Protecting Our Pensions: Lessons of the Mutual Fund Scandals
International Foundation for Employee Benefits Speech by Edward Siedle December 3, 2004
I could not have asked for a better introduction to the subject I will be speaking about than Frank Abilgnale’s fascinating tale of how he was able to steal from banks, airlines and others because they lacked systems to combat fraud.
The message I have for you today is that America’s pensions are being defrauded by their investment consultants, money managers, brokers, attorneys and actuaries (or collusion between these parties), because they lack procedures to detect and prevent wrongdoing.
I began my career in the early 1980s as an attorney with the SEC regulating the mutual fund industry. At the SEC I witnessed firsthand the extraordinarily close relationship that existed between the SEC’s Division of Investment Management and the ICI, the mutual fund industry’s powerful lobby group. There were cocktail parties at the ICI we were invited to attend and the industry conferences we went to for free. It seemed the entire ICI legal department consisted of former SEC staffers. Since the ICI paid a whole lot better than the $25,000 or so the SEC was paying at the time, many SEC staffers aspired to be hired by the ICI. So as a young attorney I was coached to treat the ICI as if it were a client to be catered to.
The SEC allowed the ICI to say in its literature that it “represented the nation’s tens of millions mutual fund investors.” Mutual fund companies were even permitted by the SEC to pay their ICI lobbyists’ annual dues with investors’ money, rather than out of their own pockets. Apparently the SEC believed the ICI could simultaneously serve two masters, that is look out for mutual fund investors as it pursued its objective of furthering the business interests of mutual fund companies. No significant piece of mutual fund regulation ever left the SEC for public comment without first having been thoroughly critiqued by the ICI for possible industry objection.
In short, the ICI looked a lot like a self-regulatory organization—like the NASD, the SRO that regulates the brokerage industry.
Many of you are not aware that in America we have, since the dawn of the federal securities laws, allowed stockbrokers to self-regulate, self-insure, self-adjudicate and even control public access to the criminal records of the brokerage industry. Is this because we as a nation believe stockbrokers are inherently trustworthy? I don’t think so. It’s because the brokerage industry has had powerful lobbyists. Unfortunately, it’s the American public that annually pays the price for broker wrongdoing that this self-regulatory organization aids and abets.
While we could significantly reduce broker fraud, the NASD, an industry group that we have allowed to simultaneously serve as a self-regulatory organization stands in the way.
Until recently the ICI had the SEC under the same spell that the NASD has had the SEC under since its birth in the 1930s. If there were any problems at all involving mutual funds, it was a “few bad apples,” or “disgruntled employees.” The industry was beyond reproach, it was believed.
The staff at the SEC labored under the assumption that mutual fund companies operated in the public interest, offering retail investors a fairly safe product at a fair price.
Well, I began investigating illegal mutual fund activity in the 1980s. I’ve written dozens of articles about it since then, reported it to senior management at mutual fund companies and reported it to the NASD, SEC and FBI. The response from management, law enforcement and regulators was: who was I to call into question an entire company or industry? No one was willing to believe, not even the federal judiciary, that wrongdoing was longstanding and pervasive in the mutual fund industry. Being a whistleblower is no fun, I can assure you.
Times have changed. Now the SEC and others actively seek our investigative insights, as opposed to cavalierly rejecting them. In the last year we have been subpoenaed by Eliot Spitzer, the Attorney General of New York, as well as contacted by the SEC and DOL for information about wrongdoing.
It’s hard to believe that it has been less than 2 years since Eliot Spitzer began his crusade. Since then, the regulated world has begun to unravel. Even as pensions and others are rushing into unregulated investments, such as hedge funds, Spitzer has been showing investors that (1) regulators have been asleep at the switch and (2) “trusted financial advisers are not to be trusted.”
We are at the very beginnings of a protracted inquiry into the ethics of financial advisers of all sorts: stockbrokers, research analysts, investment bankers, mutual fund money managers, pensions consultants, insurance agents and brokers and employee benefits consultants, to name a few. What it means to be a fiduciary is finally being more fully defined.
Yet already Morningstar, the mutual fund rating organization, that helps mutual fund companies sell product by rating funds with good past performance highly even as it tells investors “past performance is not indicative of future results,” has told investors its safe to get back into mutual funds. “The scandalous behavior of the past 25 years has been cleared up.” The ICI agrees.
