(June 7, 2004 ) U.S. Institute Senior Delegates’ Roundtable Speech |
“Bad Advice For Free”
“I will pay you a million dollars to be the investment consultant to your pension,” is an offer I made in a speech at the Florida Police Officers’ and Firefighters’ annual pension trustee school in 2002. Let me provide you with a bit of background so you’ll understand why I made this unusual statement.
In Florida we have hundreds of smaller public pension funds and a few larger public plans. In our state certain “investment consultants” (more accurately referred to as brokers) associated with major wirehouses offer to provide pensions with consulting services, including advice regarding asset allocation and manager selection, FOR FREE.
Trustees of the Florida funds who have engaged these consultants boast that they pay nothing for the advice they receive from their consultants. They snicker at funds that are such poor negotiators that they have to actually pay for consulting services. Why pay for something you can get for free, they say.
In 2002, when I gave the speech referred to above, my firm had recently completed an investigation of an investment consultant to a sizable municipal pension. The consultant was paid an annual retainer of around $300,000 to provide supposedly objective investment advice. At the outset of our investigation it appeared that the $300,000 expressly stated agreed upon fee seemed high compared to what other similarly sized funds paid, possibly twice what it should be. By the time we had completed our investigation we discovered that the consultant was actually earning approximately $4 million annually as a result of his status as gatekeeper to the fund. The consultant’s total compensation from approximately four pensions was twice that amount or $8 million, making him the highest compensated broker associated with the wirehouse that employed him.
How did he earn $4 million from a client who thought it was paying only $300,000? The consultant established a complex scheme calculated to maximize profits to his firm through manipulating the investment decisions of his pension client. The consultant never intended to earn a mere $300,000 from the account. He did not even expect to derive the bulk of his compensation from the pension. He structured his relationship with the pension such that he would earn a little money from the fund through pretending to serve as a fiduciary providing objective advice while he was earning millions from money managers who paid him in return for money management assignments. This is commonly referred to as “pay to play” and it’s rampant throughout the consulting industry.
While turning a $300,000 consulting retainer into a $4 million annual annuity is clever, consultants such as those in Florida I referred to earlier, have taken the game one step further. They say, “Pensions, pay us nothing. Out of the goodness of our hearts, we will provide you investment consulting services for free.” They forego the annual retainer and focus upon the compensation they will reap from managers who are willing to pay for accounts.
For 15 years I have spoken about the abuses in the pension consulting industry. Pensions have been slow to accept that the pension consulting industry is riddled with conflicts of interest that result in real, quantifiable harm. Conflict of interest ridden advice is bad advice and bad advice, even for free, is never a good deal. When consultants offer their services for free to pensions it is because they aren’t really working for pensions—someone else is paying them and that’s whose interests are paramount in the mind of the consultant. And in the pension arena, it is money managers that pay consultants to be hired—often to the detriment of pensions.
So in my speech in 2002 I made an absurd yet financially sound offer. I had learned from my investigations that an unscrupulous consultant could make as much as $4 million annually off a smaller pension fund. Therefore to offer to pay $1 million for such an account was reasonable.
I hoped my offer would stun listeners and cause them to think seriously about the economics and conflicts of interest related to the consulting business. While the statement had little impact at the time, it stuck in their minds. Recently as the SEC and others have begun looking into the activities of consultants, people who heard my speech in 2002 tell me they remember my $1 million offer and now understand what I meant.
The Business of Investment Consulting Today
In 1997 I raised venture capital funds to purchase and consolidate investment consulting firms. I reviewed the financial operations of many of the nation’s consulting firms. I met with anyone interested in selling. What I learned was that no one was making money from consulting. Firms that were pure and ethical were earning a decent professional hourly wage—perhaps $200 an hour. The highest paid consultants operated on the edge, hustling brokerage and other business from managers. It wasn’t their fault really—pensions were unwilling to pay for really good advice. And that’s why the investment consulting business is where it is today.
