best manage the costs. The realities of longer life spans for participants is creating all sorts of innovation on Wall Street, including what Bloomberg journalists recently described as "death derivatives."

In a May 16, 2011 article, Oliver Suess, Carolyn Bandel and Kevin Crowley describe products that could encourage defined benefit plan executives to "outsource" by transferring risks to longevity traders or entering into a financial engineering transaction in order to receive a regular cash flow that mirrors their respective ongoing obligations to retirees. What happens next, depending on how capital market participants respond to a few test cases, could mean the growth of a $23 trillion market in longevity bonds and related derivative instruments.

As with any financial engineering endeavor, education will be paramount in terms of both plan sponsors and securitized pension obligation buyers understanding underlying assumptions and risk-return attributes.

Click to read "Death Derivatives Emerge From Pension Risks of Living Too Long."

Public Pension Risk Management and Fiduciary Liability

A few weeks ago, Attorney Terren B. Magid and Dr. Susan Mangiero jointly presented on the topic of pension risk management and fiduciary liability with a particular emphasis on public plans. Attorney Magid's insights reflect a particularly unique perspective inasmuch as he served as executive director of the $17 billion Indiana Public Employees' Retirement Fund ("PERF"). Dr. Mangiero shares her views as an independent risk management and valuation consultant, author, trainer and expert witness.

Click to download the 25-page webinar transcript for public pension fiduciaries entitled "Are You Properly Mitigating Risk? Assess Your Fiduciary IQ" with Attorney Terren B. Magid (Bingham McHale LLP) and Dr. Susan Mangiero (Fiduciary Leadership, LLC). Comments about ERISA plans are provided when applicable.

Topics discussed include, but are not limited, to the following:

  • Public Pension Transparency Act
  • Discount Rate Choice
  • Dodd-Frank Wall Street Reform and Municipal Advisor Registration
  • Expanded Definition of ERISA Fiduciary
  • Fee Disclosure Under ERISA 408(b)(2)
  • Failure to Pay and Actuarially Required Contribution ("ARC")
  • Benefit Reductions
  • RFP Process
  • Fiduciary Audits
  • D&O Policy Review
  • Vendor Contract Examination
  • Qualitative and Quantitative "Investment Risk Alphabet Soup"
  • Interrelated Risk Factors
  • Key Person Risk
  • Hard to Value Investing
  • Model Risk
  • Stress Testing
  • Pension Litigation
  • Fiduciary Breach Vulnerability
  • Characteristics of a Good Model
  • Side Pockets and Investment Performance.

Comments are welcome.

Susan Mangiero Authors Pension Risk Blog For Fifth Year

Five years ago, valuation and risk management professional Dr. Susan Mangiero launched the first blog devoted exclusively to the topic of retirement plan governance and investment best practices. This unique blog, www.PensionRiskMatters.com, continues to serve as a resource for ERISA and public plan trustees, board members, actuaries, advisers, attorneys, auditors, consultants, money managers and regulators who want to explore important ideas about pension risk issues within a fiduciary framework.

Since the inception of www.PensionRiskMatters.com, the challenges that confront retirement plan decision-makers continue to mount. The U.S. Department of Labor (“DOL”) and U.S. Securities and Exchange Commission (“SEC”) each seek to expand the definition and scope of investment fiduciary duties. Pension litigation is on the rise with some lawsuits being certified as class actions and resulting in multi-million dollar settlements. Liability insurance underwriters and federal, state and international regulators are asking tough questions about risk-taking and due diligence. Lawmakers actively examine issues relating to 401(k) fees. Taxpayers worry that more than $3 trillion of unfunded IOUs will strain local budgets. Pay-to-play and other types of conflict of interest investigations grab headlines. Investors worry that bad employee benefit plan economics could roil share prices or thwart corporate mergers.

Click here to read the rest of the March 23, 2011 press release about www.PensionRiskMatters.com.

Risk Management and Valuation Blog Launches

Recognizing the continued need for actionable information about institutional investment best practices, Dr. Susan Mangiero offers analysis of critical issues affecting the $30+ trillion global buy side industry. This unique investment risk management and valuation blog at www.goodriskgovernancepays.com serves as a resource for trustees, board members, attorneys, money managers and financial advisors with asset allocation, governance, risk management and fiduciary oversight responsibilities.

According to Dr. Mangiero, “Investment risk governance is more important than ever before. As billion dollar losses continue to make headlines, fiduciaries and their counsel continue to be challenged with volatile markets, a slew of new mandates and investment complexity that requires rigorous due diligence. Litigation is increasing at a fast clip and investment professionals must absolutely embrace and demonstrate an understanding of risk management and valuation issues. Post-Madoff and the credit crisis, there is no room for complacency.”

Click here to read the February 10, 2011 press release about GoodRiskGovernancePays.com.

Note to Readers: PensionRiskMatters.com, soon to celebrate its fifth year anniversary, focuses on the many challenges confronting retirement plan decision-makers. GoodRiskGovernancePays.com takes a broader view of the industry and includes commentary, insights and analysis about important issues for pension funds and other types of institutional investment industry participants such as endowments, hedge funds, mutual funds, private equity funds and sovereign wealth funds. The coverage is slightly different and the access is complimentary. Readers are encouraged to get email updates for each of these two unique websites. Visit GoodRiskGovernancePays.com and type your email into the box by the green GO button or click here to add GoodRiskGovernancePays.com to your RSS feeder.

Model Risk Costs One Asset Manager $242 Million

According to a February 3, 2011 document released by the U.S. Securities and Exchange Commission ("SEC"), AXA Rosenberg Group ("AXA") and various related entities have settled a matter relating to model risk for $242 million in economic damages and penalties. In a company letter dated April 15, 2010, several AXA executives describe an error with an investment model as having been "discovered in late June 2009" and "corrected between September and mid-November." While there are issues about the disclosure of said problems, the official message to investors at that time was a continued commitment to risk management.

Investor fallout has occurred nevertheless with various press accounts reporting the withdrawal of monies from AXA by pension plans such as the School Employees' Retirement System of Ohio, Los Angeles Fire and Police Pensions, the City of Fresno Retirement System, Florida State Board of Administration, the Marin County Employees' Retirement Association and the Montana Board of Investments. 

As I've written before, valuation (and by extension, model risk assessment) is a key element of the due diligence of asset managers. For a list of some of the "must ask" questions about model reviews, click to read "Asset Valuation: Not a Trivial Pursuit" by Susan Mangiero, PhD, CFA, FRM (FSA Times, The Institute of Internal Auditors, Q1-2004).

Email contact@fiduciaryleadership.com if you want to further discuss model review best practices.

Public Pensions, Politics and Risk Management

According to "Florida governor wants cheaper state pensions" by Michael Connor (Reuters, February 1, 2011), Governor Rick Scott wants to put public employees into 401(k) plans and migrate away from traditional defined benefit plans. Though the state's system is "relatively strong financially," the article goes on to say that local town halls "pay between 9 and 20 percent of each worker's salary for pensions" and that "Florida's 572,000 state and local-government workers now see no paycheck deductions for a fixed-benefit pension program, which supports 319,000 retirees."

Expect more to come after Governor Scott puts his budget to the Florida taxpayers on Monday, February 7, 2011.

Notably, risk management is not any less important for defined contribution plans. To the contrary, a quick survey of some of the litigation underway is focused on 401(k) issues relating to fees, portfolio selection choices, investor education and much more. Moreover, greater pressures for reform are going to force enhanced transparency and allow little time and latitude for decision-makers to focus on prudently realizing risk-adjusted returns. The last thing a board member, lawmaker, regulator or politician wants to address is a worsening retirement IOU situation when taxpayers, shareholders, employees and other stakeholders are grumpy and impatient.

If you did not get to read it when originally published, click to download "Pension Risk Management: Necessary and Desirable" by Susan Mangiero, PhD, CFA, FRM, Journal of Compensation and Benefits, March/April 2006.

Editor's Note: Fiduciary Leadership, LLC is the new name for BVA, LLC.

Money Makes the World Go Around

It's not just Broadway that extols the virtues of money. "Money makes the world go around...that clinking clanking sound can make the world go 'round" (from Cabaret).

Any discussion about investments inevitably centers on how much was made or lost or is expected to be made or lost. That's not necessarily bad with a few caveats.

  • Performance standards must be uniform and therefore comparable across investors for a given asset class or fund.
  • Numbers alone do not necessarily reflect a robust risk management process. To the contrary, artificial performance numbers can lull investment decision-makers into false security. Contact me if you want training on the pitfalls of investment performance reporting and risk management gaps. Click here to send an email.
  • Historical numbers tell a story about what happened. Good risk management dictates the need to assess "what if" scenarios. Things change and sometimes materially so. Don't depend on historical numbers to predict the future.
  • More than a few asset returns exhibit non-normal behavior. In such cases, traditional statistical tests are limited tools for capturing extreme value behavior.

The good news is that every day offers a renewed chance to do better with respect to benchmarking and risk management. Think of existing problems as gifts. Meet the challenges head on and your organization potentially reaps significant rewards such as share price gains, capital-raising on more favorable terms, fiduciary liability reduction, reducing time and stress, keeping promises to beneficiaries and much more.

Susan Mangiero Risk Management Papers Make Top Ten Lists

In case you missed it, "Stable Value Risk Management" by Dr. Susan Mangiero, CFA, FRM was recently listed on SSRN's Top Ten download list for CGN: Financial Advisors (Sub-Topic), Corporate Governance: Actors & Players eJournal, Derivatives eJournal, Employee Benefits, Compensation & Pension Law eJournal, Employment, Labor, Compensation & Pension Law eJournals, Mutual Funds, Hedge Funds, & Investment Industry eJournal, Pension Risk Management eJournal, Regulation of Financial Institutions eJournal and Risk, Regulation, & Policy eJournal. Visit http://papers.ssrn.com/abstract=1716438 to download this November 18, 2010 speech for the Stable Value Investment Association.

Dr. Mangiero's "Pension Risk Management: Derivatives, Fiduciary Duty and Process", was likewise recently listed as a SSRN's Top Ten download paper. To download the detailed survey and analysis, see http://papers.ssrn.com/abstract=128332.

Stable Value Risk Management

Kudos to the Stable Value Investment Association for encouraging several days of lively discussions about important topics such as asset allocation, behavioral investing and risk management.

In my comments about stable value risk management, I emphasized the importance of having robust policies and procedures in place across all providers. I likewise mentioned the need for plan sponsors to investigate the use of derivative instruments on the part of both the asset managers and the wrappers, adding that some stable value funds may pose valuation challenges. Given the approximate $700 billion size of the stable value market and the widespread use of these products in 401(k) plans, financial service organizations have a golden opportunity to differentiate themselves from competitors by making their risk stance transparent with investment committee member buyers. This is especially true at a time when plan sponsors are increasingly asked to justify their due diligence and oversight of service providers.

Click to read "Stable Value Risk Management - Remarks Made by Dr. Susan Mangiero Before the Stable Value Investment Association on November 19, 2010."

You might also want to check out "Fiduciary Alert: Stable Value," provided by the team at Harrison Fiduciary. In speaking to Attorney Mitch Shames the other day about stable value risk management, he concurred with many points I made in my speech and added a few of his own. See below for his comments.

"Most of the time stable value ("SV") products are sold by recordkeepers. Often plan fiduciaries simply sign-off, thinking that they are getting a turn-key "stable" product which provides "value".  Plan fiduciaries rarely understand that SV is a hybrid product,   with an investment component and an insurance component. For instance, ask a fiduciary about the crediting rate on the stable value vehicle and they may give you a blank stare. Ask them to identify the wrap provider and describe their crediting rating and they may be equally in the dark. Finally, fiduciaries are sometimes surprised when they find out that traditional HR issues can have an impact on the wrap contract. Most all wrap contracts provide that if the work force is reduced by a certain percentage, then the wrap provider is released from the wrap coverage. So, if a sponsor has a significant plan closing, this can give rise to problems under the SV Program. Similarly, there are often restrictions on the number of participants who can withdraw from an SV plan.  Imagine if participants get sick of low returns and start shifting assets out of the SV program into equities, emerging markets, etc. This can create huge problems for SV programs.The point is that SV is extremely complicated and the devil, as always, is in the details. All fiduciaries must be familiar with the terms of the wrap agreement."

Another noteworthy read is "Risk Controls and the Coming Stable Value Surge." According to the author, Robert Whiteford, Bank of America, "wrappers and asset managers have made great progress in reducing risk in a way that should allow the existing wrappers to increase capacity in the future," adding that "new investment guidelines have been constructed to more faithfully reflect the mission of stable value funds."

Like most industries, the stable value sector is confronted with challenges to be more transparent and thereby lessen the pain for their fiduciary buyers and plan participants.

Valuing Positions in Alternatives - New DOL Scrutiny

According to "DOL rule could raise pension funds' costs: Proposed fiduciary requirement would hit appraisers of alternative investments" by Doug Halonen (Pensions & Investments, November 15, 2010), those who provide independent valuations could soon be declared fiduciaries. Remembering that there is no free lunch and that every new rule has unintended consequences, third party pricing experts are already running for cover. Some say they may exit the appraisal business at the same time that ERISA plans are enlarging their positions in alternatives and also being called upon to provide more information in their Form 5500 filings.

In case you missed it, click to access my comments on this topic, entitled "September 11, 2008 Testimony Presented by Dr. Susan Mangiero before the ERISA Advisory Council Working Group on Hard to Value ("HTV") Assets."

I had the pleasure of presenting on the same topic of risk management and valuation to the OECD and International Organization of Pension Supervisors in Paris in June 2010.

Clearly, pension plan decision-makers and their advisors, attorneys and consultants are going to be challenged to find the right balance between return and risk (with valuation questions being one type of risk). Not every alternative investment is "hard to value." Indeed, some mutual funds and other "traditional" choices have their own challenges in terms of pricing and liquidity.

Click to read "Hedge Fund Valuation: What Pension Fiduciaries Need to Know" by Susan Mangiero, Journal of Compensation and Benefits, July/August 2006.

Pulling Rabbits Out of the Hat At Sea

According to up-to-the minute press accounts, some 100 magicians are stranded in the middle of the ocean on a cruise ship with a faulty engine. Expecting a few days of fun and legerdemain, these tricksters are awaiting rescue and forced to dine on cold goodies with no air conditioning. When a colleague brought this news to my attention tonight, my immediate query was why help was taking so long. In response, I was told that passengers had to wait for a tugboat that could transport over 3,000 people (magicians included). Help is expected in short order with a full refund and a free trip for those affected.

No doubt Jay Leno and others will get a few guffaws out of this unpleasant experience for the sailing "Houdinis" - something to the effect that magicians should be able to snap their way out of trouble. The reality is that bad things can happen, leaving one feel helpless and stressed out. Also true is that adversity should and can be anticipated. That's why stress tests are so important as a way to model the unthinkable and plan accordingly. Maybe the cruise company in question did just that but, if so, why are paying customers forced to hang out for more than a few hours?

If we've learned anything from the financial market rollercoaster of late, it's this. We can't rely on sleight of hand to properly identify, measure and manage risks. Putting a contingency plan in place for any and all of the risk factors considered potentially material is good business sense. In pension land, failure to have tested the limits of a significant negative equity market has cost numerous sponsors big money. Other types of institutional investors and asset managers must heed this cautionary tale too.

Notably, in an in-depth survey conducted by MSCI Barra in 2009, "73% of pension plans and 26% of asset managers surveyed do not currently run stress tests, but cite this as a key focus going forward." This is encouraging. After all, ignoring the tail risk can lead to nasty consequences.

Other results that MSCI Barra uncovered are similar to what I found in a study of over 150 U.S. and Canadian pension plans, done in conjunction with the Society of Actuaries. Like MSCI Barra, few of our queried plan sponsors had Chief Risk Officers in place, considered retirement plan management as part of an enterprise-wide risk exercise and did not always pay close attention to risks such as liquidity. Click to access a full version of this 2008 study about the use of financial derivatives and fiduciary duty.

Pulling rabbits out of the hat is not as easy as it appears. Isn't it better to depend on a systematic and disciplined approach to mitigating those things that have the potential to destroy, if left unchecked?

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.

New Report on Endowments and the Shadow Banking System

In a new study by the Tellus Institute, wealthy college and university endowments are described as being over zealous with respect to investment risk-taking in recent years. Related losses during the financial crisis arguably account for school staff layoffs, major budget cuts and postponed construction projects. Local businesses have been hard hit too as part of the trickle-down argument against allocating to "large illiquid investments" by academic money pools, courtesy of successful graduates.

In its examination of a few of the U.S. ivory tower giants, authors had some harsh words for those who may have turned from protecting principal and "generating reliance income" to instead rely on "radical diversification" into venture capital, private equity, hedge funds and real assets. They question the existence of possible conflicts of interest when Wall Streeters serve as trustees. Compensation levels for professional endowment investing teams are likewise called into question. 

I plan to spend more time reviewing the 104-page publication as it includes many statistical tables that describe individual endowment holdings as well as the financial strength (or lack thereof) of certain schools. I am also curious to get this take on the endowment model. The flip side of course is that experienced financial professionals (whether trustees or part of a school's investment team) can add more value than someone with little or no asset management knowledge and, in a competitive world, they can command a handsome compensation package. Then there is the issue of being an alternatives wet blanket. I've long maintained that no investment is good or bad on its face and must absolutely consider a variety of facts and circumstances.

One wonders if there will be a renewed call for a study about whether to tax wealthy college endowments as proposed by the Massachusetts House a few years ago? See "Should huge college endowments pay tax?" (Christian Science Monitor, May 20, 2008).

This 104-page publication entitled "Educational Endowments And The Financial Crisis: Social Costs and Systemic Risks In The Shadow Banking System: A Study Of Six New England Schools" (May 27, 2010) is available for no charge.

BP, Fat Tails and Risk Management

Many thanks to Ms. Marlys Appleton, governance expert and financial professional. Her comments are provided below. Click to read the original blog post entitled "BP Investments - The Role of Ethics and Risk Management" (June 19, 2010). The governance storm clouds are dark indeed.

<< I believe what happened in this case is connected to internal governance issues at BP. One only has to look at their safety violation record relative to peers such as Exxon and Conoco over the last few years (as reported recently by Bloomberg News) to see that BP accepted hundreds of safety violations as a "cost of doing business". Institutional investors' failure to pay attention to safety violation records at BP reflects their lack of understanding of the need to price in poor governance. BP's safety record was known for years and now the market is forced to acknowledge and price such behavior, with devastating results.

I also think of the Massey coal mine disaster - another company whose safety record was well know. Both boards need a paradigm shift to acknowledge past failures, but for one, it may be too late. Some damages cannot be remedied by compensation alone. The fund is a good start and may reduce the need for litigation though there are likely to be lawsuits. I believe such a devastating social and environmental disaster such as this event should not be mediated through the courts, but that's another topic. Add upon this, the additional layer of inept government regulation, another example of 'poor governance' as a contributing factor.

It is my hope that institutional investors, boards and executive management embark upon a real understanding of what can happen when governance and ethical behavior break down. In the world of emerging risks, acknowledgement of "fat tail" catatrophic events needs to be stepped up with the implementation of a good Enterprise Risk Management ("ERM") process. This information must then be socialized with boards, management, and investors. >>

Free Webinar on June 21 to Look at BP Risk Issues for Investors

Click here to join us for a free webinar on June 21 from Noon to 1:00 PM EST. Sponsored by Cenario Capital, this educational event will include a case study about the BP spill in terms of investment implications and money manager due diligence.

Besides the immediate and delayed impact on sector and individual company risks, webinar speakers focus on the numerous signals that pensions, endowments, foundation and other institutional investors should be assessing on a regular basis - either directly or via their money managers. A discussion about how portfolio holdings can be vetted on an ongoing basis includes commentary about correlations, earnings forecasts, volatility, dividend yields, factor risk and valuation.

Join us for this timely convening with experts - Mr. Steve Van Beisen (Managing Director, Cenario Capital) and Dr. Petter Kolm (Director, Mathematics in Finance, NYU Courant Institute).

BP Investments - The Role of Ethics and Risk Management

The current situation with British Petroleum ("BP") raises a bevy of thorny questions, not the least of which is how pensions and other types of institutional investors should deal with the asset allocation fallout.

Let's start with the facts about institutional ownership of BP. According to Yahoo Finance and as excerpted in the table below, over 1,000 institutions owned stock in BP as of late March 2010. A relatively high dividend payout rate and dividend yield likely held great appeal for organizations seeking stability.

Things have changed materially, leaving large owners of BP stock to determine whether they should short, double up for a long-term play or exit altogether. Those that outsource their money management function rightly ask whether third party traders did enough to vet the issues associated with energy sector exposure. Additionally, one now deals with the question as to whether BP and similar types of stocks should be analyzed in the context of socially responsible investing. One organization - Fair Pensions - wants Shell and BP board members to beef up their disclosure about oil sands project risks. Lawsuits loom large too. According to "New York Pension Fund Considering Suit Against BP" by Jillian Mincer (Wall Street Journal, June 17, 2010), the New York State Common Retirement Fund owns 17.5 million shares indirectly, via its index fund allocation.

At the same time, anything that further erodes the price of BP shares could put parent company employees, gas station owners and related vendors out of work.

The oil spill in the Gulf is an environmental tragedy of major proportions. It may soon become a further financial debacle as well.

401(k) Plans, Mutual Funds and Derivatives - Hello SEC

Given that mutual funds are a popular 401(k) plan choice, it's not surprising that further regulatory scrutiny of the use of derivatives by traders is underway.

"SEC Staff Evaluating the Use of Derivatives by Funds" (U.S. Securities and Exchange Commission Release 2010-45, March 25, 2010) talks about a new initiative to review the current practices by pools of capital regulated under the auspices of the Investment Company Act of 1940. Scrutiny will focus on items such as:

  • Leverage, concentration and diversification
  • Existing risk management policies and procedures
  • Oversight of use of derivatives by fund board of directors
  • Rules for proper pricing
  • Prospectus disclosures.

Click here for more information.

Risk Management Deja Vu

A reporter recently pointed out that my 2005 article entitled "Pension Risk Management: The Importance of Oversight" was prescient for its focus on what is now the rage among defined benefit and defined contribution plan sponsors around the world. I'm humbled by his compliment but thought perhaps that others who had not read the article when it was published might enjoy reading it now. I describe the "Five C" Approach to Risk Management to include:

  • Commitment by senior management to embrace a risk culture throughout the organization
  • Comprehension in the form of enterprise-wide education to include back office, middle office and trading personnel
  • Controls that mitigate the adverse effects of rogue trading, avoid conflicts of interest and stem losses before they get too big
  • Computers to mean that risk identification, measurement and monitoring is nearly impossible without technology support
  • Communication with plan participants, shareholders and taxpayers alike that focuses on policies and procedures, compensation structure and the link between corporate and pension governance.

Click here to read "Pension Risk Management: The Importance of Oversight" by Dr. Susan Mangiero, CFA, FRM.

Editor's Note: Dr. Mangiero is currently founder and CEO of Investment Governance, Inc.

How to Work With an Outsourced Chief Risk Officer

Click here to register for a free educational risk management webinar on June 21 from Noon to 1:00 PM EST.

Please join Investment Governance, Inc. and Cenario Capital Management for a one-hour discussion on June 21 from Noon to 1:00 PM EST about the nuts and bolts of working with an outsourced Chief Risk Officer. Mr. Steve Van Besien, Co-Founder of Cenario Capital Management, and Dr. Petter Kolm, Director of the Mathematics in Finance M.S. program with the Courant Institute, New York University, will address why and how fiduciaries should consider using independent risk experts.

