(July 1, 2001) The Politics of Fraud: How Pension Politics Enable Money Managers To Commit Fraud |
"If an enhanced due diligence service were available to pensions which would indicate whether their money managers were involved in fraudulent or illegal activity, would they be interested?" That was the question I recently put to the director of one of the nation's largest public funds. The answer I received was, " I don't know whether pensions would run to or from such a service."
I wanted an honest answer and I got one. Yet the answer I received was disturbing and deserves analysis. Do pensions really want to know the truth about their money managers? And if not, why not?
Obviously pensions have a fiduciary obligation to manage assets in the best interests of their beneficiaries. Selecting and monitoring qualified, reputable money managers is of paramount importance to those funds that choose to hire external managers. How, then, do pensions scrutinize potential managers to determine their qualifications? Most funds delegate the responsibility. They retain a pension consultant to perform a due diligence review of candidates.
Two questions emerge at this point. The first is whether the pension consultant is qualified to competently perform a due diligence review. Second, and related to the first, is the question of the level of diligence envisioned. If you expect only a cursory review, then virtually anyone is qualified to perform the task; on the other hand, if you want a truly probing, substantive review, you're going to need a qualified expert.
We have written extensively on the subject of qualifications of pension consultants. In summary, we are of the opinion that "consultants are arguably the least credentialed participants involved in institutional investing and are clearly the least regulated. Consultants are not required to meet any educational requirements or have any specialized training. They are not subject to any federal or state securities or investment advisory regulations." So what qualifies consultants to perform due diligence reviews of registered money managers? As far as we can tell, they can because they say they can.
Pension consultants simply have no rational basis for claiming to be uniquely qualified to perform manager due diligence reviews. Are they qualified to interpret a Form ADV, as filed by money managers with the SEC? Can they ferret out misrepresentations related to performance or credentials? What about marketing missteps, litigation, bankruptcies and criminal histories? Or personal trading, soft dollars and other forms of self-dealing? What is it that consultants do when they review money managers? Apparently consultants do little more than compare performance data submitted to them by the manager with peer group numbers, as well as note organizational changes (including client and personnel turnover) and ultimately offer their opinion as to the firm's competence. If that is all that is required, then perhaps pension consultants are qualified for the task. A lot of credentials and training is not required if all you're going to do is be an intermediary passing prepared information between money managers and plan sponsors.
The level of due diligence review of money managers undertaken by pension consultants as described above, is the state of the art today. In other words, no meaningful review of money managers is undertaken. Pensions routinely hand billions to managers based largely upon scant information provided by managers to consultants and limited anecdotal information provided by consultants regarding managers' operations. Should pension fund participants, staff and trustees sleep comfortably knowing this is the level of review to which managers will be subjected before pension assets are doled out to them? We don't think so.
This superficial review is, in part, responsible for the "herd mentality" critics contend pensions follow. Pensions often hire managers their consultants have recommended primarily because other pensions have hired these managers. Pensions often adjust their asset allocation at precisely the wrong time for the same reason. Consultants, unable to develop substantive standards for reviewing managers, look at largely irrelevant factors, such as what the herd is doing, in guiding their pension clients. We're not saying pension consultants cannot play an important role in advising plans or monitoring manager performance; however, consultants should not be used to conduct in-depth due diligence reviews of managers.
Is a substantive due diligence process possible today-one that exceeds existing standards? The answer is a resounding "yes." Pensions that wish to seriously examine the performance and behavior of their managers can do so and, in so doing, no longer move "with the herd" but ahead of it. In other articles we have outlined what an enhanced due diligence process would look like and we will continue to do so in subsequent pieces. However, in this article we want to move directly onto the question of whether pensions really want to know if their managers are engaged in questionable conduct.
Any analysis of pension decision-making must begin with an understanding of the political environment in which pensions operate. Unfortunately most pension participants are unaware of the political pressures that may influence decisions in connection with their fund. Participants need to become familiar with these political realities to safeguard their interests from being compromised by those with primary responsibility for their plan. Pension issues are not easy to understand and while funds were performing well, many workers were satisfied to simply give their benefit statements a quick glance. However, the recent downturn in the performance of defined contribution retirement plans, in particular, is causing many participants to begin asking serious questions.
