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

According to Shannon Barrett, attorney and partner in O'Melveny & Myers' ERISA litigation practice, new fee disclosure regulations could mean more lawsuits against record-keepers and other organizations that provide services to U.S retirement plans. Cited in "New Fee-Disclosure Regs Pose New Litigation Risks for Retirement Plan Providers" by Fran Lysiak (Insurance News Net, March 2, 2012), Barrett adds that new rules "will force record-keepers and similar service providers to 'stake a position on something that is a very disputed legal issue,' referring to fiduciary status.

For more information, check out "DOL Retirement Plan Fee and Expense Disclosure Compliance: Navigating New Rules for Service Providers and Plan Sponsors." Sponsored by Strafford Publications, this March 27, 2012 webinar will feature two senior ERISA legal experts with Morgan Lewis, Michael B. Richman and Daniel R. Kleinman, and will explain Section 408(b)(2) disclosure rules and what compliance (or lack thereof) means.

Transparency is a continued mantra with regulators and lawmakers in the United States and elswhere. In a recent conference in Washington, DC called "SEC Speaks," speakers from the U.S. Securities and Exchange Commission reiterated the need for robust disclosures to promote "fair and orderly markets."

Of course more disclosure does not always translate into better disclosure but certainly there are numerous best practices as to how numbers should be reflected to empower investors and plan participants with what they need to know. As I have said many times, numbers are helpful but certainly not the totality of the risk factors that should be considered with any vendor or asset manager relationship. The process of vetting economic, fiduciary and operational risks (among others) is a complex but hugely necessary expenditure of time and money.

According to "Pension Fund Funding Ratios Dipped in Q2" (July 9, 2011), the average pension plan saw its funding ratio decrease by around two percent during the second quarter of 2011. Several factors were at work. First, higher U.S. Treasury yields "led to a lower corporate bond yield curve and pension discount rate" which in turn increased the reported number for what is owed to retirees. Second, gains on invested assets were not enough to offset higher pension liabilities.

What's interesting is that this recent version of the U.S. Pension Fund Fitness Tracker, published by UBS Global Asset Management, cites an economic boost for those plan sponsors that "adopted a pension risk management framework," with ongoing attention paid to market risk, interest rate risk, credit spreads and what they describe as active management risks.

In 2010, the OECD published "Pension Funds' Risk-Management Framework: Regulation and Supervisory Oversight" by Fiona Stewart in which readers are reminded that "Some of the decline in assets recently experienced by pension funds around the world may well have been avoided through stronger risk-management frameworks..."

Given the importance of the topic, this blogger, Dr. Susan Mangiero, is working on a paper about the fiduciary duty to hedge. In the meantime, interested readers may want to check out the SSRN Pension Risk Management e-Journal that is edited by Dr. Susan Mangiero and Dr. Shantaram Hegde.

According to former fund of hedge funds Chief Operating Officer Rajiv Jaitly, pension funds and other institutional investors should be able to "nominate independent directors to hedge fund boards." This would satisfy the goal of making sure that no conflicts of interest exist between directors and fund managers and to "meet the increasingly stringent demands of institutional investors." Pierre Emmanuel Crama, head of operations-related due diligence at fund of hedge funds Signet Group offers that the Cayman Island model is in need of repair since some offshore entity directors sit on too many boards and cannot devote sufficient time to each individual fund. The author of "Hedge fund directors should be nominated by investors, says former COO," Charles Gubert (COO Connect, March 7, 2011) goes on to say that large hedge funds may not be too interested in this kind of set-up. Capital-hungry funds or start-ups may be more open to the idea.

At the strong suggestion of a prominent hedge fund attorney, I am exploring service as an independent board member. Given my background in due diligence and investment best practices, along with time spent on several trading desks and many years in risk management and valuation, I am confident that I can add value in numerous ways. While my sample so far is only three funds (each of which invests in the billions and has a reputation for good governance), there does not seem to be enthusiasm in having someone "poke around" and comment accordingly. One hedge fund compliance officer told me that several pension funds would not greenlight them without an independent director in place for their onshore vehicle but the legal department was reluctant to have outsiders gain access to highly confidential documents. Two other hedge funds said they liked the idea but were not yet ready to act.