Of course neither of these mutual fund promoting organizations ever predicted the scandals or warned the public of the possible harm. They know nothing about and are not in the business of ferreting out wrongdoing. They help mutual fund companies sell products, pure and simple.
I assure you the mutual fund industry has not been cleaned up. In fact, most mutual fund executives still don’t believe they ever did anything wrong. Countless additional criminal and unethical mutual fund practices have yet to be probed by regulators and may never be. Many of the parties who profited handsomely from defrauding mutual fund investors have quietly walked away with hundreds of millions in ill-gotten gains.
But what I would like to focus upon today is: what can be learned from the mutual fund scandals? Here are a few of my thoughts on the subject, but this list is hardly exhaustive.
1. We now know that wrongdoing in the money management industry, which includes mutual funds, is pervasive and longstanding. These are industry practices, not bad apples. Money managers are not uniquely honest. They frequently compromise the best interests of their clients in pursuit of self-interest. Put simply, they often use client money for personal gain.
2. We now know that disappointing investment performance is often the result of conflicts of interest, undisclosed financial arrangements, excessive fees and fraud. We should never again be quick to assume that poor performance is solely due to poor investment decision-making. Frequently there are more sinister forces at work.
The mutual fund scandals taught us that the poor performance of our 401ks and IRAs were not entirely our fault. When someone is skimming money out of our retirement accounts, its difficult to accumulate wealth. There are some retirement plans in America today that are so fundamentally flawed that it is virtually impossible that participants in these plans will ever accumulate wealth. For example, if the fees related to a plan exceed 4%, participants will be exceedingly fortunate to find their principal intact upon retirement.
3. We know that the conflict of interest inherent in self-regulation is insurmountable. There is no good reason to continue to permit the brokerage industry in America to self-regulate. Today, when a significant percentage of Americans are invested in the stock market, we must take all possible action to eliminate wrongdoing by brokerages and we cannot trust an association of brokerages with this task.
4. We now know that regulators cannot be trusted to protect us. They will, over time, grow too close to the industries they are supposed to be regulating. They also do too little too late. Wrongdoers can create new scams far quicker than regulators can identify and eliminate them. Pensions are particularly vulnerable because the SEC seldom ventures into pension matters and the DOL knows nothing about the securities and asset management industries. Therefore, wrongdoing by brokers, money managers and consultants within pension plans, falls between the regulatory cracks.
5. Given human nature and regulatory limitations, we can be certain that wrongdoing in the securities and money management industries will be a constant. It can never be eliminated; it will always exist.
6. Eternal vigilance is needed to avoid financial ruin. Pensions need to take steps to combat the forces that seek to defraud their participants. Ongoing procedures should be established and followed to guard against wrongdoing.
A. Initiate your own due diligence investigations before you invest. Do not rely upon regulators. B. Recognize mistakes and investigate causes of losses. Without a thorough understanding of past mistakes, you are doomed to repeat them.
7. We now know that we must be suspicious of those who purport to provide objective advice. We must routinely search for undisclosed financial arrangements. Most providers of objective advice have been corrupted because far more money can be made through providing tainted advice. 8. Whistleblowers and others who speak of longstanding, pervasive wrongdoing will always be made to appear untrustworthy, lacking in credibility, and absurd when they take on the establishment. But often they are telling the truth. Since being a whistleblower is no fun, we should listen carefully to those who feel strongly enough to subject themselves to the attendant abuse.
Finally, we must remember that marketing dollars promoting dubious financial products will always drown out voices of caution because there is big money to be made pushing lousy products and little to be made debunking them. The greater the fees related to a product, the more money that is available to compensate salesmen and corrupt gatekeepers. Ironically, the best investment products are often conspicuously absent from retirement plans and the higher cost, poor performers dominate.
In conclusion, unscrupulous money managers, investment consultants, brokers, actuaries and attorneys defraud pensions every day. We see hundreds of cases annually and generally the pensions involved don’t want to believe it. We encounter significant resistance convincing pensions to allow us to examine the facts and identify any wrongdoing.
