“A rising tide may lift all ships but a falling tide may send them crashing onto the rocks below”
The surest sign trouble lies ahead for pensions is the recent effort by some of the largest actuarial and pension consulting firms, including Milliman, Towers Perrin and Watson Wyatt, to coerce their pension clients to agree to limitation of liability (LOL) provisions in their contracts. Actuaries and investment consultants exert tremendous influence over the investment performance of pensions since they advise funds regarding projected liabilities and design investment programs intended to address these obligations. Errors by these firms can be disastrous to pensions. What do these professionals know that has them running scared? Why are they so worried now?
Recently the actuarial industry has been subject to several lawsuits by pensions that claimed damages in the billions due to the negligent work of their actuaries. Perhaps due to the huge damages involved, these lawsuits have received a lot of publicity. For example, Watson Wyatt was ordered to pay more than $40 million in damages to the Connecticut Carpenters Pension Fund, a fund with only $170 million in assets. Towers Perrin is being sued by the Los Angeles County Employees Retirement Association (LACERA), a fund with over $20 billion in assets, for $2 billion in damages. This latter case is scheduled to go to trial in April, 2003 and will certainly be followed closely. Apparently the actuarial and consulting industry believes there are more suits coming their way. Is there any reason to believe they’re right?
As investment returns have dwindled, many funds are justifiably looking for someone to blame. A rising tide may lift all ships but a falling tide may send them crashing onto the rocks below. The falling market has exposed many weaknesses that have been there all along, unseen and unfelt. In the past lawsuits against actuaries and investment consultants have been rare. In the future, errors and malfeasance will be exposed through audits and investigations into the causes of the unexpectedly poor investment returns of many of the nation’s pensions. Public pension funds seeking additional taxpayer monies will be especially scrutinized. We are clearly entering into a new era where pensions will have to act a lot smarter in the future than they have in the past. And pensions will also have to deal with mistakes from the past, as these mistakes become apparent in the not-too-distant future. It’s a time to tighten your seatbelts and that’s exactly what these actuarial and consulting firms are trying to do.
Actuarial and investment consulting firms claim the lawsuits referred to above are jeopardizing their ability to obtain malpractice insurance. Whether or not this is true is debatable. Some industry insiders claim the supposed unavailability of insurance is a red herring. These insiders warn the largest firms are acting in concert to force limitations of liability on the industry in a manner that could raise anti-trust concerns.
Even if these firms are having difficulty finding malpractice coverage, should clients be sympathetic? Medical doctors have long had difficulty finding malpractice coverage yet patients have not limited their liability. Patients have not because medical care is too critical to risk any reduction in the quality of care a limitation of liability might foster.
Large national or international actuarial firms argue that when plan sponsors hire smaller actuarial and investment consulting firms, they are effectively agreeing to a limitation of liability because a significant error by a smaller, thinly capitalized firm would result in its demise. Therefore, they submit, it is reasonable for a deep-pocketed firm to seek to limit its liability to some reasonable level. If all the deep-pocketed firms agree on this strategy of insisting on limitations, pensions could be forced to choose between smaller, less capitalized firms with no limitations and larger, well-capitalized firms with limitations. Which would you rather have: A rich doctor who, prior to an operation, asks you to agree to a limitation of liability? Or a less wealthy doctor who puts his entire net worth on the line whenever he operates? We’d prefer the latter. There’s something very unsettling about a professional who, prior to performing a critical service, asks you agree to limit his exposure in the event he makes a mistake. Sounds like he’s anticipating his own incompetence.
Here’s a limitation of liability provision Watson Wyatt recently tried to foist on a pension:
If any of the Investment Consultant’s services do not conform to the requirements of this Agreement, the Board shall notify the Investment Consultant promptly, and Investment Consultant shall perform such services at no additional charge or, at the Investment Consultant’s option, shall refund the portion of the fees paid with respect to such services. If performance of the services or refund of the applicable fees would not provide an adequate remedy for damages arising from the performance, nonperformance, or breach of these general terms and any applicable engagement letter, the Investment Consultant’s maximum total liability, including that of any employee, affiliate, agent or contractor, relating to its services, regardless of the cause of action, will be limited to direct damages in an amount not to exceed two hundred fifty thousand dollars ($250,000) or, if greater, the fees payable with respect to the particular engagement (or one year’s fees in the case of annually recurring services) pursuant to which such liability arises. The foregoing limitation of liability shall not apply to the extent that any liability arises from the gross negligence or willful misconduct of the Investment Consultant, its employees, affiliates, agents or contractors or from bodily injury, death of any person, or damage to any real or tangible personal property. Neither party shall be liable for any indirect, special or consequential damages.”
The reality is that actuarial and consulting firms are privately agreeing with important clients to limitations of liability far greater than the amount of their annual fees. Clients have successfully negotiated higher limits in the tens of millions. While funds, such as LACERA in its current contract with Milliman, apparently are agreeing to limitations of liability, the limitation amounts are well in excess of the annual actuarial fee. The legal counsel of one large fund remarked, “Limiting damages to the annual fee amount is absurd. The fee bears no relationship to the damage a sloppy actuary can cause.” Another approach pensions are employing is to have the limitation amount be a minimum of, say $10 million, “or the maximum available insurance coverage, whichever is greater,”
What does the Department of Labor have to say about the issue? The agency is leaving it up to the “business judgement” of trustees, as long as the limitation does not include “gross negligence or willful misconduct.” So much for the guardians of the nation’s ERISA plans.
No fiduciary should ever agree to a limitation of liability (LOL). The fiduciary’s response to such a proposal should be to laugh out loud (LOL). The very role of a fiduciary to a pension fund is to ensure those providing services to the plan are held accountable. Limitations serve to reduce accountability. Mistakes by these financial professionals result in disastrous consequences to plans that bear no relation to the amount they are paid. Ask yourself: What trustee would want to be in the position of having agreed to a limitation of liability once a major financial loss attributable to the consultant has been discovered? Pensions and trustees have nothing to gain and everything to lose by agreeing to these provisions.
Investment consulting firms, including investment consulting affiliates of actuarial firms, seeking such limitations is a particularly disturbing development. First, investment consulting firms are virtually never sued by pensions—even when they should be. Second, as we have described in numerous articles, the financial benefits these firms derive from their status as gatekeepers to funds are well in excess of annual fees paid by funds. Therefore limiting damages to the amount of the annual fee paid directly by the fund is a real win-win for the consultant. He can never be liable for more than a small percentage of the compensation he derives from the fund. If the consultant earns $4 million in brokerage and conference fees from a fund’s managers, why should his liability be limited to the $100,000 fee he gets paid? Preposterous. We believe the investment consulting industry may try to take advantage of this movement for limitations of liability if the actuarial firms with investment consulting operations are successful.
One final note about the case of Milliman vs. Kalwarski that has been reported on by many of the pension periodicals. The case involves the former head of Milliman’s Washington, DC office who resigned and started another firm because his clients were leaving Milliman over this limitation of liability issue. When individuals take on large corporations involved in providing services to the pension community, where important public policy issues are involved, the pension community should rally behind their cause. Pensions, particularly public pensions, are forever claiming to be concerned with issues of national significance, such as conflicts of interest in Wall Street investment research and corporate wrongdoing. But these funds are seldom willing to actually take a stand against powerful business interests. The guardians of the nation’s pensions should speak up against those who would expose participants to risks they would never willingly assume on their own.
Happy Holidays to you all.
Setting Standards For The Investment Management Industry
