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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, 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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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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Dark pools remind me of revenue sharing.  Not much good can come from business practices or products with descriptive titles of this nature.

Whereas an avalanche of class action litigation has shed light on the practice known as revenue-sharing, New York Attorney General Eric Schneiderman, Barclays Faces New York Lawsuit Over Dark Pool and High-Frequency Trading, has focused the spot light on dark pools by filing a law suit against Barclays over its private stock trading platform… otherwise known as dark pools.

The law suit essentially claims that certain high-frequency traders were favored over other participants in the pool and that various practices were not properly disclosed.

Many of the other banks and financial services firms run similar “platforms”, so the entire financial industry has a stake in the litigation.  Schneiderman is not the only regulator involved, the SEC, charged with maintaining integrity in the financial markets, is also a key player.

And so … here goes another financial services industry free-for-all.   Mind you, these dark pools are big revenue producers, so the stakes are high.

The issues are serious and complex for Wall Street, however, I am much more interested in the fiduciary issues at stake.

Make no mistake about it, plan fiduciaries have oversight responsibility for the trading of securities held by the plan.  At a minimum, the trading practices must be reasonable, prudent and, generally, managers are required to seek “best execution.”  And, of course, this analysis must includes a review of trading costs and expenses.

The challenge and tension revolves around the fact that fiduciaries require transparency, whereas the name dark pools suggests the opposite — opacity.

At the outset, Fiduciaries need to determine whether plan assets were traded through these dark pools.  If the answer is yes, then a whole series of questions follow:

Did the plan assets get best execution?

Are other pool participants advantaged over the plan assets?

What fees are charged for trading in the pools?

Are these fees reasonable?

Are the fiduciaries assured that trading via the pools did not constitute a prohibited transaction?

How are pool operators compensated?

Are there any conflicts of interest?

Has the fiduciary been monitoring these trading practices on a regular basis?

This is merely an initial list of questions.  But, posing the questions is the easy part.  Understanding the answers is far more challenging.  In my many years of serving as the General Counsel of a global investment management firm, no area was more confusing or harder to get my arms around than the issues related to the trading desk.  Traders use a lingo and jargon that is all their own.  Sometimes getting satisfactory answers in this area requires the best of prosecutorial skills.  It can be tough going.

If they haven’t already, Fiduciaries are best advised that they begin asking these questions.  If they do not, certainly class action lawyers and the Department of Labor, most certainly will.

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Seems Like Some Fiduciaries May Be Asleep at the Switch

The SEC is attempting to cast some sunlight on to the tangle of fees charged by private equity firms.  The Deal’s Done. But not the Fees, Gretchen Morgenson.  My question, as if often the case is, “Where are the plan fiduciaries?”

Moregenson points out that in addition to the typical “2 and 20” fee arrangement (2% management fee, 20% performance fee), private equity advisory firms charge investors a host of other fees, many of which are buried deep in disclosure and other documents.

The SEC, apparently, is now hip to these tricks.

Morgenson notes that private equity investments constitute $3.5 trillion of the $64 trillion asset management industry.  The Investment Company Institute reports that as of December, 31, 2013, total US retirement assets were $23 trillion. With respect to these assets, managers must not only abide by the rules of the SEC, but also ERISA (the Employee Retirement Income Security Act of 1974).  Admittedly, many private equity funds are structured in a manner designed to avoid ERISA, however, not all are so structured.

ERISA imposes a regulatory regime which is materially different than the regulatory regime imposed by the securities laws. Whereas the securities laws rely heavily upon the “sunshine” of disclosure, ERISA places affirmative duties on fiduciaries with respect to the investment and monitoring of plan assets.

Therefore, the SEC’s efforts should be supplemented by the Department of Labor.  While the SEC can direct its attention on the advisors, the DOL can focus on plan fiduciaries.

The questions for the plan fiduciaries are simple:

  1. Were they aware of theses intricate fee arrangements?
  2. Did they analyze and review the various fees?
  3. Did they conclude that the fees are reasonable and sign-off on the reasonableness of the fees?

