Happy Birthday - 5000 and Counting

Thank you everyone for helping to make the debut of PENSION RISK MATTERS a success. We've had more than 5000 visitors to our site in just two months. Our goal is to make the blog as user-friendly as possible. We welcome your ideas and comments.

What pension risk topics are of interest to you? Email pension@bvallc.com. posted by Susan Mangiero at 5/30/2006 10:59:00 PM | 0 comments | links to this post   

Asset Allocation Anyone?

Taking time for some weekend reading, I was struck by several headlines that focus on a topic I predict we'll hear more about (much more) in coming months, namely how to best allocate assets to meet liability objectives. Here are a few examples.

"Big pension fund too equity-heavy, says consultant"

"Pension Fund to Expand Stock Buying"

"DB plan sponsors hedging their bets on hedge funds: Pension plans expected to invest $300 billion"

While a discussion of optimal asset allocation and portfolio re-balancing is left for another time and venue, a few questions and comments come to mind.

1. As new accounting rules encourage a focus on liability-driven investing, how will plan fiduciaries decide on a portfolio split between matching liabilities and generating excess return?

2. How can and should derivatives be used to transform assets and liabilities?

3. What role should alternatives play?

4. What will cause a shift away from the traditional equity-fixed income mix for defined benefit plans?

5. How should the equity risk premium be evaluated with respect to managing goals, knowing that greater reliance on fixed income is likely to widen a plan's pension deficit if equities outperform?

6. How should fiduciaries be evaluated and compensated if they focus on risk control in lieu of exceeding return targets?

7. Are decision-makers sufficiently trained to deal with surplus volatility, fat tailed distributions, side pockets and other financial delights?

8. What is the likely impact on capital markets as long-term pension investors begin to favor a radically different asset allocation mix?

As accounting rules, regulatory mandates, changing demographics and economic reality join hands, it's clear that a paradigm shift in asset allocation strategies and tactics is on its way. Are we ready? posted by Susan Mangiero at 5/30/2006 12:37:00 AM | 0 comments | links to this post   

Longer Life Spans - Bigger Pension Liabilities

According to economist John Maynard Keynes, "In the long run, we're all dead." That may be but the long run is getting longer. The Centers for Disease Control and Prevention report that "life expectancy for Americans has reached an all-time high" with women expected to live to 79.9 years and men giving way around 74.5 years. The good news is not unique to the U.S. More than a dozen countries have a life expectancy at birth of more than 80 years. What accounts for the female factor? Researchers Daniel Kruger and Randolph Nesse offer that men take more risks than women, exposing themselves to danger, especially in their twenties. (The gap seems to narrow over time.)

Living longer could be a blessing or a curse. Liz Pulliam Weston makes a compelling case that women are in retirement crisis mode. She warns that the fairer sex is likely to experience job discontinuity (and related income diminuition), earn less on average, outlive a spouse and save too little. Then there's a marriage penalty since "Single women are four times more likely than couples to live in poverty."

In pension land, longevity spells trouble. Plan sponsors find themselves in the unhappy position of having to fund benefits for an additional period. A KPMG study estimates a 2005 pricetag for British companies of "an additional 20 billion pounds in pension liabilities".

Longevity derivatives offer some hope. One form, annuity bonds, pay coupons that are linked to a pre-specfied survivorship index. From an investor's perspective, a low correlation with traditional offerings has appeal. Mortality bonds are another possibility. According to Kevin Dowd, one bond paid principal based on an international mortality index with a "generous floating coupon payment in return for accepting the risk of a reduced principal payment in the event of a catastrohic mortality deterioration". Yet another variation, still in its infancy, is the longevity swap. The outlook is mixed. In "The Grave Problem with Longevity Risk", professor Dowd describes advantages and disadvantages of this emerging market.

If actuarial predictions prevail, financial engineers could be extremely busy. Companies and governments will need help in managing pension and post-retirement healthcare benefits that are growing with kudzu-like speed. posted by Susan Mangiero at 5/29/2006 09:48:00 PM | 0 comments | links to this post   

Pension Reform - Why Wait?

The evidence that something is awry in global pension land is everywhere. While Rome burns, reform proceeds at a snail's pace. BenefitNews.com reports uncertainty about when Congressional action will occur in the U.S. Abroad, the pace of reform is different, depending on the country.

