Good Risk Governance Pays - Investment Best Practices | Risk Management | Valuation

Please join me and fellow panelists on January 24, 2012 fro. 4 to 6 pm for a topical discussion about pension risk management and governance. Given that the last few years have posed unprecedented challenges for plan sponsors, both corporate and public, as well as their asset managers and consultants, life in employee benefit land will never be the same again. Market volatility, low interest rates, increased scrutiny about carrying out fiduciary duties, calls for better disclosure and greater complexity keep pension decision-makers busy.

Hear what legal and financial professionals have to say about what keeps plan sponsors and their advisors and asset managers up at night and how they can implement best practices for pension risk management within a fiduciary framework.

The roster of speakers who will address both defined benefit and defined contribution plan best practices and concerns include:

• Mr. William Carey, President, F-Squared Retirement Solutions
• Attorney Gordon Eng, General Counsel and Chief Compliance Officer, SKY Harbor Capital Management, LLC
• Dr. Susan Mangiero, CFA, FRM, Risk and Valuation Consultant and Expert Witness
• Attorney Martin J. Rosenburgh, CFA

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I recently had the pleasure of contributing an article about the importance of risk management and service provider due diligence to The Glass Hammer website. For those who are not familiar with the group, check out www.TheGlassHammer.com to learn about this award-winning blog and online community created for women executives in finance, law, technology and big business. See below or click on "Thought Leaders: Prioritizing Risk Management" to read the full text of this commentary about the benefits of risk mitigation well done and the costly consequences of inattention or sloppy practices.

Full Text:

Thought Leaders: Prioritizing Risk Management, July 14, 2011, 1:00 pm

Contributed by Susan Mangiero, PhD, Investment Risk Governance Consultant and Author

For those financial institutions which have yet to grasp the importance of identifying, measuring, managing, and monitoring risks on a comprehensive basis, time may not be on their side. Regulators and litigators alike are forcing change.

There are countless individuals who want better information from their service providers about risk and are prepared to vote with their feet if they don’t get good answers. After all, these institutional investors themselves are confronted with a bevy of new mandates that require transparency. The good news is that change opens the door to business opportunities. Enlightened organizations that have good processes in place and have nothing to hide can differentiate themselves from competitors. Providing clients with education and data tools offers yet another way for asset managers, consultants, banks, and advisors to forge stronger relationships with their pension, endowment, foundation and family office clients. On the flip side, those who are reluctant to explain how they manage their financial, operational and legal risks may lose clients or worse yet, could end up as defendants in a lawsuit.

Pay to play conflicts, questions about hidden fees, state and federal legislation and new accounting rules are a few of the forces at work to ensure that trillions of institutional dollars are in good hands. Effective investment stewardship is no longer a luxury. Recent surveys confirm that buy side decision-makers continue to emphasize governance and risk management for their organizations as well as providers of products and services. Institutional investors can ill afford to lose money after a tumultuous few years. Investment committee members who give short shrift to fiduciary duties could end up being investigated by regulators or sued. According to federal court data, the number of ERISA lawsuits is going up. Factor in investment arbitrations, enforcement actions and “piggyback” securities litigation allegations and it is clear that unhappy investors are not going to accept the status quo.

1. Fiduciary Focus

Besides efforts underway by the U.S. Securities and Exchange Commission (SEC), the U.S. Department of Labor (DOL) has proposed an expanded definition of who should serve as a fiduciary to ERISA employee benefit plans. If adopted, countless more professionals will be tasked with demonstrating procedural prudence when it comes to the investment of over $30 trillion in money from corporate retirement plan sponsors. States are likewise seeking change in the form of trust law reforms that tighten accountability for the investment of monies held by endowments, foundations and charities. The questions now being addressed by judges and arbitration panels relate to “excessive” risk-taking, insufficient diversification, absence of independent assessments of hard-to-value instruments and oversight failures that have led to large losses that might have been highly preventable.