ERISA requires that fees paid out of plan assets must be reasonable.  In fact, a couple of years ago new regulations were issued related to plan expenses.  Mutual funds and various other plan service provides have been jumping through hoops to comply with these new regulations.  What about private equity funds?

Another ERISA concern revealed by Morgenson relates to various relationships which might give rise to conflicts of interest.  Again, ERISA takes a different approach than the securities laws.  Under the securities laws, generally, disclosure is sufficient to “cure” a conflict of interest.  The thinking is that once effectively disclosed, sophisticated investors can consent to these conflicts.

Not so under ERISA.

ERISA contains a set of requirements which preclude a series of transactions known as “Prohibited Transactions”.  The types of transactions are fairly explicit, and, simply put, they are prohibited, not allowed, barred.   It’s really plain english.   Disclosure and consent are not remedies.  Conflicts of interest clearly constitute Prohibited Transactions.

Allowing a plan to engage in a prohibited transaction constitutes a breach of fiduciary duty under ERISA.  Therefore, plan fiduciaries typically are vigilant in detecting these prohibitions.

At a minimum, in light of Morgenson’s article, and the SEC’s questioning, plan fiduciaries need to examine whether in fact a plan’s private equity investments is subject to ERISA.  If it is, then further diligence may be necessary.

These concerns are not intended to disparage private equity investments.  Private equity managers have delivered consistent returns for their investors over the past decades.  But, like any investment, past performance is not a guarantee of future results.  Private equity investments clearly can play a role within a larger portfolio of plan investments.

However, private equity investment structures need to pass the same regulatory scrutiny imposed upon all other advisors and services providers to retirement plans.

Morgenson’s article suggests that possibly plan fiduciaries may have been asleep at the switch.  Her article puts fiduciaries on notice as to where they should be directing some attention.

Any fiduciary not up to the task of demanding information and asking hard questions of private equity advisors should delegate that task to fiduciaries who are prudent experts.  Plan participants and beneficiaries deserve no less.

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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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Heighten Regulation and Executive
Ignorance:  A Bad Combination

Pension & Investment reports that many executives are “clueless” about the plans they oversee, DC Execs Clueless About Key Plan Data.

The P&I article is shocking.  Survey data reveals that on multiple levels Plan Execs don’t know the nuts & bolts of the business of running and administering their plans.  And, worse, some have just “thrown-up their hands”.

In many cases these execs are plan fiduciaries, or advise plan fiduciaries.  The problem is that plan fiduciaries can’t just “throw-up their hands”.

And yet, the role of overseeing retirement plans keeps getting more complex and sophisticated, not less.

The Investment Company Institute just reported that as of Q3, 2011, total US retirement assets were $17 trillion.   That is a big pool of assets against which various service providers can charge fees.

As the financial services industry has exploded over the past decades, the Department of Labor has finally focused the spot light on the fees and expenses charged against plans. New regulations go into effect this summer under which plan fiduciaries must approve the reasonableness of fees and expense charged to plans.

Notsurprisingly, these regulations are very intricate and complicated.  In effect, the regulations reflect the elaborate fee structures and business models which have evolved enabling various service providers to increase their revenue streams from retirement plans.

And so, a “perfect storm”, rages.  Complexity increases, the government is demanding greater oversight, and key executives and fiduciaries remain ignorant on basic facts and details with respect to the plans they oversee.

Of course consultants stand ready to advise plan executives and fiduciaries.  But, before the consultants can provide advice, the plan executives and fiduciaries MUST understand the business models for administering their plans. Otherwise, the advice is being delivered into a vacuum. How can one evaluate the advice if they don’t even understand the basic features and terms of their plans and do not understand the business of administering a plan?

At Harrison Fiduciary Group, we are proponents of an entirely  new model for the delivery of fiduciary services.  With respect to Fees & Expenses, we are experts. Our combined 30+ years in the retirement-industry has provided us with the experience and knowledge to analyze plan structures and the related fees.  The devil is in the details, and we understand the details.

By delegating this authority to HFG, plan executives and fiduciaries will not have to become experts on an area that bears little impact on their core business competency.

Perfect storms need to be heeded wisely.  Allowing ignorant plan execs and fiduciaries to make significant fiduciary decisions can lead to disasters.

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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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