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Fiduciaries, Can You Pick the Best Ones

Calpers’s announcement that it is liquidating its hedge fund investments continues to attract widespread attention.  Hedge Funds Lose Calpers, and More as reported by James B. Stewart in the New York Times.

“Foremost were fees”.   In light of the middling performance of Calpers’ allocation to hedge funds, the fees could not be justified.  One of Calpers’s “core beliefs” as stated on its website, “Costs matter and need to be effectively managed.”

ERISA takes this concept a step further.  Right in the statute, it provides that fiduciaries are required to “defray expenses”.  How the Department of Labor continues to permit the investment of plan assets in hedge funds is perplexing.

In addition to fees, however, another challenge looms large.   With over 10,000 hedge funds in the market place, how does a fiduciary pick the “best” fund(s)?   This is the same question the indexers have been asking about active managers for decades.  It is at the very core of Modern Portfolio Theory.

Apparently, even Calpers, with all of its resources and its heft in the marketplace, wasn’t able to crack this nut.

As I first identified just prior to Calpers’ announcement, Hedge Funds: Prudent Investments?, EVERY fiduciary needs to be evaluating the role of hedge funds in the portfolios they oversee.

But, the analysis can’t stop with hedge funds.   In the event that hedge fund investments are liquidated, fiduciaries then need to decide where to allocate the cash proceeds.   The investment environment it tough:

  • record low interest rates
  • record high in US equity markets
  • European debt crisis continues
  • geopolitical risks
  • Federal Reserve’s quantitative easing is about to end.

This might not be the most auspicious time for fiduciaries to be re-visiting their asset allocations in light of hedge fund liquidations.

But, fiduciaries don’t get to choose the investment environment.  They must make prudent decisions in light of the real word risks currently prevailing.

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Maybe the Start of a Trend

The nation’s largest pension fund has announced that it will be liquidating its positions in 24 hedge funds and 6 hedge fund-of-funds.  CalPERS, Nation’s Biggest Pension Fund, to End Hedge Fund Investments reported in today’s New York Times.

Possibly someone read my recent blog post, Hedge Funds: Prudent Investments?

There is little complicated about this decision.  It comes down to fees, risks, and returns.

Not surprisingly, a professional with a hedge fund advisory firm explains, “Hedge Funds are the place to be now because people are expecting a major correction.”

Really? That’s the rationale?

Getting tickets to a Beyonce concert can be justified because it is “the place to be.”  I would suggest that fiduciary decisions to invest plan assets in any asset class would be based on something more than it being “the place to be.”

It bears watching whether plan sponsors begin liquidating positions out of hedge funds.  But, I could be wrong, maybe hedge funds will continue to be the “in” asset class of choice into the future.

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Once Again, Strong Process and Substance Matters

There is not much love lost by the Department of Labor for ESOP transactions.  The skepticism, even antipathy, is somewhat justified.  Some ESOP transactions don’t pass the smell test (see my prior post:  ESOPs: Common Sense Required).

And yet, ESOP transactions continue.  Notwithstanding the bad deals, there are economic benefits to ESOP structured transactions.  Fortunately, however, ESOP fiduciaries now can operate with clearer direction from the Department of Labor.

At the beginning of the summer, the Department entered into a Settlement Agreement in Perez v. GreatBanc Trust Co with respect to an ESOP maintained by the Sierra Aluminum Company.  This Settlement Agreement afforded the DOL the opportunity to issue guidance which has the look and feel of regulations, without having to go through the long process of issuing regulations.

In short, DOL requires that the fiduciary be an active participant in an ESOP transaction.  The fiduciary must determine that financial projections are reasonable, take steps to assess the accuracy of financial data, review the selection and valuation process of the expert appraiser, and generally assure that a prudent process has been followed and documented.  This is far from a passive role.

At Harrison Fiduciary Group we have drafted a set of fiduciary policies and procedures which closely adhere to the terms of the GreatBanc settlement.   In general these procedures focus on the following:

  1. Valuation Advisor — review of qualifications, selection process, no conflicts of interest, analysis of valuation work-product;
  2. Financial Statements — reasonable reliance on financial statements;
  3. Fiduciary Process — written documentation of processes, and reliance upon valuation report; and
  4. Miscellaneous — Preservation of documents, purchase or sale of securities for fair market value (debt not to exceed fair market value of securities), consideration of a claw-back.

