(July 2, 2004 ) 401(k) Abuses: The Mutual Fund Industry’s Next Nightmare, By Ted Siedle and Steve Lansing, Sentinel Fiduciary Services |
Benchmark Financial Forms Center for Investment Management Investigations (CIMI)
Benchmark Financial Services, Inc., a firm specializing in investigations of money management abuses announces the formation of the Center for Investment Management Investigations (CIMI). CIMI will serve as a resource for aggrieved investors and operate a network of firms expert in matters related to investigating money managers, including mutual fund advisers, as well as securities brokerages, pension consultants and actuaries.
“For years Benchmark has in effect served as a repository for information regarding money management malfeasance. By announcing the creation of CIMI we are formally offering services we’ve been informally providing all along,” said Edward Siedle, President of Benchmark.
Creation of CIMI will expand Benchmark’s main focus from investigations on behalf of defined benefit pension sponsors to include corporate defined contribution plans, as well as retail products outside pensions such as mutual funds and variable annuities.
“Events of the last year indicate that pension sponsors and other investors are now prepared to peer into the shadows of the money management industry and uncover the truth about how their money is being handled,” said Siedle.
Based in Ocean Ridge, Florida, Benchmark was founded in 1999 by Edward Siedle, a former attorney with the SEC’s Division of Investment Management from 1983 to 1985. Siedle served as Director of Compliance and legal counsel to one of the nation’s largest mutual fund companies from 1985 to 1988. Siedle has been a vocal critic of money management abuses, particularly involving mutual funds and pension consultants. Investigations undertaken by Siedle have included front-running by mutual fund portfolio managers, pension consultant kick-back schemes, illegal “soft dollar” arrangements and hedge fund and venture capital fraud.
Plan sponsors and others may contact CIMI if they seek assistance in identifying or substantiating abuses and expert firms may contact the Center to offer use of their skills or to share information regarding potential investigations.
401(k) Abuses: The Mutual Fund Industry’s Next Nightmare By Ted Siedle and Steve Lansing, Sentinel Fiduciary Services
As the mutual fund scandals continue to unfold, many defined contribution plan sponsors and participants are asking whether the abuses that have surfaced impact these retirement plans as well. Participants are interested in learning whether hidden financial dealings related to their retirement plan may reduce investment returns; plan sponsors, on the other hand, are seeking guidance as to the questions they should be asking of the intermediaries and money managers they have retained to handle plan assets.
As fiduciaries, plan sponsors are responsible for selecting and monitoring the vendors they utilize within their plans. Should they do nothing in the face of such widespread mutual fund malfeasance? Or is some action required if they are to avoid possible liability? To date plan sponsors have responded by, at most, terminating managers involved in wrongful conduct. However, as the number of tainted managers has grown, and it appears that the majority of managers may have problems, identification of the issues plan sponsors should be considering seems more important than ever.
At the outset let us emphatically state that mutual fund unethical dealings permeate defined contribution plans. Undisclosed or poorly disclosed financial dealings between intermediaries which represent breaches of fiduciary duty by these parties may actually represent serious violations of the federal law that applies to defined contribution plans, in addition to the federal securities laws. In other words, where wrongdoing occurs within a defined contribution plan greater protections for investors may exist and more severe penalties for mutual fund companies, intermediaries and even the plan sponsors responsible may result.
Let us also make it clear that the abuses that have surfaced can and do negatively affect the financial results to the participants in the nation’s defined contribution plans. We are not concerned with mere theoretical breaches of fiduciary duty or harmless kick-backs. Rather we believe that malfeasance within defined contribution plans may significantly jeopardize the retirement security investors have in these plans.
In order to understand how unethical conduct impacts defined contribution retirement plans, it is essential to appreciate the role played by intermediaries who plan sponsors rely upon to assist in the management of these plans. First, every defined contribution plan is required to designate a named fiduciary. Either a formal or informal committee of the employer generally serves this function. The named fiduciary is responsible for overseeing the plan’s investments. The committee will customarily seek to hire a third party to serve as an advisor/consultant with respect to the investment function. Unfortunately, the vast majority of parties who serve in this capacity today cannot, and indeed will not, serve as a co-fiduciary because co-fiduciaries are required to disclose the compensation they receive from the intermediaries. As a result of such compensation, the investment consultants / advisors are subject to conflicts of interest. Accordingly, it is more appropriate to refer to them as brokers, as opposed to consultants.
