(February 2, 2005 ) The Art of Theft |
This month's alert includes several articles regarding the Chicago Public School Teachers Pension & Retirement Fund's board unanimous vote to ask its personnel and service providers committee to review our proposal to conduct a conflict-of-interest audit of Mercer Investment Consulting, the $10.3 billion fund's consultant.
In addition, we have included a speech entitled, The Art of Theft: How Corporate Fiduciaries Steal From America's Pensions.
The Art of Theft How Corporate Fiduciaries Steal From American’s Pensions
Speech by Edward Siedle
The duties of a fiduciary
The duties of a fiduciary to a pension can be summarized simply. Fiduciaries must act in the best interests of their clients. Indeed, they must place the interests of their clients even before their own. It’s that simple. Yet adherence to this standard is so demanding that few of the businesses that act as fiduciaries to pensions meet it. When you think about it, the duty of care required is really almost anti-capitalist. Companies are, after all, suppose to maximize returns to shareholders—they operate “for profit.” They are not in business to place the interests of their clients before their owners or shareholders. But that is exactly what is required of firms that serve as fiduciaries to pensions.
Whenever fiduciaries fail to meet the standard of care required of them, theoretically they face the risk of litigation. However, the financial statements of companies providing fiduciary services to pensions have historically been almost devoid of any reference to fiduciary risk; the valuations these firms have enjoyed also suggest little concern for the uniquely high standard of care applicable to them. There has been limited attention paid to the fiduciary risk related to these companies because historically few lawsuits have been brought for violations. This is because breaches of fiduciary duty are difficult for clients to prove without a corporate insider or whistleblower providing a roadmap and regulators have been generally ineffectual in ferreting out pension-related wrongdoing. Further, pensions that have been harmed as a result of fiduciary breaches often have opted to remain silent, as opposed to risk embarrassment and potential political fall out. Until recently statistics regarding publicly reported wrongdoing by fiduciaries would suggest that instances of unethical conduct, breaches of fiduciary duty, wrongdoing or let’s just call it “theft” are rare. They aren’t.
The truth is that the corporate fiduciaries to the nation’s pensions have been stealing for decades. Who are we talking about? The investment consultants, money managers, brokerages, custodians, actuaries, attorneys and others, including court-appointed independent fiduciaries, that are entrusted with pension assets. While the scams change over time, there is one constant: Companies entrusted with other people’s money will, over time, seek to convert it to their own purposes.
Let’s start at the top of the pension pyramid and work our way down examining how the various parties skim a little piece of the pie for themselves.
Investment consultants, unregulated firms purporting to provide objective advice regarding how pension assets should be invested and by whom, have for decades profited from serving as gatekeepers to the nation’s pensions. These firms have never really made money from providing objective advice. The bulk of their earnings have come from conflicts of interest they have created and undisclosed financial arrangements with the very money managers they are charged with vetting. Consultants hold annual “educational” conferences that money managers pay up to $65,000 to sponsor and attend. Given that a year a Harvard is less costly than these conferences that last only a few days, the veneer of an educational purpose is easy to see through. Managers pay to sponsor and attend these conferences so they can meet pension clients of the consultant and curry favor with the consultant. It’s called “pay to play” and more money managers have been hired as a result of it than ever got hired due to their investment acumen. Consultants with affiliated brokerages extract brokerage commissions from the money managers they recommend. Incidentally, we have never met a pension trustee who has seen the audited financials of a consultant-affiliated brokerage that would reveal how reliant these firms upon brokerage. Consultants even offer to advise money managers on how to get hired by consultants—for a fee of course. Then there are individuals employed by the major wirehouses that are held out as being pension specialists. Almost all of these guys are retail brokers dressed up and sent out into the world to prey upon pensions. The damage broker-consultants inflict upon pensions amounts to billions annually. If your fund has a broker as its consultant, I can virtually promise you, you’re being ripped-off.
A final note of caution on consultants: Increasingly consultants, especially broker-consultants, are strenuously resisting the inclusion of language in their contracts acknowledging their fiduciary status. There is growing concern in the consulting community, largely due to the investigations we’ve undertaken on behalf of pensions, that the conflict of interest ridden undisclosed myriad forms of compensation they receive may violate their fiduciary duties. Rather than stop hustling money from managers, they’re trying to water down the standard of care they owe to their pension clients. If your consultant resists express acknowledgement of his fiduciary status in his contract, throw him out.
Even though the vast, vast majority of active money managers don’t outperform the indices, far more pension assets are actively managed. Why is it that so little pension money is indexed? Because there is little money to be made from recommending indexing or from managing or trading index funds. That means that there are legions of active managers who are trying desperately to get hired by pensions, despite their mediocre performance. If you understand that performance is almost irrelevant in money management, then you understand that marketing is what the game is all about.