In light of the GreatBanc settlement and the general enforcement pressure being brought to bear by the DOL on these transactions, some institutional fiduciaries are exiting the ESOP marketplace.  They are unwilling to assume the risks highlighted by the Department and the Courts. This market disruption might cause concern for some service providers, but at HFG we view this as a significant opportunity.   Our competency and expertise as fiduciaries should give comfort to both plan sponsors and to the Department of Labor.  As is true for each of its fiduciary engagements,  HFG rigorously complies with its own policies and maintains contemporaneous written documentation of its process. ESOP engagements will fare no differently.

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A Practical View From the Trenches

After the drama of a Supreme Court argument, multiple amicus briefs, and voluminous commentary, the role of a fiduciary (from the perspective of a fiduciary) after Fifth Third Bancorp v. Dudenhoeffer , in the end, looks very similar to the role of a fiduciary before Dudenhoeffer.  But, while the role may be the same, the biggest difference is that attention, directed by no less an authority than the Supreme Court, has now been focused on the responsibilities and potential liabilities  assumed by fiduciaries.

Simply put, post Dudenhoeffer, fiduciaries must determine that an investment of plan assets in company stock is prudent.  Sound familiar?

Even before Dudenhoeffer eliminated the Moench presumption, leading fiduciaries recognized that oversight of a company stock account required traditional fiduciary monitoring and analytics of the investment of plan assets in company stock.  This oversight would be judged against a prudent expert standard.  Neither the responsibility nor the standard has changed.

To meet this responsibility, at Harrison Fiduciary Group, we have established a disciplined practice with respect to company stock accounts which includes regular monitoring of

  • contributions/redemptions,
  • cash balances,
  • market price, and
  • public disclosures.

Although the Supreme Court acknowledged that fiduciaries can rely upon the market price of a security (effectively adopting a modern portfolio theory of pricing), we have established a research competency which takes into account:

  • SEC public filings,
  • Financial news reports,
  • Stock analyst ratings and reports,
  • Credit ratings, and
  • Price/volatility of options or credit default swaps (where available).

In other words, every time we purchase shares of company stock, we are in effect, making the determination that the investment is a prudent one.   Similarly, we also recognize that in the event that we determine that an investment in company stock is no longer prudent, then we would be obligated to begin selling the stock.

To repeat for emphasis, however, notwithstanding the Dudenhoeffer decision, none of this is really new.

What is new post-Dudenhoeffer, however, is the recognition that company stock fiduciaries have substantive roles to play and that there is real risk and liability for failure to discharge these responsibilities prudently.  Fiduciaries of company stock accounts are not mere recordkeepers, nor do they merely “rubber stamp” the decisions of others. The Dudenhoeffer decision makes this clear.

At Harrison Fiduciary Group we not only understand these responsibilities and maintain expertise in these fiduciary skills, but we will be accountable for all fiduciary decisions that we make.

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Is it a Good Deal?

Employee Stock Ownership Plans (ESOPs) present an attractive financing tool and ownership structure for both publicly and privately held businesses.

ESOPs can be very complex.  There are many moving parts.

Lawyers, investment bankers, consultants and other advisors love complexity.  In fact, professionals often thrive on complexity.  Somehow complexity conveys an aura of expertise, and of course, expertise demands high fees.

However, the structuring of an ESOP and the decision-making process undertaken by the various stakeholders (plan sponsors, plan fiduciaries, advisors, etc.) should not overlook very simple questions:  “Is this a good deal?”  “Do the economics work?”.

In transactions of this nature, there is lots of pressure to “get the deal done.”  Pressure by selling shareholders and pressure by the bankers can all be significant.  But, it is a fiduciary’s job to ask the simple questions.

In Fish v. GreatBanc, a recent decision by the Seventh Circuit, the Court outlines what amounted to a bad business deal.  Although the precise issue decided by the Court focused on the application of the relevant statute of limitations, the underlying business deal was not pretty.

As noted by the Court, and repeated by other bloggers, Steve Rosenberg, What Happens to Company Owners Who Get Overaggressive When Selling out to an ESOP?, outsider advisors to the independent fiduciaries characterized the transaction as “the most aggressive deal structure in the history of ESOPs.”

