Emphasize Quality Over Quantity

Retirement plan fiduciaries are hiring independent fiduciaries with greater frequency.  Structured properly, the plan fiduciaries and senior management, should be insulated from liability for the actions of the Independent Fiduciary, provided that the process of selecting and hiring the Independent Fiduciary is prudent.

The process need not be tedious or cumbersome.  Furthermore, it should not be delegated to junior professionals with a mere rubber stamp approval provided by senior management.   A robust process, conducted with integrity, serves as an important foundation for fiduciary decision-making.

1.  Meet and interview the Independent Fiduciary candidate.

There is nothing more important than meeting with the potential Independent Fiduciary.   Most advisors, I suspect, would say that compiling data through an RFP process is the most important part of the process.  I disagree.

Data is important, but it does not take the place of a face to face meeting. Serving in a fiduciary capacity is a position of trust.   While technical skills can be assessed through an RFP response, trust can not.   Trust should be determine through a face to face meeting in which the hiring fiduciary attempts to gauge the way in which the Independent Fiduciary will analyze problems and execute fiduciary decisions.

2.  Assess the Fiduciary’s Independence.

The best laid plans of fiduciary protection will fail if the fiduciary is not independent.

The industry serving the retirement plans is vast and interconnected, a veritable spider web of relationships.  Hiring fiduciaries must be assured that the Independent Fiduciary does not have any relationships with the plans that could give rise to a prohibited transaction.  Focus on the receipt and payment of fees among the plans sponsor, the plan, the Independent Fiduciary and any affiliates of the above.

3. Review the Independent Fiduciary’s Procedures.

Every fiduciary should have a set of written procedures that it follows for a fiduciary engagement.  Request a copy of these procedures and evaluate them.  Ask the candidate whether they certify that the Procedures were followed.  Be assured that the  procedures are specifically tailored to the particular engagement and that they are not simply boiler-plate lists of tasks.

4. Inquire about Fiduciary Litigation.

Explore the candidate’s litigation experience.   The plaintiff’s bar is very active.  Qualified fiduciary candidates may have both been sued for breach of fiduciary duty and have won the case based on the facts; that is, a finding of the court that the fiduciary acted prudently.   Specifically, question whether the fiduciary’s procedures withstood the scrutiny of litigation.

5.  Is the Fiduciary an Expert?

Fiduciaries must be prudent experts.  Under take the requisite due diligence to determine that the fiduciary is both an expert with respect to the specific engagement and with respect to ERISA principles.   Investment/financial skills as well as fiduciary expertise are critical.  Compilation of data through an RFP can be helpful in this process.

Most importantly maintain a detailed written record of the selection and hiring process.  This documentation could be valuable if the process ever needs to be defended.

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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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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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Honest Talk about Fiduciaries

Next week, January 21, 2011, the SEC is due to deliver its report to Congress, as required by the Dodd-Frank Act, on the standards of conduct applicable to registered advisors and broker/dealers.  There is little doubt that this report will recommend a uniform standard — ostensibly, a fiduciary duty.  My greatest concern is that they will in fact adopt a unified standard and that they will trumpet fiduciary principles, but in reality it will amount to nothing more than a diluted version of fiduciary principles.

The lobbying by Wall Street has been intense.  Once the recommendations are made, the lobbying will get even more intense.  Wall Street’s business model is at stake.  This guarantees a watered down result.

In fact, the directives given by Congress to the SEC effectively preordained a diluted notion of fiduciary duty.  On the one hand Congress raises the prospect of a unified fiduciary standard, but on the other, also makes provisions for brokers to continue to sell propriety products provided there is sufficient disclosure of compesantion arrangements and conflicts of interest.   This is disappointing.

Simply put: commissions and disclosure are not consistent with fiduciary principles.

Fiduciaries are subject to a duty of loyalty.  This duty requires that a fiduciary put  client interests first, not engage in acts of self-dealing nor involving conflicts of interest.  Earning commission income from the sale of proprietary products clearly raises the potential of acts of self-dealing and conflicts of interest.  A fiduciary’s actions should never be clouded by acts of self-dealing.

Congress believes that disclosure will serve as the bulwark against acts of self-dealing.  In other words, if a broker discloses potential commissions, as well as how the commissions might impact his compensation, then the broker is “off the hook” from a fiduciary perspective.

Here, Congress is simply mistaken.  While disclosure is the corner stone of the securities laws, it does not hold the same weight as far as traditional fiduciary principles.   Under the securities laws, whether it is corporations or mutual funds, the underlying theory is that material facts need to be disclosed and investors can then exercise their own judgment based upon the facts.

