( September 2, 2005 ) Freakonomics: The Hidden Side of Managing Money
Date: Monday, July 13 @ 21:29:25 UTC
Topic: Money Matters



There are three speeches and two articles presented below.

Freakonomics: The Hidden Side of Managing Money and Pensions Speech at Texas Firefighters Conference, September 2, 2005

Freakonomics, in case you haven’t heard, is the name of a New York Times bestseller by Steve Levitt and Stephen Dubner. The subtitle for the book is “A Rogue Economist Explores the Hidden Side of Everything.” The fundamental ideas the book pursues are, according to its authors:




1. “Incentives are the cornerstone of modern life. Understanding them—or, often, ferreting them out—is the key to solving just about every riddle, from violent crime to sports cheating to online dating.

2. Conventional wisdom is often wrong. Conventional wisdom is often shoddily formed and devilishly difficult to see through, but it can be done. 3. Dramatic effects often have distant, even subtle, causes. The answer to a given riddle is not always right in front of you.

4. “Experts”—from criminologists to real estate agents—use their informational advantage to serve their own agenda. However, they can be beat at their own game. And in the face of the internet, their informational advantage is shrinking everyday—as evidenced by, among other things, the price of coffins and life insurance premiums.

5. Knowing what to measure and how to measure it makes a complicated world much less so.” Much of my career has been spent exploring the hidden side of the money management and pension industries. Some would call it the seamy side of these industries. The conclusions I have reached from years of investigations are remarkably similar to those of the authors of Freakonomics.

In short, it is my belief that:

(1) The money management and pension management industries are neither rational, fair nor moral; (2) Much of the behavior in these industries is guided by financial incentives experts hide from their clients;

(3) Expert advice is frequently subject to undisclosed conflicts of interest;

(4) As a result conventional wisdom, the advice investors hear repeatedly from experts, is frequently wrong;

(5) Confusion regarding what to measure and how to measure performance and other important factors distracts attention from mismanagement, fraud and critical reforms;

(6) The causes of underperformance or failure to achieve investment objectives, especially in the pension context, are generally so distant and subtle that they are virtually never fully exposed.

The money management business is in some respects a “con game.” On the one hand, it’s about instilling confidence in investors. Money managers seek to persuade investors that they are uniquely qualified to manage investor monies. Money managers are experts with an advertised, as well as a hidden, informational advantage. The informational advantage they express to investors is spelled out in their marketing pieces. “We scour the world 24/7 for the best investment opportunities. No one knows more about small cap investing.” Comparing what managers say about themselves versus reality can sometimes be comical. In 2002 we looked at the extent to which money managers claim to do their own investment research, versus rely upon “street research” and found some remarkably hard working people.

Mellon Equity Associates, for example, stated in Nelson’s that they only use 2% "street research" and had six equity analysts that regularly covered 3,500 companies. These guys must deserve a bonus! Money managers also advertise superior performance to appeal to investors and inspire confidence, despite the SEC warning that past performance is not indicative of future results—a warning which no one really listens to. These are the informational advantages managers talk about. Money managers also have informational advantages that are not touted.

Performance reporting is an art few industry insiders fully comprehend. Manager investment performance information is manipulated, legally and not-so-legally, by managers who are extremely adept at casting their performance in the most favorable light. After all, managers can hire other experts, such as lawyers and marketers, who advise them as to the most favorable means of presenting their performance. Any manager should be able to find some period of time over which his performance is arguably competitive to quote when necessary. Just watch CNBC and you’ll see scores of mediocre managers referring to their genius.

Performance misrepresentation is a serious industry problem. Our informal review of hundreds of manager deficiency letters issued by the SEC suggests that performance misrepresentation is the single most frequently cited violation. We have observed that violations are rampant but seldom have serious consequences. Misrepresented or unverified performance is a significant industry problem that does not receive the attention it deserves because it is not easily detected. And it may be more commonplace in the institutional market involving separately managed accounts that in the retail mutual fund market.

Inspiring investor confidence and artfully presenting performance may be as, or more important, than actually possessing investment talent. The reality is that there are many more successful money management firms (i.e., firms that make money for their owners) than there are talented money managers who do well for their clients. There are firms with trillions in assets that are very poor at managing money.

But there are additional informational advantages managers enjoy that must be taken into account in explaining industry anomalies such as the “huge firm/lousy performance” phenomena. Incentives. Again from Freakonomics: “Incentives are the cornerstone of modern life. Understanding them—or, often, ferreting them out—is the key to solving just about every riddle.” Understanding money management and pension management is all about ferreting out the hidden financial incentives. These industries are not rational, fair or moral. The “experts” involved are human and thus respond to incentives.

Conventional wisdom in these industries, the advice that investors hear repeatedly, is often shaped by these hidden financial incentives. The law in this area is quite clear. Money managers and pension investment advisers are fiduciaries required to place their clients interest before their own. However, for-profit companies are required to maximize profits for their owners, not do what’s best for clients. Thus, the standard of care required of companies that provide these services is largely inconsistent with the realities of how they operate.

The experts often provide investors with advice that is tainted with self-interest, as opposed to what’s best for the investor. In our investigations of money manager and pension wrongdoing we routinely uncover hidden financial incentives that result in poor investment decisions or recommendations. Pensions are far too quick to assume that poor results are attributable to poor decisions, as opposed to corrupt advice. The “cause” of underperformance is often corruption. But to reach this conclusion you must connect the dots, do an investigation ferreting out distant, well-hidden causes. This is a complex inquiry that may seem irrelevant, speculative or a fishing expedition.