Strangely enough, pensions will often insist they are responsible for bad decisions because they don’t understand a fraudulent scheme was operating behind the scenes. Once the scheme has been exposed, funds may become motivated to pursue wrongdoers; however, unless they allow someone to examine the facts, the wrongdoing will never be uncovered. Other funds understand they’ve been ripped off but don’t want to do anything about it for fear of appearing stupid.
Managing pensions is incredibly complicated. Virtually every fund I’ve ever met with has been victimized and this is inevitable that problems will arise, given the longevity of pensions. In light of the complexity of the pension management task, no fund that has been defrauded should be hesitant to admit to and investigate losses.
Based upon my experience, I can assure you that no pension in America—not even the largest-- has procedures in place to effectively guard against fraudulent activity.
The greatest threat to pensions today is the widespread unwillingness to confront the truth about how investment firms have profited at the expense of funds and take corrective action.
How Consultants Can Retire on Your Pension
New York Times December 12, 2004
By GRETCHEN MORGENSON and MARY WILLIAMS WALSH
NINE years ago, William Keith Phillips, a top stockbroker at Paine Webber, met with the trustees of the Chattanooga Pension Fund in Tennessee to pitch his services as a consultant. He gave them an intriguing, if unusual, choice. They could pay for his investment advice directly, as pension funds often do, or they could save money by agreeing to allocate a portion of its trading commissions to cover his fees. Under a commission arrangement, Mr. Phillips told the trustees, the fund would be less likely to incur out-of-pocket expenses, leaving more money to invest for its 1,600 beneficiaries.
Seven and a half years later, Chattanooga's pension trustees discovered just how expensive that money-saving plan had been. According to an arbitration proceeding they filed against Mr. Phillips, the agreement cost the fund $20 million in losses, undisclosed commissions and fees. And since 2001, Chattanooga has had to raise nearly $3.7 million from taxpayers to keep the $180 million fund fiscally sound.
The Chattanooga trustees fired Mr. Phillips in 2003 and, last October, filed arbitration proceedings against him, UBS Wealth Management USA, formerly the Paine Webber Group, and his new firm, Morgan Stanley. The case, which is pending, accuses the consultant of, among other things, fraud and breach of fiduciary duty. The commission arrangement was central to the problem because it put Mr. Phillips's interests ahead of his client's, the fund said in its complaint. "The very important and in many ways unique relationship that a pension fund board has with its consultant is based on trust," said David R. Eichenthal, finance officer and chairman of the general pension plan for the city of Chattanooga. "To the extent that Phillips breached that trust, we thought it was important for the pension fund to do everything possible to hold him accountable for the results."
Pension experts say the Chattanooga case is hardly rare among retirement funds. The Securities and Exchange Commission is concerned enough about conflicts of interest among consultants who advise pension funds on asset allocation, selection of money managers and other investment matters that it is conducting an industrywide inquiry. The results of the S.E.C.'s investigation are expected soon, and enforcement actions may follow. Aubrey Harwell, a lawyer for Mr. Phillips, declined to make him available for this article. Mr. Harwell said: "No. 1, these are allegations and not proven facts. And No. 2, the performance during the days that Keith Phillips was consulting were well beyond the benchmarks." Details of the commission arrangement, he added, were fully disclosed to the pension fund. But this is not the first time a pension client has sued Mr. Phillips. In 2000, the Metro Nashville Pension Plan filed an arbitration based on similar accusations. That arbitration was settled two years later, with UBS paying $10.3 million to the pension fund.
As financial services conglomerates have added a wide array of operations in recent years, the possibility of conflicts of interest has also grown. And nowhere are the conflicts more potentially lucrative - and more obscure - than in the management of pension assets.
"Recommendations to pension funds regarding asset allocation, money manager selection and securities brokerage policies are frequently driven by undisclosed financial arrangements," said Edward A. H. Siedle, president of Benchmark Financial Services Inc., in Ocean Ridge, Fla., and a former lawyer for the S.E.C. "Pensions often accept that poor investment performance is attributable to unfortunate investment assumptions when, in fact, more sinister forces were at work. Investment performance often is compromised as the result of conflicts of interest, undisclosed financial arrangements, excessive fees and fraud." An estimated $5 trillion sits in thousands of pension funds across the nation, run for the benefit of private company, state or municipal workers who rely on the funds for retirement income. Some funds are huge, with billions of dollars under management, and are overseen by a board of finance professionals. Many, however, are tiny, with just a few million dollars invested. These funds are often run by volunteers less versed in the ways of Wall Street.
