Never Underestimate the Power of Negotiation

Banks and asset managers sell products and services.  While they might wrap themselves in impressive jargon, complicated charts and graphs, and high-powered brand names, they still just sell stuff.  Like any salesman, they hate losing a sale.

In How Banks Could Return the Favor, Gretchen Morgenson reports that many municipal bonds could be re-financed at much lower interest rates, and therefore lower costs to taxpayers, except for derivatives contracts buried in the bond offering.

Terminating the derivatives would give rise to significant termination fees.  Public administrators are loathe to incur these fees.

Surprisingly …. almost shockingly … Morgenson also explains that many public fund administrators are hesitant to negotiate fee reductions with the banks.  In essence, it appears that the administrators are intimated by the Banks.

However, imagine if you will, the reverse.  Imagine that Bank A was on the bad end of a deal with Bank B.   Do you think that Bank A would simply paying higher costs ad infinitum?   Of course not.

Instead, Bank A would bring every bit of leverage into play in renegotiating the deal.  In fact, that’s what bankers do.  They love to negotiate, particularly where money is involved.  It is a truism.

So, the public administrators should do a couple of things: project their banking needs for the next 5 years, contact multiple banks, begin a bidding war …. and, tell the bank which currently holds the derivatives contract that the entire banking relationship is up for review and that it is has been put out to bid.  Furthermore, explain that re-negotiating the derivatives contract needs to part of their counter-proposal.

Then, let the chips fall where they may.

Remember, banks hate to lose customers; especially to competitors.   I suspect that there are great savings to be reaped.

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A Never Ending Source of Fees for the Pension Industrial Complex

Roger Lowenstein refers to our public pension system as The Great American Ponzi Scheme.  While supportive of the policy needs to provide pensions to public workers, I suspect that he comes to his Ponzi Scheme conclusion because of the vast gaps in funding of many state and municipal plans. Many current retirees enjoy healthy payments, while the system remains significantly underfunded.  A little bit like the Madoff investors who took out big returns as other investors were making additional contributions.

With respect to the funding issues, Lowenstein is right on point.  And, the funding issue is probably the biggest challenge facing the public system.  However, Lowenstein overlooks another critical dynamic of the pension system; that is, the investment of retirement assets and the fees paid to all of the various vendors.  Again, in the aggregate, the funding issue looms larger.  But, every dollar paid to a vendor is one less retirement dollar paid to retirees.  Research shows that these fees have a significant impact on investment returns.

If the funding system is a ponzi scheme, then the investment process for public plans is also, in many cases, a sham of another sort.

Last spring I spoke about fiduciary matters at a conference sponsored at Harvard Law School for trustees of public pension plans. The vast majority of the participants were policeman, fireman, teachers and other public employees who serve as trustees for the their retirement plans.  After spending a day working in small workout groups with the conference participants, I was struck by two significant insights:  1) the vast majority of these trustees are earnest and take their responsibilities very seriously and 2) notwithstanding this earnestness, they are no match for Wall Street.

I suspect that for some of these trustees, their formal education may have stopped at high school.  And particularly for teachers, their college careers were directed to towards degrees in education.  In contrast, the investment management industry is filled with algorithm yielding MBA’s and finance PhD’s from Ivy League schools.  In fact, one session of the conference was devoted to a liability-matching strategy so loaded with math and investment jargon that I’m convinced that my CFA partners would have been challenged to translate the strategy so that I could digest it.

This is not the exception, but the rule.  Investment concepts and the intricacies of investment products have become so extraordinarily complicated that even the best intention plan trustee cannot understand the fundamentals.   And yet, public funds continue to direct assets to the latest hedge fund or strategy pumped out by the investment management industry.

Sanity must be injected into the system.  Not only are public pension funds under funded but,  their assets no doubt are invested in expensive products, the majority of which produce average returns.  The math is not good.   Average returns and high expenses mean overall lower returns for retirees.

For the past 20 years the investment industry has fed at the trough of the $ trillions held by public pension plans.  The industry has profited beyond its wildest dreams.  Unfortunately, the retirees have not been so fortunate.

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Beware Real Estate Hubris

In the late 1970’s/early 1980’s, AT&T unveiled an attention grabbing new corporate headquarters on Madison Avenue — complete with its chippendale crown.  On 1/1/84, however, AT&T was dismantled, broken up into its regional operating companies.  Twenty-five years later, Lehman brothers presented its sleak new global headquarters.  And, poof in September of 2009, Lehman was no more.

Remembering this architectural and corporate history, I read with great interest about 510 Madison Avenue — a fancy new “trophy” home for hedge funds.