Is delay good or bad?

In his May 24 posting, American Enterprise Institute resident scholar Norman J. Ornstein makes a compelling case for acting now to reform what most people describe as a broken system. He advocates a national infrastructure that would give employees solid investment choices along with portability. While having the right to take your accumulated retirement monies from job to job makes perfect sense for today's mobile work force, we're haunted by the inevitable question about investor readiness.

Are employees willing and able to take full responsibility for making good investment choices? What role should employers play with respect to providing investment education and possibly exposing themselves to liability for offering "bad advice"? (These questions apply to defined contribution plans of any sort.) Other issues prevail.

Who picks up the tab for large unfunded liabilities that get either frozen or outright terminated? How do we best transition from point A to point B without exacerbating the situation for already troubled companies? One proposal, requiring immediate funding of high risk plans, might push sponsors into bankruptcy, thereby creating a host of unwelcome problems. States are not immune and are starting to enact legislation to do likewise. Whether these pension stabilization funds solve the problem or simply pass the buck to the taxpayer is debatable.

Finally, it's not a foregone conclusion that all reform is good. In fact, as columnist Rob Norton so nicely describes, there is a bounty of research that documents the law of unintendend consequences. Simply stated, the idea is that regulation is likely to change behavior in such a way that new (and more acute) problems arise as a result.

An alternative is industry self-regulation. While the economic merits of a free market approach are significant, it would probably be difficult to get politicos onboard.

Changes must occur. Let's just hope that regulators consider the opportunity costs and all potential outcomes for the $10 trillion retirement benefits market before speeding along the wrong path. posted by Susan Mangiero at 5/24/2006 10:19:00 PM | 0 comments | links to this post   

Do You Have Something to Say About Pension Risk and Governance?

Two motivations account for the existence of www.pensionriskmatters.com: a desire to inform and facilitate a meaningful dialogue about pension risk and governance issues, especially at a time when so many changes are taking place around the world. Based on the insightful and encouraging comments we've received from blog readers, we seem to be on the right track. Thank you everyone!

We'd like to make the blog more interactive and are therefore inviting readers to comment. We'll publish the comments at least once a month and hopefully more often.

Here are a few suggested topics. We'll add more along the way.

If you are so inclined, simply send your comments to pension@bvallc.com. If you prefer to remain anonymous, please state such so we know not to publish your name. If you want others to contact you, please include an email address in your comments.(We reserve the right to edit but we will try to preserve the essence of your comments.)

1. What do you think is the difference between asset-liability management and liability-driven investing and why do you think so few pension funds are employing these techniques (though the trend points towards increased use)?

2. Do fiduciaries have a duty to hedge market risk?

3. Should fiduciaries be required to have X number of years of investment education and experience in order to serve? posted by Susan Mangiero at 5/23/2006 11:39:00 PM | 1 comments | links to this post   

Do We Need an Easy Button for Fiduciaries?

I love my Easy Button. Designed by some clever person at office supply company Staples, I press it every few days to remind myself that solving a particular problem is possible.

You might be thinking that this all sounds silly. It's certainly not rocket science but even the most capable among us sometime need a low-cost and humorous reminder that things are not as bad as they seem, that we can achieve an end goal if we take a breath, regroup and map out a step-by-step approach. If a problem is perceived as too complex, difficult to reconcile and too hard to tackle, how can anyone possibly move forward?

Apropos to pension governance, there is an urgent need for simplification and reassurance that the process of effectively discharging fiduciary duties is possible, practical and unlikley to break the bank (in terms of time, money, energy, stress, reputation).

Fear is a big factor that can both overwhelm and paralyze. At a time when pension liabilities are mounting, sweeping regulations are on their way and millions of employees are about to retire on what they think is their guaranteed nest egg, we can ill-afford to have fiduciaries look the other way because things are too hard.

To the contrary, we need people with courage and leadership skills to stand up and be counted. This is often a Herculean task with respect to anything having to do with pension risk. Why? Good people often cower at the mention of tools and techniques such as Value at Risk, Enterprise Risk Management, Derivatives, Risk Budgeting, Liability-Driven Investing, Stress Testing, Fat Tails, Model Risk and so on. For those fiduciaries with a limited background in finance, let alone investing, the fear factor is significant.