When any of the parties hired by the plan fiduciaries to advise the plan and/or manage its assets are corrupted, plan performance will likely suffer. The recent scandals have revealed (and continue to reveal) that wrongdoing in the mutual fund industry is pervasive and longstanding. Wrongdoing within defined contribution plans, involving tacit collusion between service providers, mutual funds and brokers, is also pervasive. As scrutiny shifts to the activity of brokers working with these plans, widespread scandalous activity will surface.
Some of the compensation of intermediaries, including investment managers to defined contribution plans, is stipulated in the prospectuses and contracts between those parties and the plan sponsor. However, there are a myriad of possible hidden financial arrangements that these intermediaries may enter into between themselves that are beneficial to them but detrimental to the plan sponsor and participants in the plan.
Revenue sharing arrangements: Thanks to the efforts of Eliot Spitzer and others like him, the public is gradually awakening to the fact that mutual fund investment advisory fees are generally irrationally high. Outside of the defined contribution area, revenue-sharing arrangements between mutual fund advisers and brokers that sell fund shares have recently attracted regulatory scrutiny. Fund advisers who manage defined contribution plan mutual funds are paid retail investment advisory fees substantially greater than the fees these same managers receive for managing comparable institutional accounts. As a result, mutual fund advisers have been able to comfortably share a portion of these inflated fees with intermediaries who are instrumental in helping them gather assets. These same arrangements exist between fund advisers and intermediaries to defined contribution plans. These undisclosed payments are collectively referred to as revenue sharing. More specifically, the term refers to sub-transfer agent fees (sometimes known as share-holder servicing fees). These are payments to service providers for doing administrative work the mutual funds would otherwise handle if the investment had been made directly with the fund. It also covers various “pay to play” or “payola” schemes used to induce intermediaries to feature or use a particular fund in plans.
The amounts brokers advising can receive through arrangements with money managers may be materially greater than the fees stipulated in the prospectuses and their contracts with plans. While the broker may be conflicted in a variety of ways when it enters into arrangements for payment from mutual funds, nevertheless these arrangements are commonplace.
How substantial are the revenue sharing payments intermediaries receive from mutual funds? IOMA, in a 2001 article about revenue sharing, estimated that a total of $1.5 billion dollars changes hands in this manner each year. We have seen mutual funds pay intermediaries as much as .65% (sixty-five basis points) and $16 per participant per year for each person who invests in the fund to intermediaries. The presence of 12(b)-1 fees could increase this amount. For example, if the average account balance is $64,600 and the average participant invests in four funds (figures released by Hewitt), then there may be revenue sharing payments amounting to $475 per year per person, a figure substantially above amounts necessary for third party administrators to make a handsome profit.
12(b)-1 Fees: These are recurring marketing payments permitted under applicable law and are disclosed in the mutual fund prospectus. Intermediaries may be paid such fees by funds. It is important to be aware that the intermediaries have control over the amount of 12(b)-1 fees they earn by selecting different share classes. One prominent mutual fund family offers five share classes that include 12(b)-1 fees ranging from zero to 100 basis points.
Finder’s Fees: In addition, many mutual funds pay one-time and ongoing finder’s fees to intermediaries who bring them assets to manage. These are payments attributable to new deposits (contributions) that go into a mutual fund. While this practice may be subsiding because of new, special share classes introduced for defined contribution plans, it still takes place. One prominent fund family pays as much as 1.00% on new contributions on amounts less than $4 million or $39,000 for a $3.99 million account. Though this figure grades down as the asset size increases, it often amounts to .20% on large plans involving billions in assets or millions in finder’s fees. Further, this stipend applies to all new money-- including the transfer of existing assets from one fund group to another. As result, there may be powerful incentives for intermediaries to move assets from one fund group to another. An unintended consequence of the mutual fund scandals has been intermediaries receiving finder’s fees as plan sponsors have abandoned scandal-tainted fund groups.
Directed brokerage: Another source of compensation to intermediaries involves fund managers directing mutual fund portfolio trades to brokerages owned by intermediaries in return for the intermediary using, or even recommending, the mutual fund. In directed brokerage arrangements, the manager is compensating the intermediary with participant dollars, i.e., commissions, not his own. Revenue sharing involves the manager paying the intermediary with his own money.
