Fiduciaries must drill down on Expenses

Investment managers and service providers to qualified retirement plans must disclose the fees they charges to the plan fiduciaries of the investing plans.  The Department of Labor launched a huge project many years ago focusing on these fee disclosures which culminated in a Final Regulation being issued in 2012.

ERISA lawyers, plan sponsors and services providers have devoted endless hours to compliance with the 408(b)(2) requirements.

Where have the Private Equity firms been?   And, where have the fiduciaries been?

Gretchen Morgenson reported yesterday, Pension Funds Can Only Guess at Private Equity’s Cost, that with respect to “rates of return and hidden costs”, private equity funds are as “impenetrable as a lockbox”.

Why are plan fiduciaries still guessing?

Many private equity funds implement restrictions with respect to the character of their investors so as to avoid certain requirements of ERISA.  Notwithstanding these limits, however, many ERISA qualified funds, as well as public retirement funds, do in fact, invest in private equity funds.   The fiduciaries of these plans have a statutory duty to determine that compensation paid to service providers is reasonable.   The disclosure regulations are designed to facilitate this determination.

According to Morgenson a few public investors, namely the Treasurer of the State of South Carolina, and a member of CalPERS, have tried to obtain data and information to assess whether the fees paid to private equity firms constitute reasonable compensation.   But, obtaining this data can be a challenge.

Furthermore, the relevant accounting rules are not clear.

Despite the opacity surrounding these fees, Morgenson reports that consultants and business academics have begun challenging the accuracy of the fee disclosures.  Morgenson links to a recently released study by CEM Benchmarking,  based in Toronto which addresses many of the complexities and deficiency with respect to recent fee disclosures.

All ERISA fiduciaries are on Notice.  It is your obligation to dig deep to understand the fees associated with a private equity investment.  Any fiduciary who does not have the expertise to make these determinations, should hire an expert for assistance.  Failure to do so could be a breach of fiduciary duty.

Given the resistance by Private Equity firms to these disclosures, the requests must be persistent, consistent and demanded by all investor fiduciaries.  Plan participants deserve as much.

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Fiduciaries Should Ask This Very Question

An esteemed ERISA litigation lawyer e-mail me the other day with a question, as follows: “Mitch, would you advise an ERISA plan NOT to invest in a hedge fund which uses an “expert network”, in light of the controversies surrounding network experts?”

My reply, “I have lots of issues with hedge funds, though the use of experts is low on my list.”

In my judgment, the overwhelming concern with hedge funds is whether the fees paid to the hedge fund managers are reasonable.

On the whole, hedge fund performance is somewhat average, mediocre.   Just what would be expected in light of the vast number of hedge funds. Paying the standard “2 and 20” management fee for mediocre performance is hard to justify as prudent. (Check out out, https://www.hedgefundresearch.com, for data on hedge fund performance.)

Sure, some hedge funds have outperformed the market significantly.  But, this assessment, as is always the case, is in retrospect.  Just like selecting active managers, the question is whether the managers can be identified beforehand.

Choosing an out performing hedge fund (thereby justifying high management fees) is further exacerbated by the fact the US equities market has been on an upward trajectory since 2009.   The S&P 500 is up 150% (dividends reinvested) with an annualized return in excess of 18%.

Outperforming, where it occurs, in an overwhelmingly up market is not an impressive accomplishment.  Effectively assessing a manager’s investment skill requires investment performance over an entire market cycle, up as well as down markets.

My prediction is that when the market eventually reverses itself, and over time it certainly will, the class action lawyers are going to catch wind of this issue.  Private litigation will eventually explode in this arena.

Hopefully, fiduciaries will have done their homework.

As for expert networks?  Fiduciaries must undertake their due diligence of the compliance processes employed my hedge fund managers.  Its enough to say, “Please, no insider trading.”  Instead, assure yourself that compliance processes are sophisticated and reflect best practices.

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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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Are Plan Sponsors Up to the Task?

The responsibility for managing and overseeing a corporate retirement plan use to be back a backwater support function at most companies.  The Department of Labor, however, has just significantly upped the ante for overseeing these plans.