Could this herald the beginning of the end of hedge funds?

The Times reported, last week, that 510 Madison suffered a significant detour (namely the ’08/’09 financial crisis) in its quest to capture $100/ft rents paid by ever-flush hedge fund managers.  Under new ownership and a brighter financial environment, however, high-end amenities are once again playing well to the Hedge Fund set.

Characterized as “more like country clubs, than workaday offices”, 510 Madison includes, a spacious lobby, restaurant, pool, and fortunately, a landscaped terrace.  I mean doesn’t everyone need a terrace to relieve the stress of managing $ billions of other people’s money.

And yet, here’s the problem …. It is other people’s money (OPM) as the cognoscenti well know.

While many hedge fund investors include high net worth and super high worth individuals — presumed to be sophisticated and capable of making their own investment decisions — most hedge fund managers also welcome the deluge of pension assets they have received over the past decade (as long as the pension assets don’t constitute more than 50% of the fund.)

It is not too hard to connect the dots and recognize that the hard earned pension assets of millions of workers are supporting the lavish work digs (not to mention the mansions, summer homes and private planes) of many hedge fund managers.

Sarcasm aside — plan fiduciaries must answer a pretty difficult question before investing assets in a hedge fund.  Are the “2 and 20” fees (2% management, 20% performance fees) justified?  Or, more appropriately are these fees “reasonable”.  Hedge fund managers can only afford their toys and lush office towers because fiduciaries sign-off on these fees.  And remember, ERISA requires that the fees be reasonable.

Last year the S&P 500 returned slight more than 15%, whereas the Barclay Hedge Fund Index returned 10.9% (other indices reported even lower performance). That is pretty expensive underperformance for 2010..   Of course, one year is not a fair comparison. However, before any fiduciary can justify investing in hedge funds, they need to examine, carefully, very carefully, the  3, 5 and 10 year performance returns.

Pension plans are under enormous pressure to generate competitive returns.  Unfunded pension liabilities are staggering.  However, reaching for the latest hedge fund du jour can lead to disappointing and mediocre investment results.

The beauty of the hedge fund business model, however is that even if performance remains mediocre, the managers remained ensconced in their fancy offices, sipping lattes on the landscaped terraces. Unfortuantely, the brunt of the pain is borne by the pension plan investors.

Certainly, ERISA didn’t contemplate these results.  And someday, fiduciaries are going to have to justify the reasonableness of their actions in authorizing these investments.

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Honest Talk about Fiduciaries

Next week, January 21, 2011, the SEC is due to deliver its report to Congress, as required by the Dodd-Frank Act, on the standards of conduct applicable to registered advisors and broker/dealers.  There is little doubt that this report will recommend a uniform standard — ostensibly, a fiduciary duty.  My greatest concern is that they will in fact adopt a unified standard and that they will trumpet fiduciary principles, but in reality it will amount to nothing more than a diluted version of fiduciary principles.

The lobbying by Wall Street has been intense.  Once the recommendations are made, the lobbying will get even more intense.  Wall Street’s business model is at stake.  This guarantees a watered down result.

In fact, the directives given by Congress to the SEC effectively preordained a diluted notion of fiduciary duty.  On the one hand Congress raises the prospect of a unified fiduciary standard, but on the other, also makes provisions for brokers to continue to sell propriety products provided there is sufficient disclosure of compesantion arrangements and conflicts of interest.   This is disappointing.

Simply put: commissions and disclosure are not consistent with fiduciary principles.

Fiduciaries are subject to a duty of loyalty.  This duty requires that a fiduciary put  client interests first, not engage in acts of self-dealing nor involving conflicts of interest.  Earning commission income from the sale of proprietary products clearly raises the potential of acts of self-dealing and conflicts of interest.  A fiduciary’s actions should never be clouded by acts of self-dealing.

Congress believes that disclosure will serve as the bulwark against acts of self-dealing.  In other words, if a broker discloses potential commissions, as well as how the commissions might impact his compensation, then the broker is “off the hook” from a fiduciary perspective.

Here, Congress is simply mistaken.  While disclosure is the corner stone of the securities laws, it does not hold the same weight as far as traditional fiduciary principles.   Under the securities laws, whether it is corporations or mutual funds, the underlying theory is that material facts need to be disclosed and investors can then exercise their own judgment based upon the facts.

For a fiduciary, however, the prohibition is fairly straight forward.  No acts of self-dealing.  A fiduciary cannot use its fiduciary discretion to engage in acts of self-dealing.   And, a fiduciary cannot disclose the potential self-dealing and obtain the client’s consent.