The business of investment consulting today is riddled with fraud and conflicts.
Consultants who earn fees from money managers and are subject to conflicts of interest can afford to provide consulting advice for little or no money since the money managers are really paying them. The disclosed, agreed upon stated fee paid by the pension is generally intentionally misleading. The disclosed fee is kept artificially low—as low as is necessary to get the client. It may be a loss-leader. It may be “for free.”
Truly independent consultants who earn nothing other than the disclosed fees paid by pensions are at a competitive disadvantage. They have to compete in terms of disclosed fees with consultants who aren’t even looking to the pension to pay them and can afford to take the assignment for little or nothing. Despite statements in support of independence at consulting firms, pensions generally will not pay a higher disclosed fee to a consultant that has no “pay to play” arrangements.
The vast majority of the fees consultants earn are not disclosed. The various sources of consultant compensation and amounts are among the best-kept secrets in money management. That will not continue. Scrutiny of fees fiduciaries earn is at an all time high and it is unlikely investors will return to a state of ignorance.
The rapid aging of America alone will ensure continued intense scrutiny of pension matters. For the foreseeable future, as the first generation of Americans to purchase investment management services en masse approaches retirement, the nation will focus upon management of retirement assets.
Ironically, the surreptitious forms of compensation derived by consultants are the juice that fuels the consulting industry as it exists today—that’s where the money’s being made. Yet the surreptitious forms of compensation are a great liability hanging over consulting firms. It is the kick-backs that may threaten the survival of many of the largest consulting and money management firms.
The Future of Consulting
The future is both exciting and uncertain. One thing that is certain is that the existing business model will not survive. If nothing else, the cost of litigation related to it will bring it down.
Most consulting firms, if they were to adequately disclose the conflicts related to their operations, clients would bolt—perhaps not even because they would want to—but because, as fiduciaries, they could not defend relying upon an adviser who is really being paid by the enemy. If the consultant’s advice eventually is revealed to be not in the best interests of the fund but instead favors managers who have paid the consultant more than the fund, what pension trustee would want to defend his decision to retain the consultant? And since all active managers will underperform their benchmarks eventually, i.e., over some period of time, it is a certainty that losses related to managers recommended by the consultant that had financial dealings with the consultant will result.
Consultants should be paid more—substantially more—in disclosed fees. Surreptitious forms of compensation should be eliminated. Disclosure should be mandatory and I believe the Commission will propose such a rule in the near future. But that’s the boring stuff. There are many other business opportunities pension consultants could exploit. The pension consulting industry could emerge with a new professionalism as the regulatory environment changes. Certainly the demographics suggest that the time is ripe for evolution, if not revolution in the industry.
What This Means For Money Managers
What this means for money managers is (1) Managers should carefully review their existing marketing practices; (2) Managers should examine their potential liability for pay to play arrangements they have initiated or merely participated in which have resulted in losses to pensions—especially if the consulting firms should become insolvent; (3) Managers should prepare new marketing plans for this new regulatory and business environment.
Florida Pension Funds Wary of Merrill Lynch's Dual Role By Arden Dale Of DOW JONES NEWSWIRES
Merrill Lynch & Co. (MER) casts a long shadow over pension funds in Florida, and its influence is stirring controversy. Through a consulting business in Jacksonville, Fla., the financial-services giant advises public-retirement systems on which firms to hire to manage their money.
