Speech by Edward Siedle, Benchmark Financial Services
TEXPERS 2009 Summer Educational Conference August 25, 2009
Any discussion of the serious issues affecting public pension funds today must begin with talking about what’s going on in our nation. Public pensions exist within a broader societal context and are not immune from factors affecting society in general. Further, taxpayers pay for public pensions. Therefore the mood and plight of our society and taxpayers is important to take note of in discussing the challenges facing public pensions.
You shouldn’t need me to tell you that Americans are facing hard times. I believe that the media is downplaying just how bad things are now, as well as being unrealistic regarding a recovery in the near future. Simply put, most Americans have lost half of everything they had—half the value of their homes and half their invested savings in 401ks and other retirement plans. Now if you are a millionaire and you lose half of everything you own, you’re down but not out. If your net worth was under $100,000 to begin with and you’re over 50 or 60, you’re hurting a lot more. If you only had 10% equity in your home and your home’s value has fallen 50%, you’re stressed. Things are looking grim.
I believe unemployment is likely headed toward 20% (the unofficial or real number) and with it the number of Americans that will go without health insurance is skyrocketing. In my home state of Florida, a recent survey showed that almost 40% of Floridians had gone without health insurance at some point within the past 5 years. I suspect soon that number will approach 50%.
The largest 401k plan in the country in terms of participants, Wal-Mart, had an average account balance of $10,000 before the recent market meltdown. It’s probably closer to $5,000 now and, of course, that doesn’t include all the employees who don’t participant in the Plan. This is how the largest employer in the world takes care of its people.
My firm recently drafted a public service advertisement that read:
"401k: That's No Retirement Plan!
With a national median account balance of approximately $17,000, you can expect to receive $70 a month in your Golden Years. Can you retire on that? You and the boss need to talk."
The mood of America is bad. Many people are so scared that they don’t know what to do. They feel there is no way to recover from the blow that has been dealt to them. It’s the end of a dream.
Public pension participants, on the other hand, who didn’t get sold a bill of goods by the financial services industry acting in concert with private employers about the merits of defined contribution plans are, are riding high—enjoying benefits that most Americans are realizing they will never receive. The good news is that there has rarely in the history of this country been a better time to be a public sector employee. The bad news is that many taxpayers are feeling cheated out of their own retirements and are angry about funding public pensions.
To make matters worse the financial meltdown has walloped public pensions. Assets have plummeted, which means more taxpayer money will be required to meet public pension obligations.
Perhaps it’s not surprising that at this time public pensions are in the spotlight, under intense scrutiny. We’ve seen this before but this time I think will be different.
This time, for demographic and economic reasons, there will be a sustained national effort to uncover and address public pension abuses, as the nation grapples with how to provide some semblance of retirement security for all Americans.
This means that public funds must, in my opinion, clean house. In my experience public funds have all-too-often chosen to cover-up problems, believing that investigating and acknowledging problems makes a fund look bad or a Board look stupid. I have tried to discourage this thinking because the fact is that managing massive pension funds is highly complex and challenging, even for the most skilled practitioners. Public pension boards, made up of laymen, advised by conflicted Wall Street experts selling product should never be reluctant to admit mistakes. You can only look stupid by pretending you know everything there is to know.
The firms that gave you the bad advice or sold you the bad products or services want you to defend your decision. They will “help” sculpt your defense. Trust me-- they’re not doing you any favors.
Let’s start at the Board of Trustees level and work our way down in identifying problem areas for public funds. Based upon my years of experience, I believe there is no public pension that doesn’t have at least one of the problems we will be discussing.
Scrutiny of illegal or unethical activity by Board members is heating up. Recently I was contacted by a reporter from Detroit who told me about trustees of the city’s funds that are spending hundreds of thousands on travel. Well, I just learned from CNN that the average price of a home for sale in Detroit is now $5,000, down from $55,000 a few years ago. The city population has dwindled from 2 million to 900,000.
Unemployment in Detroit is almost 25% officially. So when a public pension trustee in Detroit spends $500,000 on travel, that money could have bought a hundred homes. This city is in a death spiral and essential services will have to be eliminated. Yet some trustees there are spending on their own travel as if this were the best of times. Not a good idea in the best of times, a terrible idea at this time.