For example, in a recent meeting with senior management at the PBGC I was asked the following remarkable question: “So what if there were kick-backs paid if performance of the pension was not impacted?” My answer was: “First, in my experience performance is always impacted where there is corruption and second, the kick-backs belong to the fund, not to the corrupt advisers.” Again, that was a remarkable question, given the source.

Thankfully, we are in the midst of a period of radical change in thinking about the securities, money management and now finally, pension industries. As a result of Eliot Spitzer’s initiatives, the nation recently was made aware that the nation’s largest securities firms have been scamming investors with tainted investment research. Spitzer drew attention to the fact that the writers of investment research were incentivized to write glowing reports about investment banking clients of their firms and, as a result, the public got fleeced.

Spitzer also has drawn attention to the fact that the mutual fund industry has been skimming from investors’ accounts for decades. That is, mutual fund companies have been charging investors excessive money management fees so they could enter into revenue sharing arrangements with brokerages and excessive brokerage fees so they could direct portfolio trades to brokerages that assisted in marketing the funds. Brokers sold the funds that paid them the highest incentives—not the funds that were in the investors’ best interests. What’s this retail wrongdoing got to do with pensions?

Many of the same firms involved in retail wrongdoing are involved in pension management. Do you believe these firms are any more reputable when dealing with pensions? Well, in fact, they probably do operate somewhat more reputably when dealing with pensions… somewhat…They still are not immune to the temptations of self-dealing and placing their interests before those of their clients.

The bottom line: Pensions are harmed as a result of hidden financial incentives that motivate the experts they rely upon. For example, the major wirehouses all have retail brokers who call themselves pension experts and prey upon unsophisticated pensions, including corporate and public pensions with hundreds of millions and even billions in assets. In Florida we have a broker-consultant pension-scamming epidemic. Over 100 Florida public pensions are currently being harmed by corrupt broker-consultants; the conflicted advice these funds are receiving from these pension scammers is costing Florida taxpayers hundreds of millions annually.

Now to talk about a problem that is specific to pensions: corruption of “gatekeepers” Recognizing their lack of investment expertise, most pension boards (over 70%) use investment consultants (who claim to have pension expertise) to advise them on broad issues such as asset allocation, manager selection and performance reporting. These unregulated or poorly regulated investment consultants exert tremendous influence over pension returns. They serve as gatekeepers to funds and purport to offer objective advice.

Unfortunately they often have undisclosed financial arrangements with the very money managers they vet and recommend. Often the managers that consultants recommend are those that compensate the consultants for their recommendations. Two disturbing economic realities are at work here. First, pensions are unwilling to pay much for objective investment consulting advice. Second, money managers are willing to pay vast sums to get lucrative investment advisory contract steered to them.

These economic realities or incentives explain the state of corruption of the consulting industry. And where the consultant gatekeeper is corrupt, where you have corruption at the top, it infects the entire organism. Our investigations we have shown that a corrupt consultant gatekeeper can cost fund 10-15% over time. Given the trillions in pensions, that’s a lot of money. I recently was contacted by law enforcement and state securities regulators about pension wrongdoing. In a speech before the state securities regulators I observed that pension scams are far more complex than retail scams. In the retail context scamming often involves only a single party’s wrongdoing. For example, a broker may churn a customer’s account or recommend an unsuitable investment.

Spitzer’s investigations gave the public insight into collusion involving brokers, money managers, research analysts, investment bankers and others. For example, the public learned that mutual fund managers often have hidden financial arrangements with brokerages to recommend investing in managers’ funds. In other words, money managers and brokers may collude to the detriment of retail investors. The investor is not sold the fund that is best for him; rather the brokerage recommends or selects the fund that provides the firm the highest compensation. A key difference between retail and pension scamming can be the number of parties involved in wrongdoing, as well as the degree of collusion between them.

There are many different hands involved in managing pensions and often more than one party is involved in the unscrupulous conduct. In some cases, participation of multiple parties is required to facilitate the wrongdoing. Collusion between investment consultants, money managers, brokers, custodian banks, actuaries and even pension lawyers is commonplace. Like Enron and Worldcom, pension scams often are not perpetrated by one or two “bad apples.” It may take a team of hired “experts” to commit the wrongdoing, opine that there was no wrongdoing and/or otherwise conceal it.

Listen to what the authors of Freakonomics have to say about the corporate scandals if the early 2000s: “Though extraordinarily diverse, these crimes have a common trait: they were sins of information. Most of them involved an expert, or a gang of experts, promoting false information or hiding true information; in each case the experts were trying to keep the information asymmetry as asymmetrical as possible. The practitioners of such acts, especially in the realm of high finance, inevitably offer this defense “Everyone else was doing it.” Which may be largely true. One characteristic of information crimes is that very few of them are detected. Unlike street crimes, they do not leave behind a corpse…” Today, believe it or not, we have no accepted, working definition of what constitutes fraud or mismanagement in the pension context.