Attendees will learn more about:

1. How to develop a risk management policy statement
2. Differences between various risk metrics
3. How to manage financial volatility
4. Having another "seat at the table" to address enterprise-level risk

And much more!

Thank you to Cenario Capital Management for sponsoring this educational event.

Pension Risk Management - Free Webinar

On May 21, 2010 from Noon to 1:15 PM EST, Mr. Ryan McGlothlin (Managing Director and Head of P-Solve US) and Dr. Norman Ehrentreich (Principal at Ehrentreich LDI Consulting & Research) will explain the basics of Liability-Driven Investing and Dynamic Asset Allocation, talk about how to choose and vet asset managers and point out key elements of an LDI-DAA policy statement. Click here  to register.

If you cannot join, please note that we will post slides and the audio recording to www.FiduciaryX.com in a few days.

If you are not yet a subscriber and are an institutional investor or have institutional investors as clients, register now for a free subscription to www.FiduciaryX.com. Go to http://portal.fiduciaryx.com/register/.

Can Great Cards Overcome a Complex Strategy?

Thanks to my husband's astute coaching, I'm becoming a big fan of bridge. Each hand presents a new challenge. In addition to deciding how to play my cards, I have to take my partner's thirteen into account as well as what we need to successfully complete the rubber. I confess that scoring remains a mystery and I'm still unclear as to how to execute certain plays. For example, the other night, I had four aces, three kings and a few queens and jacks but not much of a long hand in any suit. Somewhat of a novice, I took the safer road of bidding a particular suit rather than pursuing a "no trump" course of action. Much like bridge, institutional investors often face choices about what to do.

  • Having adequate resources does not necessarily equate to easy choices about asset allocation. I had a terrific start (lots of face cards) but did not want to risk losing the hand by following a strategy with which I was unfamiliar. Additionally, I did not want to let my bridge partner down. In pension land, having lots of money to invest should not equate to a "bet the bank" mentality (i.e. adopting an overly complex approach). Moreover, the interest of beneficiaries (like other partners) must be taken into account.
  • Some losses are imminent. Sometimes a few cards are purposely lost in early rounds as a way to gain a superior position for an ultimate win. In investing, markets can bounce around, tempting institutions to pull and run. Establishing trading limits that comport with pre-established goals and risk tolerance levels makes sense. Confusing long-term goals with short-term actions can sometimes be costly and ill-advised.
  • Switching partners from time to time offers fresh insights but is likewise hard work. Bridge takes a round robin approach that rattled me at first. After all, if I was winning with a particular partner, why should I have to change? What I've learned is that each new pairing requires a re-examination of the relationship, especially a focus on how to properly communicate with one another. While some investment relationships are ongoing, many are not. The need to clearly exchange mission-critical information is an important skill. Just as any failure on my part to discern my bridge partner's intent during the bidding process can lead to ruin, so too can a breakdown in communication between asset owner and advisor. As the consulting industry consolidates in favor of larger organizations, client communications will be tested as parties get to know each other from scratch. (Note: Interested readers may want to check out "Consultant market set for further contractions," Professional Pensions, April 30, 2010.)
  • Skill is essential but sometimes luck dominates. As much as I focus on learning the game, bridge can frustrate. If you are dealt a bad hand, you simply have to get through it, be patient and know that discipline is not a guarantee of high returns. Investing is much the same. A good process is paramount but does not mean that a portfolio's return in any given quarter is going to outbeat a particular target.
  • Know where you are going. Journalist Chuck Palahniuk observes that "If you don't know what you want, you end up with a lot you don't." If I stop thinking ahead several plays in bridge, I will unlikely miss my chance to win a particular hand. If an asset owner falls short in proper goal-setting, achieving objectives is going to be hit or miss and could certainly induce all sorts of unpleasant consequences - economic and regulatory.

Finally, bridge requires thought and hard work but can be tremendously rewarding. I learn new things all the time. The life of an investment decision-maker is challenging at best and exposes individuals to tremendous fiduciary liability at worst. Yet numerous professionals make pension stewardship their life's work because it is fulfilling, interesting and satisfying.

Reminder: April 20 Complimentary Webinar About OTC Derivatives

 

To learn more about over-the-counter derivatives and related topical issues, visit  https://www2.gotomeeting.com/register/773492546 .

We hope you can join Investment Governance, Inc. CEO - Dr. Susan Mangiero on April 20, 2010 from Noon to 1:00 PM EST for a timely discussion with executives from Northern Trust, Numerix and Sapient to discuss the current regulatory environment, OTC (over-the-counter) derivative instrument valuation and collateral management.

Negative Swap Spreads - Trouble On the Way?

If you missed "Will negative swap spreads be our coal mine canaries?" by Gillian Tett (Financial Times, March 30, 2010), it's a worthwhile read, especially given the pervasive use of triple A-rated sovereign bond yields as a proxy for the "risk-free" rate of return. A writer known as Bond Girl makes a similar observation in "10-year swap spread turns negative" (self-evident.com, March 23, 2010), adding that plausible explanations take the form of temporary and structural, respectively.

Consider the following:

  • Pension funds and other long-term investors are driving up demand to receive swap fixed payments as part of their asset-liability management strategies.
  • Some investors worry about the viability of governments to pay interest and debt on time.
  • Corporate debt issuers seek to hedge these liabilities.
  • Mortgage risk techniques are in flux, especially as the Federal Reserve Bank is no longer an active buyer of mortgage-backed securities. Read "Large-Scale Asset Purchases by the Federal Reserve: Did They Work?" (Federal Reserve Bank of New York, March 2010).

As if risk managers were not already challenged to deal with moving regulatory targets and market volatility, a negative swap curve adds to their concerns.

Editor's Note: On the topic of sovereign debt, a summary of Dr. Lucjan Orlowski's analysis of the Greek debt crisis and the likely impact on the U.S. dollar and euro will be posted shortly.

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!

Risk Management, Leverage and Globalization

In "Risk Management Q&A: Risk is a four-letter word" (Perspectives, RBC Dexis Investor Services, April 2010), I talk about meaningful changes in terms of risk management as a result of the financial crisis. My comments about leverage in the same interview are nothing new. Leverage is not necessarily good or bad. Importantly, institutional investors must understand how to properly measure leverage and establish internal controls.

"All leverage is not created equal. A short position in an actively-traded instrument has a different risk-return profile than taking on debt or synthesizing exposure with puts or a combination of derivatives."

To read the full interview, go to page 10 of "The global power shift: New directions for the world economy". I am also quoted on page 8 in the article entitled "Reversal of Fortune: Regulators could push the consolidation trend back a few years" on the topic of reactionary regulation.

Default Swaps Get the Credit

In "It's Time for Swaps to Lose Their Swagger," New York Times reporter Gretchen Morgenson points the finger at regulators for not doing enough to stem the tide of moral hazard with respect to credit default swaps. While this superstar financial analyst rightly points out that risk transference continues to favor "high octane" traders and cost taxpayers and shareholders plenty, I don't agree that more "one size fits all" regulation is the answer. There is simply no evidence that a greater quantity of statutes will bridge the gap between risk management and reward. I don't have to be a behavioral expert to know that financial traders are motivated by the money they can make in a relatively short period of time. New rules beget changed incentives and often times perverse behavior. Does the law of unintended consequences ring a bell? Let's undo all the bad rules in place and focus on incentives that count. Start with bonuses that take into account the risk cost associated with expected return. Risk budgetize trading payouts.

If I'm playing by the rules, doing a great job of risk controls and acting in good faith on behalf of the proper constituencies, why should I be forced to pay for others' folly? Wouldn't my money and time be better spent on trying to encourage prudence on the part of industry participants, while informing the market at large how much my organization is doing right? For those who are in the vanguard of excellent risk management, take a bow. Get out the megaphones. Let the world know!

In December 1994, I was honored by the International Association of Financial Engineers with first place for my student paper presentation. Entitled "In Defence of a Free Financial Derivatives Market," I cite chapter and verse about why free markets trump. Though the statistics are fifteen years old, the philosophical and economic reasons remain valid to this day. I have listed a few tidbits below.

  • Compliance costs are high and divert precious resources away from shareholder wealth creation.
  • When buy-sell preferences are masked, it is difficult, sometimes impossible, to come to terms on a particular trade. The net result could be reduced volume which could lower liquidity.
  • Not all risks are equal and to treat them that way makes no sense.
  • Derivatives, used properly, can help to reduce risk.
  • Inovation is the lifeblood of economic growth. Regulation that is designed in the dark, away from public view, discourages problem-solving.
  • The right to contract with another party is part of free enterprise. Do you really want regulators to pick and choose your business partners?

 This is not to say that the status quo works. Far from it, change is needed and fast. As a shareholder, I would like to know more about the risk management policies and procedures in place at all major financial services organizations, not to mention the knowledge and experience of their board members with respect to internal controls, leverage and complex securities trading. Disclose how changes are made to strategy and tactics and on what basis.

Let the sunshine in. Information is a great equalizer.

The View From The Other Side - Regulatory Insight

Sometimes seeing over the other side of the desk is difficult, if not impossible. That's too bad because regulators and those they oversee have a lot to learn from each other. This is especially true if you embrace a primary goal of ultimately allowing for complete self-governing as a way to ensure more efficient markets.

"Pension Funds' Risk-Management Framework: Regulation and Supervisory Oversight" by Fiona Stewart (Working Paper No. 11, International Organisation of Pension Supervisors, November 2009) gets us part of the way. This new compendium of rules and regulations categorizes pension risk rules for Australia, Brazil, Germany, Kenya, Mexico, Netherlands and the UK in four areas - "management oversight and culture, strategy and risk assessment, control systems and information, reporting and communication." An audit checklist that pension supervisors can use in their examination work is offered as an appendix as is a convenient summary table that lays out country-specific risk management regulations about things such as the role of the Chief Risk Officer.

The two sides of the fence may never shake hands but studies like this enhance the understanding as to what is expected of plan sponsors by regulators.

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.

Hail to the Chief - Risk Officer That Is

 

In "Risk Redux" by Kristin Fox, founder of Fox Inspires, LLC (Private Wealth, January 7, 2010), I am quoted extensively on the topic of risk management. I'm happy to note that others interviewed for the article reiterate many of the points I made.

Given the changed landscape, post Madoff and so on, the life of a Chief Risk Officer ("CRO") is even more harried than ever before. He or she is often expected to save the ship without impeding the traders' ability to turn a profit. Applied to hedge funds, the task is arduous indeed as the threat of global regulation looms closer and investors clamor for heightened transparency about fees, concentration of positions and overall risk-taking.

Since so many pensions, endowments and foundations are adding to their hedge fund allocations, the article is worth a read. Some of my talking points are listed below:

  • Risk management is an integral part of a firm’s culture and one of the keys to its success. “Instead of looking at risk management as a roadblock, it should be promoted as part of your culture and viewed as the best way to ensure the firm’s longevity.”
  • There is no one size fits all approach to hedge fund risk management. It depends on the size of the organization, strategy, type of clients, risk tolerance, to name a few items.
  • A CRO must ask tough questions about the risk "cost" of every expected dollar in return.
  • Compensation must support the notion of a risk culture or any other efforts to mitigate risk are doomed to fail.
  • Kick the tires on models. Ask if underlying assumptions prevail.
  • Make sure that everyone understands the nature of leverage, from the back office clerk to the front room trader.
  • Acknowledge that risks seldom live in isolation. One of the unpleasant surprises of 2008 and 2009 had to do with the convergence of risks. The traditional reliance on correlations had no place in the volatility maelstrom that created heartburn for a lot of investment professionals. "For example, with structured products, liquidity risk was arguably greater than anticipated because the quality and quantity of supporting collateral was sometimes wanting. For any financial institution that had hedged part of its structured product portfolio, it may have found itself with another risk in the form of counterparty defaults. The risks are often not additive, and a good CRO needs to truly understand the interrelationships among financial, operational and legal risks, to name a few."
  • Figure out a way to overcome the resistance of those who are already burdened with their own work but who are nonetheless critical to the risk management process. A good CRO must make friends and motivate accounting, legal, systems and trading to hold hands and come together to properly manage the R word.

Though written in 2003, my article entitled "Life in Financial Risk Management: Shrinking Violets Need Not Apply" is still relevant. I describe the building block concepts as well as the skill set required for an effective CRO.

Can You Be Too Cautious When It Comes to Risk Management?

This year has been tough for many investment professionals so it's no suprise that more than a few folks are hungering for January 1. Either 2010 is going to be "their year" or they figure that things just couldn't get any worse. Unfortunately, depending on Lady Luck, after months of tumult, is a high risk proposition and ill-advised. Add the fact that the governance benchmarking movement is gaining momentum around the world. Those who rely on a rabbit's foot or magic crystals are likely to be forced into action, regardless of their desires.

So what's on the governance "to do" list for coming months?

  • In its December 16, 2009 press release, the U.S.Securities Exchange Commission describes a new rule "that would help investors determine whether a company has incentivized excessive or inappropriate risk-taking by employees. Among other things, it would require a narrative disclosure about the company's compensation policies and practices for all employees, not just executive officers, if the compensation policies and practices create risks that are reasonably likely to have a material adverse effect on the company. Smaller reporting companies will not be required to provide the new disclosure." For more information, click to read "SEC Approves Enhanced Disclosure About Risk, Compensation and Corporate Governance."
  • Wall Street Journal writer Dennis K. Berman predicts that 2010 will usher in the "most significant regulation in 75 years" in order to "reset the financial industry's profitability, core oversight and connection to Main Street investors." (See "In 2010, Year of the Regulator" - December 22, 2009.) His view that "politics, populism and profits" are about to collide in the halls of the U.S. Congress is one that I share. When Joe Worker struggles to pay bills, let alone save for retirement, he becomes a vote-killer and that spurs lawmakers into action to create new mandates. (Whether "one size fits all" regulations work - and I contend that they induce their own set of problems - is a different discussion altogether.)
  • On December 15, 2009, the American Federation of State, County and Municipal Employees, AFL-CIO released what it describes as a "first of its kind report" entitled "Enhancing Public Retiree Pension Plan Security: Best Practice Policies for Trustees and Pension Systems" by Attorney Christopher W. Waddell. Focused on pay to play, insider trading, fiduciary duty, ethics and board assessment, the 40+ page file is worth a read. The fact that this document exists is yet another indication of the movement towards a nuts and bolts approach to staying out of trouble.

With these and countless other indications that the paradigm is shifting towards the documentation of accountability, one wonders if it is possible to be too cautious when it comes to risk management. This is not the same as asking whether someone can be too risk-averse with respect to investment management and thereby incur opportunity costs.

Frame your answer by asking yourself any of the following questions:

  • "Is there anything I could do now that would mitigate my risks in 2010 and help me avoid time-consuming and costly problems if I have to explain why I didn't do X, Y and Z?
  • Will I regret not taking the extra steps to notate my strategy, related internal controls and the general decision-making process?
  • What are the reputation-related consequences of inaction or undertaking an incomplete process with respect to enterprise risk management?
  • Will my personal and/or professional liability exposure go up if a problem arises and I am unable to explain why I did what I did?"

Will this new year be one of undue caution or simply a matter of committing to smart best practices because it is good prevention, not to mention a way to garner invaluable information and increase peace of mind?

More Focus on Pension Risk Management or Not Enough?

According to an October 2009 study entitled "Reactions to an EDHEC Study on the Impact of Regulatory Constraints on the ALM of Pension Funds" by researcher Samuel Sender, regulations discourage European retirement plan managers from focusing on long-term risk management objectives. The study further suggests that risk management is far superior to risk measurement if a focus on funding ratios steals resources better spent on ensuring the long-term viability of the plan. The 142 respondents cite a fear of tighter accounting rules and concern that regulators need to "provide incentives" to build internal models. Nearly eighty percent of survey-takers "report that dynamic strategies are difficult to implement because management agreement is needed to rebalance a portfolio." Click here to access the study.

In contrast, a new poll conducted by SEI suggests that pension risk management is a top priority for executives in Canada, Netherlands, UK and the United States. According to the November 18, 2009 press release released by SEI, "the percentage of pensions employing a Liability Driven Investing strategy has nearly triped over the past three years from 20 percents in 2007 to 54 percent in 2009. Queries about pension benchmarks sugges that decision-makers are veering away from absolute return in favor of "improved funded status." Click to read "SEI Global Poll: 3rd Annual Liability Driven Investing Poll Finds A Significant Increase in Adoption" (November 18, 2009).

A 2008 survey created by Pension Governance, Incorporated (now rebranded as Investment Governance, Inc.) supports the notion that more work remains to be done, by far. Click to read "Pension Risk Management: Derivatives, Fiduciary Duty and Process."

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.

  • 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."

Can Risk Management Be Deemed Strategic?

 

As a veteran risk manager, I was encouraged to read that risk management is starting to receive the attention that I've long advocated as mission critical. In "Risk becomes focus for trustees trying to rebound from crisis" (9/4/09), Pensions & Investments reporter Drew Carter writes that pension decision-makers are more than ready to confront the volatility beast. In particular, the goal now seems to be a choice between matching liabilities or "keeping many of the asset classes that burned them in the crisis." 

Risk management comes in many different forms. Ask a dozen retirement plan executives how they define risk and you are likely to get twelve different answers. In a way, that's part of the problem. For some, risk management might take the form of portfolio diversification via investing in absolute return strategies. For others, risk control could mean the creation of a dynamic hedging program. Which one is right?

Unfortunately, for those seeking a simple answer, there is no universal risk management panacea since every situation is different. Are there common best practices? Yes indeed and I could easily construct an optimal risk management program that embeds "must do" items versus "facts and circumstances" recommendations.

While I think we have a long way to go before risk management is front and center the way it should be, it is encouraging to know that risk is no longer a four-letter word, banished to the hinterlands of theory and geekdom. It would be grand if fiduciaries deemed effective risk management as a strategic advantage and not a burden. Good controls help to mitigate losses, sub-performance and lost opportunities. Robust risk management can also produce a goldmine of information that is otherwise unattainable unless one is carefully measuring what might go awry.

 

Interview With Susan Mangiero About Pension Risk Management

  Photo Source: University of Michigan

Pension risk management has always been important but is arguably receiving more focus now than ever before. The reason for that is straightforward. Lose billions of dollars and people pay attention. In "An Interview With Susan Mangiero" (Journal of Indexes, July/August 2009), I talk about (a) redemptions (b) correlation patterns (c) interest rate impact (d) leverage (e) hard to value investing and so much more. Click to read "An Interview With Susan Mangiero."

The take away points from the interview are several:

  • Everyone is a risk manager. There is no escape from reality.
  • Effective risk management is an ongoing process. There is no "buy and hold" equivalent.
  • Ask questions as to whom is doing what along the service provider food chain because ultimately pension decision-makers are responsible for what is or isn't done.
  • Creating an index for a strategy like Liability-Driven Investing requires thought. There is no universally accepted "perfect" way to benchmark manager performance but there are certainly good possibilities from which to choose.
  • Life for a plan sponsor is challenging but exciting. What better time to embrace the opportunity to implement a robust and holistic risk management process?

Kudos to those who have already recognized the need to identify, measure and manage the continuum of retirement plan risks. Beware of complacency however. I'm reminded of a recent risk management snafu in my life. In trying to stave off colds, I'd been using zinc swabs. To my nasty surprise, last week's newspapers suggested incremental risks associated with a strategy I took to be prudent.

Bottom line: Be diligent and active when it comes to mitigating risks. Try to plug the leaks in the bucket. Better yet, get a new bucket when you need one. Don't shortcut the future of your plan participants.

U.S. GAO Addresses Pension Buyouts by Financial Firms

Hot off the presses, the U.S. Government Accountability Office has just released "Proposed Plan Buyouts by Financial Firms Pose Potential Risks and Benefits" (March 2009). You may recall that the IRS put the kabosh on defined benefit liability trading on August 6, 2008, leaving it up to Congress to approve of disprove. See IRS Revenue Ruling 2008-45.

I've always been intrigued by the concept of a secondary trading market in pension liabilities but wondered how one might identify and manage the many risks. Essentially, the authors of this new study assert the same concerns.

"The troubling aspects of DB plan buyouts involve risks that may be difficult to foresee or quantify now or at the time of any particular transaction. It is unclear to what extent buyouts would cost less than standard plan terminations simply because of differences in regulations facing financial institutions and insurance companies providing similar services to plan sponsors instead of from economic efficiency. Further the current economic downturn has laid bare the current weaknesses and imperfections of financial regulation, with banks and insurance companies previously considered to be sound and well capitalized suffering catastrophic losses." 

From a fiduciary perspective, is there clear and present danger in the form of conflicts of interest or concerns about choosing a "proper" trading entity? (Refer to 29 CFR 2509.95-1 - "Interpretative bulletin relating to the fiduciary standard under ERISA when selecting an annuity provider " for possibly analogous guidance.)

As a plan participant, I'd want to know much more about who will ultimately sign and send my check. As a plan fiduciary, absent explicit guidance, I'd need to know more about how to discharge my duties on behalf of retirees when passing the baton to a major bank or insurance company.

Money, Happiness and Governance

In case you missed it, April is National Humor Month. Created by "best-selling humorist Larry Wilde, Director of The Carmel Institute of Humor," 2009 marks the 33rd anniversary of this celebration of fun and merriment.

For those who live in Nebraska, they must really be rolling in the aisles. What? You didn't hear?

According to a survey conducted by MainStreet.com, the home of Cliff Notes ranks top for its low number of foreclosures, low unemployment rate and low percentage of non-mortgage debt by income. Not surprisingly, Connecticut, where I call home, is number 28 out of 50 on the Happiness Index (not a good thing by the way). Being close to Wall Street, we are feeling the pinch of financial layoffs and plummeting portfolio values. California, Florida and Oregon rank 48, 49 and 50, respectively.

Along the lines of "feel good" action, I read an interesting article in the May 2009 issue of Reader's Digest in which Stanford University psychologist Carol Dweck advocates the benefits of failure. According to "How Failure Makes Us Stronger," psychology and neuroscience professor Antoine Bechara has identified two parts of the brain that are responsible for the "fear of failure" and the "lure of success." For certain individuals, the physiological response to failure is a chance to learn.

At a time when many professionals feel under siege for economic losses or sub-par performance or both, one silver lining may be new math, i.e. Failure = Second Chance.

Unfortunately, recent research suggests that not every one is ready to act anew. According to "Managers fail to control hazards" (April 6, 2009), Financial Times reporter Sophia Greene says "not so fast." Citing results of a new risk management study, certain factors such as liquidity risk have not yet "been built into risk models," possibly leaving portfolio managers (and therefore pensions, endowments and foundations) unduly exposed. In contrast, investors are described as committed to asking asset managers about risk management policies, with 10 pages of a typical Request for Proposal ("RFP") being dedicated to "risk of all sorts." In its press release, survey sponsor SimCorp describes "the lack of monitoring of strategic risk" as a concern, along with a less than robust commitment by senior management as reflected in its analysis. For an overview of other findings, read "Global survey reveals that risk function has lost status despite financial crisis" (April 1, 2009).

Recall that Pension Governance, LLC (now Pension Governance, Incorporated) and the Society of Actuaries discovered a similar lack of enthusiasm about risk management and fiduciary duties in its research. Click to access the 69-page study entitled "Pension Risk Management: Derivatives, Fiduciary Duty and Process" by Susan Mangiero. For an overview of that research, read "New Study Addresses Pension Risk Management Gaps" (October 13, 2008).

Can looking the other way make for a happy institutional investor or asset manager? Hopefully, the final answer is "no" and "open to improvement" wins the day.