I focus on commissions and disclosure because it serves as a perfect example of how fiduciary principles will be watered down.  For those of us who believe that fiduciaries have a critical role to play in our financial system, this is a disappointment.  The marketing machine of Wall Street has the potential to dilute our commitment to longstanding principles.

At Harrison Fiduciary Group, we categorically reject efforts to masquerade self-dealing and conflicts of interest.  Our business model is structured on a fee for service basis.  Our fiduciary judgment will not be clouded by the potential to earn additional compensation.

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Compensation expressed as a Percentage of Assets Under Management Needs to be Evaluated

Michael Travaglini  announced his intention to retire as Executive Director of the Massachusetts Pension Reserve Investment Management to join Grosvernor Capital Management.  With remarkable candor, Travaglini explained to the Globe; “it’s an entirely personal (decision) one.  I have a wife and three children and I’m going to provide for them.”

Simply put, it appears that he wants to make more money.  No one can fault a guy for wanting to provide for his family.

Nonetheless, Mr. Travaglini’s career evolution and ambitions raise a significant issue pertaining to compensation and fees in the world of the pension industrial complex.  With $15.6 trillion of assets held by retirement funds (both public and private), everyone wants a slice of this staggeringly huge pie.

Scanning the landscape of various players in the pension market place reveals a common methodology for calculating fees: a percentage of the assets under the control or management of a vendor.  Custodians, record-keepers, administrators, investment managers of all stripes (long-only, private equity, venture capital, real estate, funds of funds and hedge funds), in one way or another, try to tie their fees (whether an annual fee or performance based fee) to the size of the pool of assets they oversee.

In fact, the bonus element of Mr. Travaglini’s compensation arrangement reveals that this culture of compensation tied to the size and performance of an asset pool has even injected itself into government.  Public servants can now expect a performance bonus.  Does that mean that Deval Patrick should get a performance bonus if he increases employment in the Commonwealth?  What about Ben Bernanke and Tim Geithner, should they get a fee based upon the size or growth of GDP?

Admittedly, the examples of Patrick, Geithner and Bernanke are ridiculous.  But, we must ask the question, why is providing Travaglini a performance bonus not equally ridiculous?  For some reason, it appears to be more acceptable that he and his staff be eligible for a bonus.

The standard response is that bonuses are needed to attract talented professionals;  otherwise, the private sector will attract the top talent.  I don’t buy that explanation.  First, even with the bonuses paid to either Travagliani or his staff, the private sector pays many multiples of what is offered by state government.  Second, the likes of Patrick, Geitner and Bernanke, and countless other public servants could all make more money in the private sector.  Nonetheless, they choose public service.

Whether consciously or not, it is now accepted practice that many retirement plan service providers are entitled to bonuses and compensation tied to performance and the size of asset pools.  The great irony, however, is that over the past few decades, many of these services have become commodities.  Practically, everyone is doing the same thing.  There are few secrets in the pension industry.

Custody, record-keeping and administration services are almost identical from bank to bank, consultants hype the same or similar analysis and methodologies, and certainly indexing is the same all over.

In light of these accepted compensation practices, the earnings of many members of the pension industrial complex have sky rocketed beyond belief.  In his best seller from the 1940’s, Fred Schwed asked, “Where are the Customers’ Yachts”.  Today, the yachts seem somewhat quaint, now we can point to private planes, ranches in Montana and vineyards in Sonoma or Burgundy.

While compensation has hit the stratosphere, we need to acknowledge that many retirement funds (both public and private) are experiencing severe underfunding.  Let’s not forget, the service providers are being paid by the retirement plans.  Every dollar paid to a consultant or fund manager is a dollar out of the pocket of a pensioner — especially in times of underfunding.

The system is out of balance.  There is no easy prescription for a quick fix.

At a minimum, those people who have assumed stewardship roles over funds, whether as trustees or fiduciaries, must begin holding service providers more accountable on issues of compensation.  As an industry, we must seriously examine the role of bonus fees and asset-based compensation arrangements.  They must be the exception not the rule.  An overall reassessment of these compensation arrangements will no doubt lead to significant compression of fees.  As John Bogle has proselytized for years, reduced fees over time result in higher investment returns.

Finally, as for Mr. Travaglini, while he might not be satisfied with the long term prospects of his current compensation package, he must have realized that the non-financial compensation he has received from the Commonwealth has been invaluable.  Under the current system, he will leverage his years of public service, including the many contacts that he made at public funds across the country, into a lucrative career selling the services of Grosvenor Capital Management.  Compensation is a broad concept.  Not everything can be reduced to dollars and cents.

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