Friday, October 27, 2006


San Diego parts company with their consultants, providing another lesson from Amaranth.
Sophisticated due diligence may not fully identify the risks implicit in many hedge fund strategies and new investment products. Hedge fund returns are not normally distributed. They can exhibit extreme levels of skewness and kurtosis. Because of this, standard measures of volatility are insufficient to measure hedge fund risk. Mean variance analysis, which is commonly used to develop portfolio asset allocation strategies, isnt an adequate tool for these strategies.

If your pension plan has hedge fund exposure and the rationale for that investment shows up on a standard "efficient frontier", you don't have all the information you need to evaluate its risks.

Thursday, October 26, 2006

Risks Increase in Global Financial Markets

A recent CFA publication addresses the risks and rewards implicit in the growth and breadth of global capital markets.

The depth and flexibility of global financial markets has grown significantly by integrating new geographic regions, creating innovation in financial products and attracting new investors. However, these changes in market structure have also increased the potential risk and magnitude of a global financial crisis. As new investment products proliferate, untested market dynamics, market liqudity & the operational infrastructure pose additional risks.

For instance, the leveraged loan market has grown substantially through the use of new instruments such as credit default swaps and collateralized debt obligations and the use of leverage to provide attractive yields. The demand for these products is high, driven by hedge funds and other institutional investors. According to S&P, the demand (liquidity)is driving "loose" underwriting and increasing the risk when the credit cycle turns.

Tuesday, October 24, 2006

Peer Benchmarks

Northern Trust reported that the median return for their universe of 300 investment plans ($1.8 Billion avg. assets) was 7.4% YTD. For the quarter the median return was; corporate Plans 3.8%, public plans 3.7% and foundations/endowments 3.2%. Over 5 years, median return was corporate 9.4%, public 9.8%, endowment/foundation 9.4%

Monday, October 23, 2006

Investment fiduciaries own Best Execution

The DOL asserts that Plan fiduciaries have a duty to ensure “best execution” in the acquisition/disposition of plan assets. They retain the duty of oversight with this standard even if they delegate trading responsibility to their investment managers. Therfore, investment fiduciaries should be aware of regulatory guidance and practice in this area. “Soft dollar” regulation, in particular, has been somewhat nebulous and even contradictory over the years.

When the SEC abolished the fixed commission structure in 1975 , guidance was required to establish the definition of best execution. Section 28(e) of the 1934 Act provided a limited fiduciary safe harbor for brokerage commissions in excess of the amount of commission another broker-dealer would have charged, if a good faith determination indicated that the excess was reasonable in relation to the value of brokerage and research services provided. These excess commission costs for research are referred to as "soft dollars". The DOL has indicated that plan fiduciaries are not covered by this safe harbor if they do not "exercise investment discretion". In addition, the use of "soft dollars" to pay for non-research related services may be a violation of securities laws and or ERISA .

Since the adoption of Section 28(e) in 1975, the SEC has issued three interpretive releases on the subject. The first did not protect ordinary commercial products while the second, issued in 1986 changed positions and invited broad interpretation of the safe harbor coverage. The third release in 2006 provided greater clarity on allowable research & brokerage expenses. Investment fiduciaries should get familiar with this material and implement a formal process to periodically review their plans and investment manager's use of soft dollars and best execution procedures and results.

Thursday, October 19, 2006

How Employers Can Improve Defined Contibution Plans

The Financial Economists Roundtable meets annually to address an economic priority. The result of this years meeting is a set paper entitled, Best Practices for the Design of Defined Contribution Plans. . A summary of the panel's recommendations is available at Knowledge @ Wharton. It concludes that employers should:
  • implement autoenrollment
  • minimize use of employer stock
  • expand use of annuities
  • provide financial education


