Below are two related articles: a letter to the editor of Global Pensions magazine regarding the condition of America's pensions and the text of a speech entitled "The High Cost of Pension Consultant Corruption."
(We were invited to submit a letter to the editor of this pension magazine, advising their foreign audience as to the condition of America’s pensions.)
While the United States is generally regarded as being at the forefront of pension management, the overwhelming majority of America’s pensions harbor serious deficiencies. Conflict of interest ridden financial advisers, unethical money managers and brokerage schemes are commonplace, as are irrational and excessive fees. The administrators and sponsors of these funds are generally unaware of these problems, are resistant to being told they exist and are loath to take action.
For example, we recently investigated a financial advisor to approximately 100 smaller governmental pensions that is defrauding the funds it advises. While one or two members of the boards of some of these pensions have requested our review of the investment performances of their funds, none of the full boards of these funds has been willing to accept our conclusion they were defrauded. They are far more willing to accept the assurances of their “trusted” financial advisor that it is above reproach. A presumption of innocence may be appropriate in criminal matters; however, fiduciaries to pensions are required to investigate allegations of wrongdoing and take action to protect the fund.
Even when U.S. pensions determine wrongdoing has occurred, they generally merely terminate the responsible party quietly so as not to draw attention to the matter. A lawsuit seeking to recover damages is generally viewed as a public admission of a mistake.
U.S. pensions have overwhelmingly failed to implement any meaningful changes in response to the revelations of the recent research analyst and mutual fund scandals. Further, despite the publicity regarding Enron’s pension, employer stock continues to represent an alarming portion of the assets of pensions.
As additional scandals related to conflicts of interest at the highest levels of major pensions emerge in the coming months, U.S. pensions will face growing pressure to respond. Unfortunately most pensions have no idea what an appropriate response might be. Many funds continue to venture ever further into unregulated assets classes, such as private equity and hedge funds, even as the regulated world unravels.
The U.S. pension community recently took note when information surfaced regarding the pension of the Marsh & McLennan Companies. There the consultant, investment manager and mutual fund provider were all affiliates of the employer and there was a vast amount of company stock in the plan. The Marsh pension, created by a company that advises many of the leading U.S. pensions regarding pension and investment matters, is fairly representative of the condition of pension funds in the United States. Apparently the structure of the plan did not raise a red flag with any adviser or regulator.
Central to the U.S. pension problem is the fact that the U.S. Securities and Exchange Commission, charged with protection of investors in the securities markets, has seldom provided advice specifically for protection of participants in pensions and the U.S. Department of Labor lacks sufficient understanding of the securities and asset management industries to provide guidance to sponsors of and participants in pensions. While the SEC generally opines that disclosure of material facts to investors is sufficient, fiduciary duties require far more when dealing on behalf of pensions.
As the scandals continue and deepen, pensions globally should note that new fiduciary standards are emerging. In response to these emerging higher standards, pensions must question many of their basic assumptions and implement changes.
(The following speech was written for the Guns & Hoses Conference in San Diego, California in October. However, since Diann Shippione, the whistleblower trustee from the San Diego Retirement System graciously accepted an invitation to join us at the podium for an impromptu discussion of her tumultuous experience with the San Diego fund, it was not delivered at that time.)
Recently I met with the founder of a class action law firm and I told him, “Think of a pension fund as a large pyramid. Well, your entire business has been focused on one brickalbeit a very profitable brick. Your focus is on the stocks or bonds the pension invests in.” But there’s a lot more to understanding the problems confronting pensions than just reviewing their investment portfolios. For one thing, there’s the question of how these investments came to be in the portfolio in the first place. And the answer to that question is not simple or short.
Keeping that pyramid image in mind, at the top of the pyramid sits a person or firm known as the pension consultant. His job is to oversee the investment operations of the fund. He recommends an asset allocation, then reviews and recommends money managers within each asset class, monitors and reports performance, and recommends brokerage policies. He generally advises the fund on any matter related to the investment program.
He is the puppet-master, the gatekeeper that anyone who wants to do business with the fund must pass. As the gatekeeper, he is in the position to exact a toll from anyone who seeks to pass. But more on that later. His job is to provide objective, independent advice that is in the best interests of his client. We have found that pensions have virtually unshakable confidence in their investment consultants. He is the one vendor whose role is to vet the others. So clients come to think of their consultants almost like regulators-objective truthful voices exposing profit hungry, deceitful money managers and bottom-feeding brokers.
In some of our cases pension boards have been contacted by the SEC, FBI and law enforcement about their consultant and the boards turn to their consultant to tell them whether they should be concerned.
Consultants are very skilled at nurturing this heavy reliance and work diligently to deepen it. Consulting is a handholding, relationship business. Its labor intensive, demanding that consultants take calls from all board members and staff, attend monthly meetings, host events at industry conferences and more. The more dependent the fund is on the consultant, the greater the consultant’s ability to affect the outcome of a decision and that’s extremely valuable. More on that later. Another reason why it is such a relationship business is because there are no standards here-anyone can be a consultant. So you have to work real hard to keep your clients from leaving you. More on that later.