Yesterday, Gretchen Morgenson reported on the new fee disclosure requirements pertaining to $401(k) plans, The Curtain Opens on 401(k) Fees.  As the open curtain metaphor suggests, transparency will be important.  However, the new rules can’t simply be fulfilled through transparency.  It’s going to take more… a lot more.

Morgenson explains that the new rules will require plan sponsors to calculate and disclose expense ratios for each of the investment options offered to the plan participants.  With access to greater information, it is assumed that plan participants will be able to make more informed decisions with respect to their investment selections.  For everyone knows, that higher expenses eat into investment returns.

Just as plan sponsors are being required to assume additional responsibilities, however, Morgenson also reports that many managers of corporate plans are shockingly ignorant about the nuts and bolts of the operation of their retirement plans; specifically, on the expense structure of the plans. I have previously commented on then dangers of executive ignorance with respect to retirement plans. Fees & Expenses: A Perfect Storm.

The importance of these new regulations, however, is not simply that they demand greater transparency.  The significant challenge lurking under the surface for corporate managers or retirement plans is that they will now be fiduciaries with respect to the fees and expenses paid by the plans.

That is, it is not enough that they properly disclose all the various fees and expenses paid by the plan.  In addition, they will also have to sign off on the reasonableness of these fees and expenses.

Disclosure is a somewhat passive activity.  If it were merely a matter of disclosure, then plan sponsors would simply hire consultants to calculate the expense ratios and then pass those ratios along to the participants.

As fiduciaries, however, the plan sponsors must make the affirmative decision that the fees and expenses are reasonable.  This requires that they understand the economics and the entire expense structure of the plans, and affirm that the charged expenses are reasonable.

Approving fees and expenses will require a thorough understanding of the range of services and pricing for all aspects of maintaining and operating retirement plans.  The fiduciaries must make their decisions in their capacities as prudent experts.

No doubt, plan sponsors will hire consultants to assist with these determinations.  However, it is axiomatic under ERISA that plan fiduciaries cannot merely rubber stamp a recommendation made by consultants.  Or, if in fact plan fiduciaries do rubber stamp consultant recommendations, they are opening themselves up to liability.

And remember, under ERISA, fiduciaries are personally liable for breaches of fiduciary liability.

Maybe it is time for companies to get out of the plan management business.  The best course of action would be to delegate the responsibility for management and oversight of plans to proven fiduciary experts.   Independent professionals who are experts in the business of maintaining and operating plans.

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BlackRock Solutions Needs to Shed Light on Valuation Methods

Today’s Wall Street Journal, BlackRock’s “Geeky-Guys” Business, focuses a spot light on BlackRocks Solutions — a small business unit tucked away in the bowels of BlackRock, complete with its own elevator entrances, computers and separate office floors.  If nothing else, haven’t we learned from the ’08-’09 financial crisis, that “Geeky-Guys” hidden away from view have the potential to inflict great harm on our financial system.

Let’s give BlackRock Solutions (BRS) the benefit of the doubt — they have some really smart people who work really hard.  And, during the height of the financial crisis BRS assisted with the management of portfolios which held a lot of funky assets.  The system and US government (including the taxpayers) needed BRS.

As the WSJ reports, BRS provides various risk management services, including asset allocation, to major pension plans — both public and private.  As part of these services, BRS also values hard to value assets according to its own proprietary algorithms and processes.  These valuation process are secret — according to the WSJ.

While I obviously am not privy to the contracts between BRS and its clients, I have strong suspicions that BRS is hired as a fiduciary to provide these services.  Furthermore, the people at the pension plans who hire BRS are likely fiduciaries themselves.

Based upon these two assumptions, I have 2 simple questions:

1) If valuation processes are secret, how do the fiduciaries which hire BRS know that they are prudent processes?

2) Are the fees which BRS charge dependent upon these secret valuations?

These are not sophisticated questions.  But, the answers go to the heart of our pension system.