The PBGC, the guarantor of defined benefit pensions that has taken over thousands of pensions has never undertaken a comprehensive forensic investigation of even a single failed pension aimed at determining whether there were any conflicts of interest, hidden financial arrangements or wrongdoing that may have contributed to the demise of the fund. In June, the Aircraft Mechanics Fraternal Association (“AMFA”), a union representing 16,000 airline ground workers, wrote to U.S. Secretary of Labor Elaine Chao and Bradley Belt, executive director of the Pension Benefit Guaranty Corporation (“PBGC”), requesting that the PBGC conduct a forensic audit of the pension plans of bankrupt United, a subsidiary of UAL. While the PBGC has taken over the pension plans of many bankrupt corporations in the past, the April estimated $6.6 billion bailout of the United plans is the largest in history.

What was the stimulus for the AMFA letter? In May the findings of an SEC staff investigation of pension consultants, the financial advisers that pensions hire to provide objective information, were released. The Commission found conflicts of interest were pervasive throughout this industry and disclosure of these conflicts was abysmal. AMFA noticed that United’s consultant also managed money for United—exactly the conflict of interest the SEC said should be investigated. Without the SEC findings and release, AMFA would have been hard pressed to justify the need for a forensic audit.

Finally a regulator, actually two because soon after the SEC released its findings, the SEC and DOL issued a joint release, confirmed that questionable conduct was pervasive at the highest levels of pension decision-making. We may be the tipping point, signaling the beginning of a new era of greater scrutiny of pensions and a defining of what constitutes fraud and mismanagement in the pension context. At this time the issue sits before the SEC, DOL, PBGC and the nation as a whole. On August 15th two members of Congress, George Miller and Edward Marke wrote to the Secretary of Labor and the new chairman of the SEC about the SEC’s findings regarding pension consultants and requested information about any investigations the DOL had undertaken regarding pension consultant conflicts.

The letter was very specific: the Congressmen wanted to know whether any of the firms, consultants or managers that had actual or potential conflicts of interest had been investigated by the DOL and, if so, how many? Whether any of the firms were found to have engaged in prohibited transactions? What action had the DOL taken to enforce the law? Had any firms been penalized, issued cease and desist orders, banned as fiduciaries or otherwise sanctioned? I think you can guess the answer to all of the above.

I was invited to meet with senior management of the PBGC within weeks of the Miller/Marke letter. I advised the PBGC that the majority of the over 3,000 plans that they had overtaken that had consultants, had conflicted consultants that received hidden financial incentives.

Again the remarkable question resurfaced: “Why should we care if there were hidden financial arrangements if performance didn’t suffer?” “It is highly likely these hidden financial arrangements contributed to the demise of a significant percentage of these failed funds,” I said. “Are you suggesting we should investigate each fund failure?”

“Yes,” I said. “Well, we certainly hope that none of the managers we’ve hired to manage the PBGC’s assets engage in such practices.”

“They do,” I said before the speaker had even finished. So the question that sits before the government today is: Are we going to let pensions fail, promises to participants be broken, without any intelligent inquiry into whether there were hidden financial incentives that may have contributed to the demise of these pensions?

Until we determine whether kick-backs were paid, we cannot possibly answer the question as to whether kick-backs may have caused harm.

Given the complexity and long term nature of pension investment results, a massive investigative effort must be undertaken before we can answer how we got to where we are today: on the verge of the collapse of the defined benefit pension system.

Does anybody really want to know the answer?

PBGC Considers Investigating Pension Funds Emma Blackwell Managing Editor Money Management Letter

The Pension Benefit Guaranty Corp. has discussed whether to investigate if conflicts of interest, mismanagement or fraud have occurred at pension funds it has taken over or may be about to take over. The PBGC met with Edward Siedle, activist and founder of Benchmark Financial Services, on Sept. 7 to discuss whether it should do so. Siedle said most of the PBGC executives he met with were interested in doing a review. Bradley Belt, executive director, was concerned about the cost of investigations so Siedle offered to perform forensic audits on a contingency basis—if he finds no conflicts he will charge no fee. He said he could narrow the 3500 plans the PBGC has taken over down to a list of 500 or so where conflicts are most likely to have occurred.

There was also skepticism about whether conflicts of interest are as widespread as Siedle was saying. To answer this, he pointed to the Securities and Exchange Commission’s recent study into conflicts at investment consultants. “I am unable to identify any legitimate objection to our proposal to them,” Siedle said. He has not heard back from the PBGC about whether it will conduct investigations.

Calls to Belt were referred to Jeffrey Speicher, spokesman, who said he doesn’t know if the PBGC will conduct an investigation. Also at the meeting were James Gerber, cfo, Jeffrey Cohen, the PBGC’s attorney, Vince Snowbarger, deputy executive director, Judith Starr, general counsel, and several other officials.

Two members of Congress, Edward Markey of Massachusetts and George Miller of California, sent a letter dated Aug. 15 to Elaine Chao, secretary in the Department of Labor, and Christopher Cox, chairman of the SEC, urging the DoL to do a thorough examination of the financial circumstances surrounding the failure of United Airlines to meet its pension obligations. “We also urge the Department to conduct such audits of pension plans at other companies currently threatening massive pension terminations, including Northwest Airlines,” the letter states.

The DoL hasn’t yet responded to the congressmen’s letter. The SEC is going to meet with them. The Aircraft Mechanics Fraternal Association has written to Chao and Belt raising concerns about potential conflicts of interest among consultants and money managers, excessive management fees and conflicted investment transactions. Siedle said the letters prompted the PBGC to request a meeting with him. His firm specializes in investigations of pension fraud, money management abuses and wrongdoing involving consultants.

