The Duty To Investigate Pension Consultant Conflicts and Compensation
A trustee of a large pension fund submits a memorandum to the board of the fund of which he is a member. The memorandum addresses conflicts of interest of the fund's pension consultant and includes motions to require the consultant to disclose facts surrounding the conflicts identified. Specifically, the trustee makes the following motions:
1. Any recommendation by the consultant must be disclosed to the board prior to the meeting, in order to be considered at the meeting. This, of course, is a matter of basic corporate governance. A trustee does not have sufficient time to carefully consider a matter first presented to him at a board meeting. And there is no reason why he should. It is simple enough for the consultant to include its recommendations in writing, in the materials provided to the board in anticipation of the meeting.
2. The consultant must provide the board with financial information regarding annual brokerage revenues, conference fees and sponsorships, and other monies received from money managers versus consulting revenues received from pension funds. This is not an unreasonable request for a trustee to make; such information should not be considered confidential by the consultant. The board needs to evaluate the financial realities behind the consultant's conflicting lines of business. Without disclosure of the relative revenues, an evaluation is impossible.
3. The consultant disclose all brokerage and other compensation, including conference fees, consulting fees and sponsorships, received by the consultant from the fund's managers. The request for disclosure was comprehensive and included all compensation received from the fund's managers "whether in connection with managing the fund's account or not."
4. The consultant disclose any compensation received by the consultant from any manager it recommends hiring. That is, while item 2 addresses all managers and item 3 addresses existing managers of the fund, item 4 is directed at prospective managers.
5. The consultant disclose promptly any personnel turnover.
6. The consultant disclose any affiliated money management firm.
Would you be surprised to learn the fund's board voted to delay any action on the motions and may ultimately reject the trustee's call for additional disclosure? Well, that's exactly what may happen.
Why would a pension board not want to know about conflicts of interest of its pension consultant? Clearly it is a pension trustee's duty to investigate conflicts of interest wherever they arise. How could additional information about these conflicts be anything but helpful?
What are we really concerned about when we speak of risks related to consultant conflicts of interest and do these conflicts result in actual harm to pensions? Generally speaking, the potential for pecuniary reward to a consultant exists in connection with every decision the consultant guides a pension in making. Therefore, in every instance, it is important that pensions be aware of the hidden financial agenda the consultant may be pursuing.
We are not concerned with theoretical ethical dilemmas; our focus should be on who's making exactly how much money and how. For example, pension consultants receive millions a year from hosting conferences where they sell access to their pension fund clients. It's really the same game conference coordinators play: Invite pension funds to your conference for free or a small fee and charge managers, brokers, actuaries, and custodians a hefty fee to meet them. Charge managers to get into your performance database. Charge even more if you actually deliver them a pension account to manage. Tell your fund clients they should be involved in a commission recapture program and then recommend they use your affiliated brokerage. Recommend to clients that they pay their consulting fee through the affiliated brokerage.
Consultants can and do cut deals with hedge funds, private equity firms, funds of funds, real estate managers, custodians and anyone else they recommend to their fund clients. And, of course, all of this is in addition to the annual retainer the consultant receives from the fund and any manager search or project fees. An enterprising consulting firm can earn ten times more money from a fund's managers and other service providers than from the fund itself. That is why consulting firms that offer money management products, sell services to managers, host conferences and have affiliated brokerages or arrangements with unaffiliated brokerages, generally compensate their employees far better. There's more money to go around.
When fund decisions are influenced by the financial interests of a consultant, the harm to the fund is far greater than is generally understood. The question is not simply how much money the consultant has received surreptitiously. You must also factor in the damage caused by the tainted advice. This is a point often overlooked.
(For example, several years ago a pension fund discovered that its consultant had outrageously lied about his credentials. He hadn't gone to business school; he hadn't gone to college; he hadn't even graduated from the high school he said he had attended. Not only did the fund fail to seek to recover the fee paid to the consultant, it also failed to consider the damage to the fund's investment performance that might have been caused by the consultant's disreputable advice.)
As remarkable as it seems, pension officials rarely have any idea of how much money their consultants make or how they make it. Over 90% of pension funds are completely in the dark. There is no reason or excuse for this ignorance. As we regularly remind funds, answers to questions such as these can be unearthed. The problem is, as long as funds aren't seriously interested in learning the truth, whether for political reasons or because they don't believe any real harm is being done, the answers will not be forthcoming.
Do pension consultants candidly discuss these issues with their pension clients? Do they believe they have a duty to advise their clients as to the nature and extent of these conflicts? Absolutely not. Their competence and duty to advise seemingly encompasses anything a fund may encounter- asset allocation, manager and fund performance, personnel turnover at managers, real estate, private equity, international and emerging markets, hedge funds, fund of funds, brokerage-everything but consultant-related issues. Some consultants may advise their pension clients that conflicts exist. But without detailed information as to the extent of the conflict, the disclosure is meaningless.
A consultant may disclose it is in the brokerage business and propose to address this conflict by agreeing to not accept trades from the fund's managers in connection with the accounts they manage for the fund. To many trustees that sounds like a fair solution. But if they were to learn the fund's managers were engaged in substantial trading with the consultant's brokerage in connection with other accounts they manage, would these same trustees find that disturbing? What if it were revealed that every manager ever recommended by the consultant and hired by the fund, did brokerage or other business with the consultant? Often the closer you look, the uglier the picture becomes.
Getting back to our story, why would some members of a pension board oppose requesting additional information regarding their consultant? When is disclosure a bad thing? When it would force a decision you don't want to make! When a pension fund conducts a full due diligence review of its consultant's activities, the results are likely to be alarming. Certain trustees and staff may be determined, for personal or political reasons, to keep the consultant in place and oppose such inquiries.
In our opinion, every pension trustee has a duty to investigate how his pension consultant gets paid and how much. Without that information, all advice the consultant provides must be considered suspect. Since the consultant is generally relied upon for advice on all major investment issues, having a consultant who has not been subjected to a rigorous due diligence is a frightening state of affairs.
Finally, what should a trustee do when he senses his board may, for political or other reasons, resist his motion to investigate a conflict of interest he has uncovered? A number of procedural devices are available to him. First, he should request that the minutes of the meeting where the issue is discussed reflect verbatim the reasons for rejection of the motion. If need be, he can demand that the discussion be tape-recorded to preserve an accurate record. If he senses during the discussion that board sentiment is moving against him, he can withdraw the motion before the vote and submit it at a later time. After the meeting, he can write a letter to the executive director of the fund and all board members recounting the discussion for the benefit of any member who may have missed the meeting and the others he was unable to convince during the meeting. It is unfortunate that a trustee should have to resort to procedural strategies to get his board to follow the proper fiduciary course; however, pensions are periodically susceptible to personal and political struggles that cloud fiduciary duties.
If the board continues to resist exercising its due diligence duty with respect to the pension consultant, the trustee can always take the issue to the fund's participants. Pension participants, on the other hand, need to inquire as to whether their pension boards are asking hard questions such as these of pension consultants, money managers and other fund vendors. If trustees are failing to perform from their "watchdog" duties, participants should demand their removal. We all, including mutual fund shareholders, need to start watching the watchdogs and demanding more of them.
Setting Standards For The Investment Management Industry
