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Confusing Times  – Simple Measures

The headlines may change, but the theme is the same — too much debt.

Weather it is the never-ending saga of European debt (Greece, Portugal, Spain), or the debt-ceiling gridlock here in the US, policy makers, politicians, economist, investors — everyone is trying to make sense of out the debt.

No one has any answers, just best guesses.  In the midst of all of this confusion, however, fiduciaries still must act prudently.  What’s the best course of action?

First, and foremost, fiduciaries do not need to be economic or investment experts or savants.  They do not need to look into their crystal balls and predict the outcome or even the best course of action.

Instead, they must act prudently.  The following actions will advance their fiduciary obligations:

1.  Review investment policy statements and investment accounts

Simply identify the investment accounts or strategies which might be effected by the debt issues.  One could say that all investment portfolios could be effected.  However, it would not be difficult to prioritize the accounts.  No doubt cash,  money market, stable value, and other fixed income portfolios should be at the top of the list.

2.  Meet with your consultants and advisors

Pick and the phone and request a meeting with your advisors — either in person or via teleconference.  Don’t worry if it isn’t time of a quarterly or half-yearly portfolio review.

3.  Obtain their analysis of the market environment and their recommendations

Remember, while a fiduciary does not have to be an expert on these issues, your investment advisors do.   They are paid to be experts.   Therefore, they should have cogent positions and explanations for the current market environment.

4. Question their assumptions

Don’t blindly accept their responses.  Questions their assumptions.  Explore alternative options in the event that their predictions don’t materialize.

5.  Inquire if they have conducted stress tests on the portfolio

Simulating various market conditions has become a standard tool for monitoring investment portfolios.  Require  your managers to provide you with the results of these various tests.  And, most importantly, determine if you are comfortable with the results.

6.  Get recommendations in writing

Don’t be bashful.  Ask your advisors for their advice in writing.  If they hesitate, explore their motivations.  But, continue to press.

7.  Document, Document, Document

Document your process.   This cannot be stressed enough.  Contemporaneous written records of your process and the results of the process are critical to fiduciary prudence.

The issues are daunting.  The landscape changes daily.  Nobel prizing winning economists line up on every side of the issue.

For fiduciaries, be diligent about your process.  This will ensure that you are acting in the best interests of plan participants.

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Fiduciaries Really Need to be Experts

Plan sponsors need to re-calibrate their fiduciary obligations with respect to their retirement plans.  They have to ask hard questions. Do they have the relevant expertise to fulfill these roles?  Do they understand the “business” of maintaining and administering plans?  And, finally, do they want to devote time and resources to this responsibility?

In reality, most plan sponsors are too busy executing on their business strategy to worry about fiduciary matters. And, this is the way it should be.  Typically, HR and finance staff members oversee the plans and identify policies, procedures and vendors — all to be rubber-stamped by  high-level corporate committees.

This model is old-school, is broken, and must be fixed.  A recent appellate court case, in the 7th Circuit, is bringing these issues into sharp focus.  Plan Sponsors need to pay attention.

The volume and sophistication of ERISA class action lawsuits has grown significantly over the past decade.  Until this April, however, plan sponsors and retirement plan service providers have largely successfully defended against this onslaught.  This has been good news for fiduciaries.

In April, however, the 7th Circuit, previously a defendant-friendly court, handed plan sponsors and fiduciaries, a very serious set back.  In a class action suit against Kraft Foods, the court did not dismiss the case, but instead sent it back to the district court to determine whether the plan sponsor, Kraft, breached its fiduciary duty to the participants.

This holding is a nightmare for plans sponsors and corporate fiduciaries. No fiduciary wants a trial court to determine whether it’s acts or omissions satisfied the fiduciary standards of ERISA.  Likely the insurance companies will settle.

Nonetheless, this case goes to the heart of the critical importance of fiduciary processes.  With respect to a company stock fund, the court questioned whether the fiduciaries ever examined the operational structure of the fund and balanced the relative merits and drawbacks of different structures.  Furthermore, a question was raised as to whether Kraft ever reached an affirmative decision supporting one structure over another.  Surprisingly, no documentation was submitted which would support that a decision had, in fact, been made.