The PBGC executives asked Siedle whether they or the DoL should be responsible for investigations. Live pension plans fall under the DoL’s responsibility, but once terminated they pass to the PBGC. Siedle said the PBGC should conduct investigations to recover money from firms that have mishandled pension funds. He thinks the PBGC should routinely investigate pension funds it is about to take over.

The congressmen’s letter recommends that the DoL review whether United Airlines’ and Northwest Airlines’ consultants were found by the SEC to be guilty of conflicts of interest. United was advised by Russell Investment Group and Northwest used Wilshire Associates. The SEC recommended that both improve their disclosure policies. –Emma Blackwell

The Future of the Consulting Industry Speech at IMCA Conference, September 19, 2005

In June 1995 I wrote a research report entitled, “Investment Consultants: It’s Time to Clearly Define Their Role.’ In that report I stated that “many consulting firms offer services which present outrageous conflicts of interest and opportunities for self-dealing. For example, many consulting firms seek to sell performance services to the same investment managers who are interested in managing the assets of the consultant's advisory clients. Managers who do not purchase such services from the consultant may find themselves excluded from the consultant's manager database.”

To understand why I wrote that report, let me digress to give you some information about my background. After graduating from law school I went to work in the Division of Investment Management of the SEC, the Division that regulates mutual funds. Later I was Director of Compliance and Legal Counsel for Putnam Investments. It became apparent to me early in my career in investment management that while investors turn to investment professionals for superior information and guidance, much of the advice investment professionals provide is neither particularly insightful nor in the best interests of investors. The law states that money management firms owe a fiduciary duty to their clients.

The duties of a fiduciary to a pension can be summarized simply. Fiduciaries must act in the best interests of their clients. Indeed, they must place the interests of their clients even before their own. It’s that simple. Yet adherence to this standard is so demanding that few of the businesses that act as fiduciaries to pensions meet it. When you think about it, the duty of care required is really almost anti-capitalist. Companies are, after all, suppose to maximize returns to shareholders—they operate “for profit.” They are not in business to place the interests of their clients before their owners or shareholders. But that is exactly what is required of firms that serve as fiduciaries to pensions.

From 1989 through 2004 I left the practice of investment management law and became involved in the securities and money management industries. As the owner of an institutional brokerage firm, I competed with brokerages affiliated with consultants. I learned that money managers had to direct a significant portion of the trades related to accounts they received from consultants to consultant brokerages as a quid pro quo for getting the assets to manage. Other managers complained they were excluded from consultant searches, despite their performance records, because of pay-to-play schemes. In many cases I determined what they were saying was true. I saw managers with poor performance recommended and retained. Others large firms, financial powerhouses whose performances were mediocre at best, were repeatedly recommended by consultants. Clearly, the best managers were not necessarily being recommended.

However, neither the managers who prospered from consultant pay-to-play schemes nor those that suffered were particularly happy with this state of affairs. Why would the managers who prospered complain? As you know, all managers would rather have complete control over client commissions for a variety of reasons including best execution concerns and soft dollar opportunities. I also observed, as an expert in money management law, that a good deal of the information consultants provided their clients was incorrect both legally and factually. For example, one large consultant claimed it was not affiliated with any money manager. I knew this to be untrue. This consultant and a money manager shared a common parent company and therefore, under the federal securities laws, they were affiliated. It was clear to me that consultants often lacked professional knowledge to support their statements regarding pension and money management matters.

Often the advice they gave was tainted by conflicts of interest. When I researched the regulation of consultants I was surprised that these firms which so greatly influenced the investment outcomes of the funds they advised, were not required to register with the SEC and were neither required to be licensed nor credentialed. I was astounded to learn that many in the consulting industry actually disputed whether they were fiduciaries to the plans they advised.

The more I learned about consulting industry the more I became convinced there was a need for greater professionalism, integrity and depth of service. The industry needed an extreme makeover. In 1997, I raised $250 million from a prominent venture capital firm in a well-publicized effort to effect a consolidation of the consulting industry. With funding letter in hand I met with the owners of most of the leading pension consulting firms. I reviewed these firms’ staffing and resources, as well as their finances. It was a very enlightening exercise.

One of the smallest firms I met with that was rife with conflicts of interest was the most profitable, with the consultants that owned the firm each making over $1 million annually at that time. I should mention that due to criminal convictions, the firm no longer exists. Other firms, with stellar reputations and no conflicts of interest were making a decent living but hardly getting rich. Some of the largest firms, involved in brokerage and money management, were doing extremely well. But the bottom line was: no one was making significant money from pure consulting or providing objective advice to pensions. The firms that were worth buying, that had compelling finances, were making all their money from brokerage and other services they sold to money managers. They were profiting from conflicts of interest.

I observed two disturbing economic realities at work here. First, pensions were unwilling to pay much for objective investment consulting advice. Second, money managers were willing to pay vast sums to get lucrative investment advisory contract steered to them. These economic realities or incentives explained the state of corruption of the consulting industry. My great consolidation plan fizzled as it became clear that the consultants with high integrity, who were making little money, could not be married to consultants rolling in dough who were profiting from conflicts. I continued to write articles about the consulting industry, as well as other pension issues that, based upon my professional training, seemed problematic. For a while I lost interest in the consulting business. In fact, in 2000 I rolled together three companies in another industry, oil and gas, and sold the combined entity to venture funds.

