Enterprise Risk Management in the Boardroom

Thanks to Stephen Davis, editor of Global Proxy Watch, for highlighting a recent study about enterprise risk management. The three Conference Board authors - Carolyn Kay Brancato, Matteo Tonello, and Ellen Hexter -- suggest that board members may need to do a lot more work when it comes to (a) recognizing relevant risks and (b) managing them to avoid liability.

According to "Role of the U.S. Corporate Board of Directors in Enterprise Risk Management", there is a big gap between knowledge and action.

"The Conference Board study finds: Although 89.5% of directors say they fully understand the risk implications of the current strategy,

Only 77.4% of directors say they fully understand the risk/return tradeoffs underlying the current strategy.

Only 73.4% of directors say their companies fully manage risk.

Only 59.3% of directors fully understand how business segments interact in the company's overall risk portfolio.

Only 54.0% have clearly defined risk tolerance levels.

Only 47.6% of boards rank key risks.

Only 42% have formal practices and policies in place to address reputational risk.
Directors are, however, sensitive to the need for additional information:

While 71.8% of directors believe they have the right risk metrics and methodologies in making strategic decisions, 47.6% of directors would like to see more data analysis related to the company's risk profile."

So what does this have to with pension plans?

Simply put, a lot...

As more and more companies contemplate the financial and human capital impact of offering employee benefits, it's imperative to remember that pension management cannot be separated from corporate governance responsibilities, embedded in regulations such as the Sarbanes-Oxley Act of 2002 ("SOX").

Jeffrey D. Mamorsky, Employee Benefits Group Chairman with Greenberg Traurig, states: "What companies sometimes overlook is that this SOX Section 404 Management Assessment of the Adequacy of Internal Control Procedures requirement applies to pension and benefit expenses. This is an issue that cannot be overlooked since SOX includes draconian sanctions of $2 million and up to 10 years imprisonment for non-willful ($5 million/up to 20 years imprisonment for willful) certification of any statement that does not comply with SOX requirements." (See "Today's Retirement Plan Environment Leaves Much for Concern".)

In a speech to business editors, following the passage of SOX, U.S. Department of Labor Assistant Secretary Ann L. Combs sang its praises, adding that: "Some reports have criticized the Sarbanes-Oxley provisions as inadequate response to the problems brought to light by Enron and its progeny. The fact is, they are important provisions and will prevent future instances of corporate officers unloading their stock while workers are trapped in a sinking ship."

My own research in the areas of governance, compliance and litigation suggests an inextricable relationship between corporate and pension governance. Directors simply cannot ignore ERISA when making enterprise-oriented decisions. To do so could invite the possibility of financial loss, litigation, harm to reputation and/or regulatory action.

Author's Note: There are many articles that address the deficiences of SOX and regulation in general. Free marketeers advocate complete industry self-regulation or some variation thereof (and I have written elsewhere about the economic and philosophical merits of best practices versus regulation). However, whatever your opinion about regulations, including SOX, existing law is a reality. posted by Susan Mangiero at 6/24/2006 10:55:00 PM | 0 comments | links to this post   

Will the Real Pension Deficit Please Stand Up?

A flurry of activity is upon us in defined benefit land. The goal? Identify "high risk" plans early on. This, according to certain members of Congress, would be followed with additional funding by plan sponsors and thereby (hopefully) reduce the possibility of a government takeover. Critics counter that such a reform could make things worse, especially for already cash-strapped companies, struggling to stay in business. Moreover, they add that a risk classification based on unrealistic assumptions regarding early retirements at maximum benefit levels makes little sense.

The "Performance and Accountability Report: Fiscal Year 2005" shows a deficit of nearly $23 billion for the Pension Benefit Guaranty Corporation while estimating "future exposure to new probable terminations" at $108 billion, nearly four times the "damage".

In its primer on pension accounting and funding, the American Academy of Actuaries describes at least four types of numbers - service cost, accumulated benefit obligation, projected benefit obligation and present value of future benefits. They add that "Amounts calculated under pension funding rules are completely different than those calculated for pension accounting, and one must be careful not to mix the two topics."