Invariably, this concept will take hold but not without a push from institutional investors and/or regulatory mandates. As an advocate of free markets, it would be better by far to have industry respond willingly versus being forced to comply with a "one size fits all" statute.

More broadly, there seems to be a shifting balance of power in favor of cash-rich institutional investors such as pensions, endowments, foundations and sovereign wealth funds in some situations. Supply and demand forces will determine whether a U.S. hedge fund chooses to move in the direction of independent oversight at the board level. I understand the need to keep certain pieces of information under wraps. Moreover, hedge funds have their hands full right now with new rules. Discussions I've had with several other hedge fund attorneys suggest that private company managers are reluctant to give up control over the kinds of strategic decisions that would fall under the purview of a board that includes outsiders.

Only time will tell. Institutional investors, especially pension funds, are under great pressure to evidence that they've conducted a comprehensive due diligence study of their asset managers (not just at inception of a relationship but on an ongoing basis). I've talked to pension auditors, executive directors and trustees who tell me that they plan to continue voting with their feet if they cannot get the kind of information and assurances they need.

Should the concept of independent directors for onshore funds take hold, the next challenge will be how to compensate outsiders for their time and what kind of liability insurance terms they will need before agreeing to serve.

Gold has received a thumbs up from J.P. Morgan as a form of collateral for repurchase and securities lending transactions. This means that someone will need to assign a value for each unit of physical bullion and then store the amount that relates to estimated counterparty risk. According to "J.P. Morgan Will Accept Gold as Type of Collateral" by Carolyn Cui and Rhiannon Hoyle (Wall Street Journal, February 8, 2011), illiquidity fears have discouraged financial institutions from accepting gold as collateral in the past. The World Gold Council website reports that trading is a 24-hour operation, rendering the global gold market as "deep and liquid."

In contrast, a few days later, it was reported that a 300 million euro pension fund, the Stichting Pensioenfonds Vereenigde Glasfabrieken ("SPVG"), was directed to reduce its gold holdings from 13% of its assets to between 1% and 3%. The reported concern on the part of the Dutch pension regulatory body, the Nederlandsche Bank ("DNB") is price risk. Although gold has risen from $600 per ounce to in excess of $1,000 per ounce since 2008, when the Dutch glassmaking company's retirement scheme purchased bullion, a drop in value could lower the solvency ratio.

Several issues come to mind about the use of gold for financial purposes. For one thing, if I am investing in the stock of a bank that accepts gold as collateral for a large amount of transactions, I'd like to know if the bank is hedging the metal and, if so, to what extent. I'd also like to understand how they price commodities like gold and the frequency with which they reassess counterparty risk. For an institutional investor like a pension fund that holds gold as an investment, it would be helpful to understand: (a) whether they own physical quantities or stock in a company that mines the metal (b) how value is assessed and on what basis (c) whether gold holdings are hedged and, if so, to what extent (d) what role gold plays (i.e. diversification, safety, etc). An economic analysis of the risk-return for gold, like anything else, is paramount and must consider multiple factors, some of which are listed here.

If The Bond Buyer journalist Dan Seymour is correct, litigators may soon be even busier. According to "Headline Risk Drains Muni Bond Funds" (Money Management Executive, January 31, 2011), the week ending on January 19, 2011 saw investors withdraw an unprecedented $4 billion from mutual funds that invest in bonds issued by municipalities. In context, this is roughly 1% of the $470+ billion market and about $1 billion more than the former exit record of $3.1 billion for the week ending on November 17, 2010. Seymour adds that "Muni bond funds have now reported $29.3 billion of redemptions in the past 10 weeks" or "65% more than the previous record for outflows in a 10-week period of $11.5 billion established in 2000."His conclusion is that investors are scared. With credit spreads not moving out as would be expected during a flight to quality path, investors just want to leave the asset class altogether.

Another journalist with The Bond Buyer cites several muni bond portfolio managers as saying "not so fast." Headlines about bankruptcy risk grab attentions but may lure investors away from "solid, safe investments because of distorted opinions in the media." See "Don't Let Headlines Overshadow Buys: DWS" by Christine Albano, Money Management Executive, January 31, 2011.

