Faced with mounting allegations of wrongdoing, lawsuits and regulatory scrutiny, the pension consulting industry is bracing for harder times ahead. Quietly some of the larger firms are retiring or replacing key senior managers who have overseen pay-to-play schemes, spinning off conference organizing and money manager marketing operations and erecting “Chinese Walls.” Since it is virtually certain that full disclosure of sources and amounts of their conflicting revenues will be required either as a result of growing client sophistication or SEC rule in the near future, firms today are implementing strategic changes intended to blunt criticism once the numbers come out. The goal is to reduce the appearance of impropriety.
After years of telling pensions brokerage and sales to managers represent only a small fraction of their businesses, consultants will now argue that while these sources of revenue are significant and even dwarf investment consulting, there is no potential harm to clients since no linkage exists between the substantial sums managers pay them, the managers that are recommended and the performance of funds. Expect to hear “The Chinese Wall is impenetrable” or “The conference business is handled by a totally separate subsidiary” or “The money manager consulting business has been sold to an employee group.”
Don’t believe a word of it. The only Chinese Walls are in China and separate subsidiaries still share a common economic purpose, if not common employees. Look for retention of the economic benefits of ownership in cases where businesses have supposedly been sold. Furthermore, even if representations such as these are true going forward (which we do not believe), then what about all the years these pension advisors have sold money management assignments to the highest bidders? Shouldn’t clients be angry they have been lied to by their trusted advisors and investigate whether there truly has been no resulting harm?
We are confident that when disclosure comes, i.e., full and complete disclosure, the fact that the consulting industry has been lying to pension clients will be apparent to all. We’re not talking about little white lies. Rather these firms have completely misrepresented the services they provide, how they are paid and whose interests they have really been putting first. Pensions should spend some time considering the magnitude and significance of this deceit before they decide to continue relationships with their consultants.
Pension consultants have, regardless of any statements to the contrary, a fiduciary duty to their clients. (It is remarkable to us that many consultants will still seriously debate the issue of fiduciary liability.) They exert tremendous influence over the investment performance of the funds they advise—arguably the greatest of any provider of investment services to pensions. Pensions are entitled to rely upon the advice they receive and have no duty to ferret out self-dealing by their consultants. Pensions believe consultants are working for them as gatekeepers and not for the wolves on the other side of the gate. It should come as no surprise to consultants that their clients believe they are beyond reproach. Pension consultants regularly assure clients that the advice they provide is objective and free of conflicts. Try convincing a pension that its consultant is corrupt and you will get a sense of how strong is the bond between consultants and funds. We have found that even in the face of the most damning of evidence funds will defend their consultants.
As it becomes clear that consulting firms have not been honest about their business dealings funds should take pause. In the future (when full disclosure becomes the rule) it will be far harder for funds to argue that they were unaware of the dangers related to pension consultant conflicts.
In addition to breaches of fiduciary duty by consultants, we believe that certain consultant misrepresentations may actually involve violations of the federal securities laws. It appears that some consultants have misrepresented their affiliations with brokerages in their Form ADV filings with the SEC. Others have misrepresented in marketing materials and other documents their relationships with affiliated money managers. Revenue sharing relationships with managers may also be poorly disclosed. Pensions should take a good hard look at the facts before they let consultants off the hook for past misrepresentations and violations of law.
As reflected in a recent Forbes article entitled “A Bribe By Any Other Name,” many observers outside the industry are becoming aware of the severity of the conflicts related to pension consulting. As was the case with the recent mutual fund scandals where longstanding industry practices were suddenly called into question, it appears that insiders may be more accepting of pension consultant conflicts than outsiders viewing these practices for the first time. To the reporter from Forbes, it was clear that the monies paid to consultants by managers were bribes or payments made with the expectation of receiving business in return. Pension trustees may find themselves in the embarrassing position of being the last to recognize the severity of consultant wrongdoing. We understand the consulting firms mentioned in that article, which are some of the largest, weren’t very happy with the “bribe” characterization by Forbes.
As reported within the past few weeks by Dow Jones, pensions in Chattanooga, Tennessee and Coral Gables, Florida are investigating claims against their consultants and a trustee on the board of the City of San Diego pension has publicly alleged the fund’s consultant may have had brokerage relationships with the fund’s managers. (See article below.) There are other preliminary investigations we have undertaken that have yet to be reported. The heat is definitely being turned up. As we stated recently in an article in the Sunday New York Times, these developments may cause some consulting firms to reconsider the risk-reward equation related to the business. Without kick-backs the pension consulting business isn’t nearly as attractive, yet it’s the kick-backs that may expose consulting firms to billions in liabilities.
Just how hot is it getting for consultants? On April 7, 2004 Ronald D. Peyton, the President and CEO of Callan Associates, sent a letter to Callan clients responding to the Forbes article mentioned above and containing derogatory remarks regarding this firm’s work investigating consultant abuses on behalf of pensions. We were accused of “trying to start a business of investigating consultants.” Even if we were trying to start such a business, we are not persuaded that’s contemptible. Rather, we believe scrutinizing consultants only strengthens the pension community. Firms with integrity should welcome scrutiny of the pension consulting industry.
Well, we don’t have anything nasty to say about Callan. In fact, we don’t know enough about Callan’s operations to opine one way or another. However, we are eager to learn more about this firm that has reacted so defensively to our investigative work. Should the time come when we are asked to advise pensions about Callan, we would like to be as informed as possible.
An article in the May 7, 2004 Wall Street Journal indicates that Morningstar, a company which the Journal characterizes as an “aggressive mutual fund watchdog,” is planning an IPO. The article later describes an exclusive marketing arrangement the firm recently entered into with a large fund group. Some watchdog!