Keep in mind that smoothing and credit balances are other considerations as we try to navigate our way through the maze of pension metrics. New rules that address (a) the treatment of a company's pre-funding of a plan and (b) whether a sponsor can continue to average a plan's value over several years could materially impact reported pension costs. (To the extent that capital market participants react to accounting numbers as inaccurate barometers of economic health, C-level executives could be busy with related financial tasks.)

Okay, we get it. There are lots of ways to measure pension deficits but which one tells us what we really want to know?

What is the truth?

Will the real pension deficit please stand up? posted by Susan Mangiero at 6/22/2006 10:22:00 PM | 0 comments | links to this post   

Stock Options and Angry Pension Funds

The San Jose Mercury News reports a litigation backlash against thirteen Silicon Valley firms in connection with questions about their stock option programs. While arguably newsworthy, what is perhaps more telling is the role played by U.S. and foreign pensions.

Since the Private Securities Litigation Reform Act became federal law in 1995, the clout of these moneyed giants has not gone unnoticed. (There is even a blog by the name of The PSLRA Nugget.)

Several studies have tried to reconcile the intent of the law (i.e. to cede more clout to the investor tied to the largest financial stake) with outcomes in terms of fees, settlements, cases filed and so on.*

In their 2005 paper, Stephen J. Choi and colleagues write: "We find no systematic evidence that private institutional lead plaintiffs are associated with larger class recoveries. Public pension funds, on the other hand, are correlated with higher class recoveries as a fraction of the potential damage award in the post-PSLRA period. Our results are, however, consistent with the possibility that public pensions 'cherry pick' the actions in which they seek to become lead plaintiff, selecting only the cases with the largest potential damages and the strongest evidence of fraud. Further analysis is necessary to evaluate this possibility." (See "Institutions Matter The Impact of the Lead Plaintiff Provision of the Private Securities Litigation Reform Act" by Choi, Stephen J., Fisch, Jill E. and Pritchard, Adam C. April 15, 2005, NYU, Law and Economics Research Paper No. 04-08.)

According to the New York Stock Exchange Fact Book, U.S. pension funds now own about twenty-two cents of every dollar of issued corporate equity. Institutional investors (including pensions) own roughly fifty cents or one-half.

What does this mean?

Here's my humble take. As stated several times before, pension fiduciaries are in the spotlight as never before. Any investment-related loss is likely to trigger some type of response. Will it be surprising if it takes the form of litigation to recoup losses? Not really. Will it be a bad thing? Maybe. Maybe not. This is a complex question, one that cannot possibly be answered here.

More to come...


* To prevent a flood of cases migrating from federal to state courts as a result of the PSLRA, the Securities Litigation Uniform Standards Act of 1998 barred certain lawsuits from being filed in state courts. (Please be reminded that the author is not an attorney and urges readers to always seek counsel with respect to any legal question.) posted by Susan Mangiero at 6/21/2006 12:16:00 AM | 0 comments | links to this post   

Hedge Fund Valuation is a Big Deal for Pension Fiduciaries

As earlier stated, asset valuation is the cornerstone of investing. (See "Do You Really Know the Value of Your Portfolio?")

The absence of good valuation numbers makes it virtually impossible to execute vital tasks:

1. Asset allocation

2. Risk management

3. Performance evaluation

4. Selection and comparison of managers ...

(The discussion of what constitutes "good" numbers is left for another posting.)

Regulators and politicos are hardly alone in urging more prudence with respect to the valuation of certain positions. Industry groups have jumped into the fray, and some assert, it's none too soon. The Private Equity Industry Guidelines Group posted valuation guidelines a few years ago. Its mission: "To promote increased reporting consistency and transparency while at the same time improving operating efficiency in the transfer of information among market participants by establishing a set of standard guidelines for the content, formatting and delivery of information." The "MFA's 2005 Sound Practices for Hedge Fund Managers" has a lot to say about valuation policies and procedures and is well worth a read.

So why is this important to pension fiduciaries? For one thing, countless fiduciaries are allocating monies to hedge funds. Second, a recent article offers that hedge funds could have as much as fifty percent of their money tied up in relatively illiquid assets, in part (some argue) to avoid having to register their managers.