Pension fund boards typically hire a consultant to advise them on investment strategies and the hiring of money managers. Problems can crop up when these pension consulting firms, which have a fiduciary duty to the fund, put their own interests first. JUST as pension funds come in many sizes, so, too, do the consulting firms that serve them. Some are one-person operations while others work within a large financial-services firm. Among the biggest companies in pension consulting are Mercer Inc., a unit of Marsh & McLennan, and Callan Associates, a privately held company based in San Francisco.
In recent years, however, Wall Street firms have played an increasingly large role in the world of pension consulting. Merrill Lynch, Smith Barney and Morgan Stanley are all big in this field. The potential for conflicts is greatest at firms with brokerage or trading operations, pension authorities say, and it almost always involves how the consultants are compensated. The trouble is, much of a consultant's pay can be hidden from view. The Chattanooga complaint said Mr. Phillips and his colleagues controlled and manipulated the information given to the pension board, keeping it in the dark about excessive fees and conflicts inherent in the recommendations they made to the fund. Mr. Phillips's reports on the pension fund's performance were misleading, the complaint said, because they did not take into consideration all of the fees and commissions it paid.
Only when the Chattanooga board began considering rival consultants to advise it in 2002 did Mr. Phillips acknowledge the conflicts of interest in his previous arrangement with the pension fund, the complaint said. Arguing that the Chattanooga board should keep him on, Mr. Phillips said that under a new agreement conflicts would be removed, according to the complaint, and that there would be "full and fair disclosure of all brokerage practices and relationships." Money manager recommendations would be "based upon performance rather than revenue," he said, according to the complaint.
Mr. Phillips ultimately lost the Chattanooga account to the Consulting Services Group of Nashville, an independent consultant with no brokerage firm operations. A spokesman for UBS said that the firm believes the case has no merit. "We are defending ourselves vigorously," he said.
A Morgan Stanley spokeswoman said: "The Chattanooga Pension Board was a sophisticated and knowledgeable investor that was advised by its own counsel about all aspects of its relationship with us. Morgan Stanley acted properly and is confident that the board's claims will be rejected by the arbitrators." The compensation of consultants is so complex because it can come from many sources. "There are more ways for people to be compensated in the financial business than most people realize," said Joseph Bogdahn, principal of Bogdahn Consulting L.L.C., an independent consultant in Winter Haven, Fla. "The only way that you can determine if your consultant is truly independent is to audit their tax returns and their financials."
Mr. Bogdahn said he recommends that pension fund trustees ask their consultants to open up their books to show how they are paid, and by whom. He says he makes his financial statements available to his clients. Because they have a fiduciary duty to their clients, consultants are required to disclose any potential conflicts of interest in their operations. But when they have affiliations with firms that conduct trades for the pension funds they advise, these relationships can undermine the fiduciary duty. Some consultants try to get around this by hiring money managers who agree to direct their trades through the brokerage firm with which the consultants are affiliated.
Arrangements like the one in Chattanooga are the most common method used by pension consultants to ensure that commissions will go to them. In their contracts, they require the pension funds to pay their fee through commissions on trades steered to their brokerage units. This is known as directed brokerage, commission recapture or a soft-dollar arrangement. Ultimately, pension experts say, the commissions steered to the brokerage firm in such an arrangement are often worth far more than the upfront fee that is typically quoted by the consultant for his services. Pension fund trustees do not always receive a full accounting of the transactions and the commissions they generate. So the trustees do not know how much more they are paying as a result of the arrangement.
For example, during its years with Mr. Phillips, Chattanooga wound up paying his firm $2 million in commissions and cash payments, an average of $270,000 annually. If it had paid the upfront fees quoted by Mr. Phillips, the fund would have paid $154,000 a year, on average, the lawsuit said. As a result of the commission arrangement, Mr. Phillips and his colleagues misappropriated more than $870,000 in undisclosed and unjustified fees, according to the complaint.
