Pensions, Hedge Funds and Risk

On February 22, 2007, the President's Working Group on Financial Markets (PWG) released a set of principles and guidelines concerning "private pools of capital, including hedge funds." In concert with various U.S. agencies, the PWG report urges investors, creditors, counterparties, pool managers and supervisors to identify and understand fund-specific risks or walk away.

For fiduciaries, the guidelines (some of which are excerpted below) are clear. Individuals who are unable to demonstrate that a rigorous investigation of risk has taken place, BEFORE investing, put themselves in the line of fire with respect to personal and professional liability.

<< 1. Fiduciaries should consider the suitability of an investment in a private pool within the context of the overall portfolio and in light of the investment objectives and risk tolerances.

2. Fiduciary evaluation should include the investment objectives, strategies, risks, fees, liquidity, performance history, and other relevant characteristics of a private pool.

3. Fiduciaries should evaluate the pool’s manager and personnel, including background, experience, and disciplinary history. Fiduciaries also should assess the pool’s service providers and evaluate their independence from the pool’s managers.

4. Fiduciaries should consider the private pool’s manager’s conflicts-of-interest and whether the manager has appropriate controls in place to manage those conflicts.

5. Fiduciaries should conduct the appropriate due diligence regarding valuation methodology and performance calculation processes and business and operational risk management systems employed by a private pool, including the extent of independent audit evaluation of such processes and systems. >>

It will be interesting to watch what happens. Will some pension decision-makers forego investing in alternatives because the risks are considered too difficult to understand, let alone accept? Who will embrace the challenge and recognize the reality that risk management is an integral part of investment management? You simply cannot select funds without understanding how managers address financial and operational risk. When a fund invests in less liquid and/or complex instruments, the plot thickens.

Click here to read Agreement Among PWG and U.S. Agency Principals on Principles and Guidelines Regarding Private Pools of Capital.

Labels: Fiduciary Responsibility, Hedge Funds, Risk

posted by Susan Mangiero at 2/24/2007 06:30:00 AM | 0 comments | links to this post   

Options, Pensions and the SEC

It's hard to pick up a newspaper these days without reading some story about stock options - when they are granted, how often they are repriced, what portion of an executive's total compensation they represent and so on. What has authorities particularly busy is a fast-expanding review of practices such as option backdating and spring loading. As of December 31, 2006, the Wall Street Journal counts 120 companies on their option backdate list. Click here to view the options scorecard and learn about executive departures and various regulatory agency investigations.

The Free Dictionary defines backdating as "dating any document by a date earlier than the one on which the document was originally drawn up." Spring loading can mean either that "a company purposely schedules an option grant ahead of expected good news or delays it until after it discloses business setbacks likely to send shares lower." See "SEC eyes 'springloading'" as published by the New York State Society of Certified Public Accountants. In both cases, the idea is to inflate the value of the executive's stock option. (Experts remind that neither backdating nor spring loading is necessarily illegal per se, a conclusion that is best left to attorneys and regulators.)

These and other practices are important to pension fiduciaries and plan participants alike. Defined benefit plans sometimes invest in company stock. Defined contribution plan participants are often given a similar choice. Any problems with option grants, especially when they result in tax and/or accounting penalties, not to mention regulatory enforcement levies or litigation payouts, can do serious harm to an employee's retirement plan. From a fiduciary perspective, real questions could arise about the ex-ante assessment of company stock as a viable investment vehicle for a sponsored plan(s). Did an adequate due diligence review of risk factors that influence company stock price occur? Did pension fiduciaries sufficiently understand existing practices regarding executive compensation, including option awards? How often did pension fiduciaries assess option grant practices and/or inquire about industry norms, internal controls and likely impact on "shareholder" retirement plan participants?

For interested readers, the D&O Diary, authored by attorney Kevin LaCroix, has an excellent collection of articles about option backdating.

Option valuation is another topic with considerable import. Relatively new accounting rules in the form of FAS 123R set the stage for a vigorous debate about how to value employee and executive stock options (ESO's). Unlike shorter-term options that actively trade in ready markets, ESO's are more challenging to value for a host of reasons. Though a bit outdated with respect to regulations, readers may nevertheless find my article about option valuation of interest because it highlights the importance of having good inputs and an appropriate model. (Click here to read "Model Risk and Valuation," Valuation Strategies, March/April 2003.)