Is there hope? Absolutely. For one thing, fear can be managed as long as it is first recognized. According to the author of "One Small Step Can Change Your Life : The Kaizen Way" and pioneer in the area of success research, Dr. Robert Maurer asserts that fear can be a powerful tool to prepare us "for action", adding that "fear is nature's gift to awaken us to the possibilities". Then it's up to us to take one small step at a time to effect change.

Certainly a move in the right direction is an acknowledgement of those in charge that fiduciary education is a sine qua non of pension governance. To that end, this author will continue her efforts to inform and empower by trying to make complex concepts more understandable. (While the list of future topics is long, suggestions and comments are always encouraged. Email pension@bvallc.com.)

As Confucius once said, "A journey of a thousand miles begins with a single step." posted by Susan Mangiero at 5/21/2006 10:14:00 AM | 0 comments | links to this post   

Do You Really Know the Value of Your Portfolio?

Proper asset valuation is a cornerstone of the investment management process. Without good numbers, it is virtually impossible to make meaningful decisions about asset allocation, portfolio re-balancing, risk control, and manager evaluation. The challenge is especially relevant as endowment, foundation and pension fiduciaries commit billions of dollars to hard-to-value instruments at the same time that regulators are asking tough questions about methodology and process.

Anyone with fiduciary responsibilities needs to have a solid grasp of valuation fundamentals AND understand what happens in the absence of good numbers. The consequences are dire.

Duties extend to assessing external money managers on the basis of their respective valuation processes. (If you get a blank stare, worry.)

1. Do they use independent appraisers or do traders provide their own marks at the same time that they are compensated for reported performance?

2. What valuation models are used?

3. Are they recognized as standard models?

4. Are the models tested?

5. Where does the model input data come from?

6. What systems are used to value individual positions and portfolios?

7. Is model risk well understood and analyzed on a periodic basis?

The list goes on. If a plan sponsor is uncomfortable with evaluating a manager's policies and procedures, hire someone to help. Oversight is a core responsibility and cannot be outsourced away.

There is a lot to say about this subject. I'll be speaking about valuation as part of the (a) Asset Allocation & Risk Management Strategies for Institutional Investors (AARMS) conference in Boston on May 18 (b) National Association of Certified Valuation Analysts (NACVA) annual conference on June 2 and (c) Hedge Funds 101 & 102 conference for FRA, LLC in New York on June 23.

If you are interested in presentations and/or articles on the topic of valuation and model risk, contact me . I'd like to know what keeps you up at night with respect to everything valuation.

Without doubt, there is increasing emphasis on the topic of valuation with respect to both process and outcome.

Valuation is in the news!

"Understand how a fund's assets are valued. Funds of hedge funds and hedge funds may invest in highly illiquid securities that may be difficult to value. Moreover, many hedge funds give themselves significant discretion in valuing securities. You should understand a fund's valuation process and know the extent to which a fund's securities are valued by independent sources." (Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds, U.S. Securities and Exchange Commission)

"According to a survey conducted by the Alternative Investment Management Association (AIMA) in Q4 2004, 20% of the assets held by hedge funds are hard-to-value securities. But many of these hard to value assets are concentrated within specific strategies such as distressed debt, emerging markets and mortgage backed-securities. Investors in a non diversified hedge fund may therefore have up to 100% exposure to hard-to-value securities. A combination of assets with poor market liquidity, leveraged structures and their non-stable correlation with other related assets mean valuations can exhibit considerable volatility within a short period of time." (Hedge Funds: Are their returns plausible? Speech by Dan Waters, Sector Leader Asset Management, Financial Services Authority - UK, March 16, 2006)

"The more unusual the instrument or the greater the degree to which the asset payoffs are determined by a tiny fraction of the economic states the harder is the instrument to value and assess the risk." (The Growth of Derivative Securities speech by Chester S. Spatt, Chief Economist and Director of the Office of Economic Analysis, U.S. Securities and Exchange Commission, December 8, 2005)

"Diligence, prudence and caution should be applied when valuing private companies, and in particular when considering the valuation write-ups of early-stage companies, in the absence of market-based financing events." (Industry Group Releases Clarification Valuation Guidelines Endorsed By ILPA press release, October 2004) - Note: ILPA = Institutional Limited Partners Association