Profit Privatization and Socialization of Losses

Complex problems deserve a lively debate about potential solutions. That is why I've asked both colleagues and critics to guest blog on www.pensionriskmatters.com from time to time. Interestingly, few have taken me up on the offer (though I get plenty of emails about various posts). One person who has accepted the challenge to disturb and entice is Mr. Wayne Miller. Formerly CEO of Denali Fiduciary Management and a self-described passionate fiduciary advocate, Wayne invites readers to ponder his suggestions about how to (a) manage the current banking crisis and (b) save the U.S. Social Security system. When asked why he expended time in penning his thoughts, Wayne wrote that "there must be a very clear example as to how personal responsibility will be incorporated into a market principle-based framework that could lead us out of this storm" and move our nation away from "political expediency" in order to avoid being "condemned to stir inside the box we made for ourselves."

While Wayne and I have had more than a few lively debates about the merits of free markets, he and I agree that the improvement of investment best practices redounds to everyone's benefit. 

Read Wayne's proposal. Decide for yourself. You can sign his petition by visiting www.sociallyresponsiblerescue.org.

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.

Risk Management for Corporate Counsel

I am pleased to announce my participation as part of the February 26, 2009 Lexis Nexis Corporate Counsel Series. According to the official program site, the 60-minute Webcast will focus on critical corporate governance and risk assessment issues that pertain to in-house company attorneys. Click here to register for what promises to be an interesting and timely event.

I've excerpted information about panelists below. I hope you can join us.

  • Susan Mangiero, Financial Analyst, Risk Assessment and Valuation Expert -  Susan has over 20 years of experience in capital markets, global treasury, asset-liability management, portfolio management, economic and investment analysis, derivatives, financial risk control and valuation. She has worked for organizations such as the General Electric Company, PricewaterhouseCoopers LLP, Bank of America, and Bankers Trust.
  • Lynn Brewer, Ethics Expert and Author of Confessions of an Enron Executive: A Whistleblower's Story - Lynn was responsible for Risk Management in Energy Operations at Enron, worked in forensic accounting, and spent 18 years as a legal professional in private practice until she joined Ralston Purina, where she worked in Corporated Development for the General Counsel and Chief Financial Officer.
  • Jason Greenblatt, Executive Vice President and General Counsel. The Trump Organization - Jason is involved in a large number of transactions worldwide, including deals with major financial institutions, Fortune 500 companies, governmental agencies, and joint venture partners.

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."

V is for Value at Risk or Vacuous - Take Your Pick

In case you missed it, Joe Nocera wrote a user-friendly and quite interesting article about Value at Risk and the role of mathematical models in dealing with uncertainty. In "Risk Mismanagement" (January 2, 2009), this New York Times business columnist intimates that financial professionals may have relied too much on a single number, no matter how often it is updated.

This blogger wholeheartedly agrees with the premise that risk, in its totality, cannot be succinctly captured with one number, one metric, one tool, one time period and so on. While Value at Risk, a statistical measure of likely loss during a given business time interval such as a trading day, can be helpful as ONE gauge of financial exposure, it can also be of limited use if underlying assumptions do not accurately capture "typical" price behavior for a particular financial instrument. Expressed as a single number, VaR is often measured in dollars (Euros, etc) and is deemed by some as an easy way to compare trading risk across banks/companies/portfolios. It can be calculated in several ways and is provided as part of company SEC filings and bank regulatory reports.

Alas, reality intervenes.

I won't repeat what Mr. Nocera so eloquently wrote in his lengthy piece but will add the following:

  • Numbers can guide but not replace solid decision-making by rational human beings.
  • No single number can measure the many types of risks that investors and traders face.
  • Even a collection of numbers can lead to bad decisions if not supplanted with common sense and a key understanding of qualitative and quantitative portfolio risk drivers, both in isolation and in conjunction with one another. We need look no further than market outcomes in 2008 to know that bad news can beget bad news (i.e. the notion of contagion and compounding of risk factors).
  • Longer term investors such as pensions, endowments and foundations should acknowledge that Value at Risk is designed more as a tool for short-term (trading) decisions.

An important area not addressed by the article is the nature and extent of due diligence being conducted by institutional investors and their consultants before allocating monies to various asset managers. I've yet to see too many institutional investors publish a comprehensive Risk Management Policy that is separate and distinct from an Investment Policy Statement (assuming that even an IPS exists). Besides Value at Risk, Sharpe Ratio, Standard Deviation, Correlation Coefficient(s) and maybe an Information Ratio and Tracking Error(s), how much risk management analysis is being conducted before institutions say "here's my money?" The current state of pension disclosure reporting leaves us mainly in the dark about how plan sponsors drill money managers on the topic of risk identification, measurement and management. Unless you're a mushroom, too little sunlight is not necessarily a good thing.

Editor's Note: Check out www.gloriamundi.org for a broad array of papers on the topic of Value at Risk. I've also written a book entitled Risk Management for Pensions, Endowments and Foundations (John Wiley & Sons). While some of the statistics are dated, it includes some good case studies and checklists. (I am in the process of updating the book.)

It's 10 PM At Night - Do You Know Where Your Leverage Is?

Given repeated headlines of late about the role of leverage, it may be surprising to learn that there is no universal metric that captures the likely economic impact of its use. Ask ten asset managers how they measure the use of other people's money and you are likely to get ten different answers. This is a big deal since investment leverage is a key driver of performance which in turn relates to fees paid by institutional investors. While leverage can be a boon to return-hungry pensions, endowments and foundations, misused or miscalculated, leverage can result in massive and unanticipated losses. Prudent investors need to ask managers if their funds are levered, to what extent they are levered, what strategies were used to lever the portfolio and whether stop loss mechanisms have been put in place to contain things, as market conditions sour.

According to "Overview of Leverage," published by AIMA Canada, one calculation (referred to as Net Market Exposure or Net Leverage) takes the dollar difference between long and short positions and divides by a hedge fund's capital base and then multiplies the ratio by 100%. However, as Virginia Reynolds Parker, CFA rightly points out, balance sheet inputs can limit the usefulness of leverage ratios, especially if there is a big disconnect between where an instrument is likely to trade versus its stated value for financial statement reporting purposes.  (It is too soon to know whether FAS 157 compliance will close any economic-accounting gap and therefore render point in time ratios more effective as a risk gauge.)

While not all funds employ leverage, it is not uncommon for a portfolio manager to employ derivatives, margin and/or outright borrowing in order to effect a disproportionate exposure to a particular asset or liability class. Leverage can vary by strategy as documented in "The L Word" (Investment Review, Spring 2008). As author Peter Klein shows, hedge fund strategies such as convertible arbitrage employ higher leverage levels than a "less risky" market neutral strategy. However, he warns readers to take care in relying on leverage ratios alone, adding that correlations and overal riskiness of portfolios must also be considered. This blogger agrees with the notion of looking at multiple metrics but encourages investors to go way beyond numbers and look at the asset manager's process with respect to all things leverage.

Hedge funds are not the only entities to employ leverage. Wikipedia reports that leverage, measured as total debt divided by stockholders' equity, for five major investment banks (Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, Morgan Stanley) steadily rose between 2003 and 2007 to more than 25. Click here to access the source data to verify for yourself. Institutions are well familiar with 130/30 funds and variations thereof. Mutual funds use leverage as do exchange-traded funds ("ETFs'). In "Read the Fine Print on Leveraged Funds," Wall Street Journal reporter Tom Lauricella warns about the new math that can roil investment value quickly, adding that these vehicles are not for everyone.

Investors need to decide for themselves after (hopefully) doing the requisite homework about how leverage is being managed, if at all.

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?

Investment Fortune Telling?

In response to my November 19, 2008 blog post ("Pension Report Card - Process, Not Point in Time Numbers"), ERISA attorney Steve Rosenberg refers to me as a financial Cassandra. Indeed, many times of late, I've felt like shouting - "Didn't I warn about risk a hundred years ago?" While I like to think of myself as a relatively smart person, many adverse outcomes were not particularly difficult to predict. Bad process begets bad results. There has long been a plethora of red flags to signal that risk management was either AWOL or far from an independent exercise at certain organizations. I've copied and pasted Steve's commentary below. Check out his thought-provoking blog at http://www.bostonerisalaw.com/

<< There’s an old saying that nothing focuses the mind like an execution date; all trial lawyers have heard judges rephrase it as nothing focuses the mind so much on settlement as an imminent trial date. I thought of this saying when I read this article, in which of Pension Governance, whose Cassandra like warnings that companies need to focus on improving quality and other aspects of retirement plans - including their handling of hard to value assets - predates the utter disaster that has befallen such plans in the past several weeks, discusses the fact that, having now fallen into the abyss, pension plans and fiduciaries must focus their efforts on how to respond to the market collapse, which may have a larger impact on the pension plans than the market collapse itself. If there was ever a metaphorical execution date for plan fiduciaries and administrators, it’s the upcoming and ongoing storm of litigation risks, government investigations and intervention, and need to respond to the market volatility by tightening up investment strategies. If it may be hard, in hindsight, to defend the kind of alleged problems in investment management that occurred in the past that are at the heart of the “stock drop” type suits that are being filed against 401(k) and pension plans, it will be doubly hard to defend any continuation of the same types of errors in future cases, given the extent to which the world has changed over the past several weeks, both in terms of the environment in which such cases will be litigated and the expectation that fiduciaries should have learned from past mistakes. >>

Pension Report Card - Process, Not Point in Time Numbers

In "Pension Plans Under Closer Watch" (November 18, 2008), MarketsmediaLive reporter Karla Yeh quotes me as emphasizing process. Rather than dwell on singular numbers that can change over time and according to the selected time period and/or reporting rules, I urge interested parties to focus on what happens next. In the event that a defined benefit plan suffers a loss, how will things have to change as a result?

Here is the article for your reading pleasure. The original version can be found at http://www.marketsmediaonline.com/news_details.htm?wP=1&wPI=1&cN=2306.

<< Pension funds struggling with declining asset values could be hurt more by the consequences from losses than the losses themselves, said Susan Mangiero, president of Pension Governance Inc., on Tuesday.

“The real question is what actions are forced upon plan sponsors as a result of reported losses,” she added. “For some plan sponsors, the pension chain of events is significant.”

The Organization for Economic Co-operations and Development last week reported average pension fund returns plummeted by more than 20 percent between January and October, resulting in a $4 trillion loss in pension assets. In addition, consulting and actuarial firm Milliman on Monday said corporate pension funds could be $93 billion in debt by the end of the year after asset values dropped by $120 billion.

“A loss of $120 billion is hard to ignore, especially since many economists believe that market volatility is here to say, for a while at least,” Mangiero said.

To combat record losses, Mangiero said companies could be forced to contribute billions of dollars in cash or freeze their defined benefit plans if funding ratios drop below 60 percent, pursuant to the Pension Protection Act of 2006. They might also reduce benefits paid to retirees and face ratings downgrades or higher capital costs in an attempt to replenish the funds, she added.

As the New Year approaches, shareholders and plan participants will most likely watch their pension plan sponsors under a close lens to “better understand the nature of the reported losses,” said Mangiero.

In the meantime, plan sponsors will “try to figure out how they are going to recoup equity sector losses” and “may be tempted to allocate more monies to riskier investments,” Mangiero said. She added that asset allocation will be a top priority for pension plans that need to boost money management and risk management focuses. >>

Pension Magic

I had the pleasure of speaking on October 23, 2008 in Stamford, CT about "New Directions for the Financial Services Industry." Part of the "Securities Forum 2008: Weathering the Economic Storm," sponsored by the State of Connecticut Department of Banking, panelists addressed the litany of current financial problems, proposed reforms and the likely future for investors and service providers alike.

I was asked to address FAS 157 and international equivalents. In doing so, I urged audience members to make a clear distinction between accounting representation and economic reality or accept the consequences. Unless one truly understands what reported numbers say (or just as importantly don't convey), poor decisions made on the basis of incomplete or even illusory information can lead to costly outcomes (GIGO = Garbage In, Garbage Out).

I've long maintained that disclosure about process is arguably more important than single numbers, derived at a particular point in time. For example, if I'm a pension fund decision-maker who has allocated monies to a manager that in turn invests in "hard-to-value" assets, which information is more helpful to me in understanding my risk exposure to that asset manager - (1) a FAS 157 disclosure that describes possible changes that could affect results or (2) identified likely risk drivers and the controls that have been established to mitigate risk accordingly?

Said another way, am I properly discharging my fiduciary duties by evaluating risk ex poste or instead assessing uncertainty ex ante? I think the answer is obvious, isn't it? After all, no one can respond to "what was" but can certainly act in anticipation of "what might be." By the way, I do believe there is merit in regularly conducting a post-audit of what went wrong and trying to learn lessons as a result.

According to FORTUNE Magazine senior editor Allan Sloan, critics of FAS 157 allege real harm is being done when illiquid securities are marked-to-model at "artificially low market prices." Call me clueless but finger-pointing seems to answer the wrong question. Instead of focusing on FAS 157 as the culprit because it supposedly forces reporting entities to document "bad" economic numbers, why not create a standard that instills confidence in financial statement users? Sloan writes "It's easier to blame accountants for your problems than to admit you made your institution vulnerable by overleveraging its balance sheet and buying securities you didn't understand." Click to read "Playing the blame game: Will 'mark to market' accounting take the fall for the Wall Street mess?" (October 27, 2008).

Just like the magic impossibility of growing a silver dollar into four years of college tuition, accounting representation should be more than smoke and mirrors.

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.

Risk Oversight and the Boardroom

Ms. Alexandra Reed Lajoux, with the National Association of Corporate Directors ("NACD"), responds to "Pension Funds Ask - "Who is Responsible for Risk Oversight? " as follows:

"New appointees face a steep learning curve that exposes a company to risk of another kind. Excellent point, well made. Director education is the key!"

I will be speaking at the 2008 NACD Corporate Governance Conference in just a few weeks. The panel is entitled "What Directors Must Know About the Company's Pension Plan." A session description follows.

"In light of the unanimous U.S. Supreme Court LaRue decisions, panelists look at the board's oversight responsibilities of ERISA plans to assure they are well managed. Historically, many boards have been uninvolved in the plans and have not exercised adequate oversight. From a governance and risk management perspective, we look at salient issues and core elements of oversight that should be addressed at the board level."

Click to read more about the 2008 NACD Corporate Governance Conference.

Would Better Disclosure Have Helped WaMu Shareholders?

According to a September 25, 2008 press release from the U.S. Securities and Exchange Commission ("SEC Seeks More Transparent Disclosure for Investors"), pundits will gather in Washington, D.C. on October 8 to wax poetic about transparency. Two panels will convene to address "data, technology, and processes that companies and other filers use in satisfying their SEC disclosure obligations" as well as "how the SEC could better organize and operate its disclosure system so that companies enjoy efficiencies and investors have better access to high-quality information."

While I am in favor of "sufficient" disclosure to inform shareholders, plan participants and other interested parties, a critical question remains. What exact type of disclosure can really make a difference? I vote for information about process and accountability. Otherwise, financial statement users end up with snapshot assessments of mandated metrics. While these numbers could be potentially helpful, they are made less so without an understanding as to how they are derived, why they change and the extent to which an organization is exposed to economic danger. A few of the countless questions on the minds of inquiring individuals are shown below. (This is by no means an exhaustive list.)

  • Who has the authority to effect change for all things financial management?
  • Who oversees authorized persons and the latitude they enjoy to make decisions?
  • How are risk drivers identified, measured and managed on an ongoing basis?
  • What creates "stop loss" threshholds?
  • How are functional risk managers compensated?

As reported by CNN.com, JP Morgan Chase has just purchased $307 billion in assets from Washington Mutual (ticker symbol WM) in what is described as "the biggest bank failure in history." Serious stuff indeed but would more detailed financials have helped? We know that the large thrift ushered in a new chief risk officer ("WaMu replaces its chief risk officer," April 29, 2008) to "help steer the nation's largest savings and loan through the fallout of the mortgage and credit crises."

The 2007 Annual Report on Form 10-K/A for Washington Mutual, Inc. is rich with information about risk management, credit risk management, liquidity risk and capital management, market risk management, operational risk management and "Factors That May Affect Future Results." Page 5 of said document states that an evaluation of the Company's disclosure controls and procedures allows the "Company's Chief Executive Officer and Chief Financial Officer" to conclude that, "as of the end of such period, the Company's disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company..."

A company press release dated July 22, 2008 informs the public of actions taken by the Company to build up its reserves and mitigate risk. See "WaMu Reports Significant Build-Up of Reserves Contributing to Second Quarter Net Loss of $3.3 Billion." The bank's website provides a slide presentation about credit risk management also dated July 22, 2008. It details all sorts of information about the loan portfolio, including allowances for loan losses.

According to Wall Street Journal reporters Robin Sidel, David Enrich and Dan Fitzpatrick, a flood of deposit withdrawals forced the demise of this Seattle based financial house. (See "WaMu is Seized, Sold Off to J.P. Morgan In Largest Failure in U.S. Banking History," September 26, 2008).

Question of the Day: What disclosures could have helped shareholders (including pension plans) to know how bad it could get and in what time?

Low-touch regulation, not black letter rules

I had the pleasure of speaking twice at the annual SIBOS conference last week in Austria. (The 2007 event was in Boston. The 2009 forum will be held in Hong Kong.) The first panel could not have been more timely, given the current regulatory frenzy underway. Sure to cause a stir on any day, you can imagine the lively banter as market prices tumbled. Here is a summary of what ensued. This article was first published in Sibos Issues, SWIFT's daily newspaper devoted to reporting the Sibos conference sessions. You can view more articles and download each issue from SWIFT's website.

                           Regulation that fails to keep up could damage the funds market

Panelists at Wednesday's session on whether regulation helps or hinders the investment funds industry claimed to see no threat from regulation as such but plenty from sledgehammer regulation that failed to keep up with the market.

"We work in an industry that prefers light-touch regulation to black-letter rules," said moderator Bob Currie, editor of FSR. "It has good reason to." Overall, the question for panelists was not whether but how much and what kind. "Regulation creates trust and makes the system work. It's a fiduciary business with a risk asymmetry between investor and provider," EFAMA chairman Mattias Bauer pointed out. "But regulators need to ensure they create a level playing field between products, with no regulatory arbitrage."

In the UK, that's precisely what regulators had failed to do, claimed EU Consumer Representative Mick McAteer. By treating insurance products and mutual funds differently, he said, UK regulators had "failed to improve market conditions, increase confidence in the market, or create a level playing field for consumers."

A.P. Kurian, chairman of the Association of Mutual Funds of India, took a contrarian position, urging "regulatory activism" as an approach and posing as a metric for existing regulations, "whether it had survived the test of a crisis." He claimed "strict regulation and strict compliance" had helped the funds industry in his native India minimize the impact of current economic volatility.

In contrast, Pension Governance CEO Susan Mangiero warned that over-regulation counterproductively increased risk because it impeded the transfer of information between buyers and sellers. "When you have excess regulation, it becomes difficult to reward good people and penalize bad ones because everyone's concerned with compliance rather than best practice in risk management. The result is that they have no incentive to do what they should be doing," she said.

A compromise came from Jack Gaine of the Management Funds Association, who cited what he described as a "compact" between regulators and the US hedge fund industry whereby hedge funds exclusively target institutions and high net worth clients in return for a waiver on short-selling restrictions.

In any case, Mangiero suggested finally, the debate was most likely academic. "I advocate a free market approach but what I expect is more regulation," she said.

                                                                            * * * * * *

Editor's Note: While I realize that espousing capitalism during a horribly tough economic environment is inviting verbal tomatoes, it is critical to acknowledge both sides of the argument. Check out the video entitled "The Resurgence of Big Government" by Yaron Brook, September 18, 2008. Dr. Brook is the President of the Ayn Rand Institute and a former finance professor.

Risk Management Adventures

Thanks to financial planner David Boczar for sending along a thought-provoking quote from famed commodities trader Ed Seykota. Described as someone who turned $5,000 into $15 million over a dozen years, this uber trend follower Seykota cautions: "Surrender to the reality that volatility exists, or volatility will introduce you to the reality that surrender exists."

As I've written many times, risk management is not the same thing as risk minimization. Risk is neither inherently "good" or "bad" but rather a reality, with potentially crushing economic impact if ignored or given short shrift. As we've seen in recent days, some attempts to tame the risk lion have resulted in serious casualties.

It is no surprise then that pundits and reporters are asking about the whereabouts of risk managers, part of the frenzied blame game afoot. (Is there a "Where's Waldo" equivalent here?) New York Times blogger Saul Hansell pressed a lot of hot buttons with his September 18, 2008 post entitled "How Wall Street Lied to Its Competitors." My response, now one of more than 100 posted responses, is shown below.

<< I concur with much of this article. Effective risk management is much more than quantitative analysis. Many individuals are lulled into false security when given a bunch of computer printouts, accepting numbers as gospel truth. Like the fictional Detective Columbo, decision-makers must search for “hidden” information, not reflected in computer printouts. I recently testified before the ERISA Advisory Council about “hard to value” assets. Click here to read my comments. http://www.pensionriskmatters.com/2008/09/articles/valuation/testimony-of-dr-susan-mangiero-about-hard-to-value-assets/

P.S. Some of the quants sat on boards of financial institutions. It would be helpful to know more about their role as relates to oversight of risk management activities. >>

To my last point (above), it should be noted that litigation risk could be a deterrent for prospective directors with risk management experience. For example, Ms. Leslie Rahl (who is quoted in Hansell's blog post about the perils of underestimating risk of complex mortgage backed-securities) is, according to the Financial Post, named in a lawsuit filed against Canadian Imperial Bank of Commerce (CIBC), along with others such as the former Chief Risk Officer and the current Chief Risk Officer. Journalist Jim Middlemiss quotes the bank as denying allegations and expressing confidence that their conduct was appropriate. (See "CIBC hit by suit over subprime lending," July 24, 2008.) Additionally Rahl, a former Citibank derivatives division head, is listed on the Fannie Mae website as a "Fannie Mae director since February 2004."

For interested readers who want to follow the mounting litigation related to sub-prime activities, check out attorney Kevin LaCroix's blog entitled The D&O Diary. Be forewarned that Kevin posts volumes about Director and Officer (D&O) liability. Should we be disturbed that he has so much news about which to write?

What does this mean for institutional shareholders? Run, don't walk, to the closest risk management analysts who can help you decipher whether a company is doing a "good" job of identifying, measuring and managing a panoply of financial and operational pain points. Send us an email if you want some help.

On the topic of models, my article entitled "Asset Valuation: Not a Trivial Pursuit" (FSA Times, The Institute of Internal Auditors, 2004) still rings true. Check out the 10 prescriptives discussed therein. (This is by no means an exhaustive list.)

  1. Gain an intuitive understanding of the model.
  2. Ask questions of the model builders.
  3. Determine whether or not a model meets regulatory requirements.
  4. Inquire whether or not different models are being used for tax reporting versus financial statement presentation.
  5. Understand the data issues.
  6. Ask about model access.
  7. Evaluate the asset portfolio mix.
  8. Ascertain the extent to which a model incorporates embedded derivatives.
  9. Determine the simulation approach used to value path-dependent securities.
  10. Enlist senior management to assign someone from the finance team to work closely with the auditing team.

How Much More Will Pensions Lose in Financials?

One good thing about being an occasional night owl is that you get to blog about breaking news. Unfortunately, today's headlines are gloomy indeed. Here's a quick recap.