In a recent decision, the SEC notified Zions Bancorporation that its Employee Stock Option Appreciation Rights Securities (ESOARS) is "sufficiently designed to be used as a market-based approach for valuing employee stock option grants for accounting purposes under Financial Accounting Standards (FAS) No. 123R." According to Zion's press release, it is their intent to assist other public companies in valuing ESOs. I took a quick look at their site and plan to read more. Certainly a mechanism that facilitates marketability is a step in the right direction. After all, the coming together of willing buyers and sellers, under ideal circumstances, permits a flow of information that should result in the "right" price.

Editor's Note:
I am currently writing an article about option backdating as it relates to pension fiduciaries.

Labels: Fiduciary Responsibility, Options

posted by Susan Mangiero at 2/02/2007 12:02:00 AM | 0 comments | links to this post   

Paper Clip Theory of Pension Governance

In speaking to a colleague about managerial excesses the other day, I relayed the story of something that took place years ago. I was in college and worked as a bank teller in the afternoons and opened new accounts on Saturdays. The woman assigned to provide on-the-job training (long retired I'm sure) chided me for tossing a paperclip. "I'm a shareholder of this bank and every penny counts. We just don't throw away paperclips."

At the time, she struck me as old-fashioned and picky. Of course, when you're twenty, I suppose everyone seems un-cool.

What continues to amaze me is that I recall that event as clearly as if it had just happened. Her comment was an epiphany of sorts. This woman was not an executive. She wasn't even a bank officer. She was a secretary (administrative assistant in today's parlance). She wasn't responsible for the budget. No one counted supplies. Certainly one abandoned clip couldn't mean much. Yet her words resonate still. With skin in the game, she had a compelling motivation to be thrifty and encourage others to follow suit.

The relevance to pension governance is striking. When fiduciaries do not have a vested interest in adhering to best practices, will they be tempted instead to follow the path of least resistance? What motivates an individual to be a good steward of other people's money? Is it an increasing awareness of personal and professional liability that moves people to act or a concern that doing the right thing counts most?

A few days ago, I asked several financial advisors why they thought so many lawsuits focus on 401(k) fees rather than defined benefit plan fees. One response speaks volumes. "It's the company's money with DB plans but when employees pay, there is less managerial concern." Cynical or a reflection of the existing risk-reward system? Fiduciary responsibilities apply to both DB and DC plans. Yet decision-makers tend to feel pain faster and more fully when DB plan assets underperform and their compensation is tied to share price, cash flow or budget variance.

Experts agree that pension governance is AWOL at more than a few companies and statehouses. Why is that? As I wrote in Executive Decision last year, incentives are everything. Reward people for good behavior and you get what you pay for. The converse is true as well.

For those already in the vanguard with respect to effective investment fiduciary practices, kudos and keep up the great work. For those doing the equivalent of the pension paperclip toss, a good New Year's resolution is to stop.

P.S. Click here if you'd like to read "Do Fiduciaries Need Better Incentives to Make the Retirement System Work?"

Labels: Executive Compensation, Fiduciary Responsibility, Governance, Stewardship

posted by Susan Mangiero at 1/05/2007 06:02:00 AM | 0 comments | links to this post   

Do We Need a Dr. Phil for Pensions?

Where is Dr. Phil when you need him? According to a recent pension study, courtesy of the Toronto-based Rotman International Centre for Pension Management, problems "range from poor practices in board member selection to organizational dysfunction such as the lack of delegation clarity between board and management responsibilities. Weak oversight functions also have led to difficulties in sorting out the competing financial interests of differing stakeholder groups and self-evaluation of board effectiveness continues to be the exception rather than the rule."

Okay, so maybe we won't be holding hands and singing Kumbaya any time soon. However, failure to recognize behavioral impediments is a recipe for disaster. Since many companies accept the importance of employee benefit plans as a means to attract and retain talent, yet wince at their cost, HR and Treasury must find a way to work together. This is especially true as new accounting rules take effect, motivating shareholders to examine financials in a new light.