There are enormous money management firms, with hundreds of billions in assets under management, that are not very good at managing money. It never ceases to amaze me how many firms successful in marketing money management services fail to hire a single person who can do a reasonably respectable job of managing the money they bring in. It’s not hard to do and competent portfolio managers aren’t that expensive to hire. The problem is that firms that have great marketing success despite mediocre-to-poor performance soon lose sight altogether of the necessity of performance. If you can sell garbage, there’s no reason to maintain quality or improve the product.
Given the realities of the money management business, i.e. that great performance is neither commonplace nor required, managers will resort to any marketing device to get hired. If that means paying a consultant to recommend them, they’ll do it. They may offer finder’s fees and revenue sharing deals to brokers that bring them accounts. These sums come out of the manager’s pocket but are possible because the fees related to the products are so high that the manager can comfortably afford to share them with pension gatekeepers. High fees and poor performance are strong indicators that someone is getting paid off. Using client commissions to get brokers motivated to sell their mutual funds or secure pension accounts is another device managers use. Purchasing a company’s stock for client portfolios in order to persuade the corporation to hire the manager to handle its pensions is also possible. These are just a few of the ways that money managers abandon their fiduciary duties and seek what’s best for them, as opposed to what’s best for their clients.
Many portfolio managers employed by money management firms also engage in front-running and other personal trading abuses whereby they personally profit at the expense of their clients. In front-running cases the manager may be making a suitable investment for the client, but only after he has first personally profited. We’ve see portfolio managers who have earned substantially more money trading their personal accounts successfully than they earned in salary from managing client portfolios poorly. It’s not hard to profit personally when you control billions in clients monies.
Irrational, excessive investment advisory fees are also commonplace in the money management industry. We have found that some pensions pay twice what other pensions pay to the same manager for the same service. Why do money managers charge some pensions more? Because they can. If clients do not object to excessive fees, many managers believe their fiduciary duty in no way limits the compensation they may ask for and receive. These managers will argue that the fee the pension pays was negotiated before they executed the contract which gave rise to their fiduciary status. Many pensions, thinking they are being clever, require the money managers they hire to commit in writing that the fee the pension is paying is the lowest the manager offers. Money managers are extremely adept at maneuvering around the wording of these clauses so that they avoid giving their lowest rate—the rate the client believes he’s getting. In practice, “most favored nation’s” clauses are yet another device that money managers use to bilk clients.
Real estate, venture capital and hedge fund managers
Activities that are clearly illegal in the world of regulated managers of publicly traded securities, are standard operating procedure for these unregulated managers. Self-dealing, front-running and bogus valuations of portfolios are just the tip of the iceberg. We’ve seen investment consultants who buy into at a discount, or receive gratis participations in, these funds that they later recommend to their pensions clients. Some consultants receive portions of the investment advisory fees of the hedge fund managers they recommend. Hedge funds often become Ponzi schemes lacking audited financials. The audited financial statements of venture funds (if any exist) typically state that the majority of the portfolio consists of non-marketable securities the valuations of which are determined by the manager of the fund. In other words, the financial statements are meaningless. Real estate managers frequently contract with affiliated property management and brokerage entities. Real estate consultants advise real estate funds they recommend to their clients. These alternative managers tend to have far less sophisticated understandings of fiduciary standards. Further, the fiduciary standards applicable to these unregulated alternative managers are, in fact, less clear.
Most pensions have a bank serving as their custodian, holding the assets of the plan. While these banks may quote an annual fee for their services, don’t believe for a minute that’s all they are earning off your account or that the services they provide are necessarily in your best interests. For example, some custodians require pensions to sweep all their uninvested cash into money market mutual funds affiliated with the custodian. The investment advisory fees these affiliated money market funds charge for managing the cash is very high, perhaps 20 basis points instead of 10 or less. If you believe another money market fund would provide a superior return to your pension, either because it is managed better or has lower fees, the custodian will charge you 25 basis points (in addition to what the unaffiliated fund charges) for the privilege of investing your cash elsewhere. Of course, this 25 basis point penalty the custodian imposes almost always will eliminate the performance differential between the unaffiliated fund and the custodian’s fund. The very fact that this penalty exists tells you that the custodian knows it doesn’t have the best performing fund for the client. If it did, there would be no need for the penalty. As we discovered recently in one of our investigations, the custodian was receiving an undisclosed 5 basis point revenue sharing fee or kick-back from the affiliated money market fund. The custodian was interested in earning higher fees, not in doing what was best for the pension. Yes, even custodians are busy seeking ways to maximize the benefits they derive from their relationships with pensions.