  • According to a company press release (dated September 15, 2008), Lehman Brothers Holdings Inc. intends to file for Chapter 11 protection, seeking a reprieve from creditors. "None of the broker-dealer subsidiaries or other subsidiaries of LBHI will be included in the Chapter 11 filing and all of the broker-dealers will continue to operate...Neuberger Berman, LLC and Lehman Brothers Asset Management will continue to conduct business as usual..." Click to read the Lehman Brothers press release. Various stories describe a rejection by the U.S. government to bail out this venerable financial institution. In stark contrast to this news, Reuters reporters Christian Plumb and Dan Wilchins report that the bank had just reported "a record $4.2 billion" net profit. (See "Lehman CEO Fuld's hubris contributed to meltdown, September 14, 2008).
  • New York Times reporter Edmund Andrews reports that the Federal Reserve has loosened collateral rules to allow investment banks to pledge "stocks and some debt that has junk-bond status." (Read "Federal Reserve Offers No Cash but Loosens Standards on Emergency Loans," September 15, 2008.)
  • Merrill Lynch is selling itself to Bank of America and AIG is seeking billions of dollars to keep it afloat. (See "Bank of America to Buy Merrill" by Matthew Karnitschnig, Carrick Mollenkamp and Dan Fitzpatrick, Wall Street Journal, September 15, 2008 and "AIG Scrambles to Raise Cash, Talks to Fed" by Matthew Karnitschnig, Liam Pleven and Peter Lattman, Wall Street Journal, September 15, 2008.)
  • According to Reuters ("Derivatives market trades on Sunday to cut Lehman risk, September 14, 2008), an emergency session commenced at 2 pm in New York, ran for two hours and was then extended for another two years, during which "trading involved credit, equity, rates, foreign exchange and commodity derivatives." Initiated at the request of the Federal Reserve, the goal was to net over-the-counter ("OTC") derivative instrument positions among major players in order to avoid a Lehman-related meltdown. (Lehman actively trades in the OTC derivatives markets.) Bond fund giant Bill Gross is quoted as saying that a "Lehman bankruptcy risks an 'immediate tsunami' because of the unwinding of derivative and credit swap-related positions worldwide in the dealer, hedge fund and buy side universe."
  • Reuters also reports that UBS is expected to write down an additional $5 billion "on its risky investments in the second half of the year." (See "UBS to write down extra $5 billion in H2: report," September 14, 2008.)
  • This collection of financial horribles follows quickly on the heels of a recent U.S. bailout of Fannie Mae and Freddie Mac. Click to access the website page for the U.S. Department of Treasury - "Treasury and Federal Housing Finance Agency Action to Protect Financial Markets and Taxpayers."

The fallout for pension plans is not going to be pretty if pundits are correct. Interest rates will fall, boosting defined benefit liabilities. Plummeting equity market prices (especially if contagion prevails) are going to hammer asset portfolios, especially those traditional benefit plans with big allocations to stocks. Funding status could worsen, creating its own set of adverse outcomes. Exposure to troubled banks potentially spills over to pensions if (a) they are the OTC derivative counterparty on the other side and/or (b) their external money managers find themselves in that unhappy position and/or (c) they own stock in any or all of the banks in question.

On the flip side, a sagging U.S. dollar could be a blessing for institutional investors with exposure to multinational companies that earn most of their net revenue offshore. Additionally, non-U.S. equities and bonds will likely rise in value. Unless regulators curtail trades, some parties will pocket dramatic gains from having taken a direct or synthetic short position in certain stocks and bonds. Commodities might turn out to be another bright spot for some. For those with cash, if this truly marks a bottom, as some suggest, bargain hunters may have reason to celebrate.

We are hard at work, chasing down the pension-centric facts. We predict there is going to be much more to say about risk management and valuation. Hang onto your hats! We are in for a bumpy ride.

Editor's Note: When testifying before the ERISA Advisory Council on September 11, 2008, I was asked to comment about the pervasiveness of "hard to value asset" issues. I said (and the inquiring Council member agreed) that: (a) defined contribution plan participants are not immune to potential valuation-related losses (b) "hard to value assets" might characterize some "traditional" mutual funds, separately managed accounts and money market funds and may or may not apply to alternative investments (depending on the strategy and other risk factors) and (c) the importance of the topic demands that considerably more attention be paid to model risk, independence of marking-to-model or marking-to-market and the extent to which an investor or trader integrates valuation with his or her risk management policies and procedures.

Fannie Mae Gets a New Chief Risk Officer

According to Wall Street Journal reporters, James R. Hagerty and Aparajita Saha-Burna, musical chairs are moving at the nation's giant mortgage house. Besides a new chief business officer and CFO, the former Senior Vice President for Credit Risk Oversight takes the lead on all things risk. Exiting the  company is the former Chief Risk Officer ("CRO"). (See "Fannie Mae Names New Officers in Shake-Up, August 28, 2008)

According to a May 18, 2006 press release issued by the Federal National Mortgage Association ("Fannie Mae") (ticker symbol FNM), the Chief Risk Officer now being replaced came onboard to lead the "credit market, counterparty and operational risk oversight for all business units within Fannie Mae." Before joining, he headed the market risk management efforts for "the chief investment office and retail financial services" at a large bank. In that same May 18 announcement, the then Chief Business Officer (now departing) commented on the new "One Fannie Mae" approach, "with a rigorous, unified and analytical discipline."

If you are not asking already, let me do it for you. What happened since 2006? 

The Fannie Mae website boasts a "Risk Policy and Capital Committee Charter" (last amended on November 20, 2007) that exists for the purpose of assisting the Board in "overseeing Fannie Mae's capital management and risk management, including overseeing the management of credit risk, market risk, liquidity risk, and operational risk." Members are charged with duties that include risk management oversight and recommendations relating to enterprise risk.

I repeat. What happened? Inquiring minds want to know - shareholders, taxpayers and oh yes, retirement plan participants, including those of plan sponsors that invested in Fannie Mae.

As confirmed by the Pension Benefit Guaranty Corporation ("PBGC"), the Fannie Mae defined benefit plan is an insured plan. If financial woes continue (as suggested by some), could taxpayers be asked to fund a bailout of shareholders as well as a bailout of retirees (in the event that PBGC itself needs help)? (On December 8, 2007, this blog cited TheWashBiz Blog as saying that the Fannie Mae plan would be closed to new employees.)

In a related Wall Street Journal article (entitled "Pension Funds Watch Fannie, Freddie," August 28, 2008), reporter Daisy Maxey lists some public plan notables who hold more than a few shares. Here's another thought. Is a triple taxpayer play a possibility, if things get "too bad?"

  • Taxpayers bail out Fannie Mae and Freddie Mac shareholders
  • PBGC takes over Fannie Mae and Freddie Mac defined benefit pension plans
  • Taxpayers bail out the PBGC (if the insurance premiums prove insufficient to pay retirees of "assumed" plans)
  • State taxpayers are asked to help public plans that invested in Fannie Mae and Freddie Mac

As an aside, it would be quite interesting to know what kinds of risk management related questions were asked by pension plan investors of these government-sponsored entities ("GSE"). For those plans that are now exposed as the result of indexing, the situation is somewhat difficult. How can a plan exit a particular position if it has specifically allocated part of its portfolio to an identified index (part of a pure passive strategy) and that index includes a "troubled" security?  

Public Pensions and Hedge Funds

In "States Double Down on Hedge Funds as Returns Slide," Bloomberg reporters Adam Cataldo and Michael McDonald (August 14, 2008) suggest that public pensions may get a double whammy if alternative investments go south. New York, New Jersey, South Carolina and Massachusetts are just a few of the large public plans now allocating monies to non-traditional investments such as hedge funds, real estate and private equity. This is not necessarily good or bad though one wonders about the timing. Will current market volatility help or hinder plans in search of higher returns? This blogger is quoted as follows:

"It doesn't come risk-free," said Susan Mangiero, president of Pension Governance, LLC, a research firm based in Trumbull, Connecticut. "You could end up having a worse performance and the chain of events is lower funding status and increased taxes."

Managing director Eileen Neill, with Wilshire Associates, states the need to "diversify some of the equity risk" and to attempt strategies that will help match the growth in liabilities. As I told the Bloomberg reporters (though not included in this article), how one measures diversification potential is key to understand. Correlation analysis only goes so far when markets are turbulent and bad news tends to adversely impact otherwise uncorrelated markets. Additionally, correlation assumes a linear relationship when comparing returns for a particular investment pair (hedge fund versus a large cap equity index for example). When the relationship is non-linear, correlation is less useful as a gauge of potential risk reduction.

Just as important, past is not prologue. Assessing historical returns can be misleading at best. Stan Rupnik, Chief Investment Officer at the Teachers' Retirement System of the State of Illinois, is quoted as saying that "Chasing performance, especially in a public fund, can be a dangerous thing." It is important for trustees to make sure that "what if" analysis is being done on a regular basis, taking into account relevant risk drivers. Consider private equity and venture capital. An accelerating credit crisis has made it extremely difficult for companies to go public or for potential suitors to finance their bid. As a result, returns suffer. No surprise that pension investors (and their plan participants) take a hit too.

Editor's Note:

SEC Issues Compliance Alert About Sloppy Valuation Process

Hat tip to fellow blogger gal Wendy Fried for news about the recent release of an important ComplianceAlert, issued by the U.S. Securities and Exchange Commission. Click to read "Sloppy subprime valuations on Wall Street?..." (footnoted.org, July 25, 2008)

According to the SEC website, a ComplianceAlert letter highlights results of examiners' audits in an attempt to "encourage" institutions to better their current compliance and supervisory efforts. In its July 2008 letter that starts "Dear Chief Compliance Officer," the SEC staff provides a laundry list of concerns, including, but not limited to:

  • Inadequate monitoring of personal trading by advisory staff
  • Weak oversight of mutual fund boards to "confirm that the proxy service providers' recommendations were consistent with funds' policies and procedures"
  • Stale valuations of high yield municipal bond fund holdings
  • Poor or no disclosure of the increased valuation and liquidity risk when "the percentage of illiquid securities held by a fund dramatically increased"
  • Questionable quality of price verifications of collateral held by certain broker-dealers
  • Inexperienced staff who were nevertheless tasked to validate model prices
  • Lack of documentation as to valuation standards relied upon by some broker-dealers.

The letter concludes with a variety of recommendations, including but not limited to:

  • Improvement of price verification and assessment of "modeled inputs and the calibration of valuations against trades or trade information inferred from activity in similar securities and or the derivative markets"
  • Retention of records "used in determining value"
  • Getting independent product control groups involved in "monitoring collateral valuations"
  • Creating and maintaining a database that "serves as the internal repository for security position information, including periodic valuations, in order to ensure consistency amongst various inventory trading accounts and collateral valuations."

I hate to say "we told you so" but this blog has been on a tear about proper valuation process for a long time. Check out a few of our many past posts. 

With FAS 157 and international equivalent accounting rules forcing change, pension fiduciaries need to take a hard look at their external service providers' trading controls and valuation policies and procedures, if not already. Check with legal counsel but likely they will remind plan sponsors that delegation does not absolve one of the fiduciary duty to properly select and oversee vendors.

What is your biggest concern about how "hard to value" instruments are currently being assessed by banks and broker-dealers? Send us an email with your opinions.

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:

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."

Arkansas Teachers Sue Company Directors for Risk Taking

According to business vox populist Gretchen Morgenson, a Los Angeles federal judge plans to hold mortgage company executives accountable by allowing a lawsuit to proceed. In "Judge Says Countrywide Officers Must Face Suit by Shareholders" (New York Times, May 15, 2008), Morgenson quotes Christa Clark, chief attorney for lead plaintiff, Arkansas Teacher Retirement System, as urging institutional investors to recognize a "duty to seek recourse when a company's directors engage in practices that are not in the best interests of shareholders."

It is impossible to know all facts at this stage, let alone guilt. Only ensuing testimony will shed light on whether Countrywide's CEO and about a dozen directors and officers are deemed culpable. According to the complaint (not yet included in the national judiciary's repository), those described as in the know were allegedly liquidating their personal holdings while making "misleading" public statements about the financial health of the company.

Two things are notable about this case. First, it is yet another indication of the power of institutional investors, in the aftermath of the passage of the Private Securities Litigation Reform Act of 1995. Second, questions remain about whether, and to what extent, other boards will find themselves defending suspicious practices. The outcome of this lawsuit portends greater focus on who should be held responsible for financial practices. So far, the outcome is mixed with respect to the sub-prime blame game.

The Fire & Police Pension Association of Colorado ("FPPAC"), Louisiana Municipal Police Employees Retirement System ("LAMPERS"), Central Laborers Pension Fund, and the Mississippi Public Employees Retirement System ("MPERS") are listed as additional plaintiffs.

Lowballing LIBOR May Cost Pensions Plenty

According to Wall Street Journal reporter Carrick Mollenkamp ("Libor Surges After Scrutiny Does, Too - April 18, 2008), the British Bankers' Association is moving ahead to investigate the veracity of self-reported cost-of-funds numbers. The fear is that banks are paying more to borrow in the short run than they want to admit. If peers discover the truth, bank borrowers may find themselves at a competitive disadvantage. Non-borrowers will feel the pinch too as will swap and over-the-counter fixed income option counterparties and those trading the Eurodollar futures contract. The London Interbank Offer Rate ("LIBOR") is a common base rate for most short-term loans and derivative instrument contracts.

American regulators are worried too as market pundits predict that U.S. dollar LIBOR rates are likely to spiral. Just last week, three-month LIBOR loan rates rose to 2.8175% per annum, up from 2.7335%, "the biggest increase since the three-month rate rose 0.12 percentage point on August 9" when BNP Paribas prevented investors from withdrawing money from several of their funds. The current level is reported at "its highest" since March 13 when news came out about Bear Stearns.

A rising LIBOR makes swap-driven Liability-Driven Investing ("LDI") strategies more expensive for Fixed Rate Receivors - Floating Rate Payors. In addition, if quarterly checks indeed differ from estimated projections, pensions may eschew LDI strategies as too difficult to evaluate for accounting or risk management purposes.

Interestingly, quotation problems seem to be contained to U.S. dollar LIBOR situations and not other currencies such as the Euro.

Valuation - Getting on Track

As an Accredited Valuation Analyst and long-time advocate of the notion that effective risk management and valuation go hand in hand, the release of two reports that emphasize good process in these areas is welcome news. See "Principles and Best Practices for Hedge Fund Investors" and "Best Practices for the Hedge Fund Industry." Click to read "PWG Private-Sector Committees Release Best Practicies for Hedge Fund Participants" (April 15, 2008) where "PWG" stands for the President's Working Group.

While I agree with Peter Schwartz that self-regulation and market discipline is ideal, I'd like to think that calls for reform are positive reactions to problems rather than "desperate" pre-emptive strikes against statutory mandates. Is that naive? Perhaps but hope springs eternal. (Read "Valuation is the Heart of the Matter," reprinted in "Money House of Cards or Disciplined Approach?" - April 17, 2008)

Where I part company with my colleague is that I believe one can (absent a once in a lifetime event) value complex securities if they are equipped with an analytical toolbox. If we peek inside, "hammers and nails" would include: (a) reasonable assumptions (b) appropriate and tested models (c) understandable and available data (d) identification of relevant risk factors that drive value (e) methodology that can be explained to others and reflects relevant economic considerations (f) disciplined, systematic process and (g) common sense.

Ultimately, value equals price when a willing (and hopefully informed) buyer and seller agree on terms. Until then, should we surrender to what some deem as villainous fair value accounting rules or roll up our shirt sleeves and get to work, acknowledging that a calculated "value" may differ from an eventual price?

I opt for the latter because I believe action beats passivity (though some may say nein to investing in the first place). Indeed there are numerous occasions that require an opinion of value for "official" reasons (tax reporting, account redemption, fund creation, determination of hedge size and so on.) What worries me is when alternative fund managers adopt an arbitrary stance or embrace a philosophy that discourages attempts to apply reason, discipline and care.

  • Example One - Two or more appraisers may reasonably disagree on an exact identical DLOM ("discount for lack of marketability") for a particular economic interest. Yet a careful analysis of what contributes to a possible liquidity event is far superior to the X% times number of years formula in use by some alternative fund managers. 
  • Example Two - Appraisers cost a fund (or its investors, depending on which party pays) because they charge a fee to render independent, objective third party assessments.  Are pensions, endowments and foundations better off by blithely relying on marks provided by traders, knowing that they are often compensated based on reported performance (inducing an inherent conflict of interest as a result)?
  • Example Three - Should we accept that some instruments truly cannot be valued or instead identify economic and non-economic factors that impact the ability of an owner to eventually sell? Should we ignore emerging mechanisms that create markets in all sorts of "hard to value" business interests such as someone's client list or their employee stock options? 

Mr. Schwartz is certainly right to warn that some situations are challenging at best. As this blog has emphasized (perhaps ad nauseum), suitability assessment is a critical first step. It makes no sense to invest other people's money (plan participants) or encourage direct allocation (as with 401(k) plans) unless decision-makers truly understand risk drivers (qualitative, quantitative, economic, non-economic).

This blog will continue to address valuation issues. Your feedback is welcome. Drop us a line.

Editor's Note: Check out www.securitiesmosaic.com and the family of related websites. It's well worth your time. 

Pension Funds Ask - "Who is Responsible for Risk Oversight?"

In "Bear's board was busy elsewhere," Financial News reporter Jeff Nash (March 31, 2008) writes that the investment bank's board has been busy, with three individuals doing work for "at least four other public companies" and two "of those three extremely busy directors" doing double duty as members of the risk committee. Corporate governance pundits add that outside distractions do little to help business fiduciaries carry out critical risk oversight duties.

Wall Street Journal reporter George Anders likewise addresses the question of where the buck stops, or if it arrived at all. In "Wall Street Housecleaning May Bypass Boardroom," the executive director of the $12 billion Illinois State Board of Investment, William R. Atwood puzzles over the involvement of directors as relates to sub-prime losses, wondering if "directors at big banks and Wall Street firms share some responsibility for what has gone wrong." Others quoted in the April 2, 2008 article counter that it may be ill-advised to unseat veteran directors. New appointees face a steep learning curve that exposes a company to risk of another kind.

The courts will surely play a prominent role in determining who pays (if at all) as shareholders and pension plan participants file lawsuits aplenty.

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.

UK Pension Gains Wiped Out

Even British comic book hero Union Jack may not be able to save the day for some UK pension plans. According to data just released by the Pension Protection Fund, the net funding status for nearly 8,000 private defined benefit plans widened to 97.5 billion pound sterling. Worse than the 80.8 billion GBP gap reported for January 2008, this February 2008 number is deemed "highest since June 2003" and represents the fourth consecutive monthly gap. Another telling indicator of problems is the news that "In February 2008, the total surpluses of schemes in surplus fell to £32.6 billion from £37.3 billion1 at the end of January 2008." Twelve months ago, the "aggregate surplus of all schemes in surplus stood at £68.6 billion." Click to review the Pension Protection Fund data report.

Citing anemic equity performance and falling bond yields as the culprits, the report's authors add that lower bond yields resulted in a 8.1% rise in aggregate liabilities "while weaker equities have reduced assets by 1.5%." Noteworthy are the results of a survey commissioned by the PPF and carried out by KPMG that show that few respondents (defined benefit plans considered "large") employ liability hedging techniques. The chart that maps funding status to percent of liabilities seems to support a widely held belief that "where funding is severely low the schemes need to take a certain degree of investment risk to help get back to full funding, given the PPF is insuring a certain level of benefits."

Does this mean that regulatory subsidies discourage hedging? If so, the UK would not be unique in terms of a rational but perverse response to changed incentives. (The notion of unintended consequences is one of the free market economic arguments against regulation, especially when "innocents" end up paying the bill.)

Click to access the January 2008 survey entitled "Pension Protection Fund: Investment Strategy and LDI Survey."

On a related note, a survey of US and Canadian plan sponsors, focused on their pension risk management practices, is due out shortly. A collaborative effort on the part of the Society of Actuaries and Pension Governance, LLC, the results support those of the aforementioned UK survey with respect to lower than expected amount of hedging (of both assets and liabilities).

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.

Chile Pension Reform Adds to Foreign Investments

In "Chile set to boost foreign investment," Financial News reporter Johanna Symmons (January 28, 2008) describes a proposed law that increases maximum international holdings from the current 40 percent to 80 percent. This means that the half dozen authorized private fund administration companies will have more latitude in how they manage the country's mandatory individual savings accounts. When approved, non-Chilean holdings could rise as much as USD 50 billion. In addition, reform will add to retirement plans of impoverished citizens, "funded by windfalls from copper production." Credit goes to President Michelle Bachelet who identified the need for change as "her administration's most important task."

This blogger is proud to say that she worked as a financial risk management expert on an official fact-finding team in early 2006. Led by Dr. Roberto Rocha (World Bank), colleagues and report co-authors included Mr. Graeme Thompson (former Australian regulatory chief and now pension consultant) and Dr. Eduardo Walker (Pontificia Universidad Catolica de Chile). If you are interested in learning more, know that pension professionals from around the world will be presenting at The 4th Contractual Savings Conference: Supervisory and Regulatory Issues In Private Pensions and Life Insurance. Hosted by the World Bank and occurring on April 2 through 4, 2008, the discussions will emphasize the "brave new world" of pension risk management. Yours truly is presenting a session entiled "Risk Management of Pension Funds: A Practitioners View."

If you are unable to join us in Washington, DC, I invite you to read about what other countries are doing in the area of pension reform for different types of plans. Chile is a particularly interesting case inasmuch as politicians and public policy leaders often reference this Latin American system as a noteworthy and innovative model. Think of it as a national 401(k) plan of sorts. While not perfect (no system is), many people like having their own account rather than being part of a "pay as you go" system. For more information, visit the site for the Superintendency of Pension Fund Administrators and click on the English overview.

AIG Auditors 1, Traders 0 - Round 1



February 11 was a bit of an equity rollercoaster. Reports of another big price gap were to blame. According to Reuters, PricewaterhouseCoopers LLP, external auditors for AIG, "concluded that the company had a material weakness in its internal control over financial reporting relating to the fair valuation of credit default swap portfolio obligations of AIG Financial Products Corp." Those in the know estimate the unrealized valuation loss relating to credit default swaps as being close to $5 billion, much bigger than originally believed. The stock closed down 12 percent lower. (Click to read "AIG discloses hole in derivatives valuation" by Lilla Zuill.)

Several questions come to mind, not the least of which is whether internal auditors came to the same conclusion at the same time and by the same route. How did the outside auditors decide on the adjustment? What models did they use? (AIG's Form 8-K, filed with the SEC as of February 11, 2008, mentions the Binomial Expansion Technique and Monte Carlo Simulation.) How often did auditors and traders kick the proverbial tires? On the business development front, how will this news impact organizations on the other side of AIG trades? Will they ask for more collateral? Will trade size fall to reflect a reappraisal of default risk?

To be sure, AIG is not the only name in the headlines. Irrespective of any particular company, and as we've mentioned many times before, pension funds are duly exposed when they transact derivatives, buy financial company stock or bonds or allocate money to multi-purpose behemoths. Now is not the time to be shy about asking tough questions as regards risk management and valuation policies and procedures of firms such as AIG. This holds true even when a consultant is engaged. Legal experts remind. Fiduciary oversight remains.

Awhile ago, this blogger authored "Asset Valuation: Not a Trivial Pursuit" for the Institute of Internal Auditors. Topics discussed include model risk, model validation and the internal auditor's role. Also check out "The Role of the Financial Expert in Valuation of Derivative Instruments." Yes Virginia, there is lots of litigation as a result of markdowns, disclosure questions and risk management process (or lack thereof). 

On March 5, 2008 (in case you missed our earlier announcement), Pension Governance, LLC is proud to sponsor a webinar entitled "Fiduciary Risk, Trading Controls and External Asset Manager Selection." 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.

We hope to have you join us!

You Said What About Risk?

World business glitterati leave Davos, Switzerland with a renewed vigor to tackle problems du jour. Not surprisingly, those who attended the World Economic Forum had plenty to say about financial markets and risk.  