ERISA is very clear.   Plan fiduciaries are able to hire and delegate responsibilities to other fiduciaries.  If they do so, the decision to hire and delegate these responsibilities must be a prudent decision.  Furthermore, the plan fiduciaries must continue to monitor the hired fiduciaries.  How can the decision to hire BRS be prudent if the valuation methods are secret?  Furthermore, how can anyone monitor whether BRS is discharging its responsibilities in the face of secret valuation methods.

Finally, I also strongly suspect that BRS  charges a fee based upon the assets under management.  If this is the case, then the secret valuations placed upon the assets can directly effect BRS’s compensation.  This is a problem under ERISA.

Yes, the professionals at BRS are smart, and we should trust them.  But, that is besides the point.  Assuming that they are fiduciaries, secrets can’t be permitted.

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What is the Future of Retirement Plans?

Felix Salmon, an insightful finance blogger for Reuters, writes in yesterday’s NYT about Wall Street’s Dead End. Salmon notes that the sale of the NY Stock Exchange to the Deutsche Bores combined with the significant decline of companies listed on major exchanges point to a future in which corporate wealth and control is pushed into the hands of a small financial elite.  For Salmon the very notion of shareholder democracy is at stake.

And yet, much more than shareholder democracy is at stake.  The retirement and pension plans of millions of retirees (many of whom are baby boomers about to tap into their nest eggs) are also at stake.

Our retirement system depends upon robust equity markets.  It was not always so.

In the not so distant past, most retirement plans were invested in bonds.  Pension plan liabilities were projected by the actuaries and bonds were purchased to meet those liabilities.

By the mid-to-late 1970s,  a confluence of events created the pension investment world as we now know it:  1) modern portfolio theory gained traction, 2) analysts began reporting that stocks generate higher returns than bonds, “over the long term”, 3)  ERISA codified the concept of diversification, and 4) the seeds were planted for the pervasive investment and business culture which bloomed in the 80’s and beyond.

Since pension costs are “real” costs, meaning that they are a hit to earnings, CFO’s and CEO’s were all too thrilled to adopt stragegies to reduce these costs.  With pension plans it became easy.

If equities generate higher returns than bonds, and riskier equities generate even higher returns (so says modern portfolio theory), then it is an easy logical progression to shift pension plans into riskier assets.  But, forget logic …. These were real dollars, real increases in earnings and therefore real increases in share prices.

The tsunami of pension assets flowed from fixed income, to domestic equities, then international equities, to emerging markets, along with real estate, joint venture, private equity.  Even in the fixed income arena, boring treasury and corporate bonds were jettisoned for international and emerging market bonds, and bonds backed by everything from mortgages, credit cards, car loans and now even life insurance.

And of course, the Holy Grail:  the Hedge Fund.  Managers given the unfettered discretion to zap investments around the globe in any asset class, at any time.  Whatever suits the fancy of the omniscient hedge fund manager.

While Salmon might decry the loss of shareholder democracy ….I’m a little bit more selfish and I’m thinking about my retirement, and our whole retirement system.   This system is critically dependent upon the very shrinking capital pool that Salmon has identified.

The issue goes far beyond even the shrinking pool because, in fact, the pool hasn’t shrunk. Instead, as Salmon implies, it has simply passed into the control of a small elite.  The thousands of well educated college students who marched through the top rated business and law schools over the past 3 decades who now populate the investment industry.

The critical problem, however, is that our retirement system requires access to these markets and securities.  In effect, the demand has remained constant but the financial elite now controls access.  Like the robber barrons of the 19th century,  the financial elite are able to extract a high trarriff on the commodity they control.  This tariff takes the form of a “2 and 20 fee” — 2% management fee and 20% performance fee.  This entire structure (and the financial theories which underlying it) merely reinforces the control and wealth of the financial elite.

The robber barrons met their match in Teddy Roosevelt’s trust-busing zeal.  This current system is far more resilient.  In fact, a global financial crisis, a legislative overhaul of the financial system, and a joint congressional inquiry could not lay low the power of the investment industry.  Hedge Fund managers and their brethren still earn billions of dollars in a single year.