For a fiduciary, however, the prohibition is fairly straight forward.  No acts of self-dealing.  A fiduciary cannot use its fiduciary discretion to engage in acts of self-dealing.   And, a fiduciary cannot disclose the potential self-dealing and obtain the client’s consent.

I focus on commissions and disclosure because it serves as a perfect example of how fiduciary principles will be watered down.  For those of us who believe that fiduciaries have a critical role to play in our financial system, this is a disappointment.  The marketing machine of Wall Street has the potential to dilute our commitment to longstanding principles.

At Harrison Fiduciary Group, we categorically reject efforts to masquerade self-dealing and conflicts of interest.  Our business model is structured on a fee for service basis.  Our fiduciary judgment will not be clouded by the potential to earn additional compensation.

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See No Evil, Hear No Evil, Speak No Evil

The Massachusetts Supreme Judicial Court handed trustee banks a disappointing decision on Friday; Massachusetts Ruling on Foreclosures Is A Warning to Banks.  Gretchen Morgenson of the NYTimes has been a prescient observer of, and commentator on, the subprime frenzy, subsequent collapse and its aftermath.  In today’s paper, she reports on the  court’s ruling that U.S. Bancorp and Wells Fargo did not have proper title to mortgages when they instituted foreclosure proceedings.

Yes, everywhere along the way in the securitization process, people and institutions were sloppy.  Why pay attention to detail when there was so much money to be made?

However, there is a critically important sub-text here, which has far greater impact on our financial well being than simply paying attention to details.  The real issue is that the role of serving as a trustee has been dumbed down over time so that trustees claim, “not my job”  when it comes to assuming responsibilities for their actions.

The securitization process is a lengthy one with many parties participating.  However, at the end of the day, there is a trustee of a trust, and the trust holds certain assets.  In this case, notes and mortgages.

Scrape away all of the financial engineering and mumbo jumbo.  At a very minimum, a trustee must know what assets it holds and is responsible for the management and disposition of the assets.  This is not a new concept based upon fancy algorithms or computer models.  To the contrary, it is a basic principle of trust law dating back to the development of the common law in England.

And yet, in defending it’s actions, a spokeswoman for Wells Fargo, Vickee J. Adams states, “As trustee of a securitized pool of loans, Wells Fargo expects the entities who services these loans to abide by all applicable state laws, including those laws that govern foreclosure sales.”

There you go ….it’s the other guy’s fault!   Great legal defense.

Unfortunately, as a fiduciary, it is not that simple.  Yes, trustees are often authorized to hire service providers.  And, yes, trustees can make reasonable assumptions about the service providers.  But, trustees have an obligation to conduct due diligence on the service providers they hire and they have an obligation to monitor these service providers as they perform their duties.  They simply cannot hire someone and then walk away from this responsibility.

Serving as a Trustee requires the exercise of judgment and discretion.  The privilege of holding assets in trust, on behalf of another party, carries with it the obligation to act prudently. There is no way to get around this.

The problem is that the role of the institutional trustee has been dumbed down over the past decades.  The large trust banks sell their trust services as if they are simply record-keeping services.  Both the banks and their customers discount the obligations and responsibilities of serving as a Trustee.

In fact, with the blessing of ERISA, a whole new role has developed known as the “directed trustee”.  These are trustee’s whose roles are so limited  that they simply follow the directions of other fiduciaries.  It is this directed trustee role which has greatly diluted the concept of the discretionary trustee.

And so, we have ended up with a network of institutions who at one time proudly served as fiduciaries and exercised discretion on behalf of their clients, but now do everything to limit their roles.  Therefore it is now easy to point the finger of blame at someone else.

Our financial system is deeply in need of responsible individuals and institutions ready to assume fiduciary roles and discharge those responsibilities prudently.

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Values Matter, A Lot

Published on 02 January 2011 by in Uncategorized


Golden Boy Steven Rattner Crossed the Line

He had it all: Brown, Partner at Lazard, started his own firm, Quadrangle Group, appointed Car Czar by President Obama, reported net worth of between $188 million and $608 million, and he regularly rubbed elbows with the likes of Bill and Hillary Clinton, Robert Rubin and Michael Bloomberg.

Wasn’t that enough?   What more did he want?  Another vacation house, a bigger bank account, more accolades?