Two other issues involving trustees: trustees that are simultaneously employed in the financial services arena and the “revolving door” phenomena. Around the country I have on occasion encountered public pension trustees who are also money managers or brokers. Often these individuals are a lot more knowledgeable regarding public pension matters than the investment business. And, it is often the case that “but for” their public fund connections, they would have no prospects for pension business. I’m not saying that it is never advisable to have a trustee who is also employed in the business. What I will tell you is that it exposes the fund to risks, both real and perceptual.
The “revolving door” issue arises when a former Board member is employed by an investment firm that seeks business from the fund he was formerly associated with. This problem is easily dealt with by the fund adopting a policy that restricts such contracting with former Board members for a period of time. Simple solution but remarkably many pensions have not sought to address this issue.
Now let’s talk about lawyers that provide services to public pension funds.
Lawyers to public funds are increasingly coming under scrutiny.
This is a very significant problem area that has been virtually unnoticed. To begin with most public pensions rely upon local labor lawyers for advice. These lawyers tend to be hired by funds because of their relationships with labor. They may have labor law expertise but soon they begin advising fund Boards on money management contracts and other investment issues. Investment management law is a highly complex specialty and there are few lawyers nationally that know this area of law. When labor lawyers advise public pensions regarding complex investment management matters real harm results. Investment performance suffers, fees are excessive and all kinds of abuses creep into the investment process. Worst still, Boards think they are getting competent legal advice and don’t seek the specialized help they need.
Unfortunately legal ethics generally say that all lawyers can claim to be competent to handle all matters from wills, divorces, traffic tickets, real estate closings to financial derivatives, hedge funds, and soft dollar trading. Believe it or not, there are certain legal matters which require expertise: money management law in one of them.
Add to this “labor lawyer” problem unique to public pensions another problem unique to public funds, which I refer to as the “invasion of the class action lawyers” and you’ve got a real mess.
The labor lawyers that migrate to advising public funds regarding investment matters are courted by class action lawyers that offer to pay enormous referral fees if the public funds they represent join in class actions. Labor lawyers can make far more money in referral fees on class actions than in hourly fees providing labor law advice.
Some of the largest class action firms in the country have confided to me that rarely are the referral fees and related conflicts of interest involving fund counsel disclosed to the Boards. Given the highly contentious and controversial nature of plaintiff class action firms and the fact that they focus their marketing efforts on public funds, expect to be grilled about these arrangements. It should go without saying that class action law firms with criminal histories are especially problematic. Should a public pension ever hire a law firm that has a criminal conviction in its history? Money managers that are criminally convicted are shut down. Regardless of whether you believe law firms should be treated differently, I would submit to you that if your fund retains a law firm (or any other type of firm) that has a criminal history questions are going to be asked.
Pension accounting and actuarial practices are getting more attention.
There have always been concerns that a particular pension accounting practice is either opaque, or deceptive, or impractical, or all of the above. Recent news stories and opinion pieces have stated or implied that public pensions should be using a corporate pension accounting standard to measure actuarial funding levels. This line of thinking suggests that public pensions should use a risk-free investment return assumption rather than the investment return assumption used by most plans of between 7.5 percent and 8.5 percent. The debate regarding “marked-to-market” accounting and accounting for unfunded retiree health care liabilities are also concerns.
Now, let’s turn to actuaries and talk about DROP plans and Limitations of Liabilities.
Certain actuarial firms have gone around the country advising governments that DROP plans and other benefit enhancements are “revenue neutral.” These firms are increasingly being challenged because, no surprise here, these benefit enhancements have not turned out to be no cost. A highly regarded actuary that I know once told me he seriously doubts it is possible to have a revenue neutral DROP plan.
With respect to limitations of liability, I wrote in 2002 that, “the surest sign trouble lies ahead for pensions is the recent effort by some of the largest actuarial and pension consulting firms to coerce their pension clients to agree to limitation of liability provisions in their contracts.