Given the relationship of trust and confidence that exists between pensions and consultants, you would think there would be no question that consultants acknowledge their status as fiduciaries to funds. Ironically consultants still today do everything in their power to deny they’re a fiduciary. Increasingly sophisticated clients are stipulating fiduciary status in their contracts but the issue is still hotly contested.
Again, using the pyramid imagery, the consultant, at the top of the pyramid exerts the greatest influence over the investment results of the pension. But in what I call the “inverse pyramid of regulation,” he is least regulated. Unlike brokers and money managers, there are no registration or licensing requirements for consultants and no educational requirements either. Brokers have to be fingerprinted, licensed, registered, are subject to continuing education; money managers must be licensed and regulated but consultants who advise pensions on which money managers and brokers to hire, are completely unregulated. Anyone can be a pension consultant. I remember in New England there used to be a consultant whose training was as an NFL football player. But he held himself out as a pension expert and had a good deal of success because trustees at public funds loved to have their pictures taken with him and talk football.
Who are these consultants? Mercer; Callan; Watson Wyatt are strictly institutional players and then Merrill Lynch; Smith Barney; UBS and Morgan Stanley all have pension consulting groups within their organizations. Then there are a host of small, regional firms.
Not all funds have consultants but the vast majority do use them. The chief difficulty that the industry has is that no fund wants to pay much for objective consulting advice, regardless of the fact that consultants arguably have the greatest role in determining the investment outcome of the pension. (On a related point, a major problem we have in the investment industry is that no one wants to pay for independent, objective advice-even though everyone claims to want it.) So consultants price the disclosed, expressly stated fee for their service really low-perhaps $75,000 annually for a $1 billion fund. If you assume a fund this size pays 30 basis points on average for investment advisory services, you can see than the consultant gets paid very little compared to the $3 million or so the managers he recommends collectively get paid. One could argue that since the consultant is not managing or making money for the fund, he shouldn’t get paid like a money manager. But, on the other hand, it is also true that the greatest determinant of the investment outcome really is the asset allocation, not any one manager’s investment performance.
The origins of the consulting business are in the brokerage industry. Retail brokers migrated to larger pension accounts and brought with them their compensation preferences. In other words, they were accustomed to being paid in brokerage commissions. So pension consultants realized they could offer to advise pensions for low or no fee if they could hustle brokerage and other compensation on the side. In other words, if they looked to the managers they were suppose to objectively review for the bulk of their compensation, it didn’t really matter how much or little the pension client was willing to pay for this supposedly objective advice, Unfortunately the result of this compensation paradigm was that the advice the consultant proffered ceased to be objective or in the best interest of the pension. Rather consultants recommended money managers who were willing to pay them the most for the account. This is referred to as pension consultant “pay-to-play” and it’s very similar to the pay-to-play schemes involving politicians.
How much money do consultants make from the money managers they are objectively reviewing? Recently we found a consultant who was earning approximately $4 million annually from the money managers he recommended to a pension that thought it was paying the consultant $300,000 annually for objective advice. Since the consultant was making more than 10 times from money managers what the pension was paying him, you can see how consultants can offer to provide their services for very low fees or even for free. That’s bad enough but the $4 million in annual kick-backs figure doesn’t come close to the damages suffered by the fund from the tainted advice or from having been advised to hire managers that were not the necessarily the best. Underperformance added another $100 million to the damages.
The impact of these undisclosed financial arrangements nationally is staggering. Since the investment products that have the highest associated fees offer the greatest financial incentives to intermediaries that recommend the product, the composition of the portfolios of the nation’s pensions can to a large degree be explained by surreptitious payments to these gatekeepers. Why is indexing or passive management so seldom a significant component of a pension’s investment program? Because the fees related to the product are so low that’s there’s no money to share with the gatekeeper. Why are hedge and venture capital funds having such success infiltrating the pension marketplace? Because they can afford to pay the gatekeeper a hefty fee for recommending the product. Why are actively managed equities 60-80% of many funds’ portfolios? Because actively managed equity fees are higher than actively managed fixed income.
Other examples: A Chicago foundation loses a couple hundred million as a result of investing in a hedge fund that paid the foundation’s consultant a portion of the hedge fund manager’s fee. A Tennessee and Louisiana pension invest in venture capital funds in which the pensions’ consultants personally invested prior to recommending the products to the funds.
In conclusion, more often than you would imagine the cause of pension underperformance is attributable to corrupt advice. Generally, pensions attribute the losses to bad choices rather than closely examine how they came to be. Parties privy to corrupt schemes such as consultants, money managers, or custodians are unlikely to come forward. So unless pensions themselves take the initiative to scrutinize the advice they receive from vendors for conflicts of interest and self-dealing, these secret financial arrangements will continue to undermine the returns of the nation’s pensions.
Setting Standards For The Investment Management Industry