Wow.  When an advisor puts that warning in writing it is best to pay attention.  (Remember, it will be part of the record if the deal heads south.)

While many lawyers have commented on the legal issues, I’d like to provide a practical perspective, as an Independent Fiduciary.

At the outset, it is important to note that “aggressive” –taken by itself — is not necessarily a negative or a bad thing.

Many “aggressive” investments may still be prudent. But, in the parlance of modern portfolio theory, an aggressive, or high-risk investment, must be compensated for by a higher rate of return.  High risk.  High Return.

In addition, the risk of an investment must be assessed in the context of the composition of an entire investment portfolio.  High risk investments must be balanced with lower risk investment so that the overall portfolio reflects an appropriate risk level.

ESOPs present a unique challenge when it comes to risk.  That is, the company stock held by the ESOP is the sole asset held by the plan (other than some cash).

In the context of Fish, once the deal was characterized as “aggressive”, it was then the fiduciary’s responsibility to dig in.  What gives rise to the nature of the aggressive nature of the deal?  Are there ways to mitigate the aggressiveness?  Can the plan be adequately compensated for the risk inherent in the transaction?

This analysis must be a collaborate effort, undertaken by the fiduciary, the plan sponsor, and the selling shareholders.  The analysis is not intended to kill the deal.  To the contrary, the analysis is designed to enhance the deal, to afford protections to everyone involved, not the least of whom are the plan participants who must get a fair deal.

ESOPs can be very compelling structures for all stakeholders:  owners, plans and plan sponsors.  However, it is the fiduciary’s responsibilities to make sure that the risks and rewards are prudently shared.

As an Independent Fiduciary, it is my job to exercise discretion as a “prudent expert”.  While prudence includes following various processes and procedures, it also demands me to ask, “Is this a good deal for the plan?”   Financial advisors and investment bankers, it is your job to persuade me that, in fact, it is a good deal.

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“No one can serve two masters.”

Although the tradition is not mine, I can appreciate the rabbinic-like wisdom in the statement. Unfortunately, it appears that ERISA lawyers, on the whole, have not embraced this learning.

The statute, however, clearly is not agnostic on this topic.  Consistent with traditional trust-law concepts, and possibly not unaware of theology, ERISA demands a “duty of loyalty” by a fiduciary to the plan on whose behalf it is acting.

The language of statue is clear.  Dual loyalties are prohibited.  Nonetheless, ERISA lawyers (with the blessing of the courts) still continue to abide by the “two hat” doctrine.

Let me explain.

Two weeks ago, at a national conference of ERISA lawyers, a panel of in-house ERISA lawyers, reviewed a variety of issues that they encounter on a regular basis.  When the discussion shifted to fiduciary practices, one of lawyers explained the care and diligence that she employs when counseling the plan sponsor’s investment committee. This committee, of course, serves as a fiduciary to the retirement plans.  She said that she repeatedly recites or invokes the “two-hat” doctrine.

That is, in the day-to-day exercise of their corporate responsibilities, the officers owe a duty of loyalty to the shareholders of the corporation.  However, in the context of an investment committee meeting, they needed to “remove” their “corporate hat” and replace it with their “fiduciary hat”.  All decisions need to be made “in the best interests of the plan participants.”  They must disregard their duties to the corporation.

Upon recital of the two-hat catechism, every single participant on the panel nodded his or her head in agreement.   An ERISA truth had been proclaimed and knowledgable members of the ERISA bar mustered all of their reverential professionalism and genuflected at this statement of the canon.

Yes, it is commonly accepted that a corporate officer can “wear two hats”.  A chief financial officer, or a director of marketing, can spend his days (and often nights) toiling rigorously on behalf of the corporation (and shareholders), but during certain committee meetings they must shed this hat and instead, make a decision “solely in the interest of the participants and beneficiaries.”

Regularly, in corporations though out America, decisions are made related to $ trillions of retirement assets under this “two hat” theory.

For many years, I too sang from the two-hat hymnal, often a solo, just like the panel member.  However, with a bit of middle-aged experience and having weathered a systemic financial crisis, I have learned at times it can be valuable to question received wisdom, to question the hymnal.  And, sometimes even acknowledge the wisdom of traditions not my own.