According to Clara Ferreira-Marques and Sue Thomas of Reuters, Raymond McDaniel, Chairman and CEO of Moody's, declared that "A lot of things could have been done better - some are the responsibility of rating agencies, some of other participants in the market." Guillermo Ortiz, Governor of the Central Bank of Mexico, urged more transparency. "The complexity of the products and financial innovation made it more difficult -- even the regulators failed to understand. It was an exercise in collective confusion."

For those who stayed home, a trip to the conference website is telling. Part of a panel about financial markets, Dominique Strauss-Kahn, Managing Director of the International Monetary Fund, described "low interest rates, high liquidity, a breakdown in credit and risk management practices, and a shortcoming in US financial regulation and supervision" as culprits. Central bankers concluded that the "causes behind the latest financial crisis were complex" with "some time before regulators and market players can fully grasp what went wrong."  A session moderated by CNBC's Maria Bartiromo (who interviewed me about pension investing on June 14, 2007) included a comment by Walter Kielholz, Chairman of the Board of Directors, Credit Suisse about the struggle for banks to generate returns even though "for four to five years, financial institutions have believed there is too much of an appetite for risk in the market."

Here are a few of my favorite "you don't say" quotes about risk.

  • “The only perfect hedge is in a Japanese garden.” (Gene Rotberg, former treasurer, World Bank)
  • “Due to my inexperience, I placed a great deal of reliance on the advice of market professionals…" (Robert Citron, former treasurer, Orange County, California)
  • "There is no such thing as a free lunch." (Milton Friedman, Nobel Prize winning economist and author)

If you know of any interesting statements about financial risk (including those which defy rational belief), we'd love to receive them. Similarly, it would be great to get your feedback about the role of regulation. Do we need more rules to govern investing? Click here to send us an email.

 

 


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.

Fraud in France - Time to Take Our Webinar on Trading Controls?

The news broke on January 24, 2008 that a rogue trader at Societe Generale was allegedly responsible for nearly US $7 billion (4.9 billion euros) in fraudulent transactions. Hours later, Bank of France governor, Christian Noyer, tried to allay fears. Refuting any connection between sub-prime exposure and the situation at hand, Reuters reports Noyer as saying that "nobody could have foreseen the loss" but acknowledged that risk controls should have been a barrier. "Today we have seen there was a glitch in the system that was exploited by someone who I think got around five successive risk control systems." See "Bank of France head reassures after SocGen fraud" (January 24, 2008).

When contacted for comments by www.pensionriskmatters.com, Mr. Tony Turner, principal with Financial Tracking, LLC asks - "Who was watching the store and who was watching the watchers? This highlights the need for automated and consistent monitoring and alerting."

What's interesting (at least based on preliminary public information) is that the identified bad player was supposedly an expert in operations and able to use that knowledge to his advantage. Many questions arise. 

  • How should back office, middle office and front office controls change to avoid a repeat occurrence?
  • What role do humans play with respect to monitoring computer systems thought to be otherwise safe from attack?
  • Who should ultimately bear responsibility for le rogue trader?
  • Is this type of fraud a "black swan" event or can we expect more trouble?
  • What can pension fund decision-makers do to better vet their banks' risk controls?

This will not be the last time we read about fraud and its potentially devastasting impact on related parties.

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.

Risk Management Lapses Cost Money

It's always hard to get back to work after a few days off. It's especially difficult when economic uncertainty is casting a cloud of gloom over financial markets. As a result, investment risk continues to rank high as a "must do," making lapses seem even more questionable.

Our December 29, 2007 post talked about a risk management post-audit at Morgan Stanley ("Lonely CROs - Why Pensions Should Care"). A few weeks ago, Financial Times reporters Chris Hughes and Haig Simonian wrote about UBS woes, with the chairman admitting that the "Swiss bank's risk and finance unit had failed to understand the sub-prime mortgage positions that led to its $10bn writedown, even though it was aware of the massive figures involved."

In "CIBC plummets after 'underestimating' subprime risk," Financial Post reporter Duncan Mavin (December 6, 2007) cites multi-billion dollar losses due to sub-prime assets and a "hedged subprime exposure" of nearly US$10 billion, "including US$3.5-billion in a CDO with a counterparty that is single-A-rated and ratings-watch-negative." Peter Routledge, senior credit officer with Moody's, is quoted as saying that "The existence of concentrated risks in [CIBC's derivatives] portfolio points to weaknesses in strategic risk decision-making at the bank and indicate that improvements in the bank's risk management discipline have not permeated the organization as fully as Moody's had expected." A read of the CIBC Risk Management Committee Mandate suggests a focus, however incomplete, on process. In fact, a prominent risk expert sits on that committee, prompting Globe and Mail's Fabrice Taylor to write "The multibillion-dollar question: Who's minding the shop at CIBC?" (December 21, 2007). 

From the outside looking in, one can only surmise what might have happened. Lessons learned, as details are made public, will be invaluable to 401(k) and defined benefit plan fiduciaries who rely on banks all the time and for many reasons.

Lonely CROs - Why Pensions Should Care

In "Morgan Stanley reviews position of risk officer over writedowns" (December 22, 2007), Financial Times reporter Henny Sender describes the hostile environment in which some risk management gurus live. Declaring that critics now accuse the Morgan Stanley Chief Risk Officer of being late in "sounding the alarm about the dangers stemming from the bank's exposure to sub-prime related trades" or having used "language that was too technical or obscure," advocates counter that his warnings were ignored. Not surprisingly, other banks are "overhauling their risk management function after announcing multi-billion dollar losses on subprime-related trades. (Morgan Stanley reported an approximate $10 billion loss.) 

The article adds that Morgan Stanley's risk guru "was very vocal in saying that there were no proper pricing models for such trades, that positions were not being properly measured, and that the history traders used in their models was not a reliable guide." A further investigation will ultimately shed light on whether Mr. Risk at Morgan Stanley had the authority to effect significant change or was instead unaware of mounting exposures until it was too late.

The lessons to be learned here are far from trivial. Spending significant money to hire a risk wizard or team of pundits is a waste unless (a) the risk control function is recognized as essential to core operating activity and (b) these individuals are empowered to work independently of line managers. A new study suggests that the tide is turning though there is room for improvement.

According to "Beyond Compliance: The Maturation of CROs and Other Senior Executives" (GARP Risk Review, November/December 2007), researchers Annette Mikes and David Townsend describe the way Chief Risk Officers are encouraged to participate in "capital allocation and group-level budgeting and planning." At the same time, more than two-thirds of surveyed bank CROs expressed frustration at not being able to convince top management to improve risk disclosures included in public financial statements. Over reliance on risk models was cited as a concern of CROs, especially when credit allocation decisions are based on "automated model responses, with little oversight from humans." The article concludes that "the ultimate test remains the ability of risk managers to influence risk-taking behavior in the business lines."

As this blog's author wrote several years ago, Chief Risk Officers are part diplomat and part rocket scientist. Ultimately, their contributions are constrained by whether a risk culture exists within an organization. One can be technically competent but lack the organizational wherewithal to put out a fire. Read "Life in Financial Risk Management: Shrinking Violets Need Not Apply" by Dr. Susan Mangiero, Accredited Valuation Analyst, CFA and certified Financial Risk Manager.

Should pension and 401(k) plan sponsors care about bank risk management? Absolutely.

Since many retirement plans hire banks to manage assets or recommend bank funds to defined contribution plan participants, fiduciaries MUST include risk controls as part of their due diligence process when selecting, monitoring and perhaps firing money managers.

Some plan sponsors create and implement risk management policies that are separate from their formal Investment Policy Statement. Elsewhere, ERISA and public plans are hiring risk management professionals to go in-house. For example, the Ohio Public Employee Retirement System (OPERS) seeks a risk analyst who can perform tasks such as those shown below.

<< 1. Develops a comprehensive risk management program to identify, assess, manage and report investment related risks.

2. Oversees in coordination with the appropriate parties, the management of market, credit/counterparty, operations, reputation and other investment related risks.

3. Develops and participates in processes and procedures of reviewing, discussing and prioritizing risks in each major category.

4. Develops and reports risk metrics to monitor market, credit/counterparty, operations and other related risks.

5. Prepares periodic reports for senior management and OPERS Board to review investment related risks and makes recommendations, as appropriate.

6. Assesses risk management tools and capabilities, recommends improvements and implements approved solutions.

7. Reviews, monitors and oversees derivatives activities and capabilities for internal operations and for external managers in coordination with appropriate staff.

8. Performs on-site manager due diligence reviews from a risk assessment, management and monitoring perspective.

9. Leads and/or participates in various risk management committees.

10. Establishes and maintains a customer service focus work policy through example and clear, timely delineation of expectations. >>

Missing Collateral = More Risk for Hedge Funds and Pension Plans

Some investors may be getting coal for Christmas. According to a December 20, 2007 Financial Times article ("Hedge funds assess exposure to banks"), reporter Saskia Scholtes describes a role reversal with respect to risk. Whereas banks worried about hedge fund losses in the aftermath of the 1998 collapse of Long Term Capital Management, hedge funds now tally their exposure to credit-challenged banks. Noteworthy is an observation by attorney Lauren Tiegland-Hunt that one-way derivatives-related collateral agreements expose hedge funds to risk of bank failure. She adds that, even if an agreement was bilateral, banks sometimes amended terms to "prevent hedge funds from calling for collateral before a bank’s losses on the trade reached a certain threshold, with the bank’s threshold marked as 'infinity'."

Kudos to this managing  partner of law firm Tiegland-Hunt for calling attention to an important risk factor. As this blog has pointed out several times, the posting of fungible assets such as U.S. treasury bills is one way to mitigate counterparty risk. A thorough assessment of the credit worthiness of the counterparty, consideration of the expected risk associated with a particular derivative instrument and/or strategy and analysis of overall exposure to a given name are similarly important.

For those pension funds sending money to hedge fund land, make collateral assessment part of your due diligence. Derivative instruments, used properly, can sometimes offer a bevy of advantages over investing in the underlying "cash" asset. However, as Nobel prize-winning economist Milton Friedman oft-declared, "there is no free lunch." Once a derivative instrument is created, its fair value (zero at inception) changes. Unfortunately, gains can only be realized by the winner in this zero sum game if the loser does not default.

Editor's Note: To learn more about collateral issues as relates to derivative trading, check out the 2005 ISDA Collateral Guidelines. (ISDA stands for International Swaps and Derivatives Association, Inc.)

Sub-Prime Losses Keep Coming

At this rate, one could spend hours blogging about sub-prime woes, risk and whether adequate controls were in place. In a December 4, 2007 Washington Post article entitled "Losses Stack Up: Local Officials in Florida Try to Assess Damage To Investments Linked to Soured Subprime Loans " by Tomoeh Murakami Tse, I was interviewed about pension risk management implications. (Click here to access the article. You may be asked to register.) The State Board of Administration of Florida itself acknowledges the importance of risk controls, both in a November 2007 account of their sub-prime losses and in later interviews about fund withdrawals, subsequent freezes prohibiting further withdrawals and the hiring of Blackrock to develop a financial game plan.

In a recent study by the Towers Group, risk management was found to be lacking at some organizations, arguably one cause for large losses. Describing the adverse consequences of siloed risk management functions in financial institutions, authors of "Multifunctional Integration: The Positive Side of Risk," cite the need to work across divisions. They add that  "Beyond defending against threats to the organization, a more integrated approach to risk management can drive other business and client-centric benefits, including: improved quality and transparency of information; relationship pricing; process simplicity and efficiency; more effective decision making; and overall resilience."

No surprise to this risk manager and blogger who has spent over 20 years in the areas of risk management consulting, forensic analysis, board and trustee training and process assessment. In trying to convey the importance of acting before the fact, our Pension Governance team oft-repeats the importance of a holistic investment risk orientation, commencing with comprehensive training for everyone - front, middle and back office staff included. Importantly, buy-in from the top drives the acceptance of an organizational-wide risk culture and allows for resources to purchase analytical systems, hire professionals and make sure everyone has a good understanding of checks and balances. (In a recent workshop I led on risk management, I encouraged pension fund professionals to spend time with the chief risk officers employed by their banks, mutual fund and hedge fund managers.) 

Whether separate risk management activity reflects a "penny wise, pound foolish" behavior depends on a host of factors and will vary across organizations. However, delay in implementing an effective process can be costly as pointed out in a December 2007 assessment of sub-prime litigation risk by Guy Carpenter & Company, LLC. In "What’s the State of Your State? E&O Risk Uneven across the Country," authors list six factors that give rise to litigation risk for real estate professionals (though noteworthy for other related parties, given the flurry of lawsuits now being filed). See below for excerpted text:

  • Percentage of mortgages in foreclosure
  • Percentage of subprime mortgages that are delinquent
  • Number of litigation attorneys per mortgage industry professional
  • Frequency of Truth in Lending lawsuits (per million households) through Q32006
  • Frequency of banking-related lawsuits (per million households) through Q32006
  • Extent to which a state is plaintiff-friendly, i.e., is deemed a “Judicial Hellhole” by the
    American Tort Reform Association (ATRA).

Mortgage bankers and real estate brokers may be getting pink slips but litigators are busier than ever. For retirement plan fiduciaries, it bears repeating. Ask external money managers if they have sub-prime problems, query about how they are addressing risk gaps and demand to know what lessons they have learned from the credit crisis.

Pension Fund Grinch - Rate Cuts and Investment Complexity

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

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

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

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

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

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

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

Bank Risk Managers - Missing in Action?

In a recent interview on the John Batchelor show, Globalprivatequity.com, Inc. CEO Doug Miles described the current credit crisis as a "black swan" event. This summer, Miles predicted the valuation fallout associated with complex derivative instruments. Adding that banks can't know the extent of their problems anytime soon, an uncertain interest rate environment, new valuation accounting rules such as FAS 157 and infrequent trading in instruments such as Collateralized Debt Obligations make life very uncomfortable. Click here to listen to the November 11, 2007 interview with John Batchelor and Doug Miles.

In his bestselling book, The Black Swan: The Impact of the Highly Improbable, essayist Nassim Nicholas Taleb assigns three attributes to a black swan event in business. "First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable." Click here to read the first chapter, as reprinted by the New York Times on April 22, 2007. In his video interview entitled "Learning to Expect the Unexpected," Taleb describes the human brain as "designed to retain, for efficient storage, past information that fits into a compressed narrative." He adds that "this distortion, called the hindsight bias" makes it difficult to learn from past mistakes.

If true that the sub-prime situation is a black swan as Miles asserts, and taking a page from Taleb, we embrace the notion that we are blind to randomness, what then is the proper role of risk management? According to Financial Week reporter Matthew Quinn, inquiring minds are asking "Where were the risk managers?" He avers that some pundits debate whether technology can keep up with product innovation or adequately assess leverage. He suggests that, even if rocket scientists raise their hand, warnings may go unheeded, especially given banks' dependence on proprietary trading. See "Risk managers return (belatedly) to Street: Chastened banks, brokerages get religion on minimizing exposure to hidden bombs. Coulda, woulda, shoulda?" (Financial Week, November 19, 2007). 

In an article I wrote in mid 2003, I commented that the life of a risk manager is challenging to say the least. In addition to a plethora of data analysis skills, a Chief Risk Officer ("CRO") or someone with similar functional duties must be a diplomat, a motivator and a keen student of human behavior. Most people don't want to hear bad news since it usually means more work for them, not to mention the added stress and the potential damage to one's career of being tainted with a problem. Read "Life in Financial Risk Management: Shrinking Violets Need Not Apply" (AFP Exchange, July/August 2003).

Unfortunately, for retirement plan decision-makers, risk management is going to be impossible to ignore. Pension funds that include allocations to bank stocks or equity in bank-like financial organizations are already feeling the pinch. Plan sponsors who hired bank asset managers or hedge funds/mutual funds that invested in banks are going to be asked tough questions about the due diligence they performed. Did they sufficiently kick the tires with respect to understanding how the banks managed risk? Fiduciaries of banks' 401(k) plans who recommended company stock are getting sued for allegedly having done too little to assess the attendant risks. Just last week, a complaint was filed against the Federal Home Loan Mortgage Corporation ("Freddie Mac"), citing poor controls that encouraged the acceptance of "risky" loans and inappropriate appraisals of those loans. Click here to read the class action complaint against Freddie Mac.

Black swan or not, the current credit crisis is going to get nastier. Expect many more litigation complaints in the ensuing months.

Pension Fiduciaries - Have You Asked Your Bankers About Their Risk Controls?

In a November 5, 2007 statement, Citi announced that current CEO Charles Prince will step down. Robert E. Rubin will become Chairman of the Board and a search for a new leader will begin immediately. In a related story, Wall Street Journal reporters Carrick Mollenkamp and David Reilly describe Citigroup's struggles to estimate trading losses, in large part due to the fact that internal quantitative models relied heavily on credit ratings assigned to securities that were used in structuring Collateralized Debt Obligations (CDOs). With recent downgrades (to arguably better reflect risk levels), the value of Citi's sub-prime holdings similarly sank. Credit fears dampened already limited trading interest, forcing a heavy reliance on a mark-to-model approach.

As this blog's author has stated many times before, model risk is real. Bad or inappropriately used models lead to imprecise outputs. Decisions based on poor information can only lead to trouble. According to "Why Citi Struggles to Tally Losses Swelling Write-Downs Show Just How Fallible Pricing Models Can Be" (Wall Street Journal, November 5, 2007), modelers projected future expected payments for then high-rated sub-prime backed CDOs on the basis of how similar credit rated corporate bonds were trading. By not recognizing that default experience for corporate versus sub-primed backed securities differed dramatically, Citi's rocket scientists painted too rosy a valuation picture.

In a related article ("Where Did the Buck Stop at Merrill? November 4, 2007), New York Times reporters Graham Bowley and Jenny Anderson describe oversight problems at Merrill Lynch. Following a $8.4 billion charge and the recent resignation of CEO O'Neal, questions have arisen about whether board members should be more aware of daily operations, especially those areas that are likely to present problems if things go awry. Quoting Meredith Whitney, CIBC World Markets financial analyst, the point is made that Merrill had no one with sub-prime experience to serve on any of the committees charged with risk oversight and auditing. Despite creating a post for Chief Risk Officer in early September 2007, other experts cited in the article decry the lack of board/oversight committee independence from senior management, at the same time that large trading books were "hard to value."

By extension, this notion of oversight applies to pension fiduciaries. As this blog's author has repeatedly emphasized, plan sponsors MUST do a thorough job of vetting service providers (including banks) with respect to their "red flag" controls. How many pension fiduciaries ask about the existence of a Chief Risk Officer (or lack thereof)? How much detail do pension fiduciaries demand to know about each bank's risk management function, certainly for key parts of trading operations? Do pension fiduciaries ask to speak to members of the valuation team and/or those responsible for collateral management? Have pension fiduciaries asked banks about their progress with respect to preparing for Basel II and related model requirements? (Click here to read the November 2, 2007 press release from the Federal Reserve Board which describes their approval of new risk-based capital rules.) The list of other "must know" queries is long but nevertheless essential to proper due diligence.

Will clever attorneys make a case for poor process if pension fiduciaries have allocated monies to any or all of the banks now making headlines, citing breach if they failed to dig deep about risk and valuation policies and procedures?

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.

 

Private Pools of Capital - Pensions Help to Craft Policy

According to a September 25, 2007 press release for the President's Working Group on Financial Markets ("PWG"), pension funds are playing an active role in setting policy. Following on the heels of guidelines released in February 2007, one committee, headed by Eric Mindich, CEO of Eton Park Capital Management, seeks to provide the asset management perspective. A second committee, led by Russell Read, Chief Investment Officer of the California Public Employees Retirement System, will represent institutional investors such as pensions, endowments and foundations. Click here to read yesterday's press release.

Drawing on the "Agreement Among PWG and U.S. Agency Principals on Principles and Guidelines Regarding Private Pools of Capital," drafted earlier this year, committee members will consider fiduciary duties. Not surprisingly, decision-makers are asked to consider the adequacy of disclosure, risk and valuation policies. Excerpted text follows.

  • 5.1 Fiduciaries should consider the suitability of an investment in a private pool within the context of the overall portfolio and in light of the investment objectives and risk tolerances. Fiduciary evaluation should include the investment objectives, strategies, risks, fees, liquidity, performance history, and other relevant characteristics of a private pool.
  • 5.2 Fiduciaries should evaluate the pool’s manager and personnel, including background, experience, and disciplinary history. Fiduciaries also should assess the pool’s service providers and evaluate their independence from the pool’s managers. Fiduciaries should consider the private pool’s manager’s conflicts-of-interest and whether the manager has appropriate controls in place to manage those conflicts.
  • 5.3 Fiduciaries should conduct the appropriate due diligence regarding valuation methodology and performance calculation processes and business and operational risk management systems employed by a private pool, including the extent of independent audit evaluation of such processes and systems.
  • 5.4 Fiduciaries that determine to invest in a private pool of capital should ensure that the size of their investment is consistent with their investment objectives and the principle of portfolio diversification.

The guidelines merit more than a cursory review. One sentence in particular struck a chord. Citing the importance of news, institutional investors are urged to obtain and analyze data that is both frequent and "with sufficient detail that creditors, counterparties, and investors stay informed of strategies, the amount of risk being taken by the pool, and any material changes." As readers of this blog know, seeing is believing. More than a few asset managers may be unwilling to unlock the keys to the information gateway, citing economic hardship if forced to provide full disclosure. Just a few days ago, the SEC announced penalties for an asset manager who failed to file Form 13F, evidencing their exercise of "investment discretion over $100 million or more." (Note: There is no universal agreement that 13F filings permit "sufficient" information transparency. At least one court case asks whether an asset manager should be forced to file without recompense for the "taking" of added-value that results from "superior" analysis.)

Additionally, access to greater amounts of information does not necessarily beget better information. Even if available data is Goldilocks perfect ("just right"), what happens when pension investors are unable to process what has been received?

It will be informative to see what the two committees create in terms of operationalizing these fine, but arguably broad, guidelines.

Liquidity Crunch, Bonds and Pension Plans

Have the last few months of negative headlines scared you yet? If not, don't be too complacent. According to a recent survey conducted by Greenwich Associates, institutional investors have grown weary of structured financial products and fixed income securities. According to a summary provided by CFO.com writer Stephen Taub, a worldwide credit crisis "has caused a nearly complete disruption in the trading and use of many fixed-income products." Even trading in ordinarily liquid corporate bond markets has reportedly been difficult, leaving many scratching their heads as to whether the credit crisis is a short-term blip or a long-lived problem. Taub adds that the survey predates the Fed's recent rate cut. (Click here to read "Liquidity Crunch: How Long Will it Last?")

In his September 20, 2007 testimony before the House Committe on Financial Services, U.S. Treasury Secretary Henry Paulson describes the "interconnectedness" of global capital markets and the fallout from concerns over sub-prime mortgages - reduced investor confidence, reassessment of risk, and temporary diminution of liquidity. Describing self-correction tendencies of financial markets, Paulson's more sanguine take can be accessed by clicking here.

After a recent bridge game, I had a chance to ask my friend, Dr. Lucjan Orlowski, for his view of the world around us. As Senior Fellow at the Center for European Integration Studies (ZEI) at the University of Bonn; a Senior Fellow at the Center for Economic and Social Research (CASE) in Warsaw; a Research Fellow at the William Davidson Institute (WDI) at the University of Michigan School of Business, and a Research Professor at the German Institute for Economic Research (DIW) in Berlin, Orlowski's opinion counts in more ways than one. His prognosis? Not very good - In fact, he was downright gloomy with respect to jobs growth and continued ill-effects of this summer's incorrect pricing of default risk. Click here to read Lucjan's impressive bio.