On December 31st, when most of Wall Street either was sun worshipping in St. Barts, or dining on sushi at Nobu in Aspen, the NYTimes reported, New York Closes Pension Inquiry: Gets $10 Million.  So ends the drama surrounding Mr. Rattner, the Quadrangle Group, the SEC and Andrew Cuomo, the former Attorney General, and now Governor, of New York.   On probably one of the slowest news cycle days of the year, Mr. Rattner’s transgressions are practically swept under the rug.   Who is even paying attention?

I purposely characterized Mr. Rattner’s actions as transgressions rather than “alleged transgressions.”  No doubt Mr. Rattner vigorously denies any culpability.  However, from the perspective of a fiduciary, simply being involved in activities giving rise to ambiguous behavior is transgression enough.

For fiduciaries, there can be no ambiguity:  No conflicts of interest.  No acts of self-dealing. No questionable payments. No movie deals.

Mr. Rattner, and thousands of hedge fund, private equity, venture capital and investment managers, hold and manage assets that belong to other people — retirees who accumulate benefits over decades of employment.  They work “on behalf” of other people.  They are fiduciaries.

The investment stewards of pension funds must demand that all investment managers abide by fiduciary standards.  They must rebuff attempts by ERISA lawyers working on behalf of their investment management clients to eschew fiduciary responsibility .

Over a century ago, Justice Benjamin Cardozo eloquently wrote;

A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior… the level of conduct for fiduciaries [has] been kept at a level higher than that trodden by the crowd. (Meinhard v. Salmon)

Though the language is flowery, and some criticize it for being to0 vague, and therefore impractical,  the principle and spirit abides; fiduciaries are held to a higher standard.

Notwithstanding his education, prior business successes and stellar reputation, Mr. Rattner failed to conduct himself “at a level higher than that trodden by the crowd.”  That is a disappointment.  Let’s not gloss over this behavioral misstep.  Upon reflection, it may present a critical insight to the future of our financial system.

After the crisis of ’08-’09, academics, businessmen and legislators endlessly debate the pros and cons of the various proposals to shore up our financial institutions and markets.  However, the simplest, least costly and most effective remedy lies in a change of behavior.  We need leaders in the financial community to abide by principles “stricter than the morals of the marketplace.”

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Tight Liquidity Can Create Volaitility

All is good in the financial markets, right?   The stock market continues to climb; and, Frank Norris in the New York Times suggests that the thrid year of a presidential term is a good one for the stock market. On top of that, no doubt, Wall Street and Corporate America will be thrilled that a compromise appears to have been worked out on the Bush Tax cuts.  And yet, I have a quesy feeling that a perfect storm is brewing with respect to stable value funds.

You may ask, what would a recovering stock market have to do with stable value funds? Experience shows that the two move hand in hand with one another —- except, in opposite directions. This phenomena is attributable one-part to investor phsychology and two-parts to the arcane mechanics of stable value programs.

Coming out of the financial crisis of ’08-’09, many plan participants sought safety in stable value programs.  First, the programs were typically marketed as safe (and possibly even as risk free); and second, with money market rates excessively low, stable value programs offered a slightly higher return.

Bingo — higher returns, lower risks and huge waves of money shift into stable value funds.

While yields remain at historically low levels, the robust returns generated by equity funds will likely attract attention from plan participants.  So far, plan participants have been reluctant to embrace the equity markets, but at some point, and we don’t know when, the equilibrium will tip and vast amounts of retirement assets will likely flow back into equity funds.  Plan fiduciaries must anticipate that a significant portion of these assets will come from withdrawals from stable value programs.

Prudence requires that plan sponsors plan for this contingency. If plan participants “head for the exit all at the same time” to cash out of stable value programs, plan fiduciaries will have to sell assets into a falling market.  We’ve seen this movie before.

Plan fiduciaries must instruct investment managers of stable value products to evaluate and monitor their liquidity needs.  Liquidity guidelines must be re-assessed for the market conditions.

Similarly, plan fiduciairies must also review the demographics of their participant base.  Understanding previous flows in and out of various investment options, can also provide important data for assessing liquidity needs.

Of course, rising equity equities markets are generally a good thing (assuming it is not a bubble brewing).  However, there can be unintended consequences.  The stable value world is a small niche within the global capital markets.   However, it is a niche with $700 billion of retirement assets.  It is also a niche in which many investors have been promised “safe” “stable” returns.  These promises can set the stage for a calamity.

