In 2003 Time’s Running Out For America’s Pensions; The 6-Step Pension Fund Clean-up
Time may be running out for the nation’s pensions. While many of the investment scams perpetrated in the late 1990s have come to light and pension losses related to the Bubble’s bursting have been realized, most pensions have failed to take action to clean up the messes in their portfolios. Funds cannot afford to ponder leisurely about what to do next. There are statutes of limitation that apply to cases pensions might bring against those responsible for certain losses. In many states, the applicable statute of limitation is a mere three years. And this year, 2003, may mark the end of the period pensions have to mull over their alternatives for dealing with abuses related to the period of “irrational exuberance.”
What do you call a pension trustee who waits too long to respond to known problems? How about, “negligent?” The indecision pensions frequently display in dealing with difficult problems, as well as their reluctance to openly admit errors, results in a failure to recover many losses. This is bad for participants in pensions, to whom the money belongs, but it’s also bad for the country. Unscrupulous firms are permitted to continue inflicting harm. Today the best means of stopping a bad operator may be seeking civil damages. One thing is certain: we cannot count on regulators to take timely, effective action. The response of regulators to the recent market manipulations has been bizarre. While some regulatory response eventually emerged, it was too little, too late and came from an unlikely source: the New York Attorney General. The federal regulator, the SEC, delegated all responsibility to the brokerage industry’s self-regulator and the self-regulator, the NASD, proved yet again that the conflict of interest inherent in self-regulation is fatal.
But our intention is not simply to call upon pensions to file lawsuits. Now is also the time for funds to examine what they have been doing over the past ten years or so and address any weaknesses. Based upon the problems that have surfaced, pensions can anticipate where future problems may lie. Further, in light of lower investment returns predicted for the future, funds should seek to reduce their costs going forward.
Here’s our list of 6 steps every pension should undertake immediately:
1. Review Investment Advisory Fees: Pensions should examine investment management fees paid and reduce fees to, at least, industry averages. As we noted in a previous article, Why Pension Investment Advisory Fees Are So High, January 2003, an investigation we conducted recently revealed that some funds were paying as much as four times what others were for identical investment management services. We even discovered some funds were paying twice as much as others for the same service from the same manager! There is no justification for these huge fee differentials and pensions should scrutinize the fees their consultants have negotiated on their behalf. Today some managers are offering to lower their fees, in light of poor performance, in order to retain accounts. Further, some pensions are demanding managers return excessive fees paid in the past. We have entered a new era when careful examination of fees will become routine-- unlike in the past when performance was all that mattered. Funds that fail to re-evaluate investment advisory fees are simply wasting plan assets. Remember managers that use client brokerage commissions to purchase research on a “soft dollar” basis, are arguably charging more than managers with identical investment advisory fees that do not “soft dollar.” “Soft-dollaring” is a hidden investment management fee that should be considered when comparing fees between managers.
2. Review Trading Costs: Pensions should examine trading practices and costs, including use of soft dollars by managers. Institutional investors still have a long way to go in reducing the brokerage commissions they pay, as well as understanding the allocation of brokerage by their external money managers. Pensions need to ask: who are we paying commissions to, how much are we paying and why? Brokerage commissions are a huge expense for most funds. If you don’t understand the brokerage business and rely upon your consultant or money managers for guidance on brokerage matters, you’re only getting half the story. The most common practice is for funds to leave all or most of brokerage decisions to their managers. That’s foolish and costly. Consider commission recapture, directed brokerage programs or simply limiting the commission levels you are willing to pay.
3. Examine Pension Consultant Conduct: Pensions should review their relationships with investment consultants, in light of the conflicts of interest that have been identified in connection with the State of Hawaii employee pension fund and the City of Nashville fund. We know a lot more today about quantifying the harm consultants inflict as a result of their divergent business interests. Yet most funds have not demanded adequate disclosure from their consultants. Consultant conflicts may be responsible for over-allocations into equities since consultants may derive substantial brokerage income from equity managers they recommend. That is, “pay to play” may influence the asset allocation recommendations of pension consultants. Funds should review their asset allocations, not only in light of current market realities, but also for purposes of determining whether consultant conflicts may corrupt the integrity of the process whereby asset allocation is determined.
4. Examine Actuary Conduct: Pensions should review with their actuaries, their assumptions and liability calculations. Is the actuary seeking to limit liability for his work? Having an actuary that is willing to stand squarely behind his work is critical. Funds cannot afford to limit the accountability of those involved in projecting long-term financial results.
5. Examine Money Manager Conduct: Pensions should examine the conduct and performance of their managers. Serious issues may exist regarding the activities of external money managers that go beyond a simple performance calculation. For example, are managers providing accurate and timely reports? Are managers complying with all applicable investment guidelines? Have managers been straightforward in responding to requests for specific information? When performance is good, funds are reluctant to terminate a manager that has been problematic in other areas such as client servicing. Pensions should also look for the causes of poor performance and seek to understand managers’ investment processes. For example, are managers really engaging in investment research of their own, or do they merely rely upon Wall Street’s tainted research? If managers do their own research, how is it they invested in the same bad deals the investment banks were recommending? Funds should keep probing managers for answers to “what went wrong” before they are satisfied retaining managers going forward. During difficult market conditions clients can learn the most about their managers because weaknesses are exposed. With respect to “alternative” investment managers, how much do pensions really understand the activities of their venture capital and hedge fund managers? Forget about impressive performance in the past. That was then; this is a new market environment. In the absence of regulation and transparency, pensions should think long and hard about their alternative investments before retaining or allocating even greater amounts to these managers. Many of these investments cannot be exited easily or expeditiously. (Next month we will release a special report on alternative investment issues.)
6. Examine Portfolio Company Conduct: Finally, pensions should examine their portfolio holdings to determine whether any of the companies in which they are invested have engaged in actionable conduct resulting in losses to the fund. While pensions have been reluctant to participate in lawsuits against corporations in the past, such participation is routine today. Funds that fail to seek recovery of pension assets where possible, may breach their fiduciary duty to participants.
In summary, in our experience we have found that a comprehensive clean-up effort may result in significant recoveries and savings to funds going forward. Amounts exceeding 10% of a fund’s assets may be at stake. Today managing pensions no longer consists of merely hiring managers and monitoring performance. Effective management may require rolling up sleeves and solving complex problems. Poor investment decisions are easy to make but far more difficult to resolve. However, the unacceptable alternative is to simply walk away leaving money on the table. Funds that wait too long to take action may wake up to discover it’s too late.
Setting Standards For The Investment Management Industry