One asset management firm recently settled with the SEC for $242 million over a mistake with one of its risk management models. Another firm just settled with the SEC for $200 million due to problems in the way subprime securities were marked. A few years ago, a Northeast pension plan was sanctioned by the DOL for not having thoroughly vetted valuation numbers provided by one of its hedge fund managers.

When I testified before the ERISA Advisory Council in 2008, I emphasized that having good valuation policies and procedures is essential because it impacts so many decisions having to do with asset allocation, hedging and fees paid.

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In survey after survey, capital market participants complain about regulatory overload and complexity. The last thing any compliance officer wants to have happen is that his or organization is trying to do everything right but ends up on the wrong side of the law because rules differ across jurisdictions. Then there are the clever arbitrageurs who recognize regulatory differences as opportunities to exploit loopholes.

In the case of the global over-the-counter derivatives market, sized in excess of $600 trillion in terms of notional principal amount, Reuters reporter Jim Brunsden describes disparate mandates from European Union and U.S. regulators, respectivley. According to "Differing EU, U.S. Derivative Rules May Discriminate, Groups Say" (July 6, 2011), margin amounts and "different sets of licensing rules on cross-border business" could introduce costly uncertainty for investors.

In a July 5, 2011 letter to The Honorable Timothy Geithner and Commissioner Michael Barnier, ISDA and other financial market organizations listed some of the extra-territorial concerns that should reflect coordination:

• Licensing, authorisation or registration rules for entities to trade derivatives;
• Application of margin requirements to banks, broker dealers and asset managers with operations throughout the world;
• Extent to which foreign operating entities would be subject to competing authorities in multiple jurisdictions even when the parent entity is complying with home country regulations;
• Standards for recognition of central counterparties ("CCPs") in each others' jurisdictions to minimize ambiguity; and
• Indemnification provisions as relates to data collection by U.S. based Swap Data Repositories ("SDRs"), pursuant to the Dodd-Frank Act.

Those institutional investors that employ derivatives - directly or indirectly - are wise to track the regulatory discussions underway. Their costs, and related investment performance, are likely to be impacted by the constraints borne by major market dealers.

For further information, check out the following items:

• "EU parliament vote on derivatives law put off until the autumn" by Martin Banks, TheParliament.com, July 7, 2011;
• July 5, 2011 Letter from Investment Management Association, ISDA, Alternative Investment Management Association et al to Michael Barnier, Commissioner for the Internal Market and Services, The European Commission, and the Honorable Timothy Geithner, Secretary, The Department of the Treasury About Derivatives Regulations; and
• "Semiannual OTC derivatives statistics at end-December 2010."

After the last few years, it seemed that risk managers were finally getting their due respect. Alas, a new survey suggests that more work remains to be done. According to "Too good to fail? New challenges for risk management in financial services" by Rob Mitchell with the Economist Intelligence Unit, "Inculcating and embedding a stronger enterprise-wide risk culture remains an ongoing challenge."

Sponsored by SAS, this March 2011 inquiry (and June 2011 report) finds that organizations still grapple with complexity, with about half of the 315 executives expressing concerns that their "employer's risk management processes are well placed to deal with volatility" and roughly one out of three organizations being able to thoroughly vet tail risk. (Note that "tail risk" is typically defined as the chance that investment prices or returns will be "extreme" in that realized performance falls outside of three standard deviations from the average.)

Other findings of the survey suggest that the risk management function is getting support, albeit limited, from atop the corporate food chain. More than forty percent of respondents announce that "their management boards have beefed up their risk expertise." One-half of polled professionals claim that "their boards are demanding more rigorous risk reporting."

A central message of the survey is that risk management reforms are underway but that risk management needs to be seen as less of a support function and more of a strategic mainstay that addresses organizational fortunes on a holistic basis. When asked about areas in which the skills of risk management professionals should be improved, one out of every three respondents cite the "ability to see the interdependencies between different categories of risks to the organisation."

Main barriers to effective risk management include regulatory uncertainty, "poor communication across departments," incomplete data, absence of authority for the risk management role, "lack of adequate investment" and poor real-time "(intra-day) risk management." With Basel III looming for a 2019 implementation, systematically important financial institutions ("SIFIs") could see profits lowered as capital requirements tighten, forcing more and better attention to be paid to the relationship between the cost of offering various products and services and risk mitigation.