Every pension fund is subject to political influence and all decisions made by pensions have an attendant political component. In part this is due to the uncertain nature of long-term investment decision-making. The SEC requires every money manager to disclose (or confess) that "past performance is not indicative of future results." There is no assurance that even if you could hire the single "best" money manager in the world, based upon his performance through today, that he would produce the best results over the next 10 years for your fund. Conversely, there is nothing to say that if you hired the worst manager in the world, he might not in the future outperform all the others. As much as the investment community has tried to make investing a science, it simply never will be. There are few "right" answers. So pension decision-makers have tremendous latitude in allocating assets and choosing managers. You might think that the "prudent man" standard which pensions have historically been required to follow actually permits few departures from a staid investment course. But today even "investing" in hedge funds, which are about as close to gambling as you'll ever get, has been found by funds to be consistent with the prudent man rule. And all sorts of wild "alternative investments" have shown up in pension portfolios.
Many pensions have boards of trustees, some or all of which have been elected. Elected trustees have political constituencies to represent; such representation may or may not be entirely consistent with their fiduciary obligations to the fund. Some, perhaps only a few, elected trustees may be responsible for raising funds for their re-election. Other trustees are appointed and owe an allegiance to those who appointed them. Many pension trustees are not paid to perform their fund duties and may, consequently, spent little time on fund matters or be distracted. While trustees or directors are ultimately responsible for oversight of funds, most funds have staff to handle day-to-day matters. How much responsibility is delegated to staff differs from fund to fund.
The more responsibility given to staff, the more political concerns of staff need to be identified. First and foremost, staff wants to keep their jobs and to get paid more each year than the last. So staff initially seeks to curry favor with their boards. If they are given additional power, other interests of staff will sneak into the decision-making process. Add to this mix the legions of private sector money management marketers and pension consultants who get paid a lot of money to persuade funds to hire and retain their firms and a full blown picture of pension fund politics begins to emerge.
In whose interest is it to find problems related to the fund? Everyone involved looks bad when problems come to light. What pension director would willingly hold his fund out for public scrutiny as an example of fiduciary soundness? More often than not, pensions seek to avoid the spotlight and even conceal their actions from curious onlookers. Reporters will tell you that pensions subject to state "sunshine" laws seldom respond forthrightly to requests for information. Why not? Do they have something to hide?
Why would a pension not want to know when one of its managers is involved in fraudulent activity? Because to know, I have been told, is to be put in the uncomfortable position of having to either admit the mistake and take action or not act and risk further adverse developments. "Don't tell me what I don't want to know," is the response most pensions have to news of fraudulent or illegal activity. What executive director wants to tell one of his trustees that the manager he or the trustee selected is engaged in questionable activity? How often do funds publicly state the true reasons behind their firing managers? All-too-often staff and board members forget that their primary concern should be what's best for participants in the fund, regardless of whether that means having to admit to errors or problems.
The chief beneficiaries of this political drama are the money managers. As long as pensions shirk their responsibility to truly scrutinize managers, marginal managers will be able to continue to garner business. Remember that smaller, retail investors rarely have the clout and resources to conduct sophisticated reviews of their money managers. Federal and state regulators supposedly police the marketplace, but they generally do too little, too late. So it's often up to pensions to fill the void and identify money managers that might inflict harm upon their participants and other small investors who lack an effective fiduciary watchdog.
Today it is possible for pensions to enforce higher standards of disclosure and ethical behavior than even the federal securities laws require. For those funds that strive for this higher standard, the benefits are clear. Participants will receive greater protection from risks related to fraud and illegality. That does not mean that investment performance will necessarily improve. But it may and probably will. There is an enormous cost related to unethical and criminal money manager activity and it can be reduced. As participants in pension funds become more knowledgeable in the ways that their interests can be compromised by fund politics, they will increasingly demand that those responsible for safeguarding their money demonstrate compliance with the highest standards attainable, regardless of how uncomfortable staff or trustees may be with such standards.