Then in 2001, soon after 9/11 a large law firm came to me for advice. It had a large municipal pension client that had a broker employed by a major wirehouse as its consultant and he was executing all the trades for the fund at six cents a share. The law firm told the pension it had no case because the commission rate charged on the trades was reasonable. I agreed to conduct an investigation on behalf of the pension. In summary, I was shocked to discover that the consultant who was supposed to be getting paid around several hundred thousand dollars a year for providing objective advice was in reality earning millions. Worse still, the scheme he had orchestrated had cost the fund tens of millions in underperformance. That’s when I learned the true cost of consultant conflicts. It’s staggering—often amounting to 10-15% of the value of a fund over time.

The consultant reached a multi-million dollar settlement in 2002 but the word was out that consultant conflicts result in substantial, quantifiable harm. Since then, I have been consumed with work involving the consulting industry. In 2002, in a speech at a conference for Florida public safety pensions, I offered to pay the pensions in attendance $1million to be their consultant because, as I explained to them, I could earn far more than that amount by ripping them off. Some of the funds in attendance thought they were getting a good deal because they were getting consulting advice for free. I explained to them that bad advice for free is never a good deal and then I offered them an even better deal—to pay them for the right to be their consultant.

In 2003, on the heals of Eliot Spitzer’s successes involving research analysts and mutual funds, the SEC and DOL for the first time in the 20 years since I left government, called me and asked for help in combating pension fraud. I was asked how they should go about investigating the consulting industry. I suggested they begin by getting the financials of consulting firms to see how these firms make money. In order to judge the severity of conflicts, it is necessary to have specific information regarding just how much money the conflicted agent is receiving from the parties on either side of the transaction.

In February 2004, the Chairman, Retirement Committee Louisiana House of Representatives asked my firm for guidance in drafting a law to prevent pension wrongdoing. In August 2004, Louisiana became the first state to pass a pension consultant/money manager conflicts disclosure law. This law was amended in 2005 to include financial penalties for collusion involving money managers and consultants. Now the question in Louisiana is whether compliance with the law will be enforced and disclosures verified. Also in 2004, we conducted an investigation on behalf of the City of Chattanooga that resulted in a substantial arbitration claim against its pension consultant for breach of fiduciary duty and conflicts of interest.

On May 16, 2005, the findings of the SEC’s Investigation of Pension Consultants were released. In summary, the Commission found conflicts of interest were pervasive throughout this industry and disclosure of these conflicts was abysmal. The SEC made recommendations regarding policies and procedures consultants should institute to protect clients. However, keep in mind, that nothing in the SEC report dealt with the issue of whether consultants violated pension laws with respect to their past conduct. Nothing in the SEC report states that if consultants adopt all the measures the report suggested they will be in full compliance with pension fiduciary standards. The SEC report dealt ONLY with federal securities law issues. I encourage you to read the report of the SEC’s findings for a sense of the degree to which the government is slowly awakening to the hidden incentives present in pension advising.

Yes, the SEC has discovered that companies dealing with pension assets are no more rippling with integrity than stockbrokers and mutual fund companies entrusted with retail assets. The questions the SEC report didn’t answer are more important than those it did. What are the standards that apply to pensions? Is disclosure enough in the pension context? How much disclosure is required? Do managers who pay consultants get recommended more frequently? Does pay-to-play result in underperformance or harm to pensions? These are the questions that must be answered if you want to answer the question of where the consulting industry is headed. On June 1, 2005, SEC/DOL issued a Guidance Release that provided pension trustees with a list of questions to ask of their investment consultants. One of the key conclusions stated in the SEC/DOL findings was that pension consultants are, whether they like it or not, fiduciaries to the pensions they advise.

The June 1, 2005 joint release by the SEC and the DOL is hugely significant. It verified that questionable conduct was pervasive at the highest levels of pension decision-making. This may be the tipping point, signaling the beginning of a new era of greater scrutiny of pensions and a defining of what constitutes fraud and mismanagement in the pension context. It may also signal the beginning of an era of cooperation between SEC and the DOL. A June 9, 2005 Government Accounting Office release pointed out the need for such a DOL/SEC joint enforcement initiative to combat the nation’s growing pension problems. Hopefully these two agencies will continue to work together to provide guidance and enforcement in pension matters.

In a June 20, 2005 letter from the Aircraft Mechanics Fraternal Association (“AMFA”), a union representing 16,000 airline ground workers, to U.S. Secretary of Labor Elaine Chao and Bradley Belt, executive director of the Pension Benefit Guaranty Corporation (“PBGC”), AMFA requested that the PBGC conduct a forensic audit of the pension plans of bankrupt United, a subsidiary of UAL. While the PBGC has taken over the pension plans of many bankrupt corporations in the past, the April estimated $6.6 billion bailout of the United plans is the largest in history. What was the stimulus for the AMFA letter? AMFA noticed that United’s consultant also managed money for United—exactly the conflict of interest the SEC/DOL said on June 1st should be investigated. Without the SEC/DOL findings and release, AMFA would have been hard pressed to justify the need for a forensic audit.

Should the PBGC require a forensic audit of any failed pension it overtakes, corporations will think twice before dumping their pension obligations onto taxpayers and vendors to pensions may clean up their acts. PBGC mandated forensic audits would also greatly assist regulators and law enforcement in identifying abusive industry practices, as well as specific instances of wrongdoing. (See Pensions & Investments June 27, 2005 editorial calling for forensic investigations of consultant conflicts; New York Times editorial dated August 3, 2005 endorsing forensic audits of failed pensions are included below.)

