During a recent conversation with PLANSPONSOR, George Michael Gerstein, counsel with Stradley Ronon Stevens & Young, made the frank observation that “there seems to be a significant and even increasing amount of fiduciary investment risk that exists in governmental plans that is not being addressed.”
“Think of state retirement systems like CalPERS or Texas Teachers,” Gerstein says. “These governmental plans have really a lot of money to invest and strong liability demands on that money, and so they are enthusiastically pursuing things like alternative investments, greater use of derivatives, and other areas and transactions that can, quite simply, go awry if they are not properly approached.”
Gerstein believes there is lasting confusion arising from the fact that these big state-run plans are not subject to the Employee Retirement Income Security Act (ERISA)—they are expressly carved out in fact.
“But this cannot be taken as these plans having free reign to invest however they please,” Gerstein warns. “They are all subject to state law—and these state laws vary tremendously. Some are very strict and lay out very specific requirements as to how state money can be allocated. A certain fund might have a restriction that it cannot invest in more than, say, 10% real estate, for example. Many have at least some restrictions on certain vehicles or transactions.”
The real challenge for service providers is the fact that some of these restrictions have been passed in “old, obscure laws that have not, frankly, been thought about for some time by anyone.”
“And so it’s not hard to imagine the kind of challenge I’m talking about and that I’m seeing more and more in practice,” Gerstein continues. “Say, if the plan I mention above has 8% of its assets in real estate today and a consultant comes in an pitches an attractive new investment that would push it to 10.5% real estate, or even 10.1% real estate. The investment professional and the sponsor may believe they are making/receiving a prudent recommendation but in fact the consultant is recommending their client break the law.”
This line of thinking should serve as a warning to sponsors, Gerstein says, “but generally they are going to know what they can and cannot do with their money. It more so applies to cases, say, where the plans have delegated some amount of investment authority to an outside professional. It is always possible that an outside manager will be unaware of some more or less obscure restriction—especially if nobody thinks to warn them, which can happen a lot more easily than you might expect.”
NEXT: Getting ahead of the problem
According to Gerstein, there have been cases in which “well-meaning but unwitting managers,” providing various services, fail to appreciate the risk that they are taking on serving these plans. The risk can result in many unfortunate consequences—anything from inappropriate transactions being ordered unwound, with fines, through to full-fledged fiduciary breach litigation naming individuals and alleging personal liability.
Something else to consider is that any legal challenges emerging will be tried in the local court system, “and you will see providers get dragged in front of very unfavorable jury pools in most situations.” As Gerstein puts it, “you will not find it easy to defend yourself if the local pension is accusing you of wrongdoing or negligence.”
In dealing with clients on the buy side and the sell side of this issue, there is some emerging awareness about these issues, Gerstein concludes. “But it’s really not a major focus, because everyone thinks of ERISA and the fact that these plans aren’t subject to ERISA. But these plans are still subject to state laws that are very similar to ERISA.”
In fact, some states have essentially incorporated ERISA’s prohibited transaction provisions directly into their own laws over the years, but they may leave out some or all of the accompanying federal exemptions that allow ERISA plans to even operate in the real world (i.e., under Department of Labor policing) without getting totally locked up by potential conflicts of interest.
“So the grounds are there for this issue to really become significant in some places,” Gerstien concludes. “Of course, this is all manageable with diligence and care. You need to know what you’re up against. Simply put, these plans present too much opportunity for providers to pass up, even with the risk.”
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