In addition, the court was not comfortable with Kraft’s 10 year relationship with its record-keeper.  Although consultants had advised that the recordkeeping fees were reasonable, the court was critical that third party bids were not obtained and used for comparison purposes.  Maybe the court just thought that the relationship was too cozy.

At a minimum, this case indicates that fiduciaries must develop a sophisticated understanding of the technical intricacies of the mutual fund, recordkeeping, and fund administration businesses.  Relying on consultants is not good enough.  Instead, fiduciaries must dig into the weeds, compare and assess the merits, deficiencies and costs of various service delivery models.

Plan Sponsors need to focus on capturing their own target markets, developing products, satisfying customer needs and growing their earnings. Why should they be bothered with this stuff?  It can be a nuisance.

As stated in the title of this posting, fiduciary oversight is not a part time job.  There is significant subject matter and procedural expertise required in discharging fiduciary responsibilities.  Plan Sponsors should recognize the professional skill set required to serve as a fiduciary, and acknowledge that it is not in their interest to develop or maintain this expertise in house.  Plan Sponsors, as well as participants and beneficiaries would be best served by hiring expert Independent fiduciaries to oversee the plans.

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It Could Be Money in Your Pocket

Well over a year ago I wrote about the impact of fees in accumulating assets in retirement plans.in , It’s the Fees Stupid. Every 12 months is not too frequent to remind ourselves of this critical point.

In today’s NY Times, Ron Leiber sets forth a compelling analysis of the impact of fees on retirement savings in a 401(k) accounts.  Leiber also reveals a sophisticated understanding of the business of providing and pricing 401(k) services.  Revealing Excessive 401(k) Fees.

With the advent of 401(k) plans, mutual fund houses like Fidelity (mentioned in the Leiber article) launched turn-key products for plan sponsors.  Known in the industry as “bundled services”, a plan sponsor could turn to a single firm for a complete $401(k) program — all in one, they would receive recordkeeping, administrative, investment and sometimes even shareholder support services.

The mutual fund houses, had one goal in mind:  get their mutual funds on the platform of investment options for plan participants.

This was a great business model, until the class action lawyers rounded up plaintiffs to challenge these arrangements.  Numerous cases have been filed around the country, and Leiber focuses on the Fidelity case.  While the allegations are complex and nuanced according to the facts of each case, the basic claim is that the fee structures for these products were excessive and unreasonable.  Part of arguments also include allegations that the fees structures are opaque and not fully disclosed, therefore no fiduciary or plan participant could make an assessment of the reasonableness of a fee.  If a fee is not properly disclosed, it can be assessed for reasonableness.

As Leiber notes, these cases have been winding their way through the court system and it is taking a long time for the issues to be resolved.  No doubt, if the initial proceedings do not go well for the mutual fund houses, the settlements with the insurance companies will be significant.

Theses cases caught the attention of the Department of Labor, and as Leiber noted, the Department has issued new regulators requiring fee disclosures.  However, disclosing the fees is only the first step.  Fiduciaries must understand the various fees and understand the price competitiveness of the fees.  Expert independent fiduciaries could extract significant savings on behalf of plan participants.

Why does all this matter?

Leiber puts in very real terms, “just a quarter of a percentage point in annual savings now can mean tens of thousands of dollars more come retirement time.”   Why should this money end up in the pocket of mutual fund execs or sales people.   Instead, it come be “between vacation each year or two at age 75, or one plan ticket, or serveral, for the grand children to come see you annually.”

The mutual fund execs and the investment managers are likely flying around in their private planes.  Better that retirees get to spend time with their families.

Fees matter. Fees add up over time.

Prediction:  Future ligitation will focus on another mutual fund industry product:   target date funds.   More on that in another Post.

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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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Outsourced Chief Investment Officer — More Questions Than Answers

Pension investment consultants have found their latest fad …..outsourced CIO services….otherwise known as OCIO.

From benchmarking, to style boxes, every couple of years the investment consultants cook up a new fad to sell to retirement plan fiduciaries.  As a business model, replenishing the product line has served the consulting industry very well.  The question, however, is “how well have the plans performed using their advice?”