When consultants steer trades to a particular firm, a pension fund can pay dearly in other ways, too. Money managers are supposed to provide best execution - the most favorable price - on their clients' trades. But when a brokerage firm is guaranteed to receive most or all of a fund's trades, it need not work as hard on the execution of those trades as a firm that is competing for the business. Execution costs can skyrocket. A letter sent to a public pension client last January by Rittenhouse Asset Management Inc., a money manager in Radnor, Pa., described the matter succinctly: "Because we trade through your advisor, we have not selected broker-dealers or negotiated commission rates for your account and cannot actively ensure that directed brokerage terms are in your continuing best interests. Although cost is only one component of best execution analysis, many directed brokerage accounts pay effective rates of commissions that are higher than client accounts that do not have directed brokerage arrangements."
Rittenhouse said it made this disclosure because industry practices were changing and the firm wanted to remind its clients of their specific arrangements. The potential for conflicts is driving some pension fund trustees to switch to independent consultants who have no brokerage firm affiliations and are therefore not tempted to ask money managers to steer trades to them. Michael Brown is a battalion chief of the fire department in Dania Beach, Fla., and a member of the police and fire pension board; the funds had $22.6 million in assets as of last December. For many years, the board employed Merrill Lynch Consulting Services in Jacksonville, Fla., as its pension consultant. But earlier this year, the board replaced Merrill with an independent consultant that did not have a brokerage unit in its operations.
"I think they did a good job," Mr. Brown said, referring to Merrill. "But a lot of stuff had come out over the last year with reference to your big corporate money managers and consultants being at the same company. We thought it would be a better idea to have an independent consultant." Merrill Lynch Consulting Services in Jacksonville counts almost 100 pension funds in Florida as its clients. At the end of 2003, they included the $80 million fire and police funds of Cape Coral, the $40 million police fund of Fort Myers, the $26 million police fund of Miramar and the $27 million fire and police funds of Vero Beach.
Pension consultants sometimes recommend that their smaller clients buy mutual funds. What a pension's trustees may not realize is that their consultant can receive compensation from the mutual fund companies on these trades. In 2000, at the advice of Merrill Lynch Consulting, the city of Sunrise, Fla., put $10.4 million of its pension assets into three international mutual funds with similar stock holdings. The pension fund bought shares worth $3.7 million in one fund, $3.1 million in the second and $3.6 million in the third.
Merrill Lynch Consulting received commissions of 1 percent on each purchase from the mutual fund companies. But mutual funds often discount their commissions on larger trades, so if the fund had put all $10.4 million into one of the international mutual funds, Merrill Lynch Consulting would have received 0.69 percent. "Sunrise, not Merrill Lynch, selected the money managers from recommendations we provided," said Mark Herr, a Merrill spokesman. "During the five years we provided consulting services, Sunrise finished in the top quartile or quintile for results when compared to its peers." Brokerage commissions are not the only source of revenue for many pension consultants. They also receive payments from money managers who attend annual conferences at luxurious resorts set up by the consultants. The conferences are billed as opportunities for money managers to meet pension plan officials, but critics describe them as pay-to-play mechanisms. They contend that the money managers recommended by consultants to pension funds tend to be only those who paid to attend the conferences.
Earlier this year, CRA RogersCasey, an investment consultant in Chicago, held two conferences, one at the American Club in Kohler, Wis., near two famous golf courses, and the other at the Kingsmill Resort in Williamsburg, Va. Celebrities often appear at CRA RogersCasey conferences: past speakers have included Gen. H. Norman Schwarzkopf; James Carville, the political consultant; and Robert B. Reich, the former secretary of labor. The cost to attend varies. At the conferences this year, "new members" paid $40,000 while return guests were charged $35,000 to $37,500.
MONEY management firms that have attended past conferences of CRA RogersCasey include AIG Global Investment, Citigroup Asset Management, Strong Capital Management, Putnam Investments and Bear Stearns Asset Management. Matt McCormick, director of marketing at CRA RogersCasey, said that it would continue to sponsor conferences. "Our clients tell us that they add value," he said. "They tell us they have a very good comfort level that there is no impact or influence on our independent advice."
Earlier this year, Mercer said it would stop conducting conferences. Callan Associates said it was continuing to hold its meetings. "An important part of our business model is educating all clients on their fiduciary responsibilities," a Callan spokeswoman said.
Pension consultants aren't the only ones holding conferences where money managers can hobnob with pension officials. Robert D. Klausner, a lawyer at Klausner & Kaufman in Plantation, Fla., whose firm provides legal counsel to many pension funds in Florida and elsewhere in the south, runs similar meetings.