According to U.S. SEC Commissioner Roel C. Campos, "To avoid dilution and unfairness, valuation numbers must be accurate and unbiased. A key element of monitoring the risk of hedge funds is to understand the valuation used by said funds and counterparties to the funds."

Hiring an independent appraiser can go a long way to aiding this process, especially when accreditation itself entails satisfying rigorous education and experiential requirements. In fact, courts and regulatory bodies are increasingly turning away experts on valuation matters unless their credentials include specialized valuation training. (Note: As an Accredited Valuation Analyst and someone who has completed course and exam requirements for two other specialized valuation designations, I can attest to the rigor.)

With so much at stake, pension fiduciaries should be asking tough questions of their hedge fund managers (and/or consultants who recommend hedge fund managers).

1. Does the hedge fund rely on independent appraisers to provide assessments of fair market value?

2. Has a hedge fund established a proper valuation process?

3. How often are the valuations updated? *

4. Is each opinion of value well documented?

5. Are all terms and conditions of a particular economic interest specified and analyzed accordingly?

6. Does the hedge fund manager acknowledge how much of its portfolio is not valued on a regular basis, thereby affecting reported portfolio performance?

The list is long. One thing is certain. Hedge fund valuation is the topic "du jour". Can a pension fiduciary afford to invest in a hedge fund, fund of funds, private equity fund, venture capital fund, commodity pool, derivatives fund and so on, without understanding whether, and to what extent, managers have considered various valuation issues?



* Not discussed here, there are those that assert that some positions should not be valued and that doing so would jeopardize the asset allocation decision that led to investing in relatively illiquid holdings in the first place. I welcome your comments regarding this point. posted by Susan Mangiero at 6/18/2006 11:31:00 PM | 0 comments | links to this post   

Welcome Albourne Village, Hedge Fund Manager and RiskCenter Readers

We're up to 6300 visitors since late March 2006 and look forward to making even more new friends.

Today we welcome readers from Albourne Village , Hedge Fund Manager and RiskCenter, respectively.

Albourne Village "is a free and unique internet-based knowledge economy for the Alternative Investment community. The site has been designed as an ideal environment for evolving hedge-fund news, intellectual property, content and debates on current issues, as well as a valuable source of commercial contacts."

"HFM Week and hfmweek.com are produced exclusively for the international hedge fund community. Hedge Fund Manager was launched in September 2002, and is now published weekly. It is now read by over 5,500 alternative fund managers - predominantly CFO's and managing partners - and their key advisors across the globe."

Risk Center "is the first Web-based syndicated news service devoted exclusively to providing financial risk professionals with the inside scoop on breaking economic, political and financial stories, as well as the risk strategies required to measure and manage these risks. Acting as the eyes and ears for risk professionals, RiskCenter provides an information filter so that viewers do not have to search through a myriad of sources to find the key news that has been researched and written from the point of view of a risk manager."

Let us know what you think. We'd love to hear from you. posted by Susan Mangiero at 6/13/2006 12:12:00 AM | 0 comments | links to this post   

Risk Managers Get Respect

Results of a new survey from executive search firm, Risk Talent Associates, provide good news for financial rocket scientists everywhere. Total compensation for chief risk officers in 2005 rose by eighteen percent to nearly $800,000 on average, with hedge funds and funds of funds paying larger bonuses to draw "top risk managers away from traditional investment banks". Not to be outdone, president Michael Woodrow warns that alternative investment managers will soon be competing with "capital markets' firms" and asset managers who acknowledge the importance of analytics and risk management knowledge and experience.

On the pension risk front, I recently wrote about the difficulty of getting good people at the same time that talent is required to navigate some rather choppy investment waters. (See "Pension Fund Hiring - Start of a New Trend?")

I have long held the view that effective investment management is not possible in the absence of what I refer to as the "risk troika" - identification, measurement and management.

Are higher salaries for risk professionals a reflection of their importance to an organization's financial well-being? As I wrote a few years ago, risk professionals should be both knowledgeable and experienced about a wide variety of topics - market mechanisms, statistics, systems and data quality, internal controls, deal structure, to name a few. Moreover, they need to be able to (a) describe the relationship between various risk drivers and portfolio loss potential in plain language (b) work well with a cadre of people in diverse functional areas and (c) say no to new ideas that may induce unwarranted risk under certain market scenarios.