And now, the industry is off on its newest fad:  OCIO.  While each firm might tailor their services in a unique manner, the general theme is the same. Rather than offering traditional consulting services, with an OCIO, a plan turns over its entire portfolio to the consultant to be managed.

Presto Change-o!!!!  The lowly consultant morphs into the coveted role of investment manager.  Rather than receiving a fee for consulting services they can now charge fees based upon the assets under management.  And, who knows? If they are lucky, they may even get a performance fee: the holy grail of asset management.

FundFire reports on this industry trend, Consultants Tweak Outsourced CIO Message.  As FundFire explains, however, there is a lot of confusion underlying the OCIO title and the services actually being provided.   This confusion requires the industry to “Tweak”  its message.  In fact, one public plan rejected the shift from traditional consulting to OCIO because of the lack of clarity surrounding these services and this role.

Two points in this article jumped out at me.

First, a critical term is missing. Neither the consultants, nor the article, mention the term “fiduciary”.  This entire model is presented as an asset gathering and fee generating exercise by the consultants.   But where is the fiduciary obligation to the plans and the participants?

Second, the article, in the opening paragraph, references potential “new conflicts of interest” presented by this new arrangement, but does not fully explore these conflicts.  Very often consultants provide multiple services to their clients.  Adding a OCIO role can add to these potential conflicts.

Furthermore, consultants also have significant relationships with other investment managers.   This side of the relationship equation is very murky.  How will the consultant  select managers for its OCIO services?   How will these services be priced?  These are just the start of the questions.

From the perspective of the consultant industry, it is completely understandable that they want to explore new ways to develop their services.  As Shale Lapping, president of IPEX, an independent consulting firm in Plymouth, MI states, “the ability to generate additional revenue is obviously an attractive position …. The margin has always been smaller for consultants (than for managers); that’s not secret in the industry. [Outsourcing] brings in higher margins and makes it easier to retain quality talent.”

This is well and good for the consulting industry.

At Harrison Fiduciary Group, we unequivocally and categorically reject this form of the  OCIO business model as embraced by many consultants.  While it might make sense for the consultants, it doesn’t necessarily makes sense for clients.

On one level, we do support the delegation of investment oversight, monitoring and management to outside, independent experts. In contrast, however, at HFG our business model starts and finishes with our role as a fiduciary for plan assets.  First, we provide a single service to plan sponsors — fiduciary services.  We don’t have multiple services to sell, or rather cross-sell, to a plan sponsor.  We have no ability to increase our fees with a client.  We also do not have affiliates such as broker/dealers which also can give rise to conflicts of interest.  Plain and simple, we pledge:  No Conflicts of Interest.

Importantly — and maybe even heretically in our business — we will charge a flat fee for our services.   We are not engaged in an asset gathering exercise and will not charge a basis point fee for assets under management.  Anwill bed, of course, we will never charge a performance fee. Instead, our flat fee is based upon (i) the complexity of an engagement, (ii) the resources needed to execute the project and (iii) the fiduciary risks which we assume.  Our fees will never increase simply because the value of a particular market increases.

To use a much over used expression; “we are thinking outside of the box”.  We present an alternative business model for the oversight, monitoring and management of retirement assets.  We are competing against traditional big players in our field.  However, we have a principled and new approach which puts the best interest of plan participants at the core of our business model.

We are not embracing a fad by serving as a fiduciary.  The duties of a fiduciary harken back to the 16th century.  At Harrison Fiduciary Group we serve a time honored role.

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No One Seems to Care about Conflicts

A member of the board of trustees of a NY City private school provides information to a prospective parent about the school.  Sounds simple enough, but then the parent pays the trustee for the information.  Say, what?

Apparently, there is a business in this.  The NY Times reports that Aristotle Circle provides these various contacts to otherwise unconnected NYC parents.  Let’s set aside for a moment, the hyper-aspirations of parents and the crazed environment for coveted spots in select pre-schools.  Instead, let’s focus for a moment on the trustee who provided these services.

Serving as a trustee on the board of a non-profit is a fiduciary position.  The trustee owes a fiduciary duty to the Board and the organization.  Receiving a fee from a third party for either access to the school or information about the school is a gross example of self-dealing.  This trustee should be thrown off the board, ASAP.

