There are three separate articles presented below:
Louisiana First State Mandating Consultant and Manager Disclosure; Trust Me, I’m No Fiduciary; and PBGC Boss Sees No Pension Fraud or Mismanagement.
Louisiana First State Mandating Consultant and Manager Disclosure
In Louisiana a new law was passed in August 2004 relating to state and statewide public retirement or pension systems, funds and plans. The new law requires pension consultants and money managers to disclose conflicts of interest. In addition, consultants are required to disclose payments received from money managers. The statute states:
“Consultants and money managers shall provide full disclosure to public retirement or pension plan sponsors of conflicts of interest, including non-pension sponsor sources of revenue. Consultants also shall provide full disclosure of any payments they receive from money managers, in hard or soft dollars, for any services they provide, including but not limited to, performance measurement, business consulting and education.”
To the best of our knowledge Louisiana is the first state to enact such legislation. While the rest of the country is still awaiting word from the SEC regarding its investigative findings and recommendations, Louisiana has taken the bull by its horns. It is our understanding that further refinements or additions to the legislation are in the works.
State Representative M. P. Schneider, III, Chairman of the House Retirement Committee and an ex-officio trustee of the 13 state systems, invited us to testify at a March 21st hearing on pay to play practices involving investment consultants. In addition, all statewide pension systems were asked to report at the hearing on the compliance of their investment consultants and money managers with the new law. The result was a highly informative, candid discussion lasting several hours dealing in-depth with the issue of consultant conflicts. The discussion is available on-line at the Louisiana House of Representative website: http://house.louisiana.gov/rmarchive/2005/Mar2005.htm. While only limited disclosure has been received by the funds from the appropriate parties to date, it is clear that full compliance with the law will be enforced in 2005. As we testified, we believe some disturbing financial relationships between consultants and managers may be revealed through the disclosure process.
Under Louisiana law, each fiduciary is personally liable for any losses created by a breach of his fiduciary duty. Investment consultants and money managers are among the fiduciaries to whom that statue applies. With an unfounded accrued liability in the billions, the system members, the retirees and survivors and the taxpayers of Louisiana may be keenly interested in learning if any underperformance of the funds can be attributed to conflicts and collusion.
Trust Me, I’m No Fiduciary
Thanks to a strong lobbying effort by the brokerage industry, the SEC unanimously ruled last week that brokers don’t have to register as investment advisers, even when they offer investment advisory services (under certain circumstances). Why would brokers resist registration as investment advisers despite the fact that they refer to themselves as “financial advisers” and in similar terms that strongly suggest they provide investment advisory services? It has to do with the applicable standard of care. Brokers are held to a “suitability” standard and unless a transaction is egregious, the client may have a difficult time proving breach of duty by his broker. Investment advisers, on the other hand, are fiduciaries and have a duty to place the client’s best interests first. A fiduciary duty may offer stronger protection to investors. What’s this got to do with pensions?
The brokers employed by the major wirehouses posing as pension consultants have, since 2000, been advising their pension clients that they are not permitted (“by the big bosses in New York”) to include representations in their contracts that they are fiduciaries to their fund clients. A refusal to accept fiduciary status should be viewed as an admission by the broker-consultant that he is not acting with the best interests of their pension clients in mind, rather he is profiting from his gatekeeper status at the expense of the fund. A fiduciary generally cannot profit at the expense of his client; a broker can.
All consultants encourage their clients to heavily rely upon their recommendations and pensions generally do so. A relationship of utmost trust and confidence develops over time. Utmost trust and confidence are hallmarks of the fiduciary relationship. Consultants who refuse to expressly acknowledge their fiduciary status are in effect asking their clients to blindly trust them but never hold them accountable. Great work if you can get it!
Despite these efforts to deny fiduciary status, broker-consultants may still be held accountable as fiduciaries in courts of law. Nevertheless the best protection is to insist upon express acknowledgement of the fiduciary status in the contract. Why should pensions agree to remove the fiduciary representation from their contracts with consultants if broker-consultants believe doing so permits them to misbehave?
PBCG Boss Sees No Pension Fraud or Mismanagement
A recent CSFB accounting research report included an interview with Brad Belt, head of the PBGC. The subject of the report was whether the defined benefit pension system in the U. S. will turn into the next savings and loan crisis, with the U.S. Government forced to step in and bail out the PBGC. In other words, whether the U.S. taxpayer could be forced to cover the cost of failed pension plans.
Belt acknowledged that some comparisons between the defined benefit pension system and the savings and loan crisis were quite apt. As with the savings and loan crisis, the existence of a government guarantee arguably creates a moral hazard and encourages unacceptable risk taking. In both instances the regulatory systems are characterized by a lack of transparency. One significant difference the head of the PBGC stated was that “the numerous instances of fraud and mismanagement that characterized the savings and loan crisis have not appeared in the case of pensions.” This is a remarkable statement—especially considering the source. In our experience we have found instances of fraud and mismanagement involving pensions to be commonplace. Why is it that the PBGC has not found evidence of fraud and mismanagement? There are two reasons. First, they are not looking for it and second, they wouldn’t know it if they saw it. Let us explain.
The fraud and mismanagement we routinely encounter often does not involve plan sponsors. Rather, it involves firms that provide investment advisory, investment management, brokerage and other services to pensions. Wrongdoing, often involving collusion between the above parties, can and does often significantly weaken the financial health of defined benefit plans. Conflicts of interest involving investment consultants lead to overly aggressive allocations to active equity, high turnover money managers, as well as private equity and hedge fund managers. Lack of effective negotiation between consultants and managers leads to excessive investment advisory fees. Excessive brokerage commissions are likely where there is a consultant-affiliated brokerage involved. Fraudulent performance and other reporting by managers are routinely cited in the SEC deficiency letters issued to managers that we review in connection with our investigations. Then there are countless undisclosed financial arrangements involving custodians, lawyers, actuaries and others.
Where sophisticated investigative and audit procedures are instituted, the problems discussed above will often be uncovered. Yet when the PBGC assumes control of pensions, it does not undertake such a forensic audit or review of past investment operations. While the corporations that sponsor these plans may be bankrupt, the vendors who have provided investment services to the plans over the years and may have been involved in self-dealing, are not. Would it not make sense both in terms of imposing discipline in the marketplace, as well as preserving the PBGC’s financial condition, to examine whenever a plan is taken over by the PBGC whether any of the vendors may have contributed to its demise?
In the case of the savings and loan crisis parties that had caused a loss to a failed savings institution were generally barred from contracting with the Resolution Trust Corporation in connection with the bail out work. What if parties that engaged in wrongdoing in connection with pensions, resulting in uncompensated losses to pensions, were prohibited from contracting with the pensions PBGC handles?
To be sure there is also fraud, or at least mismanagement, involving sponsors of defined benefit plans, including outrageous actuarial assumptions and other accounting shenanigans; absurd percentages of company stock in plans; and questionable hires of money managers, consultants and other parties. These factors may also contribute to any defined benefit plan bail out that may be necessary in the future.
In conclusion, while the PBCG may not be aware of numerous instances of fraud and mismanagement involving defined benefit pensions, they exist. However, we need to begin to define fraud and mismanagement in the pension context, versus savings and loan. Finally, the PBGC needs to establish today procedures for dealing with the massive defined benefit failures we all know are coming.
Setting Standards For The Investment Management Industry