Wednesday, October 18, 2006

Target Retirement Funds - Prefab vs. Home Brew; Ford Motor Co Study

The Pension Protection Act of 2006 will create a new paradigm in the investment profile of participant directed plans. Target Retirement Funds(TRF’s) are beginning an inevitable and rational (simply selected, diversified portfolios which are constantly monitored and consistently rebalanced while providing a fiduciary safe harbor) march to dominate 401(k) plan investment allocations. Several recent articles stimulated our thinking on alternative TRF implementations.
An article in Investment News indicated some advisers are urging employers to create their own customized TRF’s by using the population of funds available in the plan. Alleged benefits of the "home brew" from the advisors perspective were better information and control over the asset allocation and individual funds in the mix. This leads to a carefully unstated but strongly implied promise of better performance than the pre-fabricated TRF”S offered by proprietary providers which could be populated with the “mid level funds..put there by managers who are eager to generate assets in a fund that might be struggling” according to the article

While we don’t necessarily take exception to the notion that the pre-fab TRF’s are designed to meet both their sponsors economic objectives as well as their clients investment goals, we suspect there are probably not that many plans where the customized TRF solutions based on their existing fund lineup would both; have an inherent expected performance advantage and the “expected” excess returns would out-weight the added expense and liability that the sponsors would bear in creating it. We think this is so because; most plan investment menus are limited and fund selection is often driven by standards other than portfolio optimization, active management of individual fund choices is counterproductive and has a long tail in 401k plans and plan fee structures are often similar between prefabs and across investment menus.

Limited Investments (Asset Class) Options - The average 401(k) plan investment choices do not generally span the efficient frontier and are predominated by large cap equity funds which have the lowest statistical probability of outperforming their benchmarks. In addition, the ERISA suitability standard, as generally interpreted in practice, limits many investment line-ups to “core” investments. Institutionally driven TRF asset allocations should, under the principles of modern portfolio theory, include a broad array of asset classes, some of which might be deemed unsuitable and present fiduciary exposure on a stand-alone basis. Real estate is a good example of an asset class that is broadly used in institutional strategic asset allocation practices but is fairly limited in 401(k) plan line-ups.

Advisor Added Value by Active "Control"
The promise that advisors can optimize TRF return performance by actively managing the individual fund holdings within a TRF mix is largely illusory. Other than for the short term persistence inherent in some momentum strategies, fund performance is largely related to asset class exposure and accident. In addition, the process required to remove or add funds within a 401(k) plan has a fairly long horizon due to the various layers of authorization and communication which must happen before fund changes are implemented.

Investment Fees are not proportional to Plan size
The 401(k) fee industry fee structure is asymmetric in favor of providers. Fees can go up to ensure provider profitability for smaller plans but fees often don’t go below the level of fees (profitability/revenue sharing) implicit in mutual fund structures. Larger plans should enjoy economies of scale in investment fees. However, the predominant use of registered mutual funds, which often only have several price classes, limits the scale economics that many plans could take advantage of. Plans that use lower priced trusts or that have broad index fund coverage in their plans may be able to take advantage of the this via a customized TRF vs. certain prefab TRF’s.

We noticed that the Ford Motor Co 401(k) plan recently announced some 401(K) fund changes. To provide an anecdotal ex post example of the performance differential between a prefab TRF and a similarly constructed customized fund, we used the Ford Motor Co. 401(k) Plan as an example. We obtained a list of the investments in Ford’s 401(K) Plan at We did limited due diligence on the holding list and concluded it was reasonably current, though it did not reflect the recently announced fund changes.

We took the asset allocation of the Fidelity 2040 Freedom Fund as of 9/30/2006 (selected for its predominant equity allocation) as implied by the Morningstar category of each of the funds held within the Freedom Fund, and built 3 portfolio composites (rebalanced quarterly) with this static asset allocation. Historical return results are posted below.

FREEDOM 2040 STATIC – a composite using the Fidelity funds held within this fund of funds as of 9/30/2006. To create a 5 year history, we used an appropriate index return series to fill the gap for those funds with less than a 5 year track record.