Klausner & Kaufman's sixth annual client conference was in March at the Hyatt Regency in Fort Lauderdale, Fla. Among the eight companies that paid to sponsor the 2003 conference were Merrill Lynch and Davis Hamilton Jackson & Associates, a money manager based in Houston that Merrill often recommends to its pension clients.
According to documents detailing the various advisers to police and fire pension funds in Florida, Mr. Klausner's firm provides legal advice to 19 funds. Twelve of them employed Davis Hamilton as a money manager, or Merrill Lynch Consulting as a consultant, or both. Mr. Klausner did not return calls seeking comment.
Davis Hamilton appears often among the pension fund clients of Merrill Lynch Consulting, even though the firm has produced less-than-stellar returns in recent years. Davis Hamilton has managed the Lake Worth Police Officers' Pension Fund, for example, and for the six years ending in 2003, it beat its benchmark index only one-third of the time. For the year ending 2003, the police fund's overall return, including both stocks and bonds, ranked in the bottom 26 percent of the peer group used by Merrill.
A trustee at a public fund in Florida, who asked for anonymity because he feared reprisals from the firms involved, said his fund is advised by Merrill Lynch and has employed Davis Hamilton. Although the money manager's performance has been lackluster in recent years, this trustee said Merrill Lynch continued to recommend that the pension fund retain Davis Hamilton. The trustee said he was concerned that Merrill's support of Davis Hamilton had to do with the fact that Davis Hamilton steers "virtually all" of the pension fund's trades to Merrill.
Davis Hamilton did not return calls seeking comment. Merrill's spokesman said: "We do not require any client or any manager to direct its trades to us. The choice always belongs to the client." The Merrill spokesman added: "We don't pay to play. We don't have conflicts of interest that injure or work against our clients. We fully disclose our fees face up on the table. The only reason we do well is because we provide excellent work for our clients."
Trustees of the city retirement system in San Diego are in a battle over the practices of Callan Associates, one of its consultants. Diann Shipione, a volunteer trustee and a financial adviser, has called for the consultant's resignation because of payments Callan has received from money managers it has recommended to the fund.
For example, Ms. Shipione said, one of the money managers recommended by Callan had only two full years of experience and a performance ranking in the bottom 30 percent of its peers nationwide. Only after she questioned the recommendation did it emerge that Callan had a significant economic relationship with the money manager, she said.
Callan's spokeswoman said the performance of the San Diego pension fund spoke for itself. For the five years ended Sept. 30, she said, "San Diego was in the top 1 percent of our public fund universe and was in the top third in each of those five years." She added that in a typical year, less than half the investment managers recommended by Callan were its clients.
But Ms. Shipione said: "These pay-to-play practices are systemic. A consultant's advice should come in the form of an objective recommendation, but in reality it may be the result of self-serving economic gain. Pension trustees need information about the business of investment consultants and their sources of revenue. It would at least give us information with which to test the consultant's objectivity."
Indeed, among the documents requested of pension consultants by the S.E.C. in its investigation are a full accounting of the compensation received by consultants, not only from their pension plan clients, but also from the money managers they recommend.
Mr. Siedle, who investigates money management abuses on behalf of pension fund clients, said these funds could be easily defrauded because they had no procedures in place to detect and prevent wrongdoing. "The greatest threat to pensions today is the widespread unwillingness to confront the truth about how investment firms have profited at the expense of funds and take corrective action," he said.
Gary Findlay, executive director of the Missouri State Employees' Retirement System, said his organization had tackled the problem of conflicted consultants by using a consultant that receives no revenue beyond the direct fees it charges the fund.
"Our consultant has no relationship with a broker dealer and they sell no services to money managers," Mr. Findlay said. "One of the things that we rely on from our consultant is to provide us with guidance on the basis of undivided loyalty. Their interests are aligned with our interests only, and I do believe that's what it's all about."
MONEY TROUBLE IN HALLANDALE
BY HARRIET JOHNSON BRACKEY
THE MIAMI HERALD
Sunday, November 21, 2004 Section: Business Page: 2E
Investment returns among the worst in the nation. A money manager resigns without giving a reason. A search begins for a new advisor. Welcome to the world of the Hallandale Beach Police and Fire pension fund. At $55 million, it's one of the smaller funds in South Florida. But it is notable for its recent turmoil and poor performance.