In June I was contacted by law enforcement regarding certain pension consultants and I also was invited to speak specifically about pension matters at the annual state securities regulators conference. It is my understanding and belief that both law enforcement and state regulators are motivated to begin investigating pension cases. In late August the City of San Diego filed suit against its pension consultant alleging a “pay to play” scheme involving the consultant and the city’s pension money managers. The complaint alleges that the consultant was paid undisclosed brokerage commissions, conference fees and other forms of compensation by managers it recommended. Another investigation involving the same consultant is underway at the Ohio Bureau of Workers Compensation and while it does not involve a pension fund, the findings of that investigation, including scrutiny of the pay-to-play activities of the fund 145 money managers, will impact pensions.

What’s notable: The San Diego case alleges that the pay to play scheme resulted in underperforming managers being hired. That is, pay to play results in damages! This is something the SEC did not say. Finally, this month I met with the senior management of the PBGC, the federal agency that guarantees the nation’s defined benefit pensions and advised them that fraud and mismanagement are pervasive in the pension industry. Further I advised that, given the hidden economic incentives involved in the pension consulting industry, that the agency should conduct forensic investigations of the thousands of pensions it has already overtaken, as well as any new pensions it terminates. Believe it or not, the PBGC has never conducted any such investigations.

Future of consulting:

(1) There will be significant additional pension scandals and failures in the future. (2) Hidden financial incentives, conflicts of interest and malfeasance involving vendors to pensions will surface increasingly, especially with respect to troubled plans. OBWC; San Diego; Illinois; Philadelphia.

(3) Consultants will figure prominently in these scandals and failures.

(4) Law regarding fiduciary duties of sponsors of, as well as vendors to pensions will rapidly develop as a result of scandals and failures.

(5) Internet and other information gathering technologies will ensure greater transparency.

(6) The informational advantage consultants enjoy will shrink. For example, performance and other information regarding money managers will become more accessible.

(7) Hidden financial arrangements and conflicts will have to be disclosed or eliminated. (8) As hidden financial incentives evaporate, convention wisdom regarding pension investing, e.g., asset allocation, will be re-examined. (9) Consultants will have to develop more substantive, depthful services to justify their fees. Finally, pensions must be persuaded that in order to receive objective expert advice, they must pay investment consultants substantially more.

In conclusion, the consulting industry is entering a period of rapid change. The product and its pricing, as well as the economics and ethics of the industry are all changing. I believe a new professionalism will emerge. Those of you who believe you can continue doing business the old-fashioned way, I believe are in for very hard times ahead. On the other hand, the opportunities for those of you who embrace change and think creatively about how to improve the industry are very exciting.

The Growing Scrutiny of Pensions Defining Pension Fraud and Mismanagement Speech at TEXPERS, August 22, 2005

The evidence is growing that wrongdoing involving companies providing services to pensions has been longstanding and pervasive and costs the nation’s pension plans billions annually. Scandals involving pensions are surfacing daily. Who are these parties: investment consultants, money managers, securities firms, actuaries, attorneys and others. Due to complex political, regulatory, investment and legal issues, pension wrongdoing has not received adequate attention from federal and state regulators or law enforcement. This is changing. In June I was invited to speak at the state securities regulators annual conference and advise regarding ramping up scrutiny of pensions at this time. It was an eager, interested audience and behind doors closed to the public we had a lively, substantive exchange of information. They’re armed and ready now.

I recently have received similar very serious indications of interest from law enforcement. It is clear that state regulators and law enforcement are going to make protecting pensions a top priority going forward. I predict that in the future these parties may lead the way in investigating pension wrongdoing, not the SEC. Why has pension wrongdoing been neglected for so long? Corporate plans: The Department of Labor, the agency charged with regulating corporate pensions, generally lacks knowledge of the money management and securities industries, has offered little meaningful guidance to corporate sponsors on these issues and has been even less effective in investigating wrongdoing and enforcing the laws.

For example, the former president of a firm which was involved in a massive case of pension fraud in the late 1990s, recently testified that federal officials did little to stop the scheme despite spending almost a decade investigating it. At a US Senate Committee on Health, Education, Labor & Pensions hearing on 9 June on protecting America’s pension plans from fraud, Grayson issued a chilling testimony of the failure of regulatory oversight on the part of the Department of Labor to stop fraudulent activities. “Based on my observations the DOL has a limited understanding of private investments and a general lack of accounting skills,” testified Grayson. “This results in the DOL having long “open files” which makes them largely ineffective.”

Grayson said that there was a need for the DOL to employ highly trained accountants like the SEC to audit pension investments at least once every two years, as well as the unions themselves to ensure that no conflicts of interests exists. So much for the DOL. The Securities and Exchange Commission, on the other hand, is highly knowledgeable about money management and securities but is subject to political pressures and has seldom ventured into pension matters.

State securities regulators, I believe, have to some extent presumed that corporate pensions were adequately regulated on the federal level. I believe law enforcement may also have operated under the same presumption. Finally, of course, these cases often involve complex financial dealings that are difficult for even seasoned pension professionals to fully comprehend. Public Pensions: Investigations of public pensions, neither governed by ERISA nor regulated by the DOL can raise additional sensitive political issues.

The political dimension of these cases may explain federal and state regulator reluctance in investigating public pension matters. Law enforcement investigations of these matters have, on occasion, resulted in public embarrassment.