It used to be that serving as outside counsel to pensions was a pretty sleepy business. A lawyer could earn a decent living billing his clients on an hourly basis, at a less than stellar rate, for his services. With the passage of the Private Securities Litigation Reform Act, which required class action firms to seek the largest holders of securities to serve as lead plaintiffs in their cases, suddenly local pension lawyers were being offered substantial referral fees by national class action firms if they could persuade their pension clients to lead such class actions. These referral fees, paid for doing little more than making an introduction, could easily exceed the entire annual compensation the local attorney derived from his traditional billings. The result has been that local pension lawyers have now drifted into investment matters they have little or no expertise in handling, offering advice that may be tainted by the referral fee arrangements they have. Local pension lawyers and national class action law firms now have their own pay to play schemes that pensions need to monitor. In my opinion participating in class actions is good for pensions and the country. But certain local pension lawyers, driven by greed, have lost sight of what’s best for their clients as they seek to profit from their relationships with pensions.
One lawyer we encountered hosts an annual conference where he permits pension consultants, money managers, brokers and class action law firms who agree to pay $35,000, to speak at his conference for public pensions. Apparently his pension clients are not concerned that the substantial fees these parties pay to sponsor a conference that last only a few days may undermine the objectivity of his legal advice.
In certain cases federal courts in the past have appointed “independent fiduciaries” to supervise pensions. Often this has amounted to hiring the foxes to watch over the chickens. Major Wall Street money managers and affiliates of the money managers acting as independent fiduciaries have parceled out pension portfolios to high cost, poor performing firms with whom they have longstanding, undisclosed business arrangements. Over the years, courts have interpreted “prudent” to be synonymous with commonly accepted industry practices followed by prestigious money management firms. Only recently have courts begun to understand that the money management industry is utterly lacking in ethics—especially the higher ethical standards involved in managing pensions.
Appointments of independent fiduciaries by courts have often amounted to invitations to steal and the judges overseeing these arrangements have been blind to skimming happening right under their noses.
This has got to be one of the worst businesses to be in. While a pension may only pay $100,000 or so a year for actuarial services, if the actuary makes a mistake, his potential liability is huge. Further, plan sponsors may demand unrealistic actuarial assumptions, such as assumed rates of returns of 8% or more. If the actuary is unwilling to go along, he gets fired. Many actuaries have grown increasingly concerned regarding opinions they provided during pre-2000 boom years which have become costly to their clients.
In response to these concerns, all of the large actuarial firms have banded together seeking to impose limitations of liability onto their clients. This is particularly troublesome and clearly not in the best interests of pensions. These provisions seek to limit the actuary’s liability to the amount of his annual fee. Obviously, the annual fee he receives bears no relation to the amount of damage his negligence can cause.
Limitations of liability may benefit actuaries but they are never, ever in the best interests of pensions. If trustees are not permitted to limit their liability to pensions or pension participants, why should any vendor to a pension be so permitted?
Limitations of liability are generally not permitted under the federal securities laws in money management contracts. But virtually all other vendors to pensions increasingly are seeking to impose limitations of liability in their contracts. Remember: Limitation of liability (LOL), your response should be Laugh Out Loud.
The pension business is rapidly changing and growing vastly more complex. Everyday revelations regarding conflicts of interest, self-dealing, unethical conduct, and outright theft by corporate fiduciaries to pensions are surfacing. Pensions generally are reluctant to move quickly and don’t want to be the first to do anything. This is often referred to as the “herd mentality” that plagues pensions. Furthermore, prudence in investment matters generally requires careful analysis of all risks before committing funds.
While waiting for the herd and moving slowly generally makes sense in investment matters, pensions often fail to recognize that when it comes to protection of assets, they should move quickly.
In matters of protecting pensions, the distinction of being first will be to your credit—an honor. So I would encourage all of you, be the first to detect and address wrongdoing by the corporate fiduciaries to your fund. Take immediate action to stop the stealing.
February 20, 2005 GRETCHEN MORGENSON New York Times Unmasking That Pension Consultant
IT'S something of a mystery why the huge and presumably powerful public pension funds in this country have been so loath to investigate whether they have been hurt by their consultants' conflicted loyalties. After all, the biases in these organizations are of enough concern to the Securities and Exchange Commission that it has conducted an industrywide investigation of pension consultants and may recommend enforcement actions against some of them.