So what does all of this mean for pension funds? Let us count the ways.

1. Diminished liquidity could imperil a plan's ability to meet its short-term obligations. This is especially serious for mature plans or in situations where labor contracts offer few opportunties to revise cash outflows. How should strategic asset allocations change to reflect a sustained credit crunch (if you accept that premise)?

2. Fewer companies are making their way to capital markets. Will a reduction in fixed income security issuance and/or a widening bid-ask spread make it more difficult for pensions to execute any type of liability-driven investing tactic that involves bonds or bond derivatives?

3. Will a weakening U.S. dollar, likely to experience even more downward pressure as oil producers switch to Euro invoicing, compel plans to seek out international assets? Will plan sponsors need to ask external asset managers more questions about risk controls, notably currency hedging techniques, as a result?

4. Could lower U.S. interest rates push some plans over the edge in terms of funding status and inevitable financial consequences?

5. Will changing correlation patterns, and the related reduction of diversification potential, leave defined benefit plan sponsors in a position of having to take on more risk? In the event that FASB requires additional pension investment risk disclosure, will corporate plan sponsors begin to feel pressure from shareholders as market volatility is more explicitly embedded in financial statements?

These are but a few possibilities for those who see the glass half empty and draining fast.

Is Disclosure Really That Hard?


Investment risk disclosure continues to take center stage. In "Clearing the Financial Fog - Emily Barrett ponders the virtues of transparency" (Wall Street Journal, MarketBeat Blog, September 14, 2007, posted by Tim Annett), the point is made that full disclosure is fraught with problems.

"The trouble with transparency is, there’s just something terribly obscure about it."

"In some ways, banks are already engaged in the clarification process, as more are forced to take back on their books funds previously buried out of regulators’ reach. This includes loans lying around in banks’ warehouses waiting to be chopped up and sold to raise money for private-equity takeovers. A number of bank sponsors of hedge funds have also been forced either to cut credit lines, or, as in the case of Bear Stearns Asset Management, to commit financing to shore them up. But there are limits to how clear banks can be. The complexity of structured finance, which deals in layered bundles of debt, doesn’t lend itself to easy analysis."

“The problem is exposures get buried in different structures,” said Jim Caron, rates strategist at Morgan Stanley. “I don’t think it’s a lack of willingness to get things out to regulators, there’s just a natural lack of transparency in these structures.”

Click here to read the aforementioned post in full.

To be sure, deciding on what and how to provide information is not an easy task. Nevertheless, access to sufficient and meaninful information is vital to good decision-making on the part of institutional investors such as pension funds. Here is the comment I posted.

<< As I’ve written many times (www.pensionriskmatters.com), pension fiduciaries have an obligation to make informed investing decisions. Whether pensions are counterparties to a derivative-related trade (mostly with banks on the other side) or they invest in funds (mutual/hedge/etc) that invest in derivatives, the information they currently get from their trading partners is limited at best. A plan sponsor must understand enough about risk controls and risk drivers for a particular investment/counterparty/asset manager so the investment committee can answer a fundamental question - Are we likely assuming too much risk for the expected payout if we transact with this bank/asset manager? In my view, financial institutions have a golden opportunity to disclose meaningful information about their risk exposures with institutional investor clients, going beyond mandatory requirements. Besides building goodwill, they may be able to attract (and retain) additional assets to manage by fully acknowledging the pension plan’s pain points (need for solid risk information). This does not necessarily translate into providing more information but rather providing “better” information that directly addresses economic risk-taking, and related controls. A joint interview with the portfolio manager and risk manager is one option. Providing the pension plan investor with the bank or asset manager’s risk management policy or statement of risk-taking is another positive gesture. Working with an independent third party to vet risk management process on behalf of the pension plan investor is another possibility. Comment by Susan M. Mangiero - September 18, 2007 at 1:10 pm >>

Valuation Problems Are Going To Cost Plan Sponsors Big Time

This blog's author recently had the pleasure of addressing an audience of hedge fund compliance officers and auditors about valuation issues - a topic near and dear to my heart. As an accredited appraiser, a certified financial risk manager and someone who has worked with models and trades, I am fully aware (and in fact often tout) the inextricable relationship between risk analysis and valuation. Simply put, effective financial risk management does not occur in a vacuum but rather depends on reliable valuation numbers. GIGO (Garbage In, Garbage Out). If a fund manager relies on faulty information, the inevitable result is flawed process, including (but not limited to) inaccurate hedge size (if hedging occurs), imprecise performance reports, possible asset allocation or portfolio re-balancing mistakes, trading limit utilization problems and so on. 

From the investors' perspective, the trickle down effect can be costly. Any "issues" at the asset manager level directly impact fees paid by pension funds, their own asset allocation decisions, not to mention cash flow and funding status breach as possible forms of "valuation fall-out." Valuation is the proverbial four-letter word in investment risk management. Cause for consternation, valuation issues are often complex and demand rigor with respect to policy creation, implementation and review.

Being somewhat impolitic, yet wanting to convey an important message to an important audience of hedge fund professionals, I cited chapter and verse about valuation pitfalls from a pension fiduciary's perspective. Including the need to get private placement memorandums that address what and how the fund manager intends to assess the portfolio on a regular basis, I explained the rationale for use of an independent third party to either render opinions of value, or at the very least, conduct a valuation process check. Even when a hedge fund does not exceed the twenty-five percent ERISA money limit (pursuant to the Pension Protection Act of 2006), best practices abound for both the fund manager and the pension investors alike. Interviewing traders, along with the asset manager's Chief Risk Officer, about valuation policies and procedures is another good idea. If a fund has no functional risk manager, ask why. Interestingly, one person responded to my comments by declaring success at drafting sufficiently obtuse documents that would likely keep investor accusations at bay.

In today's Wall Street Journal, reporter Eleanor Laise tells readers that it's not just hedge funds caught in the valuation cross-hairs. Mutual funds have their own issues. For example, when a security is not frequently traded, multiple methods might generate disparate "fair value" estimates. Quotation quality runs the gamut from the use of stale prices to "accommodation quotes" offered by "friendly brokers." Time-of-day selection is another conundrum, especially in the case of non-U.S. securities or instruments such as highly customized derivatives. Laise adds that "valuation policies can vary substantially from fund to fund." In some situations, an independent outside firm provides prices. Elsewhere, internal models or broker-dealer quotes are used. (See "Funds Struggle with Pricing Pitfalls," Wall Street Journal, September 17, 2007.)

As I've written (and presented) many times before, plan sponsors who sit silently by, without grilling asset managers about their valuation policies and procedures, are asking for trouble. Pension fiduciaries have a duty to oversee external fund manager performance as relates to the stated risk tolerance and return goals. This includes a weighty discussion about price quotes, marking to market (or model) and provider quality. (Not being an attorney, plan sponsors should seek counsel for a precise assessment of their responsibilities.)

With new accounting rules on their way and a variety of significant valuation unknowns, subprime loan-related losses may look like a walk in the park. What we don't know can hurt!

Editor's Note:

Pension Governance, LLC has partnered with the National Association of Certified Valuation Analysts to develop a technical workshop on hedge fund valuation. Click here for a course description. Other programs are in the works. Click here to read more about our June 28, 2007 webinar about hedge fund valuation. (The recording and program materials are available for a modest fee.) If you want additional information about valuation training for your board, risk analysis or process checks, click here to drop us a line.

 

 

 

Salaries and Bonuses for Investment Risk Professionals

According to the Michael Page International Salary Survey 2007, "demand for risk professionals continues to grow with increasing focus on strong technical skills" at the same time that "packages have been upgraded as clients struggle to retain/attract the best people." According to their research, total compensation for directors in the market risk area ranges from $350,000 to $800,000 while directors in the quantitative areas enjoy $400,000 to $950,000 in salary and bonus.

So how do pension professionals fare? In the Lonestar State, things aren't so bad. According to American-Statesman reporter Robert Elder, the Texas Retirement System board just approved a bonus plan that could mean $9 million in goodies for its investment staff. He adds, "The pension fund faces a shortfall of $12 billion between its assets and payout obligations, and retirees haven't had an increase in benefits in six years. It serves 1.2 million active and retired public school workers." (Click here to read "Bigger bonuses approved for Texas Retirement System investment staff" - September 14, 2007.)

From the outside looking in, it's impossible to know if Texas is on the right track or not. After all, Harvard Management Company lost "dozens of staffers" over compensation. While not a pension fund, the Boston experience is one of many where seemingly high pay packages are insufficient to keep talented risk professionals in place.

Expect plan sponsors to feel the pinch even more. According to its newly released "Strategic Plan FY 2008-2013," the Pension Benefit Guaranty Corporation announced plans to "improve risk monitoring and early warning activities and align resources to assure proper plan terminations." Of course, plan sponsors are likely to want their own team to tackle pension risk for a variety of reasons that go beyond regulatory inspection. This blog author's contention is that the investment management process is incomplete in the absence of a comprehensive risk management policy.

The bottom line is that risk managers don't come cheap. Plan sponsors (regardless of plan design - DB or DC) should factor in the costs of hiring skilled leaders in this area now, before demand skews in favor of the sellers even further.

Click here to read "Pension Risk Management: A New Paradigm" (Risk! - January 2007). Click here to request an email copy of "Life in Financial Risk Management: Shrinking Violets Need Not Apply" (AFP Exchange - July/August 2003). You may also want to click here to read our September 4, 2007 post on the topic of investment banking compensation.

LDI Costs Go Up for Plan Sponsors as LIBOR Soars

While seen by some as a new-fangled name for an old concept ("keep your eye on the liability ball"), liability-driven investing ("LDI") is taking the defined benefit world by storm. Thought by some as a panacea for mismatched assets and liabilities, one type of LDI strategy entails the use of an interest rate swap (or a portfolio of swaps) whereby a plan sponsor receives a cash amount tied to a fixed rate (usually a specified treasury yield plus X basis points). Its obligation as a Floating Rate Payor is determined by the set level of a variable rate benchmark such as the six-month London Interbank Offered Rate ("LIBOR"). Like anything else, there is no free lunch. Besides the collateral a plan sponsor must pledge to the counterparty (such as a major bank), yield curve changes are another factor. Moreover, as LIBOR rises, the plan sponsor must pay more when swap settlement occurs. (This assumes the absence of an interest rate cap that could otherwise create a ceiling as short-term rates climb.) This is exactly what has been happening of late.

According to the Wall Street Journal, ("Libor Pops Up," September 6, 2007), LIBOR has steadily risen over the last few weeks. Even more troubling, its parallel moves with the Fed Funds Rate have been shattered by credit market turmoil. "In normal market conditions, Libor tracks the Federal Funds rate pretty closely, and as recently as July the two were just 13 basis points, or hundredths of a percent, apart. As of Wednesday's close, that gap had grown to nearly 50 basis points, or half a percent. With exposure to the U.S. mortgage market cropping up in seemingly unlikely places, such as banks around Europe, banks that lend at Libor are expressing concern, through the rising rates, that borrowers who appear safe may prove to have something ugly hiding on their balance sheets."

While the British Bankers' Association suggests stability as of September 7, 2007 (due to central bank intervention), one wonders if this can be sustained. After Friday's disappointing jobs number in the U.S. and statements from money folks worldwide ("The credit crunch is only just beginning."), plan sponsors may find themselves exchanging one problem (pension gap) for another (rising short-term rates that drive up swap floating obligations). 

Add market volatility and new regulatory mandates for disclosure to the mix and it's seat belt time for pension fiduciaries with financial decisions to make. Moreover, in "Why Libor Defies Gravity: Divergence of a Key Global Rate Points to Strain" (September 5, 2007), Wall Street Journal reporters Ian McDonald and Alistair MacDonald note that many other short-term rates are actually falling even as LIBOR and related financial instruments struggle. That's cold comfort if a corporate plan sponsor issues commercial paper or borrows via a short-term facility tied to LIBOR.

More to come about an increasingly important topic - LDI and pension financial management.

Editor's Note:

1. Click here to access LIBOR rates from the British Bankers' Association.

2. Click here to access H15 Selected Interest Rates from the Federal Reserve.

3. Click here to read derivative instrument FAQs, courtesy of the International Swaps and Derivatives Association, Inc.

 

Some Pension Funds Say to Hedge Funds - Hold On There

Wall Street Journal reporter Craig Karmin reports that, post credit crunch, some public pension funds are having second thoughts about hedge fund and private equity investments. Cited as a "significant reversal in thinking," the article points out that pension funds have oft-cited alternatives as a way to diversify against shifts in market conditions. (See "Pension Managers Rethink Their Love of Hedge Funds," August 27, 2007.)

In an August 26 article entitled "Just How Contagious is That Hedge Fund," New York Times contributor and financial pundit, Mark Hulbert, debunks the notion that all hedge funds generate market-independent returns. He attributes asset class interconnections and similar strategies made by large hedge funds as culprits. A loss in one sector or fund is likely to appear elsewhere. Investing in "hard to value" positions is another challenge. (This blog's author, an accredited appraiser, is working with the National Association of Certified Valuation Analysts to develop a hedge fund valuation course for October 2007.)

The Pension Governance team has been playing the role of Cassandra for many months. Click here for our January 4, 2007 post about contagion, the notion that what occurs in one market or fund cascades throughout the system. Regarding valuation, we've described the issue ad nauseum. Click on the Hedge Funds and Valuation folders on the left side of this blog's home page for lots of posts about these two topics.

For those who missed our six webinar series entitled Hedge Fund ToolboxSM, we're nearly finished with the ebook equivalent. Email us if you want to be notified when it's ready.

Pension Risk - Did You Miss the Man in the Gorilla Suit?

While on a "sort of" vacation at a health spa in Arizona, this blog's author has treated herself to some "fun" reading, in between exercise classes and tending to business. As such, I came across an article in the Science Times section of the New York Times that I would have ordinarily set aside. Written about perception and reality, it seems to perfectly capture current happenings in pension land. Coincidentally, its August 21 publication date was the same day I fielded an invitation from CNBC to address whether pensions are taking on too much investment risk, where one goes to unearth information about pension investments and whether there is anything a plan participant or shareholder/taxpayer can do about "excess" pension risk. Unable to coordinate schedules, I will not appear on August 22. However, I encourage readers to download the Squawk Box video of the segment about pension risk. It promises to be interesting and timely.

Let me connect a few dots.

According to George Johnson, author of the aforementioned article, "Sleights of Mind," magicians succeed by exploiting what are described as cognitive illusions - "disguising one action as another, implying data that isn't there, taking advantage of how the brain fills in gaps." According to The Amazing Randi, this means that assumptions are often mistaken for facts.  Courtesy of the Visual Cognition Laboratory at the University of Illinois, a short video illustrates that observation skills are mixed. Only a few audience members who watch a film of basketball players - and then count how many times a particular team (categorized by shirt color) scores - ever notice the man in a gorilla suit walking on stage. (By the way, did you know that there is such a thing as National Gorilla Suit Day? Click here to learn more.)  

How this relates to pension risk is as follows. We know that billions of pension dollars are moving into derivatives, hedge funds, private equity funds, commodity pools, infrastructure, real estate investment trusts and so on. We know that some of these funds invest in economic interests that are "hard to value." We know that not every fund has a solid risk management policy. (Current newspaper headlines make that point abundantly clear.) We know that not every pension fiduciary has a finance background, let alone investment expertise. We know that finding out about a pension fund's holdings and liability risk drivers is often difficult. Form 5500 reports filed by ERISA funds are stale and overly general. Public funds might provide some information online or in response to the Freedom of Information Act but likely not on a frequent enough basis. Even financial footnotes are notorious for what they don't say about pension risk (on both the asset and liability side). It's rare if we even know who is making multi-million decisions about employee benefit plans, let alone be able to review their resume to gauge "suitable" knowledge and experience. We've blogged many times about meaningful disclosure, or more precisely, lack thereof. Click here to access past posts on this topic.

In a soon-to-be released survey about pension risk (co-developed by Pension Governance, LLC and the Society of Actuaries), there is clear evidence that pension fiduciaries perceive that they are doing a great job of vetting external managers with respect to risk management at the same time that the questions they profess to ask are overly simplistic. (Look for the executive summary to be released in mid-September.) Our forthcoming www.pensionlitigationdata.com clearly indicates a surge in allegations of breach on the part of the investment fiduciary(ies).  Coincidence? Maybe not.

If the Fed and international central bankers are unable to quell investors' fears, we move into a recession and/or different asset classes get hit hard in terms of price volatility, life is going to be very tough for plan sponsors. Poor practices will likely come to light as large losses occur. Risk is truly a four-letter word. Absence of a rigorous risk identification, measurement and management system (policies, procedures, operations) will leave little room for defense.

 We are going to write much more on this topic in coming months. It's too important to ignore.

P.S. The nice photo comes to readers from the National Zoo.

Man or Machine - Do Pension Trustees Know?

The war between man and machine is no longer science fiction. As market turmoil continues, some experts suggest that "quant" funds may be making things worse. In "Blind to Trend, 'Quant' Funds Pay Heavy Price" (August 9, 2007), Wall Street Journal reporters Henny Sender and Kate Kelly describe the inadequacy of statistical models to accurately estimate "how risky the market environment had become." Losses by more than a few hedge funds are one result of automated trading.

In today's paper, New York Times reporter Landon Thomas Jr. adds that banks are starting to feel the pain as well and not just because of questionable credit issues in the sub-prime market. "Strategies employed tend to be not only duplicable but broadly followed — the result being a packlike tendency that has helped increase market volatility."

Investors seeking to withdraw funds has exacerbated liquidity concerns. Leverage is another stated worry. By definition, borrowing money allows a trader to take a bigger position than would otherwise be possible. Short selling and derivatives are oft-cited as other leverage-inducing techniques. When times are good, leverage can magnify positive returns. The flip side is that leverage results in bigger losses when things deteriorate.

Leverage is not per se "good" or "bad." However, investors must understand the extent to which a fund levers its trading and therein lies the rub. There are multiple ways to measure leverage and its impact on reported performance is not  well understood. (There is no universal consensus about how returns should reflect the "L" word.) Click here to see some examples recently added to the CFA Institute's site about Global Investment Performance Standards. (Choose Leverage/Derivatives from the pull-down menu.)

This blog's author adds "There is so much more work to be done in the area of disclosure and transparency. The amount of information that outsiders are missing is staggering. Even insiders may not have the full picture unless they know what questions to ask." Email us if you want a copy of "Deciphering Risk Management Disclosures" by Dr. Susan M. Mangiero, AIFA, AVA, CFA, FRM.

If pension fiduciaries thought that interviewing traders and portfolio managers was tough, try asking questions of R2D2.

Model Risk - Great Unknown for Pension Plans

In "How Street Rode The Risk Ledge And Fell Over," Wall Street Journal reporter Justin Lahart writes that "many lenders, funds and brokerages were following statistical models that grossly underestimated how risky the market environment had become." Warnings about model error or "model risk" are not new. In "Model Risk and Valuation" (Valuation Strategies - March/April 2003), Dr. Susan M. Mangiero, CFA and Accredited Valuation Analyst, suggests possible red flags, adding that the consequences of a poor, inaccurate or incomplete model (or problems with data) can be dire. She adds that what constitutes a "good" model is likewise important to assess. This is sometimes made more difficult when inputs themselves must be modeled. For example, in the case of derivatives related to credit risk or mortgage loans (dominating headlines of late), estimating variables such as prepayment or recovery rates is an important precursor to any valuation of the derivative instrument itself. Email us if you would like articles about model risk and valuation.

Pension Risk Management Course

The RiskMetrics Group and Susan Mangiero, author of Risk Management for Pensions, Endowments and Foundations, are pleased to present an introductory course on Investment Risk Management for Pension Funds. The two and a half day workshop addresses investment risk measurement and valuation fundamentals, along with an overview of new pension rules and regulations as they relate to procedural prudence. Combining lectures, cases and lab work, plan sponsors will learn about risk management standards, how to apply various risk assessment techniques and what to avoid in creating and implementing a risk management plan.

Who should attend: chief investment officers, portfolio managers, corporate governance officers, chief risk officers, trustees, risk analysts and board members

Instructor: Dr. Susan Mangiero, CFA, AIFA, AVA, and FRM, President and CEO Pension Governance, LLC.

Dates:
Wednesday- Friday, September 12-14, 2007

Time:
September 12-13 - 9:00 am - 5:00 pm
September 14 - 9:00 am - 12 noon

Location:
RiskMetrics office
1 Chase Manhattan Plaza
44th Floor
NY, NY 10005

Email education@riskmetrics.com to register for the course or to obtain additional information about cost or content. 

Space is limited so, please reserve your space today.

Are Fiduciaries Paying Enough Attention to Default Risk?

According to Wall Street Journal  reporters Kate Kelly, Liam Pleven and James R. Hagerty, at least ten funds struggle with sub-prime loan woes in the form of diminished portfolio values. As if that isn't bad enough, some institutional investors are being given the unhappy news that withdrawals are suspended. For pension funds in search of liquidity, look elsewhere. (See "Wall Street, Bear Stearns Hit Again By Investors Fleeing Mortgage Sector," Wall Street Journal, August 1, 2007.)

As the fallout continues, with no end in sight, it is worth repeating that fiduciaries are on the hook for creating, and then following, a prudent process with respect to investment selection. ERISA itself mandates that employee benefit plan fiduciaries must carry out their duties in the sole interest of the plan's participants and with the "care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims."

These few words speak volumes about the many things a plan sponsor must consider before committing money to a particular instrument, strategy or asset manager. Questions naturally arise. A few of them are shown below.

1. Have plan sponsors sufficiently queried asset managers about how they measure default risk ?

2. How are structured financial transactions collateralized?

3. Who is responsible for collateral management?

4. What safeguards exist to enforce collateral quality and amount?

5. Do asset managers make their policies and procedures available to plan sponsors who want to know more about valuation, operational controls, collateral issues and trading limits?

6. Are positions being marked to model?

7. Who reviews the integrity of the model and related data inputs?

8. What could cause estimated default risk to rise for "questionable" borrowers and how are asset managers tracking identified risk drivers?

9. What are the investors' rights to withdraw funds?

10. Does an asset manager reserve any capital against its expected risk exposure, voluntarily or otherwise?

Several observations are in order. First, investment problems are not unique to small funds. To the contrary, some large mortgage-related funds (in terms of assets) are currently in crisis mode. Second, recent market drops and rising credit spreads are forcing companies to delay IPOs or incur higher costs of capital. This means that all investors are invariably impacted. Third, the fallout is global, with several prominent non-U.S. funds announcing big hits.

This may be the beginning of the end for easy credit and the start of a "brave new world" for plan sponsors who cannot afford a "see no evil, hear no evil, speak no evil" approach.

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.

Public Pension Plans and Hedge Funds

Washington Post reporter Tomoeh Murakami Tse writes about the growing number of public pensions with current monies allocated to hedge funds or thinking about making an investment. She quotes Larry Swartz, executive director of the Fairfax County pension funds' board of directors as focused on many factors. "It's about developing a smoother return stream and managing the level of volatility in the retirement system year to year."

In stark contrast, Masachusetts Secretary of State William F. Galvin counters that "There's an inconsistency between the concept behind hedge funds, which is high-risk, high-return, and the concept behind pension funds, which is little risk, guaranteed return."

So who is right? Do hedge funds offer a way to reduce risk or do they instead add risk to a portfolio?

Without knowing more about a particular hedge fund's strategy and quality of  risk controls, it would be hard for anyone to make a blanket statement, one way or the other. What is important is process. Yours truly, Susan M. Mangiero, President of Pension Governance, an independent research and training company, is quoted as saying that survey results suggest that pension funds are too easy on hedge fund managers. "A pension fund manager really needs to ask some tough questions about how the hedge fund is valuing these assets." Importantly, it's not just valuation but a host of other factors that fall into the "must know" category before monies should be committed. See "Public Pension Systems Betting on Hedge Funds" by Tomoeh Murakami Tse , Washington Post, July 24, 2007.)