What are the political dimensions of these cases? In a case filed in Lucerne County, Pennsylvania, it has been alleged that there may have been a pay-to-play scheme involving vendors to the pension making political contributions to elected pension board members in return for pension contracts. Alternatively, vendors may hire politically connected intermediaries, as opposed to paying elected board members themselves, to secure public pension contracts. That is, in the former case elected officials serving on public fund boards may accept bribes and in the latter, public pension investment decision-making may be tainted by political influence peddling. Another example, I have seen in Florida, is public pension board members who may have personal accounts with the pension consultant’s brokerage firm or other money manager vendors to the fund. Investment opportunities, such as “hot issues,” that rightfully belong to the pension may instead be allocated to influential public pension board members for their personal profit. (Of course, this conduct may also occur at corporate pensions.) Public pension scandals emerging in San Diego, Illinois, Ohio and Pennsylvania all involve serious political issues. Public pensions are a political minefield and before aggressively pursuing these cases it is understandable that regulators and law enforcement might choose to proceed with the utmost of caution, or not at all. “Pre-Spitzer” versus “Post-Spitzer” thinking However, we are in the midst of a period of radical change in thinking about the securities, money management and now finally, pension industries. As a result of Eliot Spitzer’s initiatives, the nation recently was made aware that the nation’s largest securities firms have been scamming investors with tainted investment research. Also, Spitzer has drawn attention to the fact that the mutual fund industry has been skimming from investors’ accounts for decades. While I have investigated mutual fund illegalities since the 1980s, I can assure you from personal experience that “pre-Spitzer” you couldn’t convince state or federal regulators or law enforcement that mutual fund managers could do wrong. Thankfully today there is growing awareness that professional, registered money managers and securities firms often engage in wrongdoing. The untold story is just how much money manager and securities industry scamming has undermined the retirement security of the nation’s investors. As I testified to the Banking Committee of the U.S. Senate, trillions have been skimmed from the accounts of the nation’s workers into the accounts of investment executives over the past 25 years. Many of the same parties involved in retail wrongdoing have also been scamming pensions. For example, the major wirehouses all have retail brokers who call themselves pension experts and prey upon unsophisticated pensions, including corporate and public pensions with hundreds of millions and even billions in assets. In Florida we have a broker-consultant pension-scamming epidemic. Over 100 Florida public pensions are currently being harmed by corrupt broker-consultants; the conflicted advice these funds are receiving from these pension scammers is costing Florida taxpayers hundreds of millions annually. Pension scams are far more complex than retail scams. In the retail context scamming often involves only a single party’s wrongdoing. For example, a broker may churn a customer’s account or recommend an unsuitable investment. Spitzer’s investigations gave the public insight into collusion involving brokers, money managers, research analysts, investment bankers and others. For example, the public learned that mutual fund managers often have hidden financial arrangements with brokerages to recommend investing in managers’ funds. In other words, money managers and brokers may collude to the detriment of retail investors. The investor is not sold the fund that is best for him; rather the brokerage recommends or selects the fund that provides the firm the highest compensation. A key difference between retail and pension scamming can be the number of parties involved in wrongdoing, as well as the degree of collusion between them. There are many different hands involved in managing pensions and often more than one party is involved in the unscrupulous conduct. In some cases, participation of multiple parties is required to facilitate the wrongdoing. Collusion between investment consultants, money managers, brokers, custodian banks, actuaries and even pension lawyers is commonplace. I encourage you to read my speech, The Art of Theft, which was written for the Teamsters annual pension trustee training conference earlier this year, for more information regarding the ways in which various parties can steal from pensions. (See Benchmark’s Library of Articles) Like Enron and Worldcom, pension scams often are not perpetrated by one or two “bad apples.” It may take a team of hired “experts” to commit the wrongdoing, opine that there was no wrongdoing and/or otherwise conceal it. As I stated in The Art of Theft speech, I am not aware of any pension, not even the largest, that has adequate procedures in place to prevent and detect fraud related to all the various parties that have a hand in managing the assets. Corruption of “gatekeepers.” Recognizing their lack of investment expertise, most pension boards (over 70%) use investment consultants (who claim to have pension expertise) to advise them on broad issues such as asset allocation, manager selection and performance reporting. These unregulated or poorly regulated investment consultants exert tremendous influence over pension returns. They serve as gatekeepers to funds and purport to offer objective advice. Unfortunately they often have undisclosed financial arrangements with the very money managers they vet and recommend. Often the managers that consultants recommend are those that compensate the consultants for their recommendations. Our investigations have shown a corrupt consultant gatekeeper can cost fund 10-15% over time. Given the trillions in pensions, that’s a lot of money. We have been investigating pension consultant wrongdoing since 1996. Self-dealing and conflicts of interest are at the core of these cases—losses in the cases we have pursued on behalf of smaller funds have ranged from $30 to over $100 million. But there are hundreds of these cases out there, some involving the largest pensions in the world. We’ve been contacted about investigations from Guam to Bermuda. The fact that few cases alleging pension consultants abuses have been brought is best explained by political considerations. It is in no one’s interest (except for the participants in these funds—and they have little information about, or control over, the fund’s investment operations) that wrongdoing be exposed. Board members fear culpability and parties to the daisy chain of corruption obviously will vigorously oppose the truth coming out. Consultants and money managers have symbiotic relationships—managers praise the consultants who recommend them and vice versa, before the pension client. The perfect crime Thus, pension wrongdoing is often the perfect crime: huge gains with no victim that complains! Imagine stealing vast sums from a financial institution that was too embarrassed to report the crime. That’s exactly what’s been happening to our nation’s pensions. In the past pensions have not known they were being ripped off but recently, as of June 1, 2005 when the DOL/SEC, we entered a new era. Today, ignorance is no longer an excuse. There are lawyers around the country who are researching suing on behalf of participants and taxpayers for recoverable losses, when pension board fail to take action. Swift shift of focus onto pensions

