Harrison Fiduciary

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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Plan Fiduciaries Should be Paying Attention

Will the European Central Bank step into the market and buy European Sovereign Debt?   That’s the $ trillion question.

Articles abound trying to predict the future.  Will the ECB cave or not?   No one can be responsible for an accurate prediction of the future.

These debates have been brewing for 18 months.  Bankers, however, are getting nervous.In Banks Build Contingency For Breakup Of the Euro, Liz Alderman reports that banks are developing plans in the event that unimaginable break of the Euro in fact comes to pass.

While analysis and hand-wringing serve a purpose to highlight and issue, nothing takes the place of contingency planning.

Beginning with my blog post on July 25, 2010, Debt, Debt, Debt, I have been warning plan fiduciaries that they need to be monitoring the impact of the European debt crisis on their own portfolios and trading strategies.

If the Banks, which were universally “asleep at the switch” in the lead up to the sub-prime crisis are now wrestling with contingent planning with respect to the impact of European sovereign debt, it behooves plan fiduciaries to be engaged in similar planning.

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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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