No fiduciary should ever agree to a limitation of liability. In 2002 I wrote the fiduciary’s response to such a proposal should be to laugh out loud (LOL). The very role of a fiduciary to a pension fund is to ensure those providing services to the plan are held accountable. Limitations serve to reduce accountability. Mistakes by these financial professionals result in disastrous consequences to plans that bear no relation to the amount they are paid. Ask yourself: What trustee would want to be in the position of having agreed to a limitation of liability once a major financial loss attributable to the consultant has been discovered? Pensions and trustees have nothing to gain and everything to lose by agreeing to these provisions.”
Investment consultant conflicts of interest continue to surface. The SEC, DOL and Attorneys General are investigating pay-to-play schemes involving these “gatekeepers” to pensions. I have been talking and writing about these abuses since 1995. Over the years the SEC, GAO, DOL, Attorneys General and judges have all confirmed my early analysis. At this point there is absolutely no disputing that an unscrupulous pension consultant that corrupts the integrity of a fund’s investment process, for personal profit, can cause massive harm—far greater than the kick-backs he receives from the money managers. Yet I am perpetually amazed that most Boards, even when confronted with the harm or damage will say, “We like him. He’s a good guy.”
Like him all you want, love him, even marry him—just don’t let him be your pension consultant.
What might explain Board reluctance to scrutinize investment consultants? Could it be more than love?
In one state I was told by a Board member that many Board members had private accounts with the consultant. Some Board members had apparently done exceedingly well in their personal accounts as the pension fund tanked. I was shown account statements and we referred the matter to the FBI. Board members personally investing with a fund’s consultant raises serious, even possibly criminal issues.
As we are learning from the New York Attorney General some consultants have entered into compensation arrangements with persons affiliated with elected officials or trustees.
Given the controversies around the country related to pension consultant conflicts, you need to investigate whether your consultant is engaged in self-dealing. An honest consultant should never oppose a review of his work. After all, investment consultants are in the business of reviewing the work of money managers and money managers submit to such reviews regularly. Why should consultants be immune? A corrupt consultant can cause more damage than a corrupt money manager.
Now, let’s turn to money managers.
In the money management industry, kick-backs and all sorts of undisclosed financial arrangements involving conflicts of interest with are commonplace. In the political realm campaign contributions and all sorts of influence peddling are commonplace. Public pensions present an opportunity for both.
As an old friend of mine who is a money management marketer told me the other day, “A money manager without money is not a money manager.” Getting the money to manage is critical, as is keeping it. Remember that the money management business is like driving a taxicab: the goal is to keep the passenger in the cab as long as possible with the meter running.
If a money manager pays a placement fee to a politically connected individual, it may be criminally actionable. That’s what’s been going on in New York and around the country. What if a money manager makes a secret payment to another vendor to the pension, such as an investment consultant?
Could that be criminal? An analogy would be the contractor hired by the city to build a road who requires all the subcontractors to kick-back city monies to him. Sounds illegal to me. The hunt for criminal activity involving public pensions has just begun. The investigations of placement fees have just begun. Placement fees are commonplace and can be found in every state. Indeed, some firms have been found to have engaged in such payment arrangements in multiple states.
It is becoming apparent that the marketing of private equity, hedge funds, venture capital and real estate to public funds has involved payments to elected officials and relatives of elected officials. This seems to be a bigger problem for the Democratic Party but both parties are involved.
A very serious related problem is the performance of the private equity, hedge funds, venture capital and real estate that have been sold to public funds. In my investigative work I have found that the performance of these investments, which consist of illiquid, hard-to-value securities, is far less stellar than marketers would have you believe. Public scrutiny of hard-to-value investments marketed through political connections will continue to be controversial.
In conclusion, I believe 2009 will be a “tipping point” for public pensions. Taxpayers, angry regarding their own lack of retirement security, will pounce on any public pension shenanigans. We are entering an era of heightened scrutiny of public funds. Think of it this way: Public funds are the next Madoff.
The best defense for public funds in this new era of sustained scrutiny is to investigate fully before the reporters show up at your door. And I don’t mean the old so-called “forward looking operational reviews” that were undertaken by public funds in the past to smooth over or cover up transgressions. Nobody’s buying those self-serving reports anymore. I mean the real thing: rigorous scrutiny of anyone who has been involved with the investment process. Given the mistakes of the past which I can assure you will continue to surface around the country given the mood of the nation, I believe anything less than a sincere effort will only lead to the demise of the nation’s public pensions.