In a Sept. 30 report to the pension board last week, board consultant Merrill Lynch ranked Hallandale Beach in the bottom 4th percentile of the 93 public pensions Merrill advises in Florida. Only eight had worse performances than Hallandale Beach over the last 12 months.
STOCK MARKET ``When the stock market was strong, we did great,' said board chairman Alan Miller. ``I don't know if it is fair to judge what's gone on in the past four years because of the market.'
Indeed, public pension funds suffered through three years of losses, on average, from 2000 to 2002, says Mercer Investment Consulting, which advises plans nationwide. But last year, the median public pension plan returned almost 24 percent.
And, for the 12 months ended Sept. 30, the median public pension fund gained 13.1 percent, according to Mercer. Hallandale Beach gained only 6.9 percent.
These results have left the fund with insufficient assets to pay what it owes retirees. The most recent numbers show that Hallandale Beach's fund had only 71.8 percent of its liabilities covered. (The fund could be meeting its current obligations, however.) The average pension fund, Mercer says, has nearly 80 percent.
To fill the gap, the city and state must contribute almost $3 million this year to the fund. The state kicks in part of that. Last year, contributions totaled $3.3 million. In 2002, the amount was only $333,035.
One explanation for the weak showing: Four years ago, the city sank $10 million into technology stocks. Today that investment is worth $2.4 million. The financial services company managing the tech investment, Pimco, resigned from the job Nov. 12 via a voice mail message.
No reason was given, said Miller. Merrill Lynch says Hallandale's own trustees decided to go into tech stocks against Merrill's advice.
``The performance decline in recent years is directly attributable to a decision made by previous trustees to disregard our advice and make a major investment that has lost most of its value,' Merrill spokesman Mark Herr said in an e-mail.
BOARD OF TRUSTEES Like other public pensions in Florida, Hallandale Beach's Police and Fire fund is run by a board of trustees, drawn mostly from the ranks of city employees. Miller, the chairman, is an accountant who does not work for the city.
The trustees make decisions, generally relying on Merrill for advice on such things as which money managers handle their investments.
The managers, according to the performance reports for the fund, do almost all of Hallandale Beach's stock and bond trading through a brokerage called Citation, which is a unit of Merrill. Under Merrill's fee agreement with Hallandale Beach, Merrill credits half the commission generated from trades against the annual fee charged to the pension fund. This is known in the industry as a soft-dollar arrangement.
Such arrangements alarms Edward Siedle, an independent investigator of money managers. He believes that in soft-dollar arrangements, pension funds don't always pay the lowest price for services. Hallandale Beach's fund, recently, paid an average 4 or 5 cents per share for its trades.
Other brokers that are not related to the pension consultant might charge less or rebate a greater percentage to the fund, according to Joseph Bogdahn, an Orlando pension consultant.
Siedle has done a preliminary investigation into Hallandale Beach and 11 other Florida pension funds. He's found abuses in other cities with other pension consultants. For example, in Nashville, where he conducted an investigation that lead to a $10.3 million settlement with UBS PaineWebber, ``The city thought it was paying its pension consultant $788,747, but the consultant was actually earning $1.4 million a year in commissions and there was lots of other compensation,' Siedle said.
For now, Miller said the board is happy with Merrill's performance, although the board did decide last week to solicit bids from new pension consultants. Miller said it was because a request for proposals from pension consultants had never been done before.
The pension board also agreed to hold a special meeting Dec. 20 to review its investment strategy. Mayor Joy Cooper, who is a pension trustee said, ``We want to see if we can get better performance out of the plan and the consultant going forward.' Illustration: photo: Hallandale's water tower (a)
Caption: J. ALBERT DIAZ/HERALD STAFF RESERVES: Unlike Hallandale's water tower, the reserves for the city's police and fire pension fund does not have enough liquidity to function properly. Keywords:
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PUBLIC PENSION PROBLEMS By HARRIET JOHNSON BRACKEY, Herald Business Writer Memo: MONEY MATTERS Published: Sunday, November 21, 2004 Section: Business Page: 1E A lot of drama is playing out in the normally quiet world of public pension funds.