Not too many people can fill those shoes! posted by Susan Mangiero at 6/12/2006 10:31:00 PM | 1 comments | links to this post   

Vive Le Liability-Driven Investing

Global Investor Magazine cites survey results from J.P. Morgan Asset Management that show a surge of interest in liability-driven investing (LDI). An impressive forty-eight percent of respondents admit to using, or planning to use, an LDI strategy. Four countries lead the way: the Netherlands, Denmark, Sweden and the UK. The common theme - regulations that "push pension schemes to value their liabilities with market rates".

Interestingly, more than seventy percent of respondents cited the need for an LDI approach, even for plans in surplus.

Some take-aways for US plans?

1. The use of derivatives by retirement plan sponsors is likely to increase as interest in LDI rises stateside.

2. Regulation and accounting standards that encourage liability management will be the likely catalysts for change.

3. Managers, consultants and plan trustees will need (and hopefully want) to become more savvy in the areas of derivative instrument valuation, risk measurement and controls.

4. Traditional asset allocation models may have to give way to a new paradigm that emphasizes portfolio splitting into separate return and liability-managed components. posted by Susan Mangiero at 6/12/2006 12:12:00 AM | 1 comments | links to this post   

Increased Liability for Fiduciaries, Trustees and Plan Sponsors?

Fiduciary liability is serious stuff. As earlier discussed, ERISA litigation statistics suggest a precipitous increase, especially with respect to issues of fiduciary breach. (See "Pension Lawsuits".)

According to Reish Luftman Reicher & Cohen attorney Joe Faucher, ERISA fiduciary liability can apply "when the plan expressly designates a person as a fiduciary, generally as the plan administrator, plan trustee, or member of an administrative committee". It is also relevant when "a manager performs a function that ERISA deems a fiduciary function". Examples include the following:

1. Influence or control "over the management of the plan or any authority or control over management or disposition of the plan assets"
2. Provision of investment advice in exchange for a fee
3. Discretionary authority as regards plan administration

On June 13, Greenberg Traurig attorney and Chairman of the Employee Benefits Group, Jeffrey D. Mamorsky, will be joined by Rhonda Prussack, Fiduciary Liability Product Manager for the National Union Fire Insurance Company and IRS Senior Employee Plans Examiner and Large Case Reviewer, Randy G. Sammons.

The topics?

1. Trends in Litigation
2. Regulatory Environment
3. IRS Audit Initiatives
4. Prescriptive Techniques to Avoid Litigation

Is a new wave of trouble about to crash around us?

With an increased focus on compliance, governance and best practices, we're likely to hear much more about fiduciary breach. Keep in mind that even service providers such as CPAs, money managers and consultants are vulnerable, personally and professionally. (The author is neither an attorney nor CPA. Readers are urged to seek advice from appropriate professionals as to whether they are fiduciaries to a plan and what that entails.)

Though not a panacea for eliminating oversight duties, outsourcing is gaining in popularity. Independent Fiduciary Services CEO Samuel (Skip) Halpern provides some compelling reasons as to why and when to seek help in the form of an independent fiduciary.

Look for much more on this topic in coming months! posted by Susan Mangiero at 6/10/2006 12:29:00 AM | 0 comments | links to this post   

Managing Cash Flow or Returns?

With so much talk about actuarial assumptions and related shortfalls, little is said about absolute dollars (or pounds or pesos and so on). This is a mistake. Retirees can't pay their bills with paper returns. They need cold, hard cash. Even with defined contribution plans, there is the issue of a "pseudo" liability. Should 401k plan sponsors better track employee demographics and pick investment choices accordingly? (Some experts offer that lifestyle funds are a step in the right direction. That's a topic for another day.)

A new retirement index from the Center for Retirement Research at Boston College suggests that time may be nigh to reinvigorate the debate.

Returns or cash flow? That is the question.

On a rather bleak note, the Center reports that "nearly 45% of U.S. households are at risk of being unable to maintain their standard of living in retirement".

Scary stuff, beneficiaries are not the only ones affected. Investment and risk managers alike face new challenges when the goal is to match liabilities versus beating a benchmark.