“Soft dollars”: Intermediaries may also derive additional financial benefits when money managers purchase investment research from the intermediary’s brokerage with fund commissions. This legal though controversial practice is all the more egregious in the defined contribution context where greater fiduciary duties apply.
One of the most insidious aspects of the practices described in this article is the explicit and implicit costs to participants resulting from these conflicts of interests. An example of the explicit costs resulting from these practices is that far too many brokers advising plans are being compensated at an effective rate of several thousands of dollars per hour. Once a plan is sold, the nominal amount of work to maintain the relationship and income stream is remarkably low relative to broker compensation. This situation becomes progressively more acute as the plan grows in asset size. Intermediaries deserve a fair wage, but compensation of a broker that is exponentially greater than what skilled pension professionals receive is egregious.
An example of the implicit costs is the selection effect brokers impose on sponsors by limiting the choice of vendors during a search to retain a service provider. Too many plan sponsors are under the illusion that when a broker evaluates five, ten or even fifteen alternatives the sponsor is getting an unbiased, impartial spectrum of qualified choices. But if all the options presented use high cost retail mutual funds with large revenue sharing, the process is hardly objective. Some of the most qualified service providers who are excluded pay nominal, or no, revenue sharing. The implicit cost also manifests itself by how scarce institutional index funds are in plan menus. Low cost index funds are not selected because the fees related to these funds are not sufficiently excessive to permit meaningful kick-backs to gatekeepers.
A formal, business like process is the best way to address these conflicts of interest. First, a sponsor must engage the services of a totally independent, experienced professional who will represent and warrant he will serve as a co-fiduciary to the plan and committee. Then an exhaustive compensation and relationship disclosure document requesting the details of any payments should be submitted to and signed by all intermediaries to the plan. Refusal to sign this document is immediate grounds for dismissal. All service contracts should be read to understand any hard dollar fees charged by the intermediaries.
Once all the necessary data and disclosures have been compiled, a spreadsheet can be constructed to calculate the direct and indirect costs of maintaining the plan. When these expenses are determined and verified a sponsor is finally equipped with the requisite information needed to determine total costs and to map appropriate actions steps. The deck may be stacked, but with a sound process plan sponsors can avoid being taken.
It is important to understand that all of the revenue sharing and broker compensation belong to the plan and participants, not to the intermediaries. There are multiple ways in which defined contribution plan intermediaries may be compensated by advisers managing plan assets. All of these little known business practices involve serious conflicts of interest. It is clear that intermediaries that participate in revenue sharing arrangements violate the fiduciary duty they owe to the plan. They cannot be relied upon to effectively protect the interests of the plan when they derive a financial benefit for recommending certain managers. Further, the intermediaries may open themselves to far greater liabilities than the mere compensation they receive from these arrangements. If performance falters, intermediaries may find themselves shouldering the blame.
SEC Pension Probe Spurs Interest In Old Callan Deal
By Allison Bisbey Colter DOW JONES NEWSWIRES
NEW YORK (Dow Jones)--Recent scrutiny of the pension consulting business has renewed interest in a prominent consultant's sale of a broker-dealer firm six years ago.
In 1998, Callan Associates Inc. of San Francisco sold its registered broker-dealer Alpha Management Inc. to BNY Brokerage Inc., a Bank of New York (BK) subsidiary formerly known as BNY ESI & Co. The sale came on the heels of a recommendation by the U.S. Labor Department a year earlier that pension-plan sponsors avoid using consultants with financial ties to brokerage firms.
It wasn't the end of Callan's relationship with Alpha, however.
To this day, Callan directs clients to trade through BNY Brokerage, and also collects payments from the brokerage each year, according to filings the consultant has made with the Securities and Exchange Commission.
The SEC has been looking into ties between consultants, who tell pension funds how to invest their money, and brokers, who execute the trades for these funds, as part of a wider examination of the industry begun last December. Though the SEC hasn't indicated it is looking at the relationship between Callan and BNY Brokerage specifically, Callan is one of many consulting firms that have been asked to supply data as part of the probe.