A number of pensions that fund the retirement of municipal workers, police officers and firefighters have suffered extremely poor investment results in the last few years. If pension funds can't earn enough money to pay retirees, the taxpayers end up paying the difference.
In some cities, that's already begun.
The $55 million Hallandale Beach Police and Fire Pension fund's returns are so rotten, for example, that the city and state together this year are having to kick in almost $3 million to shore up the fund. That works out to $244 per taxpayer.
In North Miami Beach, the police and general employee pension funds have grown an average of 0.9 percent a year in the last five years. Nationwide, the median public pension plan grew 4.1 percent a year in the same period, according to Mercer Investment Consulting.
To have enough money to meet its obligations to retirees, North Miami Beach needs an 8 percent annual return. The trustees who manage these funds are starting to question the reasons for the poor performance, and cities such as Hallandale Beach and Delray Beach are considering formal reviews.
The Florida Public Pension Trustees Association, a nonprofit educational group, did not return repeated phone calls seeking comment. One subject of these reviews is the role of the consultants hired by trustees to advise them on their investment decisions.
In Coral Gables, the city fired and then sued its pension advisor, UBS Paine Webber. The lawsuit claims that by following the advice of UBS Paine Webber consultants, the pension fund lost $25 million in 2001 and 2002.
In the last year, the consulting business has been scrutinized by federal regulators. The Securities and Exchange Commission is nearing the end of a one-year sweep of the lucrative pension consulting industry, according to a source at the commission.
It is investigating whether consultants are recommending investment managers based on payments they receive from those managers rather than what's best for the pension. These payments could be called referral fees, or they could be agreements by the money managers to route stock trades through the consultant's brokerage arm.
CONFLICT OF INTEREST
``If you are a broker and you also execute trades for the managers you placed with your pension consulting clients, then it's an inherent conflict of interest,' said Gregory McNeillie, senior vice president of Dahab Associates, a pension consulting firm with offices in Fort Lauderdale and Boston. Regulators also are looking into whether consultants properly disclosed their compensation arrangements to the plans.
The SEC has not made any specific allegations about public pension plans in Florida or about investment managers named in this story. Edward Siedle a former SEC attorney who now investigates abuses for pension funds, says he has examined pension records in a dozen Florida cities and has found numerous problems. These include compensation deals he says could be netting pension consultants 10 times more than the consultant discloses.
The system drains the pension funds of millions of dollars, ``like a leaking bucket,' Siedle said. ``The water keeps going in but it keeps dripping out at the bottom.'
And Orlando pension consultant Joseph Bogdahn concluded in a recent white paper on conflicts of interest in his industry that ``the Florida public pension market is overpaying consultants in excess of a million dollars each year.' His paper includes a copy of an agreement from the American Funds group that shows it pays a 1 percent commission to any dealer who brings in between $1 million and $4 million for its Class A shares. American Funds spokesman Chuck Freadhoff confirmed that fee.
Paying or offering some sort of kickback in order to be recommended to a pension plan ``is so prevalent that well over half of the investment managers that call on me actually ask what they need to give up.'
Ultimately, these deals cost the taxpayers.
Large consulting firms, which include Mercer, Callan Associates, Watson Wyatt & Co. and Merrill Lynch, have denied accepting any fees that sway their investment recommendations to pension funds.
Merrill, which advises Hallandale Beach's fund, ``fully discloses its fees, face up on the table,' spokesman Mark Herr wrote in an e-mail response to questions. ``We play by the rules and we give our clients excellent service,' Herr wrote. UBS Paine Webber, Coral Gables' former pension advisor, denies the city's claim that it breached its fiduciary duty to the pension plan. Spokesman Peter Casey said the firm ``believes the board's claim is entirely meritless and we will vigorously defend ourselves against it.' Across the nation, concern is growing about consultants and conflicts of interest, said Nevin Adams, editor-in-chief of Plansponsor, an industry magazine for pension and retirement plans. The magazine recently published a survey in which most plans said they want their pension advisors to be free of conflicts of interest. MAKING A PROFIT ``There are clearly situations where people are making recommendations based not on what is in the best interests of plan participants but on what pays them the most,' Adams said. ``There's a lot of money changing hands and the people ultimately paying these fees are simply not aware of it,' he said.
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