Two Hedge Funds Report Assets Are Nearly Gone

           

Wall Street Journal journalists Kate Kelly, Serena Ng and Michael Hudson report that two once-large hedge funds are barely worth the paper that documents their existence. According to a letter to investors, parent Bear Stearns has already committed $1.6 billion in a "collateralized repo line to the High-Grade Fund" but cautions that prices are dropping fast. At the heart of the matter is the challenge to "place values on assets tied to subprime home loans" that are not actively bought and sold. (See "Subprime Uncertainty Fans Out - Bear's Hedge Funds Are Basically Worthless; More Bond Fire Sales," Wall Street Journal, July 18, 2007.) 

As an accredited appraiser, I'm here to say that there is an entire industry of valuation professionals who eat, live and breathe process, standards and methodologies. In fact, following the U.S. savings and loan debacle in the early 1980's and the 1989 enactment of the Financial Institutions Reform, Recovery and Enforcement Act ("FIRREA"), Congress essentially sanctioned the work of several entities - Appraiser Qualifications Board and the Appraisal Standards Board. For more information about the Appraisal Foundation and its history, click here.

So the hullabaloo about valuation problems (likely the tip of the iceberg) is extremely important but ignores a critical point.

In general (and not necessarily germane to this particular pair of hedge funds), a failure of institutional investors to oversee who renders value numbers, how, and on what basis, opens the door to "anything goes." Independent assessments of models and processes are arguably more important than ever before. If plan sponsors feel uncomfortable with the rigors of valuation and risk management, hire experts to help. Make sure that they know what they are doing. Ask whether they have specialized credentials and experience.

Why is valuation so important? Numbers drive nearly EVERYTHING financial,  from performance reporting to risk management to determination of fees and asset allocation decisions. GIGO - Garbage in, garbage out - could be very hard to explain as an acceptable basis for good decision-making.

If you are interested in reading a June 4, 2007 interview I gave to Securities Industry News about hedge fund valuation, click here.

Hedge Fund Returns - Illusion or Fact?

 

Financial News reporter William Hutchings writes that more than a few hedge funds trading in "illiquid" securities engage in smoothing of returns. Citing research conducted by his firm, RiskData CEO Olivier Le Marois says that "instead of following a mark-to-market process to price securities based on what the market is giving for the securities, they are implementing a subjective process of evaluation." While an independent third party could objectively provide an opinion of value or vet the process in place, smoothing empowers the portfolio manager to decide "the value of the securities he is trading." As an aside, for those who invest in hedge funds, consider how many Private Placement Memorandums give a manager full discretion over what and how often positions are valued. (Click here to read "A third of funds hide their true volatility" by William Hutchings, Financial News, July 12, 2007.) 

RiskData earlier announced that they would market something called the Bias Ratio. Developed by one of their fund of hedge fund clients, Protege Partners, this approach examines "month-to-month changes in net asset value" against various statistical return patterns, by asset class. (See "Risk Manager Markets Method To Monitor Hedge Fund Results" by Michael A. Pollock, Smart Money, July 3, 2007.)

On June 27, we wrote that the SEC intends to query hedge funds about their approach to valuing "hard-to-value" assets. Given recent headlines about billion dollar value mistakes, can pension fiduciaries afford not to ask tough questions about process? We repeat what we said then. "In the event of an asset write-down, fiduciaries are going to be grilled about the extent to which they vetted the valuation policies and procedures of hedge funds in which they invested. Absent any documentation to explain the (hopefully thorough) due diligence process they employed, pension decision-makers will squirm. A pretty picture - NOT!" (Click here to read "SEC Announces Investigation of Hedge Funds' Valuation Methodologies.") 

In the event that a pension fund hires a consultant or fund of funds manager, are they digging deep into valuation issues? Can they? (As an accredited appraiser, I can vouch for the rigor of training and experiential requirements as regards valuation.) If they don't "own" the valuation oversight duty, who does? At a recent hedge fund valuation workshop I co-led, a colleague read from a fund administrator's client contract, highlighting the section that disclaims responsibility to vet valuation numbers provided by the hedge fund. You often find similar disclaimers from prime brokers and custodians, forcing pension funds to ask - "Who is paying attention?"

If true that valuation numbers from hedge funds are passed through the hands of multiple parties and no one is asking rigorous questions about their quality, aren't pension fiduciaries greatly exposed to liability? The issue is made more complex when various service providers such as consultants play the role of fiduciary.

Answers to questions about valuation should be more than an optical illusion.

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.

Tulip Craze Redux and What Models Mean to Pensions

Since the mid 1600's, tulips have come to symbolize economic bubbles. Excess demand for the floral beauties led Dutchmen to pay a hefty price, resulting in the tulip mania of the early 17th century.

One wonders if a June 24 article by New York Times reporter Gretchen Morgenson hadn't been inspired by this tale of yore. Entitled "When Models Misbehave," this prize-winning business columnist describes the challenges of assessing securities that trade in relatively illiquid markets. In the absence of ready buyers and sellers, traders mark to model, making assumptions about the future behavior of inputs such as interest rates. Unfortunately, problems may arise if the underlying assumptions make no sense. Consider the notion that past is prologue. Referring to the sub-prime debacle currently plaguing several large financial institutions, Morgenson describes 2006 and 2007 lending practices as overly generous and likely to tighten. Correctly recognizing that future supply-demand conditions for credit might change leads to an altogether different model outcome.

Lack of independence or "the fantasy that a firm's principals prefer" is another concern. Blind acceptance of model-generated outputs as gospel could mean a subsequent, and arguably tainted, outlay of serious money to other trades.

Morgenson has a good point.

It's easy to be lulled into false security with computer-generated numbers. Unfortunately, bad values beget bad economics. A computational flaw, unstable or inappropriate model and/or low-integrity data could end up costing investors millions of dollars. Trading decisions based on garbage are expensive mistakes.

Good model-building is a start. Validating, testing, revising and testing anew should follow. Heady stuff but anything else might be considered remiss. Importantly, it's up to investors to query asset managers about what's inside the black box.

Anecdotally, I'm not sure there is enough of this rigorous oversight happening right now. As an accredited appraiser, I'm disturbed by the laxity of investigation about valuation and the related process of risk management.

With new accounting rules on their way, we'll talk much more about models and model risk in future posts. In the meantime, click here if you'd like us to send you information about valuation and modeling.

Pension Fiduciaries - Time to Wake Up and Smell the Coffee, Part Two



In "A Conversation with a Fiduciary" (published by Morningstar), independent pension fiduciary Matthew D. Hutcheson provides a thought-provoking assessment of ERISA Section 404 and passive versus active investment choices for 401(k) plan participants. Click here to read the article and here to read Hutcheson's March 6,2007 testimony about 401(k) fees before the U.S. House of Representatives.

On the other side of the fence, Financial Times writer John Authers extolls the virtues of Dave Swenson's "uninstitutional portfolio" approach in his June 9, 2007 article about the Capital Asset Pricing Model and market efficiency. With more than two-thirds of the endowment fund for Yale University in alternative assets "which are not readily marketable," the contrast is telling. While the evidence seems to strongly support Swenson's approach for Yale, issues abound with respect to alternatives investments and command attention. "See "Yale puts academic theory of investment into practice.")

I co-led a workshop on the valuation of "hard to value" assets on June 12, 2007 and came away with a renewed appreciation of the fact that more than a few institutions may truly be in the dark with respect to risk factors. Worth mentioning again is that risk itself is not bad. However, risk that is ignored cannot be measured and, by extension, can certainly not be managed. For most investors, limited resources make it difficult to replicate the Connecticut Ivy's success. Addressing a recent gathering of alumni, Swenson said that "Yale is set up to make high-quality active management decisions" with a staff of twenty and a long time horizon.

The debate continues with respect to style because it is a crucial (nay impossible to ignore) element of investment management. Strategic asset allocation and tactical implementation are likewise integral determinants of fiduciary liability for a given organization. To the extent that Hutcheson reminds us to focus on the "F" word and move the conversation to process that supports duty, plan beneficiaries applaud.

Tell us what you think. Should fiduciaries do a better job of justifying when active strategies make sense? We will talk more about these issues because there is a lot to say.

Click here to email your comments. Please indicate if you would like the comments kept private.

Survey Shows That Pensions Worry About Risk Management and Valuation





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

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

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

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

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

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

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

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

Pensions and Hedge Funds and Private Equity - Assessing Risks

In case you missed it, here is the link to a video of my appearance on CNBC's Morning Call.  While I concede that it's impossible to have an in-depth conversation in only a few minutes, several things are worth mentioning as a result of the May 17 chat with host Mr. Mark Haines.

1. Not all institutional investors have a large staff to vet different investment ideas. Moreover, large does not always mean better. Witness Fannie Mae and Amaranth Advisors. "Thorough" is the watch word.

2. If considering a hedge fund, ask if the fund has a functional risk manager who monitors, tests and reviews policies for financial and operational trouble spots. Does that person have independence and authority to effect meaningful change?

3. I believe the other speaker in this segment said that private equity avoids having to deal with the daily volatility of being invested in public equities. Caution - The absence of a ready trading market does not necessarily mean that there is less risk. Some could easily assert the opposite. Private equity deals, because they are private, entail valuation challenges, difficulty in liquidating ownership interests and so on.

4. The use of correlation (a measure of linear association) to gauge diversification benefits depends on having good data for all relevant time periods. If using an inappropriately long calendar period (example: last ten years), output may reflect a smoothing out effect which therefore underestimates "true" volatility.

5. There is much more to say on the topics of risk management and valuation!

Hedge Fund Toolbox - Webinars for Pension Fiduciaries

At a time when pension funds explore new ways to buoy funding, billions of dollars are being allocated to hedge funds and fund of funds. Either direct or part of a portable alpha strategy, alternative investments offer potential benefits but often bring new challenges in the form of multi-tiered fees, valuation, leverage, transparency, short-selling, illiquidity and operational risk. Add to the mix the mandates of the Pension Protection Act of 2006 and one thing is clear. Pension fiduciaries are on the hook to demonstrate a solid understanding of the structural and financial characteristics of hedge funds and fund of funds and what could potentially cause problems if left unchecked.

To help pension decision-makers better understand this important area, Pension Governance, LLC has created the Hedge Fund ToolboxSM – a series of six webinars that focus on hedge fund economics, operations and legal considerations. Webinars are scheduled as follows:

•Hedge Fund Fees, Performance and Transparency (June 14, 2007)
•Hedge Fund Documentation, Background Checks, Enforcement and Litigation (June 19, 2007)
•Role of Consultants and Financial Advisors in Selecting Hedge Funds (June 26, 2007)
•Hedge Fund Valuation, Use of Side Pockets and New Accounting Rules (June 28, 2007)
•Hedge Fund Leverage, Use of Derivatives and Risk Management (July 10, 2007)
•Hedge Fund Operational Risk (July 12, 2007)

Register to attend the entire series or individual webinars. If you miss an event, recordings will be available for a modest fee for non-subscribers. Webinars are free to all Pension Governance subscribers. For more information, go to http://www.pensiongovernance.com/webinars.php?PageId=58&PageSubId=59.

About Pension Governance, LLC:
Pension Governance, LLC (www.pensiongovernance.com) is an independent research and analysis company that focuses on benefit plan related investment risk, corporate strategy, valuation and accounting issues, with the fiduciary perspective in mind. Pension Governance, LLC is registered with CFA Institute as an Approved Provider of professional development programs.

Media Sponsors:
Pension Governance, LLC is proud to have Albourne Village (www.albournevillage.com), Hedgeco.net (www.hedgeco.net) and the National Association of Certified Valuation Analysts (www.nacva.com) as media sponsors.

Contacts:
Pension Governance, LLC
Susan M. Mangiero, 203-261-5519
Ph.D., CFA, AIFA, AVA, FRM
PG-Info@pensiongovernance.com

Can Warren Buffet Be Wrong About Derivatives?



According to various press reports, in his conversation with Berkshire Hathaway shareholders, CEO Warren Buffett reiterated his concern about the use of derivatives, "saying that excessive borrowing by traders, investors and corporations will eventually lead to significant dislocation in the financial markets. In fielding a question Saturday about derivatives, which he once referred to as "financial weapons of mass destruction," Mr. Buffett told shareholders that he expects derivatives and borrowing, or leverage, would inevitably end in huge losses for many financial participants." He further added that "The introduction of derivatives has totally made any regulation of margin requirements a joke." (See "World According to Buffett: How Media, Oil -- Among Others -- Matter" by Karen Richardson, Wall Street Journal," May 7, 2007.)

We've written about derivatives many times and will continue to do so. (I've even written an entire book on the topic.)

Derivatives are everywhere in pension land. Defined benefit plans consider liability-driven investing and portable alpha strategies (often entailing the use of derivatives). On the DC side, qualified default investment alternatives sometimes involve futures, options and/or swaps. Hedging company stock in 401(k) plans might rely on the use of derivatives. Many external money managers employ derivatives and pension fiduciaries are responsible for vetting their risk process and procedures.

So the pivotal question is whether derivatives are a hindrance or a help. Certainly a market that topples $400 trillion in global size reflects widespread popularity. Like anything else, however, fiduciaries who don't understand the incremental risks are putting themselves in harm's way.

Much more to come!

Pension Risk Management Tipping Point




I am the author of a book entitled Risk Management for Pensions, Endowments and Foundations (John Wiley & Sons, 2005). A primer about risk management (no math by design), the feedback has been gratifying. I'm particularly proud of the comments citing ease of use. (The book is replete with examples, checklists and references).

However, it's no Da Vinci Code in terms of sales. While I'd like to write a sequel at some point, few are competing for the honor and no one is knocking down my door to buy the movie rights. (You can visit our online bookstore at www.pensiongovernance.com - Products, Books for what we think constitutes a good readling list.) True, it's non-fiction and written for a limited audience. Yet one wonders why, in today's benefits climate, more people aren't fast and furiously laying pen to paper to describe how to tackle what is arguably one of the most important topics in pension land - risk management. If there is a single message I can impart to those who will listen, it is this.

ANYONE involved in pension investing is a de facto risk manager. Believe it. You are.

Whether focused on the asset or liability side (or both), risk is an integral part of financial management. Those who deny this truism expose themselves to possible trouble down the road. Personal and professional liability aside, plan sponsors who passively manage risk (whether defined benefit or defined contribution) through ignorance or benign neglect invite unwelcome scrutiny. Unless they are lucky, litigation, economic loss and/or damaging headlines are high probability events.

Besides, plan sponsors who give risk management short shrift lose a precious opportunity to improve things. An effective process forces a plan sponsor to identify, measure and control risk on an ongoing basis. Taking inventory (in terms of uncovering sources of risk) enables plan sponsors to make meaningful changes. Lower costs or enhanced diversification are two of many possible benefits associated with the activity of collecting and analyzing data as part of the identification of risk drivers.

So a natural question arises.

Why don't more plan sponsors pay attention to risk management, whether for themselves or as part of hiring, reviewing and perhaps firing money managers and consultants? Asked another way, what is the tipping point beyond which risk management becomes front and center at meetings of board members, trustees, investment committees and so on?

Here are a few thoughts.

1. Based on the preliminary results of the pension risk management survey now underway, and co-sponsored by Pension Governance, LLC and the Society of Actuaries, there seems to be a HUGE gap between belief and reality. Many respondents say they actively pay attention to risk management. At the same time, they cite limited or no use of risk metrics other than standard deviation and/or correlation. (We'll talk about limitations of basic risk metrics elsewhere.) How can you improve on something you think you are already doing well?

2. Many plan sponsors are tasked with benefits-related work as an add-on to their regular job. Often, there is little organizational incentive for them to excel. In a way, it's a lose-lose proposition. They assume significant fiduciary liability with little or no recognition in the form of additional money, better title or other types of perquisites. At the same time, if they do a bad job, there is no escape. It's all downside. Sadly, there is so much perceived ambiguity about what constitutes a "good" job that it's often difficult to hold someone accountable. (Note the term "perceived" versus "real.")

3. Not all attorneys (litigators and transactional) feel comfortable with finance concepts, let alone financial risk management. That knowledge void arguably makes it easier to let risk control gaps slide unless, or until, an egregious act occurs.

4. Establishing a financial risk management process is seldom fun (or at least sort of enjoyable) for most people. It is often a complex activity that requires copious amounts of money, time, concentration and energy, especially if a plan's investment mix (DB or DC) extends to multiple asset classes. Moreover, benchmarking the process, and making appropriate changes thereafter, likewise consumes large chunks of time and money. Is it any wonder then that its ranking on one's "to do" list plummets in the absence of a strong risk culture?

5. When market conditions are "good" and benefit costs decline as a result, people tend to get lulled into false security. Instead of focusing on structural issues, it's easier to breath a sigh of relief and say "problem solved." Alas, markets change all the time and putting off the inevitable is hardly a smart move.

So what's the tipping point that has everyone wearing "I'm a risk manager" button? Certainly lower interest rates and/or an anemic equity sector are factors, as is regulation. A few recent surveys cite mandates as a central force in encouraging, sometimes forcing, plan sponsors to radically revise their asset allocation strategies and focus on plan risk.

Most folks think we're moving closer to the pension risk management tipping point. I agree but counter that movement is relative. Until (and hopefully not "unless") plan sponsors recognize the URGENT need for financial risk management, investment stewards remain vulnerable on many counts and that is not a good thing for anyone!

Risk Center TV - Hedge Fund Risk and Plan Sponsors

For those who don't know, RiskCenter.com has recently started broadcasting interviews with risk management professionals. I had the pleasure of being interviewed a week ago about a few of the many steps that pension funds can take to assess hedge fund risk. Clearly, in just a few minutes, it's impossible to provide more than a few soundbites. However, allow me to reiterate one point.

Before plunking down monies to invest in a hedge fund or fund of funds, ask to meet with the risk manager and request a copy of their risk management policy. If the fund has no official risk manager, ask to meet the person who assumes functional duties (if not the title). If the fund tells you that their risk management policy is proprietary, ask for a general description of risk controls and the system of oversight. If you still get push back, think about your comfort level if something goes awry and you are asked why you invested anyhow, even though your request for information was rejected. (Even if information is provided to you, you may want to assess whether the information is "enough.")

Some may assert that the Private Placement Memorandum (PPM) is sufficient. See for yourself. In my view, the PPM often addresses risk in overly broad and vague terms, certainly not enough to give a pension investor any meaningful amount of information about the risk management process.

If you would like to see the short interview, go to www.riskcenter.com and click on the relevant video. If you would like more information about hedge fund risk and valuation issues, contact us at PG-Info@pensiongovernance.com. We will be uploading information next week to www.pensiongovernance.com about a forthcoming series of webinars we call the Hedge Fund ToolboxSM. Our series of webinars known as the Private Equity ToolboxSM is already in the works. We have a spectacular line-up of speakers.

P.S. These comments do not reflect investment, legal or governance advice. Readers still need to meet with their counsel about their fiduciary responsibilities as regards hedge fund investing.

Pension Governance, LLC Launches New Website Devoted to Pension Risk Issues



Pension Governance, LLC is proud to announce the launch of a new website for pension investment fiduciaries. In what is believed to be a unique online information portal devoted to pension investment risk and valuation issues, and reflecting original content from practitioners, www.pensiongovernance.com combines independent analysis and research with commentary about urgent issues affecting both defined contribution and defined benefit plans.

At a time when pension finance dominates headlines around the world, investment committee members, treasurers, CFOs and trustees are confronted with a slew of new challenges and a need to “connect the pension governance dots.”

The primary goal is to empower investment fiduciaries with objective educational information about relevant issues before they commit millions of dollars and countless hours to a particular strategy. Dr. Susan M. Mangiero, president of Pension Governance, LLC and author of Risk Management for Pensions, Endowments and Foundations, adds, “We want to create a meaningful conversation about pressing and oft-complex investment and risk issues that are not going to go away any time soon. We have put together a top-notch group of contributing editors from a variety of disciplines, including law, insurance, treasury, alternative investments and corporate governance. Our strategic partners join us in our efforts to promote investment fiduciary education and best practices.”

In addition to the Knowledge Center Library, www.pensiongovernance.com includes interesting features such as Pension Chat (interviews with industry leaders), Courthouse Corner and Fiduciary Focus. Soon to come is the Pension Parade of Horribles, a source of information about bad practices and lessons learned.

Subscribers can read annotated online articles from a variety of news sources, access research team members via Ask Professor Pension, download original content from expert practitioners, receive Pension Risk AlertSM and attend webinars for no additional fee. A forthcoming webinar is a June 4 discussion about 401(k) plan governance in the aftermath of the Pension Protection Act of 2006. Another webinar, part of the Hedge Fund Toolbox - a series of discussions from the pension fiduciary perspective - is a May 15 discussion about fees, documentation and key person background checks. Many other webinars about a variety of pension topics such as valuation, liability-driven investing and performance analytics are in the works and will be announced shortly.

Web designer Dawn Barson, co-founder of think creative group, llc, describes the care taken to build an infrastructure that permits Pension Governance editors maximum flexibility. “Knowing how much the editors want to keep the site fresh, we worked hard to build a robust administrative console so that new features can be added all the time.” Additional programming is already underway, with many more functions being designed to help investment fiduciaries access information and analysis quickly, easily and in a cost-effective manner.

With over thirty years of experience in the pension industry, Dan Carter, Pension Governance Vice President of Business Development, describes a sea change in the challenges that confront fiduciaries. “There is so much to know in this field and getting it from independent sources is critical as never before.” Mangiero concurs, “There is no shortage of content. We’ll be adding to the site all the time. People should check back often for updates.”

Visitors can sign up for a free two-week trial subscription by going to www.pensiongovernance.com and are encouraged to submit requests and comments to PG-Info@pensiongovernance.com.

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."

Derivatives, Mutual Funds and Pensions



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

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

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

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

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

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

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

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

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

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

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

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

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

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

Risk Lessons from the Financial Services Industry

                                                  
Regulation of financial service companies has long been a catalyst for pro-active risk management. Banks, for example, are obliged to address risk controls and measurement of risk as they ready themselves for Basel II compliance and related capital charge calculations. (The Bank for International Settlements describes the Basel II Framework as a "more comprehensive measure and minimum standard for capital adequacy that national supervisory authorities are now working to implement through domestic rule-making and adoption procedures.")

So results from a recent Deloitte survey of global financial institutions are surprising and a bit worrisome. Interviewing Chief Risk Officers at more than 130 global financial institutions, the "Accelerating Risk Management Practices" report finds that only 47 percent of respondents describe their institution as "extremely or very effective in managing risks associated with business continuity/information technology (IT) security, 43 percent each for operational and vendor risk, and 35 percent for geopolitical risk." This is in contrast to more than 70 percent who report good standing in the areas of market, credit and liquidity risk. The survey results also suggest a need for additional work in the area of credit products and commodity derivatives, including energy.

Noteworthy is the migration of risk issues to the board level, something we think makes sense for pension plans as well. While the Deloitte survey finds that 84 percent of reporting institutions have a Chief Risk Officer in place, little information is available about this role at plan sponsors. (The just released survey, co-sponsored by Pension Governance, LLC and the Society of Actuaries, asks about the existence and responsibilities of a Chief Risk Officer.)

Surveys like this are good reminders that a risk manager's work is never done!

Editor's Notes:

1. Click here to read the March 26, 2007 press release issued by Deloitte.

2. Click here to read an article about the job of Chief Risk Officer entitled "Life in Financial Risk Management: Shrinking Violets Need Not Apply" by Susan M. Mangiero



New Pension Risk Management Survey Launched

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.

