Harrison Fiduciary

Simple & Risk Free?  Hardly.

Plan participants have flocked to Stable Value programs to the tune of $700+ billion. As the name implies,  and most investors believe, these programs are touted as safe investment options for plan participants.  Maybe yes, maybe no.

Offering investment yields greater than money market funds, without the volatility of bond funds, Stable Value programs are hybrid investment and insurance products.  An investment manager manages the underlying cash portfolio, and an insurance company or bank then guarantees (or wraps) the book value of the program.  In essence, the value of the fund is not suppose to go below $1/share.

Hybrid products, however,  offer complexity, and complexity presents risks.

In the current low interest rate environment, unique risks confront plan fiduciaries.

To date, stable value plans have generated a higher investment return than money market funds because they can invest in securities with longer durations, paying higher interest rates.  When interest rates turn higher, however, this benefit becomes a drag.  Money market funds are more nimble and can take advantage of the higher rates in a rising rate environment.

Since most Stable Value funds are “marketed” as higher return investment options, plan participants will be very surprised to learn that their Stable Value options may be paying returns less than money market funds.  Employees must be educated on the true risks and mechanics of Stable Value Funds.  Failure to educate employees properly can bring sizable fiduciary risks on the plan sponsor.

With interest rates so low, Fiduciaries must not only monitor an upturn in rates, but they must also track withdrawals from Stable Value programs.   If interest rates do not increase, participants undoubtedly will begin switching into investment options generating higher returns.  Whether this makes investment sense is irrelevant.

The wrap contracts (which guarantee the value of the stable value program) often contain covenants that require the Program to maintain a minimum number of participants or assets in the Program.  Falling below this threshold constitutes a breach of the wrap agreement, and would allow an insurance company to walk away from the guarantee.   This is a total disaster from the perspective of the plan fiduciaries.

The very name “Stable Value” lulls everyone — participants and fiduciaries, alike – into a false sense of security.   These are highly technical and complicated investment options that should be monitored, evaluated and negotiated by Stable Value experts.

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Credit-Related Strategies Warrant Heightened Scrutiny

It’s called the Great Liquidation.  As reported in today’s NYT, The Haggling for Troubled Assets Begins, “hundreds of billions of dollars of bad investments …are going up for sale”.  Fiduciaries must ensure that these bad investments do not end up in retirement plans.

Notwithstanding TARP, QE1 and QE2, financial institutions still hold impaired or “bad” assets.  This simply means that the assets are still held by institutions at values that are likely far in excess of their fair market value.

And so, the Great Liquidation begins.  The term — coined by Fortress Investment Group — refers to the prediction that “you’re going to see in the next five years, more financial asset liquidations than you’ve seen in the sum total of the past 100 hundred years.”  An exaggeration?  Ok, let’s assume it’s simply more than in the pat 50 years – that’s still a lot of assets being put up for sale.

If this appears daunting, don’t worry.   Fortress already has $12.7 billion of assets devoted to credit-related private equity and hedge funds.  No doubt the entire spectrum of the Wall Street herd — investment banks, commercial banks, hedge funds and private equity firms — will be bulking up in this area, if they haven’t already.

Just imagine a 2% management fee and 20% of profits on “hundreds of billions of dollars”.  Now that’s a nice bonus pool!

Before the Great Liquidation Orgy (my term) begins, however, Wall Street is going to need to raise money to indulge in this financial bacchanalia.  Certainly there will be private investors, wealthy individuals, sovereign wealth funds.  But the $16 trillion pool of pension assets is the granddaddy of all funding sources.

I can just see the entire pension investment consulting industry working itself into a frenzy cranking out their graphic laden presentations recommending Credit Related investment strategies and firms.  The graphs and the statistics, no doubt will be very impressive – worthy of PhDs.  But Beware.  “Its déjà vu all over again”.

Think back to the early 90’s.   Who had heard of hedge funds?   Private equity firms were still referred to as LBO firms.  In terms of financial markets and products it was a different era.  As the new century dawned, however, investment strategies and products exploded in complexity.  Simultaneously, in order to remain relevant, the pension consultants began touting these new products.