Well, last week, the ice finally began to crack on this important issue. The board of the Public School Teachers' Pension and Retirement Fund of Chicago is reviewing a proposal to conduct a comprehensive conflict-of-interest audit of its investment consultant, Mercer Inc., a unit of Marsh & McLennan. The fund has $10.3 billion in assets and has been a Mercer client since 1990.
It may seem like a baby step, but remember that this is the don't-rock-the-boat pension world. Among these often meek managers, it is literally a shot across the bow. If the Chicago teachers' fund goes ahead with the audit - it will decide next month - it may very well encourage other pension funds to conduct similar investigations.
It's about time.
Some $5 trillion sits in pension funds nationwide. Their beneficiaries are teachers, firefighters, bus drivers and other public employees, as well as workers at private companies that still offer traditional pensions for retirement.
The people who run these pension funds hire consultants to help them identify the best money managers with whom they should invest. Unfortunately, these consultants can also receive revenue from money managers for other services the consulting firms provide. These financial arrangements between money managers and consultants can increase a pension fund's costs and lead to biased advice about money managers. Investment performance can be compromised.
But dubious pension consultant practices affect more than just retirees. If the pension funds don't earn enough to meet their obligations, taxpayers in the affected towns and cities will have to pay the difference.
Pension consultants come in all sizes. Some work in small companies, others as part of larger organizations. Recently, big Wall Street brokerage firms have stepped up their pension consultant operations.
Consultants have a fiduciary duty to their clients and must disclose any potential conflicts of interest in their operations. When they have affiliations with firms that conduct trades for the pension funds they advise, these relationships can undermine the duty to put clients' interests first. Some relationships are hidden from view; a consultant can hire a money manager who agrees to funnel all trades through the consultant's brokerage arm, and the transaction costs are rarely spelled out. Another source of conflict has been the practice among big consulting operations like Mercer's and Callan Associates, a private company in San Francisco, to sponsor conferences at sumptuous resorts where money managers pay to mingle with pension fund overseers. The trouble with such arrangements is that the consultants may be tempted to recommend to their pension fund clients only those managers who pay to attend.
Mercer stopped holding conferences last year. But Callan and other consulting firms still sponsor them.
While such conflicts among consultants have existed for years, few pension funds have done anything about them. Some funds have hired small, independent consultants without the ancillary operations that create conflicts. A handful of pension funds have sued their consultants and received money in settlements.
For years, a trustee of the Chicago teachers' fund had requested a complete accounting from Mercer of the compensation it received from the fund managers it had recommended. For years, Mercer declined to comply, citing confidentiality agreements with the money managers.
Last year, Mercer became more forthcoming with the fund about the revenues it received and their sources, said Kevin Huber, the interim executive director of the fund.
Stephanie Poe, a Mercer spokeswoman, said that since Mercer began working with the teachers, the fund had outperformed its benchmarks. Mercer, she added, has provided all the information the fund sought relating to potential conflicts.
EDWARD A. H. SIEDLE, president of Benchmark Financial Services in Ocean Ridge, Fla., and a former lawyer for the S.E.C., investigates money management abuses on behalf of pension fund clients. If the Chicago teachers' fund decides to audit Mercer, Mr. Siedle will conduct the inquiry; he will not charge for his services.
"Our investigations reveal that investment consultant pay-to-play schemes involving collusion with money managers have cost funds amounts ranging from 10 to 15 percent of assets," Mr. Siedle said.
Ms. Poe said that Mr. Siedle was a frequent critic of Mercer and was involved in litigation against another Marsh unit. "While we welcome any objective independent review of our work," she said, "we question whether such an audit by this person can by its very nature be objective."
Mr. Siedle said that he was, in fact, now investigating four Mercer rivals and would have recommended an audit of the Chicago fund regardless of who its consultant was. The S.E.C. and the Labor Department have recently sought his views on issues involving pension consultants.
The Chicago fund recently put its consulting contract up for bid from other providers. Mr. Huber said this was not because of concerns about Mercer.
The fund hasn't done this since 1999, Mr. Huber said. "It's time to do it again to make sure we're getting a competitive price."
But price is rarely the whole story. Conflicts are costly but often come to light only after serious digging.
Here's hoping that other funds will follow the teachers' lead.
Chicago Public School Panel to Consider Consultant Audit February 15, 2005 Pensions & Investments
Chicago Public School Teachers Pension & Retirement Fund's board voted unanimously to ask its personnel and service providers committee to review a proposal to conduct a conflict-of-interest audit of Mercer Investment Consulting, the $10.3 billion fund's consultant.
The audit proposal, made by Benchmark Financial Services, would seek to determine if the plan "was harmed as a result of conflicts" surrounding Mercer, according to the proposal. Patricia Knazze, fund president, said the committee will assess, among other issues, what information Mercer has provided in regard to the allegations and the capability of Benchmark to conduct such a probe. The panel will report to the board at its March 17 meeting.