For a moment, let’s set aside legal principles, theology, as well as editorial sarcasm, and examine the “real” world.

Another participant on that morning’s panel, explained that the retirement assets of her corporate plan (in excess of $15 billion) are “so important that the CEO personally appoints the members of the fiduciary committee.”

When a CEO handpicks members of a committee, everyone takes notice.   While CEO lieutenants may be adept at various technical and managerial skills, often, intense loyalty to the CEO is a common attribute.  (Dissidents typically do not typically rise to the C-suite).

This loyalty often includes a precise understanding of the CEO’s goals and priorities with respect to corporate strategy and is often rewarded by promotions, committee appointments, raises, bonuses, stock options and other assorted perks.  The senior managers are properly incentivized to advance the vision of the CEO.

Upon assuming a spot on a fiduciary committee, however, these same senior managers are required to shed the very skills that contributed to their corporate rise.  When making decisions on behalf of the plans, they are suppose to set aside any allegiance to the CEO, forget about the stock options they may have patiently accumulated over the years, and make decisions irrespective of an impact on corporate earnings.

The potential for conflicts of interest are real; they are not the abstract musings of lawyers and academics.   Many transactions squarely put the corporation and the plan on opposite sides, with competing goals.

So, can these corporate offices so deftly switch hats as ERISA lawyers assume?   Are fiduciary committee members so professional, so trustworthy, so ethical, that they are immune to the human impulses which gave rise to: “No one can serve two masters.”

Aren’t we all engaged in a collective willing suspension of disbelief as to the artifice of the two-hat theory?  Isn’t it time to say enough?  Let’s bring meaningful independence to the fiduciary oversight of the nation’s retirement plans.  The stakes are way too large not to.

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An Independent Fiduciary Protects All Parties

With rising interest rates and CEO’s tired of pension-related balance sheet surprises, the volume and size of annuity transactions is bound to explode.

Experience teaches that exuberance in financial markets and products can lead to some very painful losses.  The Department of Labor is concerned.  It has seen this movie more than once.

Multiple factors go into the corporate decision to “de-risk” the balance sheet by purchasing annuity contracts.  Months of work go into this decision.  One key factor is the cost of the annuity, as well as the cost of executing the transaction.  While these transactions can be expensive to execute, senior corporate managers are also incentivized, and have a duty of loyalty to the company, to minimize these expenses.  Lower expenses enhance earnings.

However, annuity pricing is efficiently correlated to the credit quality of the issuer of the annuity.   In other words, lower credit-quality issuers charge less for their products.  The corollary is also true; higher credit-quality annuities are more expensive.

Left to their own devices, corporate managers are incentivized to purchase the cheapest annuity available even if it reduces the credit quality of the issuer.  This pressure is very strong.

Plan fiduciaries and participants, however, have a different view.  They are interested in the strongest credit quality issuer available, price be damned.  Remember, prior to the annuity purchase, the pension plan is funded by a diversified pool of assets, thereby mitigating investment risk.

An annuity purchase,however, substitutes a single issuer for this diversified pool.   The pensions of thousands of plan participants are dependent on this single issuer.  The issuer goes bankrupt, the pensions are lost… forever.

The conflicts for senior managers (some of whom are plan fiduciaries) in executing these transactions are real.  Should they pay up for higher credit quality; or, should they sacrifice credit to enhance earnings.

ERISA provides a single answer.  Fiduciaries must act in the interests of participants.

In the early 1990’s the bankruptcy of Executive Life Insurance Co. provided a huge wake-up call.   Many plans were invested in Exec Life products and they absorbed huge losses.

In response,  the DOL issued guidelines in IB 95-1 setting forth numerous requirements regarding the purchase of annuity contracts.  Post-Executive Life,  the DOL requires that a plan purchases the “safest available annuity”.   In reaching this determination, the DOL requires that 6 six factors be analyzed, price of the annuity is not one of the factors.

Recognizing the potential conflicts of interest and the competing pressures of corporate managers, these IB 95-1 suggests that an independent fiduciary be hired to make the the “safest available annuity” determination.

Unfortunately, plan sponsors don’t like hiring Independent Fiduciaries. They don’t like paying the fees and they don’t like a second set of eyes reviewing their judgments.  If corporate managers want to purchase an annuity from XYZ Insurance Co, they don’t want a third party telling them that they should purchase the annuity from DEF Insurance Co.  And, they really don’t like that an Independent Fiduciary will retain its own lawyers and advisors for the transaction.