But Merrill also reaches deep into the funds through its brokerage business, which executes stock trades for pension funds in the state. Fund trustees are increasingly wary about the link between the two businesses. A big question is whether money managers recommended by Merrill return the favor by picking Merrill as a broker. Concerns about the dual role and influence of Merrill and other pension advisers are coming to the fore because of the Securities and Exchange Commission examination of the pension-consulting business in general. "We've heard these issues. One is you have to make trades through Merrill to get on the Merrill Lynch list," said John J. Keane, executive director and administrator of the $900 million Jacksonville Police and Fire Pension Fund, which has used Merrill's consulting service as a performance monitor for over a dozen years and still does. A growing number of Florida pension funds want to know more about the relationships between their consultants, including Merrill, and affiliated brokers. In addition to concerns about so-called pay-to-play practices, they have questions about the use of soft-dollar arrangements, in which brokers collect higher commissions on trades in return for providing research and other services to advisors. Consultants affiliated with brokers potentially reap substantial unreported revenue that way. Joseph Bogdahn, principal of Bogdahn Consulting LLC, an independent consulting firm that competes with Merrill for pension clients, said trustees at several funds have asked him how to spot conflicts, including those involving directed brokerage.
"People have asked us, 'How do they have such a cheap fee?'" said Mr. Bogdahn. "There's compensation that trustees don't understand." Plantation, Fla. lawyer Robert D. Klausner said his law firm has started requiring consultants to disclose all sources of income generated from its accounts. "I think the question which is being asked not only of Merrill but of all the investment house-based consultants regards disclosure," he added. "There have been public expressions of concern that soft-dollar arrangements are resulting in additional compensation that needs to be disclosed."
Mr. Klausner said after a pension-fund client of his firm requested more disclosure from Merrill, the company added reporting on all brokerage-related revenue to the client in quarterly reports. Even advisers without affiliated brokers are being asked for more disclosure, he added. "We disclose all material relationships, and the portfolio transactions are initiated by unaffiliated, independent fiduciaries," Merrill spokesman Mark Herr said in an e-mail. "Most important, we keep the client's best interest paramount."
Merrill Says It Gets Business On Its Merits Mr. Keane said his relationship with Merrill is a good one. Unlike some others, he noted his fund doesn't rely on a consultant to help pick money managers. Instead, it conducts its own searches through public bulletins that request proposals from firms.
"The board doesn't have the concern that some funds have who didn't know it was going on, who may have said, 'Hey, we didn't know that investment company XYZ was doing business with you and you were getting a rebate,'" said Mr. Keane.
Nonetheless, a stream of brokerage transactions links the Jacksonville fund with both its money managers and Merrill, according to Mr. Keane. Merrill is one of five firms the fund recommends that its managers use to recapture some brokerage commissions. Trustees "vigorously encourage our managers to participate in the commission-recapture project," he said. Under commission-recapture programs, brokers rebate a portion of their commissions to investment managers and clients. "I think a lot of the trade goes through Merrill," noted Mr. Keane, adding, "We don't designate among the five which commission-recapture broker is the preferred." Merrill said the money managers it recommends as advisers aren't chosen because of where those managers choose to execute stock trades for pension funds.
"Very simply, we do not engage in the practice of 'pay for play,' said Mr. Herr. "We get our pension business on the merits, and we keep the pension business on the merits because we serve our clients' interests."
Despite that stance, rumblings about Merrill and other firms with affiliated brokers have been heard in the state for years, according to veterans of the Florida pension community. Some consultants recommend the same brokerage houses "time and time again," said Ray Edmondson, executive director of the Florida Public Pension Trustees Association.
"I find that strange," he added. "There's ways of funneling money back to these consultants that nobody knows about. With Merrill, it's to the point where you have to trade through a specific broker before you get on a list for pension funds."
In general, alleged pension conflicts like those the SEC are looking into can take several forms, but they all come back to the sway consultants exercise over pension trustees. Those officials rely on advisers as gatekeepers who tell them which money managers to hire. In turn, the argument goes, money managers feel pressure to pay to play, or give kickbacks of various forms in return for recommendations to pension trustees.
Edward A.H. Siedle, a former SEC attorney who investigates pension consultants, said there are many unanswered questions involving broker consultants who advise pension funds.
He added, "We have found cases here in Florida where the broker consultant is getting a fee kickback from the money manager, cases where the pension is not getting the appropriate mutual-fund breakpoint and where a substantial portion of the brokerage is going to the consultant whilst the consultant maintains he is providing his service for free."
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