The bigger issue, however, is how come this trustee is so tone deaf to a blatant conflict of interest?  Did the trustee have any qualms about these actions?  Furthermore, how does Aristotle Circle build a business model on these fee for services, and introductions?

A few weeks ago, Berkshire Hathaway announced that David Sokol had made personal investments in a company in which he then encouraged Warren Buffet to buy.  Neither Buffet, nor his right hand man Charlie Munger, seemed to think that there was anything wrong with these actions.  Sokol tendered his resignation only after pressure was raised by outsiders.

Whether it is the heir apparent of Berkshire Hathaway or an ambitious NY city parent, no one seems to be bothered by these conflicts of interest.

Try as we may to overcome the financial crisis through new rules and regulations.  No meaningful progress can be made until we address this very simple business proposition.  People who hold positions of trust — in any organization — must avoid any appearance of a conflict of interest.

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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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David Sokol’s Resignation from Berkshire Hathaway Doesn’t Pass the Smell Test

Full disclosure:  I have been a long time shareholder of Berkshire Hathaway.  Therefore, I’m particularly disappointed with the current episode of bush league antics from corporate America.  I expected more from Berkshire, Warren Buffet and Charlie Munger.

I want to set aside the legal analysis of whether Sokol’s action constitute insider trading or a breach of a duty to the corporation, shareholders or anyone else.  No doubt, talented lawyers will line up arguing both sides of these issues.  Irrespective of the final legal assessment, these facts stink.

As reported in yesterday’s New York Times, by Reuters, Sokol learned about Lubrizol  because Citigroup had an investment banking assignment from Berkshire to bring potential acquisition targets to Berkshire’s attention.   In effect, Sokol learned about the Lubrizol opportunity in his capacity as an employee and officer of Berkshire.  He then took that information and used it for his own benefit.

This egregious behavior was then compounded by the fact that he turned around and pitched the Lubrizol deal to Buffet.  He also attended a meeting with Lubrizol’s CEO in the process — no doubt that he scored this meeting because of his position at Berkshire, it was not in his personal capacity as an investor of $10 million in Lubrizol’s stock.  (Although a lot of money, $10 million investments don’t typically afford an investor a one-on-one meeting with a CEO).

Simply put, Sokol abused a position of trust.  Buffet and Munger’s failure to call him out on it only exacerbates these inexcusable actions. In fact, Munger makes the tired excuse: “Few people understand how good he is, how really good he is”.  In other words, he’s so good that he is above the rules. The ultimate rationale of elitism; members of the club can’t possibly do anything wrong.

Corporate governance experts are explaining that Berkshire’s internal policies (Code of Conduct, Insider Trading Policy, Conflict of Interest Policy, etc) need to be reviewed and possibly re-vamped.  As a fiduciary, I am a huge proponent of rigorous policies and procedures.  However, policies and procedures are only as good as the judgment of the people who enforce them.  Nothing replaces strong business ethics.  And, as anyone who has worked at in a large organization knows — a culture of strong business ethics  starts at the top.

Buffet and Munger’s staunch support of Sokol sends a strong message not only through the capital markets, but also throughout the entire Berkshire entity.  Just possibly, there are two sets of rules:  one set for the rank and file and one set for those who are “really good”.  In large organizations everyone sniffs out these double standards and the integrity of the culture begins to erode.

Our financial system has survived a near death experience.  Congress attempted a legislative fix through Dodd-Frank which is now mired in a political and regulatory  morass.  As I have stated before, real reform will never occur until behavior is reformed. We need business leaders with the courage to proclaim that conflicts of interest are intolerable and unacceptable. Failure to do so undermines the integrity of our financial system.

Warren Buffet use to be such a leader.  For decades, he has only taken a minimal salary from Berkshire for the stated reason that he wanted his interests to be aligned with shareholder interests.  A noble and unique position in corporate America.   Somehow David Sokol missed this message.  Maybe he and Buffet should pull out some of the old Berkshire annual reports.  They provide an exemplary primer on corporate ethical behavior.

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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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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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