Ironically,  the intensity of the resistance by senior managers to hiring an Independent Fiduciary actually illustrates and proves the very conflicts of interest outlined above.

Corporate managers who forgo an Independent Fiduciary might one day be in the position of having to prove to the Department of Labor that they transcended these conflicts and acted in the interests of plan participants.  In the context of large losses (possibly $ billions) That will be a hard argument to make.  The DOL will be very suspicious.  Remember, there is personal liability for breaches of fiduciary duty.

In the end, an Independent Fiduciary will make decisions in the interest of the plan participants.  However, the corporate managers can take great comfort from knowing that the conflict of interest is significantly mitigated by the hiring of the Independent Fiduciary.  Whether they understand it or not, the Independent Fiduciary provider significant protections to the corporate managers.

Corporate managers should focus on executing their corporate strategies.  Let the Independent Fiduciaries wrestle with the complexities of purchasing annuity contracts.

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Are Fiduciaries Paying Attention?

There are always naysayers.  Prognosticators and analysts who even in the best of times foresee disasters looming on the horizons.  I am very prone to be influenced by those cautious advisors.

However, over the course of my 25 year career, I have learned that more often than not the extremes rarely materialize and decisions based upon more moderate outlooks usually prevail.

And yet, right now, the magnetic pull of impending disaster and hyper-vigilant caution feels overwhelming.

Where will a crisis materialize? To name just a few potential catalysts, some of which were identified by global leaders at a recent gathering in Lake Como, Italy:

  1. Collapse of the Euro
  2. US Fiscal Cliff
  3. Middle East — either the Arab Spring or Israel/Iran
  4. Hard Landing in China
  5. Hyper-inflation.

Any one of these factors alone could trigger financial and/or political upheaval the likes of which our generation has never experienced.  But, what if 2 or 3 erupt concurrently.  I shudder to imagine.

As a fiduciary I worry about these things.  I’m required to make prudent decisions which can have long lasting implications for people’s retirements.  I take this responsibility very seriously.  Workers and retirees have worked long and hard to assemble their retirement nest eggs.

Of course, I can’t predict which crisis will occur or the consequences of any of these crises.  And, I’m very skeptical of anyone who offers any predictions, especially predictions with specificity.

Ever cautious, however, I’m trying to understand how to plan around these various potential crises.  Most importantly, I want to know how other investment fiduciaries are planning;. or if not planning, whether they are thinking about each of these various factors as they manage other people’s money.

I’m particularly concerned due to the general herd-like mentality of Wall Street, investment professionals and retirement professionals.   For the most part everyone does the same thing.

For example, before the 2007 financial crisis, and as $billions were being directed into various mortgage-backed securities and derivatives, industry professionals from various disciplines were all taking comfort in VAR — Value At Risk.

I never understood VAR, and I still don’t.   However, it was a numerical representation of the “risk” inherent in an investment portfolio.  Investment professionals cited VAR as if it was the holy grail. Everyone felt that they had mastered risk because the VAR calculations indicated so.

In retrospect, VAR proved to be overly narrow and somewhat simplistic.  VAR was meaningless as markets plunged and portfolios were depleted.  VAR was ephemeral, but the losses were real.

I’m nervous about today’s equivalent of VAR, and I don’t even know what it is.

Today’s $18.9 trillion of ERISA assets (as reported as of March 31, 2012 by the Investment Company Institute), are all generally managed the same way.  Steeped in the principles of Modern Portfolio Theory, retirement plans hire consultants who develop intricate asset allocations, spreading risk among all the asset classes.  Plan sponsors then hire multiple managers with proven track records in the specific asset class.  The industry supporting this system is gigantic.

This system has been in place for 25+ years.  In the explosive boom years beginning in 1982 all has worked well — for the most part.  However, the 2007 Financial Crisis revealed fissures in the extraordinarily complicated and intricate edifice constructed by the retirement investment industry.

What about the storm clouds forming on the horizon?  Are the foundations of the edifice strong enough?  Are fiduciaries exploring whether any levees are in place, and if so, whether the levees are capable of weathering the storm.

