Public Pension Shortfalls and Consultant Conflicts
September 1, 2002
Public Pension Shortfalls and Consultant Conflicts: What's the Connection?
Chicago Teachers Adopts Consultant Disclosure Policy
We are pleased to report that after several years of persistent effort by trustee Jack Silver, the Public School Teachers' Pension and Retirement Fund of Chicago has finally approved a policy requiring existing and prospective money managers of the fund to disclose annually brokerage, conference fees and other forms of compensation paid to the fund's investment consultant. As you may recall, a year ago the consultant refused to provide such conflict of interest information to Silver, citing a duty of confidentiality it owed to its money manager clients (which apparently superseded its fiduciary obligation to the fund). At that time the fund's board failed to support Silver's demand for consultant disclosure. While the new policy approved by the fund is misguided in that it fails to recognize a consultant's fiduciary duty to disclose any conflicts of interest related to the supposedly objective advice it provides to the fund, disclosure by the managers is better than no disclosure at all. We should note two facts that may help explain this change in the attitude of the board of the Chicago fund. First, the President of the fund who had long opposed consultant disclosure was on the verge of retirement. Second, Fortune magazine had just completed a story entitled "The Seamy Side of Pensions", which detailed Silver's long struggle. The Fortune article also described the investigation this firm conducted regarding the investment consultant of another client, the Metropolitan Employee Benefit Board of Nashville and Davidson County.
Finally, we note that in connection with a recent international equity search undertaken by the Chicago Teachers' fund, 3 out of the 4 managers recommended by the consultant indicated that they had paid tens of thousands of dollars to attend the consultant's annual client conferences. At least one manager also disclosed it had paid tens of thousands of dollars to an affiliate of the consultant for advice regarding marketing to pensions. This is the first glimpse the board has had into the economics of the consulting business, the divergent lines of business consultants pursue and the related conflicts of interest.
Mounting Suspicions
We have often warned pensions that their consultants make substantially more money from investment managers interested in buying access to pension clients of the consultant than from advising pensions. Unfortunately this is a message some pensions simply don't want to hear. The Chicago Teachers' board is well on its way to understanding the total financial benefits consultants derive from relationships of trust and confidence with funds. Every board should conduct an inquiry into the financial dealings of its consultant that could jeopardize the integrity of the fund.
Pensions are beginning to ask questions regarding "pay-to-play." We're hearing from funds literally around the world that have growing suspicions. More investigations will soon be underway.
Greater Risks To Public Funds
Public funds are most vulnerable and represent a huge risk to the country and their participants for four reasons.
First, massive amounts of money are managed in public pensions and these funds have massive benefit obligations to their participants. If these funds are unable to meet their obligations to their participants, it is the taxpayers that will have to come up with the difference.
Second, these funds are not subject to comprehensive federal regulation such as ERISA. Rather, they are governed by state or local statutes that differ dramatically and many of which offer little guidance.
Third and perhaps most important, public funds are susceptible to political pressures that may lead them to make disastrous decisions, as well as resist openly admitting mistakes they have made. Failure to admit mistakes often compounds the losses to funds. The individuals responsible for regrettable decisions may save face but the participants or taxpayers will pay the price.
Fourth, these funds have lay boards of trustees lacking training in investment matters. Wall Streeters like nothing better than the opportunity to educate uninformed institutional investors as to the merits of whatever product they are selling.
One final note: public funds are more likely to retain investment consultants than corporate pensions and consultants generally play a more influential role in connection with their unsophisticated public fund clients.
Consultant Conflicts May Explain Public Pension Shortfalls
Conflicts of interest in investment consulting result in massive, substantial harm. It is not easy for boards, especially public pension boards, to understand the harm funds are exposed to when the advice their consultants provide is corrupted by self-interest. Since consultants recommend asset allocations and money managers (and frequently push specific managers), consultants have tremendous influence regarding overall fund performance. The bear market is forcing many funds to ask, "What went wrong?" The answer to this question for many funds may be found in examining the actions of their consultants.
"Public Pension Plans Come up Short" read a recent Wall Street Journal headline. According to a study by a consulting/brokerage/money management firm, more than half of public pensions are underfunded, up from 31% two years ago. The author of the study concludes, "a year from now things are going to look worse." Apparently poor asset allocation decisions and too high a proportion of equities is the reason for the growing shortfall. Hmm… Who recommends asset allocations and equity manager selections? What is the relationship between underfunding and consultant self-dealings?
As we have explained in previous Alerts and have shown in the investigations undertaken on behalf of clients, consultants have the most to gain when they recommend active managers, specifically active equity managers with substantial portfolio turnover. These managers charge the highest fees (thus have lots of money to attend consultant conferences and contract for consultant marketing advice) and have lots of brokerage dollars to kick-back to consultants. Could it be that the financial incentives received by consultants-- the brokerage, conference fees and other consulting fees paid by money managers-may have contributed to or even caused the unfortunate performance of many public funds? Could public fund over-allocations to equities be attributable to consultant conflicts? We think so. If we are right, then the true cost of pension consultant corruption is enormous and cleaning up the consulting business should be of paramount importance to the country.
Follow-Up on Compelling Consultant Disclosure
In response to the request we put out to our thousands of readers for the audited financials for any pension consultant's brokerage firm, we received nothing. Even the consultants-of-consultants we spoke with indicated that while they have asked, they have never seen the audited financials of the firms they review. The consultants simply refuse any requests for such documents. The best kept secret in the pension world remains untold. When will funds begin to demand answers?
Setting Standards For The Investment Management Industry