Pensions, Hedge Funds and Risk

On February 22, 2007, the President's Working Group on Financial Markets (PWG) released a set of principles and guidelines concerning "private pools of capital, including hedge funds." In concert with various U.S. agencies, the PWG report urges investors, creditors, counterparties, pool managers and supervisors to identify and understand fund-specific risks or walk away.

For fiduciaries, the guidelines (some of which are excerpted below) are clear. Individuals who are unable to demonstrate that a rigorous investigation of risk has taken place, BEFORE investing, put themselves in the line of fire with respect to personal and professional liability.

<< 1. Fiduciaries should consider the suitability of an investment in a private pool within the context of the overall portfolio and in light of the investment objectives and risk tolerances.

2. Fiduciary evaluation should include the investment objectives, strategies, risks, fees, liquidity, performance history, and other relevant characteristics of a private pool.

3. Fiduciaries should evaluate the pool’s manager and personnel, including background, experience, and disciplinary history. Fiduciaries also should assess the pool’s service providers and evaluate their independence from the pool’s managers.

4. Fiduciaries should consider the private pool’s manager’s conflicts-of-interest and whether the manager has appropriate controls in place to manage those conflicts.

5. Fiduciaries should conduct the appropriate due diligence regarding valuation methodology and performance calculation processes and business and operational risk management systems employed by a private pool, including the extent of independent audit evaluation of such processes and systems. >>

It will be interesting to watch what happens. Will some pension decision-makers forego investing in alternatives because the risks are considered too difficult to understand, let alone accept? Who will embrace the challenge and recognize the reality that risk management is an integral part of investment management? You simply cannot select funds without understanding how managers address financial and operational risk. When a fund invests in less liquid and/or complex instruments, the plot thickens.

Click here to read Agreement Among PWG and U.S. Agency Principals on Principles and Guidelines Regarding Private Pools of Capital.

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.

Leverage: Friend or Foe to Pension Investors?



In today's New York Times, reporter Jenny Anderson talks about lackluster returns for some hedge funds. In "Hedging '06: Year to Read the Caveats," she quotes Christy Wood, CALPERS senior investment officer, as saying that this year marks the third year that "the global equity markets and long-only managers outperformed hedge funds" and that "If you threw all these in an index fund net of fees, you would have done better than if you put it in the hedge fund industry."

The article continues that CALPERS has another $3.5 billion to invest, beyond the existing $4 billion in hedge fund investments. Their appeal, says Ms. Wood, is equitylike performance with bondlike risk.

The numbers are compelling. Courtesy of data from Hedge Fund Research, the article describes inflows in excess of $110 billion through Q3-2006, compared with $47 billion last year.

What caught my eye is the quote about leverage and the notion that markets have all but ignored situations like Amaranth and its reported $6 billion loss.

Excerpted from this piece, investment advisor Stewart R. Massey, founding partner of Massey, Quick & Company, is quoted as saying that "If there's a lesson in 2006 - and no one talks about it anymore - it's that leverage is a very dangerous thing" and "there's too much out there."

On the face of it, leverage is not necessarily bad (nor is it necessarily good). However, in bad times, levered investments can cause significant harm to a pension fund portfolio. Let's hope that fiduciaries are asking good questions about leverage and not forgetting that things can sour quickly. Far from an exhaustive list, here are a few basic queries for hedge fund managers.

1. How does your fund measure leverage?

2. What is the fund's average leverage measurement?

3. Are there particular market conditions and/or investment positions that worsen leverage?

4. What is the fund's stop-loss policy as a way to curtail trouble before it's too late?

5. How does the fund value its "hard-to-value" positions and what is the likely impact on reported leverage?

6. Does the fund's leverage vary over time or has it been relatively stable?

7. How does the fund's leverage metric compare with similar strategy hedge funds?

8. How does the fund' return compare with similarly leveraged peers?

9. Does the fund's risk management policy address leverage?

10. Does the fund plan to do anything different going forward that would materially impact leverage? If so, why and what policy changes will occur as a result?

Bond Demand Influenced by Pensions



There is a lot of evidence, anecdotal and otherwise, that various capital markets are affected by policy. The impact on price and trading volume depends on a host of factors, not the least of which is the nature of the new rules and regulations. So it is with government bonds, domestic and foreign.

In the aftermath of the Pension Protection Act of 2006, many plan sponsors, under pressure to address funding gaps, are adopting an active stance towards interest rate risk management. While strategies can and do vary, trading in bond markets in the U.S. and elsewhere have been affected by a surge in demand for longer-term bonds. According to Reuters journalist Richard Leong, "Appetite for 30-year bonds and other long-dated assets has been fierce as pension fund managers have been stocking up on them to ensure they have enough income-generating assets to meet future obligations, traders and investors said." Additionally, stripped bonds "offer longer duration and more predictable income than a cash bond." (See "Pension demand leads to long bond stripping," December 7, 2006.)

By definition, a stripped bond represents a decoupling of the interest portion from the repayment of principal. The latter is sold as a zero coupon bond. According to Investor Words, "Strip is an acronym for Separate Trading of Registered Interest and Principal of Securities."

Much more will be written about interest rate risk management in later posts. For now, you can find definitions, checklists and step-by-step examples in a book I wrote in 2005 for John Wiley & Sons. Entitled Risk Management for Pensions, Endowments, and Foundations, there is an entire chapter about fundamental concepts. Other chapters address futures, options and swaps, respectively.

Competing methods and products to manage interest rate risk abound. However, the tradeoffs are far from identical. This means that plan sponsors are quickly having to learn about financial risk control, whether they like it or not.

Hedge Fund Disclosure - Round Three



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

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

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

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

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

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

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

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

Pension Fund Risk Management: Act Before the Fact


I've been in sunny Las Vegas the last few days, courtesy of the Association for Financial Professionals (AFP). Part of AFP's concerted effort to provide its members with additional risk management resources, I led a Sunday workshop on getting started, creating an effective process and choosing an appropriate risk metric.

During my talk, I cited the importance of having a risk culture in place, without which (in my view) it is virtually impossible to make meaningful changes.

So what is a risk culture? How does it reflect an organization's willingness to act before the fact? Can some organizations differentiate themselves by taking a prescriptive approach to minimize litigation, reputation and non-compliance risk? What are some characteristics of a company with a risk culture?

Here are a few thoughts.

1. A company described as having a risk culture is one for which risk management is embedded in every aspect of the company's operations and not seen as a separate, stand alone activity. It is integral to each policy, procedure, strategy and tactic adoped by the firm.

2. By acting before the fact, a company can save money and time by anticipating problems and determining appropriate solutions now, avoid unwanted stress from outside investigators - regulators, litigators, watchdog groups - and maximize shareholder wealth by identifying oportunities for improvement.

3. Studies increasingly suggest that shareholders and consumers favor companies that do the right thing on their own rather than being forced into good behavior. This implies that effective risk management has an economic value beyond the obvious loss avoidance potential.

4. When evaluating whether a company has a risk culture, consider the following questions.

(a) Do senior level executives and board members "talk up" the company's commitment to a risk culture?

(b) Are risk management policies and procedures made public? At a minimum, employees and shareholders need to know.

(c) Are risk issues communicated clearly and with sufficient detail?

(d) Are employees reviewed and/or promoted on the basis of their adherence to risk management objectives? By extension, are they demoted or otherwise penalized for not wearing the risk badge of honor?

(e) Have ample systems and staff been provided to support a meaningful risk management effort?

(f) Does the company have a Chief Risk Officer? If so, does that person report to the board and enjoy adequate independence to make exceptions to the rule, as needed?

Applied to pension funds, the issue of a risk culture and taking steps to act before the fact is huge. ERISA fiduciary breach litigation is skyrocketing as are ERISA liability insurance costs, not to mention the economic urgency for mitigating risk in the presence of large and growing liabilities.

What better way to convey a message to shareholders and plan participants alike than to say "We recognize risk and actively manage it. It does not manage us."

Here are some things that companies (and public plans) can do to get started.

1. Create a table that lists various types of pension fund risk drivers, estimated probability of occurrence and financial impact.

2. Create, and publicize, a risk management policy for each plan. It should include the vetting process for money managers with respect to their risk management policies and procedures. In addition, it should address alternative strategies for controlling risks identified in step 1. (The list is long. Write us if you want to know more.)

3. Hire a Chief Risk Officer (CRO) who has responsibility for retirement plans. In most companies, it is simply not feasible to have a benefits CRO. However, a CRO with responsibility for enterprise value creation and/or protection should be asked to consider all benefit plans when building a storm-proof risk shelter.

4. Get the team onboard by including risk issues in performance reviews. For example, someone with pension investment responsibilities should be rewarded on the basis of risk-adjusted performance.

5. Recognize that a process is ongoing and requires care and feeding.

It's never too late to get started. To do otherwise invites trouble. Gambling is great in Las Vegas but do you really want to explain losses or sub-par performance to the inquiring public, let alone a regulator or opposing side attorney?

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. >>

Pensions and Derivatives, the "D" Word



Are derivative instruments a recipe for disaster, an integral part of effective investment management or something in between? As explained in "Derivatives: The $270 Trillion Gorilla", meteoric growth around the world speaks volumes. At the same time, the incremental risks are real and cannot be dismissed.

Financial News reporter Renee Schultes writes that few fund managers "have the operational infrastructure and expertise to trade outside the listed and less-liquid listed derivatives market." (See "Managers struggle with OTC derivatives trading", Financial News, September 25, 2006.) Financial Times journalists Paul J. Davies, Gillian Tett and Saskia Scholtes chronicle efforts to address operational issues related to derivatives. (See "Derivatives dealers' tough match", Financial Times, September 25, 2006.)

New accounting rules and regulations encourage a paradigm shift that emphasizes risk analysis. Liability-driven investing is the new "it" topic and, by extension, derivatives are getting a serious look by public and ERISA pension fiduciaries alike. Money managers use derivative instruments as well for a variety of reasons such as transforming cash flows, leveraging exposure to a particular asset class or hedging. The Towers Group, a research and consulting firm, reports that "buy-side derivatives usage" is expected to "explode, bolstered by the shift to electronic trading, search for alpha, and more accommodating regulations (such as changes to ERISA and the adoption of the Prudent Investor Rule), which allows derivatives usage in pension funds and institutional money management." (See "Growth in Derivatives to Have Profound Impact on Wall Street Firms", September 18, 2006.)

The ultimate question is whether the expected benefits outweigh the costs. I wrote an entire book on this topic. Written for fiduciaries and related parties, Risk Management for Pension Funds, Endowments, and Foundations is a primer about the risks and benefits of derivatives and, more broadly, risk identification, measurement and control. I could easily write a second book about the topic. There is so much to say.

That is why subsequent posts will address the topic of derivatives, and the fiduciary implications of their use.

For those who want to read more, here are links to earlier blog posts and some articles I've written about risk management.

1. "Derivatives Get the Blame"

2. "Operational Risk and Derivatives"

3. "Derivatives Valuation: One Size Does Not Fit All"

4. "Pension Risk Management: What We Don't Know Can Hurt"

5. "Five Keys to Risk and Risk Management"

You can find lots more by going to our online library. You may also be interested in receiving our complimentary ezine about risk and valuation. Click here to sign up. (A link to our privacy policy is at the same URL.)

Managing Pension Yield Curve Risk



"A Different Strategy on Pensions" by New York Times reporter Mary Williams Walsh (September 9, 2006) showcases International Paper Company for its use of swaps as a way to hedge interest rate risk. She writes that "International Paper's $7 billion pension fund, which covers 175,000 people, is three years into a broad revamping, one that the company believes will protect it from the forces that wreaked havoc in the last few years."

Several points are worth mentioning.

First, the Pension Protection Act of 2006 makes a practice known as smoothing more difficult. The implication? It will be harder for companies to disguise funding problems going forward. Changes due out any day from the Financial Accounting Standards Board are likewise expected to put the kibosh on this type of illusory reporting mechanism. CFO.com reporter Helen Shaw writes that FASB Chairman Bob Herz opposes smoothing and favors a more accurate representation of funding status. (Click here to read her 2005 article.)

Second, defined benefit plans are affected by changes in interest rates (and related yield curve shifts). As rates drop, pension liabilities increase. (The extent to which they rise depends on a host of factors.) Moreover, a drop in rates (depending on the cause) could depress the return (assumed and realized) on some (not all) investments, thereby widening the pension gap and making things worse.

Third, the effectiveness of any interest rate hedging technique is influenced by current levels of interest rates, capital market conditions, the shape of the yield curve, the steepness of the yield curve, choice of instrument and so on. That's why Fed watching is such a popular activity.

Fourth, the pension situation is not hopeless. While some companies and municipalities are in dire straights (perhaps well on their way to financial distress or outright failure), other organizations can and should consider what works, what doesn't work and why.

Pension governance best practices are worth the time. Millions of people count on decision-makers to evaluate plausible solutions as a way to keep their word.

Pension Risk Rollercoaster



In "All risk and no reward?", Peter Davy describes the shift to a risk-based paradigm which, for some fiduciaries, is a brave new world. No longer likely to be encouraged to look at returns only, decision-makers will need to revisit "risk 101" fundamentals and then some. Enthusiasm about liability-driven investing is one good sign. Evaluating pension issues in the context of corporate strategy is thought to be another step in the right direction.

Somewhat surprisingly, a survey taken of mostly UK FTSE-listed firms by Mercer Human Resource Consulting and the Association of Corporate Treasurers ("ACT") indicates a low use of derivatives. ACT technical officer Martin O'Donovan suggests that trustees are dubious about "more complex strategies" and prefer avoiding what they don't understand. (Our survey results reflect a greater willingness to use derivatives.)

This blog's author is quoted as saying that "if the renewed emphasis on risk management means anything, it is that fiduciaries must be able to justify their investment decisions" and that "process is everything". The issue of a fiduciary duty to hedge is something worth pondering. (Click here for a nice piece by attorney Randall Borkus on the topic.) If pension fiduciaries are arbitrarily restricting use of any financial instrument without due consideration of the benefits and advantages, are they acting properly? (Readers are reminded to contact legal professionals for advice about what constitutes proper fiduciary duty discharge.)

One thing is certain. The next few years are going to mean breath-taking changes for retirement plan professionals.

Are you ready?

Survey Shows That Institutional Investors Are Worried




In a survey co-sponsored by Pension Governance, the RiskMetrics Group and Ulysses Partners, institutional investors expressed concern about a variety of issues, including:

1. Fiduciary breach litigation
2. Underfunding
3. Asset allocation mix
4. Investment return assumptions
5. Realized investment returns
6. Investment risk
7. Valuation
8. Regulation

In excess of fifty percent of respondents said they would like to know more about risk measurement and risk management. That makes sense, given survey results that point to beta, duration and, in the case of derivatives, notional principal amount, as favored ways to track position limits. As explained in great detail in Risk Management for Pensions, Endowments and Foundations, care must be taken to properly interpret these numbers, understand their strengths and limitations and undertake a comprehensive analysis of risk. Only twelve percent of respondents declared Value of Risk as a way to track position limits. Seventy-nine percent of respondents said that they do not currently use risk budgeting.

Interestingly, forty-six percent of respondents affirmed the use of more than ten money managers. No one answered "yes" to the question: "Do you use zero money managers?" The message? Institutional investors must make sure that the risk and valuation dialogue with external managers is comprehensive and clear. Outsourcing does not absolve fiduciaries of their oversight duties.

Seventy-five percent of respondents answered that the primary responsibility for making strategic risk management decisions rests with a committee. Only two percent answered that consultants or external money managers play this role. Arguably fiduciary education is critical for all committee members who collectively decide on all things risk. (As an aside, committee decisions should reflect analysis by all members rather than having some individuals passively accept the recommendations of one or two "leaders". The author is not an attorney. Fiduciaries should seek legal counsel for advice regarding relevant duties.)

Several results merit special comment.

More than ninety percent of institutional investors with assets in excess of $1 billion said that they know the amount of leverage being used by external money managers. At the same time, they expressed concern about risk management and admitted to using only a handful of risk measurements. Additional research is required to get behind these seemingly contradictory answers.

More than sixty percent of institutional investors with assets in excess of $5 billion cite the use of custodians as providers of "independent" valuation numbers. Only forty percent of investors with assets between $1 and $5 billion use custodians for this job. As institutions gravitate towards assets for which there is no ready public market or for which public market trading occurs infrequently, contacting qualified appraisers is worth investigating. Valuation disputes often end up in arbitration, litigation or regulatory enforcement actions and more than a few experts have been disqualified for lack of specialized training. Forty-eight percent of respondents claimed a concern about how hedge fund assets are valued.

For interested readers, click here to read "Hedge Fund Valuation: What Pension Fiduciaries Need to Know". Click here to read "Asset Valuation: Not a Trivial Pursuit."

Sixty-two percent of respondents confirmed that derivatives are permitted. Worry about the risk associated with derivative use, inadequate systems to monitor and manage risk and lack of familiarity or experience with derivatives showed up most often as the reasons for prohibiting their use. Seventy percent of users cited the use of equity and fixed income derivatives. When asked about instrument categories, sixty-three percent cited the use of futures contracts, fifty percent cited the use of interest rate swaps and forty some percent checked off credit derivatives and currency swaps. About thirty percent of respondents cited the use of options, both exchange-traded and over-the-counter.

Seventy-seven percent of people who completed the survey said that they "feel that institutional investor fiduciaries are more vulnerable to being sued in the aftermath of recent corporate, government and non-profit scandals."

This begs some important questions.

1. What are fiduciaries doing to better protect themselves from allegations of breach of duty?

2. Are investment committee members being recruited, retained and compensated on the basis of their investment knowledge and experience? If not, do they plan to introduce educational and experiential requirements soon? If not, why not?

3. Do fiduciaries respond best to the carrot or the stick approach? If the latter, will an increase in litigation result in better governance? If not, what will prompt organizations in need of improvement to do a better job?

4. How will pension reform and new accounting rules affect the investment risk strategies adopted by public and private funds? (The expectation is that derivatives and related risk management strategies will climb to the top of the MUST DO list in response to anticipated reforms and new rules.)

5. How are fiduciaries carrying out their duties with respect to properly analyzing non-traditional instruments and strategies?

The development of follow-up surveys is underway. Contact Dr. Susan M. Mangiero, CFA, Accredited Valuation Analyst and certified Financial Risk Manager (FRM) for more information.

Risk Managers Get Respect



Results of a new survey from executive search firm, Risk Talent Associates, provide good news for financial rocket scientists everywhere. Total compensation for chief risk officers in 2005 rose by eighteen percent to nearly $800,000 on average, with hedge funds and funds of funds paying larger bonuses to draw "top risk managers away from traditional investment banks". Not to be outdone, president Michael Woodrow warns that alternative investment managers will soon be competing with "capital markets' firms" and asset managers who acknowledge the importance of analytics and risk management knowledge and experience.

On the pension risk front, I recently wrote about the difficulty of getting good people at the same time that talent is required to navigate some rather choppy investment waters. (See "Pension Fund Hiring - Start of a New Trend?")

I have long held the view that effective investment management is not possible in the absence of what I refer to as the "risk troika" - identification, measurement and management.

Are higher salaries for risk professionals a reflection of their importance to an organization's financial well-being? As I wrote a few years ago, risk professionals should be both knowledgeable and experienced about a wide variety of topics - market mechanisms, statistics, systems and data quality, internal controls, deal structure, to name a few. Moreover, they need to be able to (a) describe the relationship between various risk drivers and portfolio loss potential in plain language (b) work well with a cadre of people in diverse functional areas and (c) say no to new ideas that may induce unwarranted risk under certain market scenarios.

Not too many people can fill those shoes!

Managing Cash Flow or Returns?



With so much talk about actuarial assumptions and related shortfalls, little is said about absolute dollars (or pounds or pesos and so on). This is a mistake. Retirees can't pay their bills with paper returns. They need cold, hard cash. Even with defined contribution plans, there is the issue of a "pseudo" liability. Should 401k plan sponsors better track employee demographics and pick investment choices accordingly? (Some experts offer that lifestyle funds are a step in the right direction. That's a topic for another day.)

A new retirement index from the Center for Retirement Research at Boston College suggests that time may be nigh to reinvigorate the debate.

Returns or cash flow? That is the question.

On a rather bleak note, the Center reports that "nearly 45% of U.S. households are at risk of being unable to maintain their standard of living in retirement".

Scary stuff, beneficiaries are not the only ones affected. Investment and risk managers alike face new challenges when the goal is to match liabilities versus beating a benchmark.

1. Which part of the portfolio should be allocated to liability matching versus return enhancement?

2. What strategies make sense?

3. What is the role of mean-variance optimization when a portfolio is split?

4. Is it feasible to regularly evaluate demographics to reflect worker mobility when asset allocation changes are expensive or otherwise difficult to make?

5. What are the ancillary issues associated with liability matching techniques such as the use of derivatives?

The list of MUST ADDRESS questions is long. Risk control critically depends on the objective at hand.

Derivatives: The $270 Trillion Gorilla


The just released pension fund asset management guidelines, courtesy of OECD (Organisation for Economic Co-operation and Development), state that "legal provisions should address the use of derivatives and other similar commitments, taking into account both their utility and the risks of their inappropriate use".

I will devote considerable time to the topic of derivatives and pensions in this blog. For now, I will make a few introductory comments to hopefully whet your appetite.

1. Derivatives can be used in a variety of ways to manage assets and/or liabilities and for both defined contribution and defined benefit plans (though there are significant differences with respect to strategy, risk assessment, accounting treatment and so on). I have written a lot about this topic, including a book and countless articles, and there is still much more to say. Identifying, measuring and managing risk is a cornerstone of being a good investment fiduciary.

2. The derivatives market is huge. According to the Bank for International Settlements, outstanding over-the-counter derivatives contracts (in terms of notional amounts) exceeded $270 trillion when estimated in June 2005. Think about it. In comparision, the U.S. national debt tally is approximately $8.36 trillion. Estimated 2005 gross world product is $59.38 trillion. The global derivatives market is the proverbial 200 pound gorilla of the financial world. It is worthwhile understanding why this market continues to grow. (Stay tuned!)

3. Derivatives are contracts that "derive" their value from the value of an underlying security, commodity, index or other type of instrument. For example, the value of a gold derivatives contract depends on the price of cash gold. (Derivatives valuation is a broad topic and will be addressed in other postings.)

4. The term "financial risk management" typically refers to the use of derivatives in some fashion (though this is not always the case).

5. Pension fiduciaries who ignore derivatives, especially if the Investment Policy Statement restricts their use, may want to rethink their stance. They should know that financial performance is impacted by the price behavior of derivative instruments if they have allocated monies to: (a) hedge funds or mutual funds that employ derivatives (b) asset-backed securities such as mortgage-backed bonds or collateral default obligations (c) convertible bonds (d) callable bonds (e) currency sharing agreements (f) private equity with warrant arrangements (g) contingencies of any type and the list goes on.

6. Derivatives, used improperly, can wreak havoc. Much more will be said about the identification and measurement of risk, how to determine appropriate use and a host of other critical MUST KNOW elements of the decision-making process.

7. The issue of a fiduciary duty to hedge is an ongoing and interesting legal question.

8. Financial engineering opens the door wide to a variety of new investment opportunities for pension funds. Fiduciaries must know (or learn) how to evaluate each opportunity. Outsourcing does not eliminate the fiduciary's duty to monitor.

9. Using derivatives is seldom a one-time event but instead requires a commitment to evaluate economic efficacy on an ongoing basis.

10. Creating a risk management process is just the beginning. I will address the Five C Approach(SM) as a way to assist fiduciaries.