Terms of the Alpha deal weren't disclosed in 1998, but details have emerged recently in filings with the SEC. For instance, Callan is getting "periodic fixed payments" each year from BNY Brokerage, according to a March 12 filing. Under terms of the deal, Callan appointed BNY Brokerage as its "exclusive agent for the conversion of brokerage commissions paid by Callan's clients in respect to those client (sic) electing to pay for Callan's services through a directed brokerage arrangement established by the client," according to the filing.
Callan is also obligated to introduce its other clients to BNY Brokerage and "to advise them that BNY Brokerage is Callan's preferred broker for paying Callan's fees through commissions."
Arrangements of this nature aren't unusual in the pension-consulting industry, according to Bank of New York spokesman Kevin Heine.
"Callan's clients have a choice," said Heine. "They can either pay cash or use commissions, and if they elect to use commissions, BNY Brokerage is the provider. These arrangements are common in the industry. Callan receives the same payments for its services whether or not commissions are involved."
The question comes down to whether this arrangement means that BNY is officially affiliated with Callan, which it would be required by the SEC to disclose. Deanne Christopulos, a Callan spokeswoman, referred to the SEC filings when asked about the relationship between Callan and BNY.
For its part, Callan maintains it doesn't have an affiliated broker. In a 2002 e-mail to Diann Shipione, a trustee of the $3.2 billion San Diego City Employees' Retirement System, James Callahan, a senior vice president at Callan, wrote that "Callan's fees are not nor were ever based on trading activity with Alpha/BNY ESI." And in an e-mail message last month, Callan spokeswoman Christopulos wrote that "Callan does not have a broker-dealer affiliate nor do we have arrangements for any brokerage compensation from any broker/dealer." Callan described BNY as "our preferred broker which clients may elect to use or not," in another message last month.
Neither Callan nor the Bank of New York has said how long the relationship will remain in place. Callahan, the Callan executive, told Shipione in the 2002 e-mail that payments associated with the deal are to be spaced out in equal installments over an eight-year period.
Heine confirmed the Bank of New York has been "paying a consistent amount of the purchase price each year," and added that "typically when we structure an acquisition like this the purchase price is paid over time."
Critics Question Ties To BNY Brokerage
Nonetheless, the arrangement has raised questions among critics of the pension-consulting business.
"Whether a true sale of a broker-dealer has occurred or not is a reasonable question for clients to ask," said Edward A.H. Siedle, a former SEC attorney and mutual-fund executive who investigates pension fund-related fraud, and is now president of Benchmark Cos. in Ocean Ridge, Fla. "The disclosures (in SEC filings) raise numerous questions and I believe that clients should review the underlying sale documents and examine the economic realities to see whether Callan has maintained the benefits of ownership or not."
As for the SEC probe, the agency is studying whether conflicts of interest exist between consultants and investment firms they recommend to pension trustees to manage fund assets. The agency has said it is focusing in part on "all direct and indirect means by which consultants and their affiliates/related entities are compensated for their services and products."
Alleged conflicts can take several forms, but they all come back to the powerful influence of consultants as gatekeepers who advise pension trustees about which money managers to hire. Managers can feel pressure to "pay to play," a term for providing payment in various forms to consultants in return for recommendations to pension boards, according to critics. In the case of a consulting firm with an affiliated broker, a question is whether money managers recommended by the adviser return the favor by sending trades through the broker affiliate.
"The nagging question for the plan sponsor is this: If a money manager is trading through a broker that has a consultant affiliation, is the manager pursuing the lowest commissions available and best net execution for the plan sponsor or is the manager's focus more on what may help the manager maintain and/or acquire money management business?" said Gary Findlay, executive director of the Missouri State Employees Retirement System in Jefferson City, Mo.
As it happens, Callan's sale of Alpha followed closely an intense period of scrutiny by the Labor Department of the ties between pension funds, their advisers, and broker-dealers. In 1997, the Labor Department began a review of the use of soft dollars and directed brokerage by pension-plan sponsors and fiduciaries through its Erisa Advisory Committee, a group that deals with pension rules as stipulated by the Employee Retirement Income Security Act of 1974. Though the committee concluded that both soft dollars and directed brokerage have some benefits, it recommended that plan sponsors avoid soft-dollar conflicts of interests "by hiring only consultants with no financial arrangements with brokerage firms."
Nearly half of all pension-plan sponsors with $100 million or more use investment consultants, according to a 2003 survey by Nelson Information, a division of Thomson Financial.