In time, consultants were recommending significant shifts in allocations to “Alternative Investment Classes”.  It was not surprising to see allocation recommendations of 8%, 10%, 15% or more to alternative asset classes.  In fact, in the summer of 2008, I had lunch with the Chief Investment Officer of a university endowment who said that they had allocated 45% of the endowment to hedge funds.

We all know the outcome of this story.  In the end, the investment returns of many plans were negatively affected by these allocations.  No one knows yet, if in the long run the plans were better off or worse for these significant allocations to Alternative Asset Classes.

We do know one thing, however.   Consultants merely make recommendations.  Plan fiduciaries hold the real power in making allocations to asset classes and to specific managers.

Without a doubt fortunes will be made in the course of the Great Liquidation.  The question is whether retirement plans need to venture into this arena.  Fiduciaries must invest assets prudently.   When a new asset class emerges, such as credit-related investments, how is a manager evaluated?  What’s the track record?  How is risk measured?  How are projected returns evaluated against the risks that are assumed?  What about due diligence on investments?

The list goes on and on.

The Media is going to feature the newly minted credit-related billionaires.  Investment returns may likely be huge.  The allure of jumping into these investments will be strong.  The consultants will be putting on a hard press.

Plan fiduciaries must be very wary.  For those who do decide to play in this game, make sure you do your homework.  Remember, you are investing other people’s hard earned retirement dollars.  Keep the financial debacle of 2007-2009 at the forefront of your mind.  And, tread carefully.

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Not In-House Lawyers

Any lawyer who has worked in-house in a financial services firm, no doubt, is not surprised about the mortgage documentation mess.  Articles abound in the newspapers:  Gretchen Morgenson, One Mess That Can’t be Papered Over; Joe Nocera, Big Problems for Banks: Due Process; and a NYTimes editorial, More on the Mortgage Mess.

As I have experienced, and many, many friends and colleagues have confirmed, few issues command less respect than properly documenting a transaction, a process or a meeting.  Everyone on Wall Street, and throughout the financial services industry views themselves as a deal-maker, a trader, a big-picture gal or guy.  Documentation is clearly beneath them.  (Yes, this condition crosses gender lines).

I will never forget in the early 90’s when equity swaps and other over –the –counter trades were gaining in popularity.  We were wrestling with the documentation process … executing confirms as well as master agreements.  Admittedly, it is a tedious process.

The Wall Street model had junior associates who worked directly on the trading desks who were responsible for completing first drafts of trading documents.  Deals were only kicked up to the legal department in the event that negotiations broke down over issues like indemnification or other liability limiting provisions.

Not so in our organization.  Notwithstanding my otherwise well-honed skills of persuasion, no one on the trading desk wanted anything to do with documentation.  Any piece of paper with more than 2 paragraphs of written English clearly was a “legal document” and belonged with “Legal”.

I tried to explain that understanding the legal documentation between two parties provided a junior person with valuable training.  Certainly someone who aspired to be an equity or fixed income trader would gain insight into their roles if they understood the contractual nature of the obligations they were creating.

I might as well have been from Mars.   Everyone just wanted to “do deals”.  Very few people were interested in “dotting the ‘I’s’ or crossing the ‘T’s’”.  In the excitement of wracking up large bonuses over the last decade, few people wanted to be bogged down by the careful, detail-oriented work of getting the documentation right.

And throughout Wall Street and beyond, the very people who were disdainful  of documentation, eventually assumed leadership of their firms.  Everyone knows, that the tone is set at the top.

Tens of thousands of mortgages, middlemen, issuers of securities, underwriters and sales people —the fact that there is a mess, does not surprise me.

Go take a poll of in-house lawyers.  I’m sure they read the various accounts of the mortgage mess simply shaking their heads with a profound sense of understanding.

As a lawyer, and as a fiduciary, I know in my gut (in my kishkes) that documentation is crucial.  For when the dust settles, all that is left are the documents.  Lawyers know that, and so do judges.

Fiduciaries have an obligation to act prudently on behalf of their clients.  There is no excuse and no tolerance for the lack of diligence in assuring that all documentation is perfect.  That is our duty.

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