Benchmark President Edward A.H. Siedle wrote of "conflicts of interest present in the investment consulting industry involving undisclosed financial arrangements between pension consultants and money managers. In the past, your board has been concerned about these conflicts and has sought disclosure from your consultant. … Your board has, simply put, been unable to determine whether these undisclosed arrangements between your consultant and money managers might have had a detrimental impact upon the investment performance of your fund."
Brad A. Blalock, Mercer consultant to the fund, said the firm has disclosed its financial arrangements with money managers
Impatient Plans Turn Up Heat On Investment Consultants
February 17, 2005 Fundfire
Pension funds are getting tired of waiting for official word from the Securities and Exchange Commission on the results of the agency's inquiry into practices at investment consulting firms. Pension plans are taking steps on their own and quizzing their consultants about potential conflicts of interest, formalizing conflict of interest policies, and investigating their consultants' practices.
"I think we are starting to see some momentum," says Ted Siedle, head of The Benchmark Companies and an outspoken critic of consultant conflicts-of-interest. His company offers its services to plan sponsors who want an investigation of a system's vendors. That momentum may be picking up in Chicago, where the Chicago Teachers' Pension Fund is considering hiring Siedle's firm to audit the system's consultant, Mercer Investment Consulting. The $10 billion system is reviewing a proposal and may make a decision next month.
Mercer says it would welcome an investigation. "Mercer Investment Consulting is always forthcoming about our relationships with all parties," a spokeswoman says. "We welcome any review that increases transparency within the investment consulting industry."
Siedle says this potential client is the largest fund that he knows of "that has actually indicated an interest in having an investigative review" of potential conflicts of interest. But other plan sponsors are also paying increased attention to those issues, including the largest of them all, the $183 billion California Public Employees' Retirement System. The system is developing a consultant conflict of interest policy, which will spell out exactly what the system's consultants must disclose to the system, and how often. The system has never had such a policy before.
The current draft of the policy says real or potential conflicts of interest do not necessarily mean a consultant can't do business with CalPERS – but thatt the system must know about it, so it can be "managed" or otherwise dealt with. That's been the system's policy all along, a spokesman says, and adds that the protocol under development does not represent a change in how the system does business. "It's more about formalizing these issues into a policy across our entire consultant pool," he says.
It will still be a few months before the policy is finalized and adopted. An earlier draft was sent to the system's existing consultants, and the system received "extensive" comments that were incorporated into the policy, a staff memo says. The comments themselves were not available. The latest version will be sent to consultants for further comments before trustees consider adopting the policy.
The spokesman says the recent attention to conflicts of interest, including the SEC investigation and pay to play scandals, has helped spur interest for a formal policy. "Certainly this is one of the issues that we have to address," he says. "It's something we pay close attention to, and formalizing it will help."
It's not just CalPERS. Bill Bogle, managing partner at New England Pension Consultants, says it seems the vast majority of plan sponsors don't have a formal conflict-of-interest policy for their consultants. "Most clients have a policy statement that focuses on what their managers can do. There's often something about the consultant in there, but it hasn't been nearly as tailored to that as it has been to the managers. Maybe that'll start to change."
Siedle agrees. "It is extremely uncommon for a fund to have such procedures in place. It's virtually unheard of, even at the largest funds." He adds: "Indeed, up until about a year ago, most funds were unwilling to believe that the vendors, the corporate fiduciaries that they have retained, could be parties to wrongdoing."
Bogle says plan sponsors have been paying more attention to the consultants' revenue streams since the mutual fund scandals hit in 2003, and agrees with Siedle that interest has especially intensified in the past year or so. "That coincided with the SEC's investigation of consulting firms. The publicity around that helped make plan sponsors aware that they should ask those questions," he says
The SEC launched its investigation into practices at consultant firms in late 2003, but has not reported its findings. Some consulting firms have reorganized, or sold off or closed some business units that might pose a conflict of interest, and some are reportedly negotiating with the agency in hopes of fending off regulatory action. In the meantime, according to Siedle, who works closely with a number of pension systems in Florida, plan sponsors have grown impatient with the SEC. "Even as recently as a week ago, we were hearing, 'We've been waiting for the SEC to give us some guidance before we do anything.'" Now, he says, those plans are ready to take action on their own.
NEPC and other independent consulting firms – those whosse revenue comes exclusively from its consulting clients – have been clear beneficiaries of the increased aattention. "We've definitely benefited from that," Bogle says. "We've had numerous referrals and new client inquiries recently."