Consultant relationships with
pension boards are drawing regulatory attention
» Rebellion in Tennessee
» Curbing Conflicts
» What Next?
Suddenly, it's pension consultants who find
themselves in the hot seat that malfeasant CEOs occupied
just a few years ago—particularly consultants to public
funds. A report released in May by the Securities and
Exchange Commission concluded that conflicts of interest
were pervasive in the pension consulting industry and that
disclosure of conflicts by pension consultants to clients
was abysmal. While that SEC report was predicated on a
sampling of just 24 firms (see
"Disclose
Sure," PLANSPONSOR, July 2005
), public pension plan boards have since been excoriated
for lax oversight and tolerating personal relationships
that create conflicts of interest while, on the private and
Taft-Hartley side, the Department of Labor has been
criticized for an inability to comprehend and regulate
these problems. Industry critics are not surprised at the
activity, charging that too many funds, particularly public
pension funds, have closed their eyes to the issue of plan
sponsor/consultant relationships. "It boils down to
such an unhealthy reliance on consultants, to the point
where law enforcement, regulators, and self-regulatory
organizations can come in to say they're investigating
the consultant—and the board goes to the consultant and
accepts his reasoning that he's done nothing wrong,"
says Edward Siedle, president of the Center for Investment
Management Investigations at Benchmark Financial Services
in Ocean Ridge, Florida.
This exact scenario has played out at several of his
clients, Siedle says, although he declines to identify
which ones. "Pension consultant conflicts are just as
pervasive in private pension funds as public funds," Siedle
adds, "but, because public funds are subject to greater
disclosure rules and greater public scrutiny, it's more
apparent."
Barclay Grayson, former president of Portland,
Oregon-based Capital Consultants LLC, told the Senate
Committee on Health, Education, Labor and Pensions in June
that the DoL lacks the skills and knowledge to protect
pension plans. Grayson, whose
testimony
was part of hearings on protecting America's pension plans
from fraud, could claim expertise in the matter, having
served 14 months in federal prison for his role in a scheme
that resulted in losses of more than $350 million,
primarily from union pension funds. His personal experience
indicated that the DoL "has a limited understanding of
private investments and a general lack of accounting
skills," said Grayson, who cooperated with
investigators.
top
Rebellion in Tennessee
Disputes that have arisen in Nashville and Chattanooga
illustrate some of the issues. Following an investigation
that began early in 2003, the trustees of the Chattanooga
General Pension Fund in Tennessee fired the plan's
investment consultant.
In October 2004, the board filed arbitration proceedings
against the consultant, William Keith Phillips; his former
firm, UBS Wealth Management USA; and his new firm, Morgan
Stanley. The complaint accuses Phillips of fraud and breach
of fiduciary duty, alleging some $20 million in losses due
to his failure to disclose conflicts of interest.
The case is expected to come to arbitration early next
year, says Michael McMahan, an attorney with Nelson,
McMahan & Noblett, which represents the $193 billion
Chattanooga pension board. Morgan Stanley disputes the
charges.
This was not Phillips' first client dispute questioning
his ethics and business practices, however. In March 2000,
KPMG Peat Marwick produced a scathing audit report on
Phillips and PaineWebber (later UBS Wealth Management) for
the Metropolitan Employee Benefit Board of Nashville and
Davidson County, which oversees some $1.6 billion in
pension assets. Nashville's legal department was preparing
to file a lawsuit alleging conflicts against Phillips and
his firm, but settled the dispute for $10 million in March
2002.
KPMG undertook the audit after David Manning became
finance director and raised concerns. "[The plan's
compensation costs] seemed higher than usual," he says,
without elaboration.
Manning-also noticed high levels of securities and money
manager turnover. Nashville's new mayor wanted to institute
audits of city agencies, he says, and the pension agency
was chosen for the first audit under the program. "It
confirmed concerns," said Manning. "The issued report was
honest and straightforward with regard to abuses and, as a
result of the audit, we ended the relationship [with
PaineWebber]."
The KPMG report alleged that Phillips' compensation
arrangement created the conflicts and abuses. Nashville did
not compensate Phillips with a direct flat fee. Instead, he
and PaineWebber benefited from a soft-dollar arrangement.
Phillips received commissions on all trades the pension
plan made on both fixed-income and equity investments, with
no cap. As a result, the report alleged, the plan placed
almost all of its trades through PaineWebber. Because
active strategies produced more commissions, Phillips
discouraged the board from passive investment strategies.
Phillips and PaineWebber also failed to disclose fully how
much compensation they received.
Chattanooga had the same compensation arrangement with
Phillips and knew of Nashville's arbitration proceeding,
but the Chattanooga board waited two and a half years after
the Nashville revelations before launching an
investigation. "We were told it was strictly a political
maneuver because of changes in the Nashville government,
and we took it at face value," says McMahan.
Despite those two well-publicized "strikes," Phillips
still consults to pension funds and, today, other
consultants work for plans under similar questionable
arrangements. Both Chattanooga and Nashville were using a
brokerage firm that also provided consulting services, an
arrangement that Siedle contends is inherently
conflicted.
Consultant/brokers are motivated to select investment
managers on the basis of their willingness to pay
commissions as opposed to their investment merits, he
argues. Furthermore, commissions are likely to be higher
and execution inferior, he argues, and the investment
manager is not likely to complain if it receives higher
manager fees.