At a minimum fiduciaries should be talking about these issues.  They should demand that other investment fiduciaries outline their analyses and their proposed responses.  The debate on these issues should be robust and rigorous.

Unfortunately, my sense is that many are simply hoping that the clouds dissipate never gaining the force of a full fledged storm.

Personally, I often carry an umbrella when there is the slightest hint of rain.  Now, I’m concerned that an umbrella will be a mere cipher in an upcoming devastating storm.

Fiduciaries, what do you think?

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“All the News That’s Fit to Print” and More

Who doesn’t love a deal, especially in today’s economic environment?  This past Sunday’s NY Times, 23 October 2011, not only offered an update on global current events, but also serves as a virtual handbook for retirement plan fiduciaries.  [Go fish it out of the re-cycling bin ... yes, I still read the physical newspaper; one of life's daily pleasures.]

Starting with a bold graphic representation of the European credit crisis sprawling across two pages of the Sunday Review, Bill Miller’s,  It’s all Connected: An Overview of the Euro Crisis is clearly worth more than 1000 words.   At first blush, it seems too confusing … just too much to get one’s head around.  It’s much easier to turn the page.  Better yet, flip to the Travel or Arts & Leisure Section.

Retirement plan fiduciaries, however, don’t have that luxury.  Ignoring the financial issues brewing in Europe would be irresponsible and imprudent.

And yet, even for a responsible fiduciary, where does one begin?  If only there were a true sage, who had all the answers and could predict the outsome.

Fiduciaries don’t have to be sages.  They simply need to be prudent and responsible.  At the very least, every fiduciary committee, whether for state & local plans or for corporate plans, should be exploring the impact of the European issues on their plans and on their investment policies.

A daunting proposition, but plan fiduciaries don’t have to operate in a vacuum.  Instead, they should turn to each of their investment fiduciaries and pose the following questions:

  1. What is your analysis of the European debt crisis?
  2. Does this analysis have any impact on your investment strategy and our portfolio?
  3. What’s the weakest link in your analysis?
  4. Have you constructed contingency plans?

No doubt, every investment advisor will have a different answer, and fiduciaries will need to piece together conflicting data points.  But, in the end, plan fiduciaires must make sure that their investment fiduciaries are themselves being prudent.  Fiduciaries can’t predict investment results, but they can, and must, ensure prudent processes and decision making.

If the above advice seems too general, and therefore too simplistic, and maybe even worthless, then let’s turn to the front page.  Gretchen Morgenson and Louise Story’s, Bank’s Collapse in Europe Points to Global Risks, examines the bailout of  Dexia Bank whose problems, in part, stem from gorging on too much sovereign debt.  Using Dexia as an example, Morgenson and Story extrapolate various scenarios, and related policy issues, raised by potential rounds of bailouts of banks and their trading counter-parties.

I’d supplement their analysis by drilling down to an equally ominous set of challenges to which they allude: repos, securities lending and short-term commercial paper.  Most all banks (domestic and foreign) fund their operations, in large part, through repos and other forms of commercial paper.  Remember what happend to Lehman when no one would fund their short term paper?  And, what about securities lending pools stuck with rapidly declining collateral?  Just ask plan fiduciaries who were unable to terminate investment managers becaus securities were tied up in frozen securities lending pools.

Need more questions to ask?

Let’s not forget about money market funds.  Gretchen Morgenson, in the Business Section,  How Mr. Volker Would Fix It, also wrote about Paul Volker’s blunt recommendations about reforming the financial system; starting with money market funds and the residential mortgage market. Money market funds are huge purchasers of sovereign and bank debt.  As has also been previously reported, many of these funds have been paring back their European exposure.  Plan fiduciaries overseeing 401(k) plans holding money market funds need to be questioning their managers about strategies for addressing these global banking issues.

Plan fiduciaries, however, also have to ask about STIF’s (short-term investment funds).   Every custodial bank runs $ Billions in STIF’s, unregulated funds which no doubt are also chock full of sovereign and bank debt. Fiduciaries, are you asking your custodian banks about their STIFs?