To the best of our knowledge no mutual fund rating firm predicted any of the mutual fund scandals or has ever seriously commented upon the legal or ethical issues related to the management of mutual funds. These firms have catered to the mutual fund industry by issuing ratings specifically intended for use in marketing; the mutual fund companies have paid handsomely to include these ratings in their advertisements. At best these firms have provided investors with a review of the past performance of funds—a review that is meaningless if you accept that “past performance is not indicative of future returns.” Mutual fund investors who have relied upon these ratings have been regularly disappointed.
Mutual fund ratings firms may seek to appeal to potential IPO investors by exaggerating the depth of the services they provide, even as they deny liability to mutual fund investors in fine print in the advertisements of the mutual fund companies that pay for their ratings. While “watchdog” status may be coveted in the current scandal-ridden environment, it is inconsistent over the long term with a business model that relies upon a steady stream of income from the mutual fund industry. Will these firms be permitted to continue to have it both ways? Hopefully the conflicts related to these firms’ operations will attract legal or regulatory attention in the future.
San Diego Pension Trustee Wants Look At Consultant's Role By Arden Dale 5 May 2004
Dow Jones News Service
A Securities and Exchange Commission review of pension fund advisers has prompted a new twist in the controversy over the role of a prominent consultant to the San Diego city retirement fund. Callan Associates Inc., a pension consultant headquartered in San Francisco, has advised the $3.2 billion San Diego City Employees' Retirement System for over a decade. The fund has been under particular pressure lately. A group of retired employees sued it in 2003, concerned that contributions haven't been adequate. Earlier this year, pension worries were partly responsible for a downgrade of the city's credit rating. Diann Shipione, a trustee of the San Diego fund who for years has raised concerns about possible conflicts of interest involving Callan, said recently that the firm tried to obscure its role in an ongoing SEC review of the pension-consulting business.
"It appears this investigation relates to the very issues raised in this system over the past four years," Shipione wrote in a March 21 memo to the pension fund board. "Among them is the 'pay-to-play' practice that involves Callan's recommendation of investment managers (even when they are gross underperformers or inexperienced) possibly because those managers compensate Callan for doing so."
Like many other pension advisers, Callan was asked to supply information about its dealings to the SEC. The agency launched the examination - not an official investigation at this point - last December. But Callan didn't disclose its role in the review to the San Diego fund until February, after the SEC began a separate review of the city's financial disclosure practices, according to Shipione.
Callan spokesperson Deanne Christopulos said in an e-mailed statement that the firm doesn't comment on specific client relationships. However, she said Callan "has provided written correspondence to all of our clients informing them of the status of the current SEC examination." "In addition," Christopulos wrote, "our Callan consultants have addressed specific client questions as they arise."
Many consulting firms have been tapped for the SEC probe, which is industrywide. The agency is studying a broad array of issues, including the use of so-called "soft dollars," Wall Street lingo for above-market brokerage commissions used to pay for services including research and marketing.
Since at least 2002, Shipione has been raising concerns about practices at the San Diego fund, and questioning whether Callan has acted ethically. In a June 7, 2002, letter to board member Richard H. Vortmann requesting a comprehensive audit of the fund, Shipione listed a slew of concerns, ranging from conflict of interest and disclosure policies to risk management, asset allocation and investment strategies. At the time, Shipione said she wanted Callan to address how the issues were being handled. "This issue just seems not to go away," said Shipione in an interview on Wednesday. "The potential conflicts of interest will continue to exist and erode public confidence until they are openly debated and new standards of behavior are established." Shipione, who is vice president of investments at UBS Financial Services, commented for this article strictly in her role as trustee of the San Diego fund.
Another concern she detailed in the 2002 memo involved the relationship between Callan and Alpha Management Inc., a registered broker-dealer affiliate it sold in 1998 to BNY Brokerage Inc., a Bank of New York Co. (BNY) subsidiary formerly known as BNY ESI & Co. According to Shipione, since the 1980s, some money managers for the San Diego fund were told to direct trades through Alpha. The easiest, simplest, and most untraceable way of paying a consultant is through execution costs and commissions, Shipione wrote in her 2002 memo.
Critics of the pension-consulting industry have raised strong concerns about whether brokerage commissions are a powerful source of so-called pay to play abuses. Some have raised questions about whether Callan has continued to profit improperly through Alpha. Bank of New York spokesman Kevin Heine declined to comment, saying that financial terms of the deal weren't disclosed at the time of the bank's acquisition of Alpha. "According to the terms of the transaction, BNY Brokerage Inc. makes periodic fixed payments to Callan each year," Callan's Christopulos said in the e-mailed message. "Callan receives no benefit from any brokerage trade from any broker/dealer." Further, Callan doesn't have a broker-dealer affiliate, nor does it have arrangements "for any brokerage compensation from any broker/dealer," according to Christopulos.
Frederick W. Pierce, board chairman of the San Diego pension fund, dismissed Shipione's complaints about Callan and the fund in general. He said the retirement system, which along with most other pension funds lost money in recent years due to adverse market conditions, has rebounded dramatically this year. A settlement with the retired workers who brought the lawsuit is imminent, he added. "The overwhelming majority of the board does not agree with any of the allegations that Miss Shipione has made," said Pierce.
But Edward Siedle, a former SEC attorney who investigates pension consultants, said that anything contributing to the underperformance of the fund should be carefully examined by the fund, regulators and law enforcement. "Cases such as these involving highly volatile pensions merit the highest degree of scrutiny because of the potential for a disastrous outcome," said Siedle, owner of Benchmark Financial Services, an Ocean Ridge, Fla., company.
Setting Standards For The Investment Management Industry