Siedle has targeted Merrill Lynch Consulting Services,
which he says serves more than 100 public pension funds in
Florida alone, and he has very publicly offered to
investigate those fund arrangements with Merrill Lynch on a
contingency basis.
Merrill Lynch's consulting arm, however, is separate
from its brokerage arm, so conflicts are less inherent,
says Robert D Klausner, a partner in the Plantation,
Florida, law firm of Klausner & Kaufman, PA, who has
looked into Merrill Lynch on behalf of a client pension
fund in Florida.
Klausner, who also is general- counsel for the National
Conference on Public Employee Retirement Systems (NCPERS),
admits that some trades of consulting clients are executed
by Merrill Lynch. It would be hard to not do so since it is
one of the biggest brokerage houses in the country, he
adds, and, even if trades are made through Merrill Lynch's
brokerage arm, those fees never make their way back to the
consulting arm. Furthermore, unlike Nashville and
Chattanooga, Merrill Lynch discloses all fees it receives,
says Mark Herr, spokes-person for Merrill Lynch & Co.
in New York.
"The ideal situation is one in which you can be assured
that investment consultants are acting for your fund with
undivided loyalty, particularly if they are serving in a
gatekeeping capacity for the selection of money managers,"
says Gary Findlay, executive director of the $6.5 billion
Missouri State Employees Retirement System. "If the
consultant also serves as a broker/dealer or has an
affiliation with a broker/dealer, there will always be some
question regarding whether or not revenue received directly
or indirectly by a consultant from a money manager has in
any way influenced the consultant's screening process in
connection with hiring and firing decisions. If the
consultant does have potential financial conflicts,
transparency is critical."
The SEC appears to agree. In a June 21 speech at the New
York Stock Exchange's First Annual Securities Conference in
Manhattan, Annette Nazareth, director of Division of Market
Regulation, said the agency is working on a proposal that
would address conflicts of interest in soft-dollar
practices of investment advisers and broker dealers.
Soft-dollar arrangements may create incentives for
investment managers not to optimize client execution
strategies, Nazareth said, resulting in higher client
trading costs, poor performance, and artificially high
commissions.
The SEC offered no details as to what specific- changes it
is considering, however.
top
Curbing Conflicts
While acknowledging that inappropriate arrangements do
exist between board members and consultants, they are rare,
argues Fred Nesbitt, executive director and legislative
counsel of the National Conference on Public Employee
Retirement Systems (NCPERS) in Washington.
A clear line of demarcation should separate the
investment consultant and money managers as well. The
consultant should not be involved in the transactions and
should not be executing trades as a broker or managing
money. "Boards should have a pure consultant who in no way
is involved in the management of the money or is involved
in the transaction," says Nesbitt.
Plan sponsors must also monitor the commissions their
money managers are paying to broker/dealers affiliated with
a consultant other than their own, warns Findlay
Public fund trustees as a whole want to do what is right
by the plan, says Nesbitt; the problem is the quality of
the information presented to them. "Trustees can be fooled,
just like anyone else can be fooled," says Nesbitt. "If
they had accurate information they would not be misled, so
obviously they are being misled because the information is
not accurate."
In interviewing consultants, the first question boards
should ask is how the consultant will make his money. All
fees should be disclosed, particularly with brokerage-based
consultants, says Klausner. "The biggest issue is a failure
to disclose," says Klausner.
"If it's disclosed, then the trustees can decide if the
business model works or if there is an appearance of
impropriety."
Accuracy of the information presented to trustees is
also an issue, Nesbitt says. NCPERS recommends that pension
boards have several investment consultants. Both Nashville
and Chattanooga had all the information provided to them
come from one source, says Nesbitt. Prior to his
termination, Phillips served as the only investment
consultant to both the Chattanooga and Nashville funds.
"Obviously, if all their information comes from one source,
you can get in trouble," Nesbitt says.
However, although he personally disagrees with
soft-dollar practices, Manning admits that public fund
boards like them. "It's easier," he explains, "than having
to go justify a public appropriation to pay a consultant on
a hard-dollar basis." The unwillingness of boards to ask
for money is also the reason why investigations and audits
are rare. Even if the fund winds up paying more for
services through soft-dollar arrangements than up-front
fees, he says, because the fees are taken from investment
gains on assets, it is sometimes perceived as easier than
having to justify the appropriation annually.
Moreover, it can be a lot more expensive. At the start
of his relationship with Chattanooga, Phillips said that
the fund could pay $154,000 as a direct fee annually for
investment consulting, or not pay anything directly but
allow him to be compensated through brokerage commissions.
Chattanooga chose the latter and wound up paying Phillips
an average of $270,000 annually, according to the
arbitration statement of claim.
top
What Next?
Other than the SEC's new soft-dollar rules, which remain
to be seen, most experts expect little action from the
federal government, however. "State securities regulators
and law enforcement have little confidence that the SEC
will engage in any meaningful cleanup of the pension
consultant business," says Siedle.
Most action probably will confine itself to regulatory
enforcement against individual consultants, predicts
Klausner, adding that this is likely to consist of the SEC
telling the consultant to provide better disclosure of its
practices.
The DoL is unlikely to do anything in this area, Siedle
and Klausner agree. This is a consultant issue, explains
Klausner, and the DoL regulates the funds while the SEC
regulates the consultants. "The DoL seems to think that the
SEC is responsible for the behavior of consultants,"
Klausner said.
top