In Risk Management for Pensions, Endowments and Foundations, Dr. Susan Mangiero talks about the urgent need for training across functions and job titles so it is alarming that 44 percent of respondents cite a 7 percent drop in the risk management training of the general workforce in 2011 from 2010. Fifty-four percent of risk executives describe a 9 percent decline in data quality and integrity with mergers and acquisitions leading to a related problem of disparate information technology systems. Without a good process in place to collect information, it is hard to measure and manage risks thereafter.

At a time when risk management is arguably as important as it has ever been in terms of protecting enterprise value, Financial Times reporter Justin Baer writes that "US regulators are warning banks to protect their risk-management staff and systems from any planned cost cuts as Wall Street grapples with a challenging year of meagre results." "US banks warned against shedding risk staff" references the Senior Supervisors Group of global bank regulators as urging financial institutions to do much more in the area of building a robust risk mitigation infrastructure.

Should an elephant fall, the audience will hear a thud. Should global financial institutions give short shrift to improving risk management policies, procedures, systems and practices (for those companies for which this applies), the economic "noise" will be deafening. Now is not the time to move backwards with respect to risk management.

Note to Readers:

• Click to read "Observations on Developments in Risk Appetite Frameworks and IT infrastructure," Senior Supervisors Group, December 23, 2010.
• See "Too Good to Fail? New Challenges for Risk Management in Financial Services" for a summary of the 2011 SAS sponsored survey conducted by the Economist Intelligence Unit.
• Download "Life in Financial Risk Management: Shrinking Violets Need Not Apply" by Susan Mangiero, AFP Exchange, July/August 2003. Note that BVA, LLC now does business as Fiduciary Leadership, LLC.
• Click to order Financial Engineering: The Evolution of a Profession by Tanya Beder et al (John Wiley & Sons, 2011).

According to a new survey sponsored by John Hancock Financial Network, "eighty-five percent of retirement plan advisors are currently performing services traditionally performed by plan fiduciaries, although most are not declared plan fiduciaries." While seen as an opportunity for business development, survey respondents declared a need for more "fiduciary guidance, competitive information" and updates about new rules and reguations. Notably only about one-third of queried advisors self-described as "investment experts." See "John Hancock Financial Network's 2011 Retirement Plan Advisor Survey Suggests Advisors Need New Level of Support from Broker-Dealers," June 30, 2011 Press Release.

They are not alone in recognizing that the playing field is soon to change. More than a few pundits predict that an expansion as to who serves as an ERISA plan fiduciary is more a "when" versus an "if" on the part of the U.S. Department of Labor ("DOL").

In "Dalbar Creates Registered Fiduciary Program for 401(k) Advisors," Money Management Executive writer Lee Barney writes on June 29, 2011 about the importance of duty of care education. In a Nationwide Financial press release dated June 28, 2011, readers learn that fifty percent of its plan sponsor clients cite fiduciary risk as a critical challenge.

In "DOL's Borzi Fights Critics of Proposed Fiduciary Rule," Advisor One contributor Melanie Waddell (June 28, 2011) describes the DOL leader's attempt to clarify outstanding concerns. First, she asserts that an effort is underway to coordinate with other regulatory bodies, while pointing out that "SEC follows securities laws and will be assessing putting brokers under the same fiduciary mandate as advisors, while the EBSA has a statutory structure under ERISA that defines fiduciary, so 'it's unlikely that our rules would be identical, and Dodd-Frank doesn't say they have to be.'" Second, she adds that ERISA spawned retirement vehicles such as IRAs so it makes sense for this $4 trillion market to fall under the watchful eyes of the U.S. Department of Labor. Third, she does not believe that brokers will receive fewer commissions with the advent of an expanded fiduciary rule.

No doubt there is much more to come on the topic of ERISA plan fiduciary liability.

Note to Readers: EBSA stands for the Employee Benefits Security Administration which is part of the U.S. Department of Labor.