Rather than turn to our elected officials for a systemic change (remember, their campaigns all seek funding from the financial elite), I suspect that the solution lies in the streets of Tunis and Cairo.  Please bear with me.  This is not so farfetched.

Again, in yesterday’s Times, the lead article, Tunisian-Egyptian Link That Shook Arab History, explains that collaboration among educated professional young Tunisians and Egyptians, as facilitated by various forms of social networking, contributed enormously to the toppling of these regimes.

Collaboration by educated, well informed and connected people works.

While I do not want to suggest parity between the needless physical and emotional suffering of exploited populations and the inequities of our financial system.  I do think that the techniques of reforming entrenched power structures can be similar.

Our system has gotten to where it is, in part, because retirement plan decision makers –our financial stewards — have allowed it to develop.  They continue to pour money into hedge funds, private equity and other similar investment strategies.  The allure of these returns is too great.  Unfortunately, individual returns can fall far short of promised possibilities.  And, the huge fees remain.  And these managers remain empowered.

The solution? Retirement plan fiduciaries must, “Just Say No”.  No more to extravagant fees; no more excuses for underperformance; and no more allowing managers to avoid fiduciary responsibility.  Collectively and loudly they must object to this entrenched system.

Plan fiduciaries must demand that investment managers put client interests first.  Not simply as an advertising campaign, but as statements of their core values and business ethics.

Systemic transformation does not come form a change in rules by those vested in the status quo.  That is a recipe merely for change at the margins.  True change comes when people tap a latent but unrecognized source of power. This power transforms behavior which in turn transforms systems and institutions.  Yes, the answers can be found in the streets of Cairo and Tunis.

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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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“Financial Innovation Boosts Economic Growth,” an Oxford-style debate — featuring Jeremy Grantham, a doyenne of investment management, and author Richard Bookstaber, author of A Demon of Our Own Design: Markets, Hedge Funds and the Perils of Financial Innovation, opposing the proposition, and Myron Scholes, Noble Prize winner, and Robert Reynolds, CEO of Putnam Investments, in favor of the proposition — is summarized in an Appendix to Grantham’s January 2010 Quarterly Newsletter entitled, “What a Decade!”

In offering stinging criticism about the investment management industry, from which he admits he has profited handsomely, Grantham provides:

Clients can’t easily distinguish talent from luck or risk taking.  It’s an unfair contest [between clients and the investment management industry], nothing like the fair fight assumed by standard Economists.  As we add new products, options, futures, CDO’s, hedge funds, and private equity, aggregate fees per dollar rise.  As the layers of fees and layers of agents increase, so too products become more complicated and opaque, causing clients to need us more.

The ultimate industry insider acknowledges that the game is stacked against the clients in favor of the service providers.  Ironically, however, he includes that the high fees, complexity and opacity, create greater reliance upon the industry itself.

Au Contraire!!  The trifecta of high fees, complexity and opacity cries out for the role of professional fiduciaries to cut through the jargon, smokescreens and hype surrounding the investment of plan assets.

To focus momentarily just on fees, as fiduciaries, with respect to administrative expenses, we clearly have an obligation to “defray reasonable expenses.”  The explosion of fee litigation clearly bears this out.  However, with respect to investment management fees the directive is not as explicit, but nonetheless the obligation to monitor fees is critical.  Certainly there is an obligation to make sure that fees are reasonable, but the exclusive benefit language in ERISA also suggests that where possible, fiduciaries should work to reduce fees wherever possible.  Simply put, any reduction in fees is an increase in the assets available for plan participants and beneficiaries.

The current shock to the financial system, as well as to client portfolios across the board, provides a unique opportunity for fiduciaries to review all of their investment relationships not only with respect to investment performance, but also with respect to fees.  Fiduciaries must ask themselves a hard question; are the fees being charged by private equity, real estate, venture and hedge funds justified by the investment returns being generated and the risks assumed?

The current financial environment levels the playing field between the investment management industry on the one hand, and plan fiduciaries on the other.  Plan fiduciaries must jump at this opportunity to exercise responsibility to strike deals in the best interest of their plans. Negotiate, negotiate, negotiate!

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