1. Which part of the portfolio should be allocated to liability matching versus return enhancement?

2. What strategies make sense?

3. What is the role of mean-variance optimization when a portfolio is split?

4. Is it feasible to regularly evaluate demographics to reflect worker mobility when asset allocation changes are expensive or otherwise difficult to make?

5. What are the ancillary issues associated with liability matching techniques such as the use of derivatives?

The list of MUST ADDRESS questions is long. Risk control critically depends on the objective at hand. posted by Susan Mangiero at 6/09/2006 12:33:00 AM | 0 comments | links to this post   

Derivatives Get the Blame

In a recent Washington Times article entitled "Derivatives: Global roulette wheel", editor-at-large Arnaud de Borchgrave describes a global market now topping $300 trillion as reason to "fasten your seat belt". It's not clear what precipitated his dire warnings about systemic risk and classification of risk management talk as "gobbledygook to the layman". (Take a look at our March 2006 posting about derivatives.)

It's true that the use of derivatives introduces incremental risk such as the possibility of counterparty non-performance or problems with settlement. (Arguably netting and collateralization help to reduce some of the transaction-specific risk.) At the same time, derivatives used properly (and this is an important qualifier) can mitigate financial risk, transform cash flows, transfer risk, enhance asset performance or otherwise synthesize exposure to a particular risk-return position. How else could the market have grown to its giant size had it not been for a large number of participants who were (and are) willing to trade with each other?

At the risk of dating myself, I did an analysis about fifteen years ago that showed that derivatives-related losses were a fraction of disappearing dollars due to fixed income security defaults for the time period in question. It would be interesting to update the analysis and gauge whether derivatives are indeed the equivalent of a financial hurricane, wreaking damage far and wide.

One key issue (among many) is the measurement of risk. Consider a fixed-to-floating interest rate swap with a $20 million notional principal amount or "face value". Depending on the particular counterparties and deal structure, this popular size measure fails to convey meaningful information about potential loss. The incremental exposure for a counterparty that hedges its short-term commercial paper costs by entering into a swap as a fixed rate payor is not the same as a counterparty that receives floating in anticipation of higher rates.

Derivatives are not necessarily for the faint of heart nor should they be shunned as the proverbial bad boy of finance. posted by Susan Mangiero at 6/06/2006 12:05:00 AM | 0 comments | links to this post   

Pension Fund Hiring - Start of a New Trend?

According to its website, the Canadian Pension Plan Investment Board is in a hiring mode. Responsible for investing funds received from the Canada Pension Plan, the now C$98 billion fund is seeking several dozen qualified people in the areas of investment and risk management.

A few months ago, a major UK newspaper cited the dearth of qualified pension investment and risk management professionals at the same time that expertise is urgently needed. Is this the start of a hiring trend? Are pension experts suddenly in demand? If so, why? Some likely reasons include:

1. New retirement plan regulations

2. Changed accounting rules

3. More complex investment strategies

4. Recognition that investment and risk management go hand in hand

5. Notion that hiring seasoned staff can minimize fiduciary breach exposure

6. Explosive growth in pension litigation

We may be in for a bumpy road. If true that there are insufficient experts available who can connect the pension risk dots, it will be difficult to make meaningful changes in a cost-effective manner. posted by Susan Mangiero at 6/04/2006 12:58:00 PM | 0 comments | links to this post   

Fiduciary Insurance for Hedge Funds

According to a recent story in HedgeWeek, hedge fund liability insurance may merit some serious consideration. Regulatory enforcement actions and investor lawsuits are on the rise, in the U.S. and elsewhere. Hedge fund directors are arguably more vulnerable than ever before, especially in areas such as valuation and trading controls.

Bigger and more frequent claims make for unhappy insurance underwriters. The logical result? Higher premiums, reduced coverage and larger deductibles.

For pension fiduciaries with hedge funds on the shopping list, now might be the time to ask managers even more questions about their policies and procedures - content, frequency of review and revision, oversight and metrics for determining "errors".

After all, pension fiduciaries themselves are under more scrutiny and are unlikely to want to invest in a hedge fund or fund of fund with few or no documented policies and procedures. posted by Susan Mangiero at 6/02/2006 01:32:00 AM | 0 comments | links to this post