A hat tip to the "Securities Arbitration and Litigation" blogging team. Their February 8, 2011 post entitled "Enough Transparency in the Municipal Bond Market?" cites a recent study from DPC Data about the paucity of financial disclosures by municipal bond issuers. According to "DPC Data Issues New Study on Transparency in the Municipal Bond Market" (February 3, 2011):

• Issuers of 60 to 70 percent of 17,000 municipal bonds file information "too late to be of practical use in credit risk analysis."
• For the bonds issued from 1996 through 2003 that were still outstanding between 2005 and 2009, "56 percent of issuers/obligors did not file annual disclosures for one or more years; 19 percent did not file for any of those years."
• "At least a third of the expected disclosures were never filed in the designated official repositories."

As DPC Data CEO Peter J. Schmitt suggests "there is no way around the fundamental need for timely financial statements to obtain critical information that can warn investors of impending problems."

Pension plan IOUs are another drain on municipal coffers. With unfunded retirement plan liabilities estimated at $3 trillion, state, city and county issuers with employee benefit funding gaps (excluding healthcare obligations), the last thing a municipal bond investor wants is a nasty surprise heretofore not disclosed in a timely and complete manner.

Late last week, U.S. Congressman Devin Nunes and U.S. Senator Richard Burr introduced the House version of the Public Employee Pension Transparency Act, H.R. 567. The goal to "amend the Internal Revenue Code of 1986" and "provide for reporting and disclosure by State and local public employee retirement pension plans." Failing to comply with this proposed rule, if approved and passed into law, could push the cost of borrowing up for numerous public entitities since they would be denied federal tax exemption status. This means that investors in turn would not be able to exempt realized bond income and would likely rethink the risk-return profile of muni bonds.

Having done a lot of work in the area of performance metrics and risk measurement, I will be the first to tell you that numbers can be misleading. Investors must look beyond reported data to have a solid understanding of the economic exposures they face when deploying assets. The problem is that one cannot even begin a proper analysis without access to information.

As the U.S. Securities and Exchange Commision begins its exploration of the disclosures made (or not as the case may be) by state and local bond issuers, expect a lot of questions from unhappy investors about the due diligence conducted by their advisors and consultants if no one has sufficiently granular information to do a good job of default risk assessment.

Reader's Note: Click to read "$3 Trillion Challenge" (Governing Magazine, October 2007) and a sidebar interview with Q&A Interview With Dr. Susan Mangiero about public pension finances.

As more and more enforcement actions and lawsuits focus on who knew what and when, it's no surprise that politicians are clamoring for more transparency. One issue that has caused agita raised eyebrows is the extent to which pension trustees travel for business.

As reported in "Detroit pension trustees take flight on funds' tab" by Jennifer Dixon (Detroit Free Press, June 14, 2009), some individuals may have taken perks to a whole new level by attending conferences in far flung corners of the world, miles from Detroit. Attending conferences is not a bad thing. To the contrary, trustees need to be well-informed about the investment decisions they make, including possible allocations to global money managers. As I was quoted then, I still maintain that "Public pensions need 'a clear policy about travel...It's public money, and taxpayers and plan participants would like to know the money is being properly spent." I further added that prudence requires a policy that explains what constitutes a "legitimate and reasonable expense, from a governance aspect and budget aspect."

In an effort to shed light on expenses incurred by public pension trustees, Michigan State Representative Tom McMillin has introduced House Bill No. 4156 to amend current legislation by mandating investment fiduciaries to "publish and make available to the public on a website all expenditures made by the board of the system, including, but not limited to, travel expenditures by board members and the system budget."

Expect more of these initiatives to shed light on how pension plan dollars are being spent.

• The U.S. Department of Labor now mandates more disclosure about service provider arrangements with its Form 5500 Schedule C filing rules. 
• Various states are busy at work to curb "pay to play" abuses by making information available as to how asset managers are selected to control billions of dollars.
• The U.S. Government Accountability Office has urged that more information be shared about retirement plan dollars making their way into hedge funds and private equity funds.

For further reading, check out the following items:

• "The 5500 Nightmare: Completing the Schedule C" by Fred Reish, Bulletin, March 11, 2010
• "S.E.C. Tightens Rules on Public Pension Funds" by Edward Wyatt, New York Times, June 30, 2010
• "Defined Benefit Pension Plans: Plans Face Valuation and Other Challenges When Investing in Hedge Funds and Private Equity," U.S. Government Accountability Office, July 20, 2010