Let’s look at how much has happened in the pension arena in less than 2 years. In late 2003, both the SEC and DOL asked my firm for assistance in investigating pension matters. In the 20 years, first time. In February 2004, the Chairman, Retirement Committee Louisiana House of Representatives asked us for guidance in drafting a law to prevent pension wrongdoing. In August 2004, Louisiana became the first state to pass a pension consultant/money manager conflicts disclosure law. This law was amended in 2005 to include financial penalties for collusion involving money managers and consultants. Now the question in Louisiana is whether compliance with the law will be enforced and disclosures verified. On May 16, 2005, the findings of the SEC’s Investigation of Pension Consultants were released. In summary, the Commission found conflicts of interest were pervasive throughout this industry and disclosure of these conflicts was abysmal. On June 1, 2005, SEC/DOL issued a Guidance Release that provided pension trustees with a list of questions to ask of their investment consultants. One of the key conclusions stated in the SEC/DOL findings was that pension consultants are, whether they like it or not, fiduciaries to the pensions they advise. The June 1, 2005 joint release by the SEC and the DOL is hugely significant. It verified that questionable conduct was pervasive at the highest levels of pension decision-making. This may be the tipping point, signaling the beginning of a new era of greater scrutiny of pensions and a defining of what constitutes fraud and mismanagement in the pension context. It may also signal the beginning of an era of cooperation between SEC and the DOL. A June 9, 2005 Government Accounting Office release pointed out the need for such a DOL/SEC joint enforcement initiative to combat the nation’s growing pension problems. Hopefully these two agencies will continue to work together to provide guidance and enforcement in pension matters. In a June 20, 2005 letter from the Aircraft Mechanics Fraternal Association (“AMFA”), a union representing 16,000 airline ground workers, to U.S. Secretary of Labor Elaine Chao and Bradley Belt, executive director of the Pension Benefit Guaranty Corporation (“PBGC”), AMFA requested that the PBGC conduct a forensic audit of the pension plans of bankrupt United, a subsidiary of UAL. While the PBGC has taken over the pension plans of many bankrupt corporations in the past, the April estimated $6.6 billion bailout of the United plans is the largest in history. What was the stimulus for the AMFA letter? AMFA noticed that United’s consultant also managed money for United—exactly the conflict of interest the SEC/DOL said on June 1st should be investigated. Without the SEC/DOL findings and release, AMFA would have been hard pressed to justify the need for a forensic audit. To date, as unbelievable as its seems, the Pension Benefit Guaranty Corporation, the government agency that insures private corporations, has never undertaken a forensic investigation aimed at ferreting out wrongdoing involving vendors to any corporate pension it has overtaken. This agency has never investigated possible wrongdoing before using government funds to bail out a corporate pension. That’s great news for firms that may have profited from advising a failed pension (and even contributed to its demise) but horrible news for taxpayers. Should the PBGC require a forensic audit of any failed pension it overtakes, corporations will think twice before dumping their pension obligations onto taxpayers and vendors to pensions may clean up their acts. PBGC mandated forensic audits would also greatly assist regulators and law enforcement in identifying abusive industry practices, as well as specific instances of wrongdoing. (See Pensions & Investments June 27, 2005 editorial calling for forensic investigations of consultant conflicts; New York Times editorial dated August 3, 2005 endorsing forensic audits of failed pensions are included below.) Finally, on August 2005 the City of San Diego filed suit against its pension consultant alleging a “pay to play” scheme involving the consultant and the city’s pension money managers. The complaint alleges that the consultant was paid undisclosed brokerage commissions, conference fees and other forms of compensation by managers it recommended. Another investigation involving the same consultant is underway in Ohio. What’s notable: The San Diego case alleges that the pay to play scheme resulted in underperforming managers being hired. That is, pay to play results in damages! This is something the SEC did not say. Conclusion The result of wrongdoing by vendors to pensions is that, with respect to corporate pensions, employee retirement security is being undermined. Many corporations have already and more in the future will fail to honor their obligations to retirees. With respect to public pensions, taxpayers must contribute more and more to fund pensions that are being drained as a result of wrongdoing by parties hired to handle pension assets. That is, taxpayers are paying more to fund public pension obligations than necessary. At some point taxpayers, many of whom will be struggling to provide for their own retirements, may say enough is enough. In conclusion, we are entering a new era of heightened scrutiny of pensions. This is not surprising since as the nation ages all eyes are turning to pensions. We are beginning to see the outlines of what constitutes fraud and mismanagement in the pension context. I encourage all of you to embrace these changes with an open mind. Plan sponsors should be willing to examine how they manage pensions and money managers should examine how they run their pension businesses. Many accepted pension truths, some already subject to mounting questions will be rejected in the near future. The worst thing to do is respond defensively as questions arise and refuse to examine your behavior. (Public pension operating in a political arena frequently tend to develop a hostile attitude toward those raising questions or offering new solutions.) If you seek out new advice, guidance and insights you will be fine. In this brave new world of pensions, assume 30% of what you are doing is wrong and must change. That’s not so bad, is it? Yes there is a revolution coming in pensions but no one need be killed.






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