"Preliminary results from a survey on the pricing of hedge fund portfolio assets suggest that considerably more than one-third of managers mark hard-to-price securities in equity and fixed-income portfolios according to their own models, rather than using dealer's prices." (Model-Driven Pricing Common for Illiquid Securities, HedgeWorld.com, February 3, 2004)

"Investment Adviser Defrauded Hedge Funds, SEC Suit Alleges" (Derivatives Litigation Reporter, January 15, 2001)

"Ambiguity clouds valuation methods" (Financial Times, February 25, 2002) posted by Susan Mangiero at 5/17/2006 11:34:00 PM | 0 comments | links to this post   

Who Wants to be a Fiduciary Anyhow?

I do a lot of public speaking. I enjoy it, especially when the audience participates by providing commentary, war stories and lessons learned. As part of a recent presentation about pension governance and hidden risks, I asked what I thought was a rhetorical question.

Why would anyone want to be a fiduciary?

Often the pay is bad and the hours are long. (Individuals seldom receive any additional compensation at the same time that they are asked to assume significant responsibilities that put them directly in the "line of fiduciary fire".) One might say it's like being asked to constantly eat your peas without any hope of ever getting dessert.

Not surprisingly, several members in the audience answered: "We can't figure out why anyone would want to be a plan fiduciary."

Keep in mind that most people don't get a choice in their current position. If what they are tasked to do meets the functional definition of a fiduciary, bingo!

I'll be the first person to say that it's a good thing that people are willing to serve as fiduciaries. Assuming they are capable, knowledgeable and conflict-free, their service can make a world of difference.

Therein lies part of the problem. As I've described in other postings, pension work may not be a person's primary job and it becomes an issue of squeezing time out of an already hectic day to carry out fiduciary duties. Others may feel ill-equipped to tackle multi-million dollar decisions.

Perhaps the supply-demand dilemma for qualified fiduciaries accounts for what can only be described as a heightened interest in the notion of hiring an independent fiduciary. In his May 2006 paper on this topic, Mr. Samuel W. Halpern (former U.S. Department of Labor attorney and president of Independent Fiduciary Services, Inc.) describes some of the situations that lend themselves to hiring an independent fiduciary. These include:

"1. managing employer stock

2. tender offer

3. in-kind contribution

4. unpaid contributions

5. sale-leaseback

6. securities class action regarding employer stock

7. retiree medical plan

8. union sale to pension fund

9. merger of mutual funds

10. transaction between two investment vehicles sponsored by a single investment firm."

Echoing these sentiments about conflict and the need for independence, law professor Paul Secunda wrote that "it is not generally a good idea to represent a company or individual corporate officers in both their corporate and fiduciary capacities" and that non-lawyers should seek independent counsel for the ERISA plan and not "rely on existing corporate counsel to also represent them in their fiduciary capacity". (You may want to contact Professor Secunda for a copy of his paper entitled "Inherent Attorney Conflicts of Interest Under ERISA: Using the Model Rules of Professional Conduct to Discourage Joint Representation of Dual Role Fiduciaries".)

Is this the beginning of a new and better paradigm? posted by Susan Mangiero at 5/16/2006 08:47:00 PM | 0 comments | links to this post   

Do You Know the True Cost of Your Retirement Plan?

That a relationship between investment performance and fees exists is hardly news. Fees matter. However, it's not quite as simple as it may seem. Fees vary by amount, timing and form. A two percent fee, charged upfront, hurts more than a two percent fee that is levied on the back end. A no-load fund that charges higher annual expenses might cost an investor more than a fund with an upfront charge but lower annual expenses. For mutual funds and exchange-traded funds, the U.S. Securities and Exchange Commission provides a handy calculator with the qualifier that "the results should be compared for several funds or different classes of a single fund".

Importantly, lower may not necessarily mean better. Consider performance fees such as those charged by numerous hedge funds. If an investor understands and willingly acknowledges likely risks, a performance fee may be an acceptable price to pay for participating in returns that exceed a pre-specified benchmark.

However, good decision-making cannot take place in the dark. As described below and in a GAO report about mutual fund disclosure, transparency is not always easy to come by.

1. Database vendors typically provide returns on a gross basis because that is how they are reported by participating money managers. Evaluating a large number of funds requires manual adjustments to facilitate an "apples to apples" basis. This is time consuming to say the least and sometimes difficult to do.