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Securities Lending Pays for Custody

Louise Story’s original article was the subject of an editorial in Friday’s New York Times, The Bank Wins.  Both the original article and the editorial use the opportunity to engage in the popular and easy task of bank bashing.   However, jumping onto this bandwagon simplifies and overlooks otherwise complicated dynamics underlying our financial system.

Securities Lending– typically knows as Sec Lending — most often is tied to the custody services provided by banks. In fact, in the early days of Sec Lending, the Sec Lending units of banks were often housed within the custody area of banks. And custody sales people often sold Sec Lending relationships.  It wasn’t until the explosive growth area of the late 1990’s when they were granted status as separate divisions or areas within a financial firm.

Sec Lending became a very hot “valued-added” service for the custody banks.   First, pension plans hate paying custody fees.  But they have no choice because ERISA requires that plan assets be held by a custodian (either a bank or an insurance company).  Second, from the bank’s perspective there is little sexy or exciting in the realm of custody other than various accounting and record-keepping services — essentially commodity type products.  Sec Lending, however, holds out the prospect of significant fees.

Pension plans which engage in  Sec Lending can net the revenue generated by Sec Lending against custody fees.  The tight relationship between custody and Sec Lending is reflected in  Mercer consultant, Jay Love’s statement that,”Whenever we say no Securities Lending,” then they say ‘well, we need to talk to you about your custodial fees.'”

Ms. Story also states that “Banks often pressure pension funds to participate in securities lending, pensions consultants say.”   Yes, banks clearly want to sell Sec Lending services, but focusing on “pressure”  seriously mischaracterizes the relationships between banks and pension fund decision-makers.

The custody and Sec Lending business is highly competitive.  Banks don’t like to lose customers … especially to competitors.  Fees and relationship are highly negotiable.

Pension plans have enormous leverage.  They do not have to accept the terms foisted upon them by banks.  And, they have the ability to shop terms around the various banks.  This happens all the time.  There are few secrets in custody/Sec Lending marketplace.   Remember, the pension plans always have the option of saying “no”.  Nothing requires Sec Lending.  This is a powerful position from which to negotiate.

Ms. Story, and the Times editorial, paint a picture of hapless powerless pension plans who are manipulated and at the mercy of the big bad banks.

This simply isn’t the case.  Pension plans must simply exert their fiduciary powers.  Plan fiduciaries must assess  the various risks posed by financial products and accept those risks when they are being adequately compensated.  In order to assess risks, however,  the risks have to be understood.  And this is the rub.  If Mr. Davis (see, Part I) of the New Orleans municipal employees fund is representative of pension decision makers, then assessing risk will be a daunting task.  Clearly, he never understood Sec Lending and therefore was in no position to assess the risk.

To be fair, there were abuses by the banks in Sec Lending.  Investment guidelines with respect to the investment of cash collateral were violated and if many of the facts set out by Ms. Story are corroborated then serious conflicts of interest arose.  Absent these abuses, however, Sec Lending works.  Plan fiduciaries simply have to exercise their fiduciary duties and decide whether they are adequately compensated for these risks.

In light of the abuses, Ms. Story and others suggest that further regulations might prevent future abuses.  No new regulation is needed. Both ERISA and the current Securities Laws are very effective regulatory schemes.  Instead, we need a system in which fiduciaries pose a force as strong as Wall Street’s. http://harrisonfiduciary.com/about/

Attention should be focused on the thousands of plan fiduciaries –many of whom are no different than Mr. Davis.  As Ms. Story states, “no one would take Jerry Davis for a financial hotshot.”  This is a difficult statement to parse.  For it suggests an element of ridicule or even a patronizing attitude.  No, Mr. Davis isn’t a financial hot shot.  But, this isn’t a joke.  He is in the position of making fiduciary decisions on behalf of thousands of workers.  This is not about being a hotshot.  This is about the prudent investment of hard earned retirement dollars.

With over $16 trillion held in retirement plans, it is not surprising that Wall Street devotes significant resources to developing products and services for this market.  The people on Wall Street are both smart and aggressive.   It’s not enough to state that Mr. Davis isn’t a financial hot shot.  Plan participants deserve fiduciaries who are as well versed in investment products as the salesman of Wall Street.

Ms. Story has focused attention on a little understood, but highly profitable product for Wall Street.   This spotlight is critically important.  However, she should follow up her efforts by digging into the qualifications and competence of the fiduciaries overseeing America’s retirement plans.  My prediction is that many would be shocked at what passes for fiduciary oversight. Strong, well trained investment fiduciaries could effect significant financial reform without a single new statute or regulation.

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