If Miller’s graphics and Morgenson”s and Story’s articles don’t arm fiduciaries with sufficient questions, then turn to The Little State With the Big Mess, an eye opening article about Rhode Island.  The tiniest state, but the biggest pension woes.  Hard to know where to begin asking questions about the Rhode Island mess, but how about starting with the newly revised investment return assumption of 7.5%, down from 8.25%?  Is that a prudent decision?  Where did that number come from?  An easy question to ask, but maybe the answer is not so simple.

Finally, turning from the newsprint to the magazine, Daniel Kahneman, Nobel prize winner in Economics, Don’t Blink! The Hazards of Confidence, writes about the behavioral phenomena that confidence in our own judgments creates a bias that can lead us to ignore hard facts which contradict our judgments.  Focusing on investment performance, Kahneman explains that notwithstanding quantitative proof that certain investment managers added zero value to the investment process, these managers were nonetheless awarded bonuses on the assumptions that they “added value.”  Assumptions die hard.

By the way, maybe someone should forward a copy of Kahneman’s article to the fiduciaries of the Rhode Island state and local pension plans.  I’m still struggling with 7.5%.

Fiduciaries beware.  Don’t be so confident.  Ask lots of questions and work hard not to be so confident in your assumptions.  You are not just investing your own assets … instead, you are investing on behalf of hard working plan participants and retirees.

And I thought that I’d relax with a cup of coffee and a leisurely read of the Sunday paper.

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Asking the Right Questions — a Fiduciary Responsibility

Sovereign debt (Greek and others) continues to plague financial markets.  My last few posts have tried to illustrate that these are not abstract issues, but can have real impact on money market funds, securities lending and stable value programs.  Fiduciaries must understand these implications.

Today the NYTimes reports that many money market funds have been paring back their exposure to european bank debt.  Wary Investors Shun European Banks.  As explained in the article,  European Banks rely heavily on short term funding provided by U.S. money market funds.   And, let’s not forget that most US investors turn to money markets as safe investments.

Not surprising, there is a wide spectrum of investment views on european sovereign and bank debt.  The Times points out these different views and, these differing views make markets. Again, no surprises here.

When asked about money market funds’ exposure to european debt, Deborah Cunningham, a senior portfolio manager at Federated Investments commented, “We’re always rethinking it and assessing it, but we’ve not come up with a different answer,” she said. “We don’t feel there’s any jeopardy with regard to repayment.”

Similarly, a spokesman from Fidelity Invetments, Adam Banker explained, “We’re very comfortable with our money market funds’ European bank holdings, including French bank holdings.”

Both Federated and Fidelity are huge players in the 401(k) retirement arena.   The article reports that they manage $114 billion and $428 billion, respectively in money market funds (note, the article was explicit about the Federated money market assets under management, where as the Fidelity number was not specifically identified as money market assests. However, Fidelity reports that it currently manages $1.5 trillion of assets, so it is reasonable to assume that $428 billion is held by money market funds).

The real point is that Federated and Fidelity collectively manage more than $500 billion in money money market funds.  Thousands of plan participants are relying upon their judgment with respect to the safety and security of the participants retirement assets.

The volatility of financial markets these days is historically very high.  In large part due to questions raised by European Debt.

Fidelity and Federated must do better than “we’re very comfortable”  or “we don’t feel there’s any jeopardy … “.  Those are nice quotes for a NYT article.  But for fiduciaries these quotes should constitute red flags.  If we have learned nothing else from the financial crisis, bland statements issued by corporate spokespeople have the potential to hide serious issues.  According to the Times article, Federated has about 13 to 17 percent of assets … invested in French bank debt”.   That is not insubstantial.  It begs further explanation.

For any Plan Sponsor whose retirement plans offer Fidelity or Federated money market funds, pick up the phone today.  Just ask a few basic questions.  Remember, other smart investment professionals are not comfortable.  They in fact see potential jeopardy ahead. Fidelity and Federated must explain their positions.  Here’s a few questions for starters:

  • Why are you comfortable?
  • Why isn’t there any jeopardy?
  • How did you analyze your investment positions to reach this conclusion?
  • What assumptions did you make?
  • What are the weakest points in your analysis.

As if often the case …. a few open ended questions can spark a very enlightening discussion.

Plan fiduciaries have an obligation to ask these questions and assess the reasonableness of the responses.

Rarely would I turn to Ronald Regan for wisdom, but here goes,  ”Trust, but verify.”

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