2. Fees vary by type of fund, strategy and timing. Care must be exercised to take into account relevant factors.

3. Fees change over time. Past fees may not be a bellwether of future fees.

4. Reported performance may not reflect all elements of a portfolio as would be the case with side pockets or similar mechanisms. Refer to Barry Schachter's hedge fund blog for comments about side pockets.

5. Mutual fund expenses may not be reflected in published performance reports, forcing one to review the Statement of Additional Information.

6. Institutions and retail clients do not bear the same costs so fee analysis must incorporate any differences.

According to BenefitNews.com, New York Attorney General Eliot Spitzer announced plans to "examine how 401(k) investments are allocated and whether fund managers are exacting higher fees than participants believe they are paying".

What this portends is anyone's guess. Investigations have the potential to shed light on the important topic of investment fees. Of course, institutional investors should be asking lots of tough questions before they commit dollar one to any particular manager. In fact, it's their duty to behave prudently and proper inquiries, during the RFP process and in-person interviews, are a perfect time to dig deep. posted by Susan Mangiero at 5/14/2006 07:48:00 PM | 0 comments | links to this post   

Conference About Fiduciary Risk and Responsibilities

Institutional investor clients such as pensions, endowments and foundations have always had unique needs because of their size and breadth of asset mix. Regulations, accounting and economic considerations are likewise important, especially now. Fiduciary accountability has taken on a new urgency as headlines about big losses motivate shareholders and taxpayers to demand reform. Integral to the process is the proper identification, measurement and management of risk.

Join Dr. Susan M. Mangiero, CFA, FRM and Accredited Valuation Analyst for an update about investment performance pitfalls, sources of hidden risk, risk control gaps and valuation challenges that directly impact the way institutions invest and what advisors can do to assist them.

Addressing the topic that "Risk is More Than a Four Letter Word", Dr. Susan M. Mangiero joins an impressive group of speakers as part of the FI 360 Annual Conference about fiduciary risk and responsibilities. posted by Susan Mangiero at 5/07/2006 11:54:00 PM | 0 comments | links to this post   

Wobbly Third Leg - Social Security at Risk

A three legged stool is often used to describe retirement planning: private savings, pension benefits from employers and Social Security. The problem is that each leg is becoming increasingly wobbly. We already know that the national savings rate in the U.S. and elsewhere is anemic at best. Pension plans are either non-existent at countless companies or undergoing radical transformation in the form of rescinded benefits, transfer of risk to employees (via a defined contribution plan) or complete termination.

Making matters worse, Social Security trustees have just rung the alarm bell on what many thought was a safe bet. According to the recently issued trustees' report for 2006, "the fundamentals of the financial status of Social Security and Medicare remain problematic under the intermediate economic and demographic assumptions. Social Security's current annual surpluses of tax income over expenditures will soon begin to decline, and will be followed by deficits that begin to grow rapidly toward the end of the next decade as the baby-boom generation retires."

The trustees acknowledge that the program passes a "short-range test of financial adequacy" but "continues to fail our long-range test of close actuarial balance by a wide margin. Projected OASDI tax income will begin to fall short of outlays in 2017, and will be sufficient to finance only 74 percent of scheduled annual benefits in 2040, when the combined OASDI trust fund is projected to be exhausted."

How much worse can it get?

The year 2040 may seem an eternity away but not when you take into account the miracle of technology and its effect on longevity. Living longer is arguably a gift but what happens when people who live for another twenty to thirty years past retirement run out of money? (Check out a May 9, 2006 conference about aging and the impact on financial markets, sponsored by the North American Securities Administration Association.)

Far from trivial, people may simply not have enough money to get by. Working longer or exiting retirement to work again are possible solutions. In fact, some seniors find that they prefer to work. However, what if employers resist hiring older workers? What if some jobs require physical stamina that may not exist as one's body ages? According to a new survey released by the Metropolitan Life Insurance Company, working past sixty may be driven more by financial necessity than desire.

One thing is clear. Things have got to change. Otherwise, be prepared for a tumble as one or more of the stool legs break.

Note: OASDI stands for "Old-Age, Survivors, and Disability Insurance". posted by Susan Mangiero at 5/07/2006 09:24:00 PM | 2 comments | links to this post