Public funds don't get a free ride. Taxpayers are frustrated and unhappy. With GASB 45 about to give the word deficit new meaning, public plan executives are going to hear the howls of protest in city halls throughout the U.S.

Working across disciplines and functions is the new mantra in employee benefits land. Pension decision-makers will need to coalesce or risk doing an incomplete or poor job of navigating stormy waters. A possible result? Increased personal and professional liability, coupled with a host of nasty financial outcomes for plan sponsors.

This is no time to argue over turf!

Labels: Fiduciary Responsibility, Governance

posted by Susan Mangiero at 12/19/2006 12:02:00 AM | 0 comments | links to this post   

Tis the Season for All Pension Fiduciaries ...

Dear Santa:

I've been a good pension fiduciary this year so I hope you remember me in a few days. It's been a tough year, with 2007 definitely looking grim. Do I merit a few extra brownie points for tackling my work with a smile and "can do" attitude? I'm trying hard but each day seems to bring a bundle of new challenges.

Here's the rest of my wish list.

1. Ten percent or better equity returns

2. Conflict-free service providers who really try to understand what problems we need to solve

3. Regulatory guidance that promotes a better understanding of how to comply with the Pension Protection Act of 2006

4. Recognition that my job is important

5. Liability insurance protection that helps me do a good job without worrying about significant personal exposure

6. Clarity about the incremental risks associated with strategies such as liability-driven investing, portable alpha and plan design

7. No major hedge fund blow-ups

8. Consultants and money managers who speak plainly

9. User-friendly analytics that support fiduciary due diligence

10. Vacation between the "pension problem" and the "health care crisis"

I better stop here so I can get this note to the North Pole in time for a jolly holiday arrival. By the way, what is your pension plan like? Say hi to Rudolph.

Thanks Santa!

HWPF
Hard Working Pension Fiduciary


Editor's Note:

Click here if you'd like to add to the list or see what your peers think. Neither your name nor your email address will be made public.

Labels: Fiduciary Responsibility, Humor

posted by Susan Mangiero at 12/18/2006 12:02:00 AM | 0 comments | links to this post   

Life of a Benefits Manager Heading Into 2007?

An homage to Norwegian painter Edvard Munch (born on December 12, 1863) Google's same day banner is reprinted herein. A reminder perhaps that 2007 is sure to create some agita for more than a few benefits managers and other related decision-makers?

Here are a few reasons for upset:

1. New pension accounting rules for companies

2. New OPEB (other post-employment benefit) accounting rules for municipalities

3. Forthcoming derivative accounting rules for public funds, similar to FAS 133 for companies (Remember that derivatives are getting more attention as possible elements of a liability-driven investment strategy.)

4. Anticipated Congressional oversight hearings about pension funds, 401(k) fees and hedge funds

5. Stated SEC consideration of rule changes as they apply to alternative investments (and possible impact on pension funds investing in hedge funds)

6. Proposed Form 5500 disclosure rule changes regarding service providers, fees and other elements of pension investing

7. Continued taxpayer upset regarding the cost of municipal benefits and a desire for lower property and state income taxes

8. Continued escalation in pension litigation

9. Continued focus on plan design and expected impact on an organization's cash flow

10. Continued focus on the Sarbanes Oxley - ERISA (corporate governance-pension governance) link

11. Anticipated guidance about default options for defined contribution plans (and related fiduciary impact)

12. The remaining 900+ pages of the Pension Protection Act of 2006

13. Projected worsening of the Social Security situation and likely impact on financing of the "three-legged" stool

14. Continued longevity patterns (good for retirees but expensive for employers)

15. Projected lower interest rates that increase liabilities

16. Anticipated pressure on asset returns

17. International pension woes and possible contagion for the U.S.

18. Predicted health care benefit cost increases that make pensions pale in comparison

19. Continued need to attract and retain scarce pool of talented workers with good benefits while keeping costs low

20. Continued scrutiny from ERISA and D&O liability insurance underwriters (and related impact on coverage and cost of coverage)

The good news is that there are lots of possible solutions but make no mistake. The new year will definitely entail major changes and challenges for all.

Labels: Challenges, Fiduciary Responsibility, Regulation

posted by Susan Mangiero at 12/13/2006 12:30:00 AM | 0 comments | links to this post