FORD 401k – a composite using the actively managed funds within the Ford 401k plan in the same allocation as the Freedom 2040 static using Morningstar categories. Since Ford had no mid-cap funds, the mid cap allocation was split on a market weighted basis between Fords small & large cap equity funds. Real estate was excluded since this asset class wasn’t represented in the Freedom 2040.

FORD 401K BM a composite representing the asset allocation implicit in the Freedom 2040 Static using appropriate benchmark indicies for each asset class and style

Though purists can quibble about the details, the results of this example align with our intuition that a composite of carefully and specifically selected actively managed individual funds available in a 401(k) plan would not seem to have a distinct performance advantage over an exclusively actively managed and similarly carefully selected prefab TRF or for that matter an index based TRF. There may be some justification to the argument that having funds from the same provider in both TRF’s leads to this result. One could argue more broadly however, that systematic excess return in any diversified portfolio of actively managed funds should be similar over time since alpha by nature should be uncorrelated. We'll leave the conclusion about the sign of the expected excess return for another time.

Annualized Return through September 2006

Portfolio1 Qtr1 Yr2 Yr 3 Yr4 Yr5 Yr
Ford 401K2.8%10.2%12.3%12.2%15.6%9.1%
Freedom 2040 Static3.2%10.1%13.4%13.3%16.4%9.8%
Ford 401k Benchmark4.3%10.6%13.2%13.6%16.7%9.6%

Calendar Year Returns September 2006

Ford 401K6.0%8.6%10.3%31.9%-16.8-7.1%
Freedom 2040 Static6.2%9.8%12.1%31.1%-17.1%-10.3
Ford 401k Benchmark8.0%7.7%12.8%31.5%-17.8-10.9


Monday, October 16, 2006

DOL Advisory Opinion 2006-08a Posted

DOl Advisory Opinion 2006-08a, which addresses fiduciaries consideration of plan liabilities in portfolio asset structure, was posted today and is available here.


DOL Advisory Opinion 2006-08a

The United States Department of Labor has released Advisory Opinion (2006-08A) requested by JPMorgan's Investment Bank. This Advisory Opinion provides defined benefit pension plan fiduciaries with greater clarity on the consideration of liabilities and associated risks as part of prudent investment decision making.

US pension plans have generally managed assets with an eye towards maximizing long term investment returns rather than managing pension surplus volatility. The expressed preference has been to sacrifice funding stability with long term funding minimization. Large equity allocations have been characteristic of US Plans, with an equity allocation averaging around 60%. Changes in the pension environment will stimulate interest in asset liability (surplus) management, as indicated by the JPM opinion (which has not yet been posted to the DOL website).

As Plan's mature and increasingly freeze benefits, the proportion of active participants to retirees and terminated vested employees will decline. As this happens, overall plan liabilities become more predictable and facilitate offset by similar duration fixed income strategies. Equity has also been important as an inflation hedge for future wage increases for plans with large active populations. The need for this protection will diminish as active plan populations decline.

Surplus immunization strategies will never be prominent when Plans are underfunded since sponors would prefer to fund from their assets rather than their pocketbooks. As the PPA 2006 regulations effectively force improved funding, the risks and volatility associated with a large equity exposure designed to improve funded status may begin to outweight the theoretical higher expected returns.

Finally, the convergance of US accounting rules with international accounting standards will limit sponsors appetites for the traditional equity oriented pension portfolio exposure. Financial Reporting Standard 17 issued in November 2000 and implemented in 2003 requires market value accounting and income statement recognition of both assets and liabilities. This had consequences internationally. UK pension funds had historically allocated a high proportion of their assets to equities, relative to the US, Japan and other European countries, with a 71% equity allocation in 2000. However, this allocation fell to 56% as UK pension funds switched assets into fixed income securities according to the FSA.

As the imlicit "costs" of higher expected returning equity- centric pension portfolios grows due to the changing pension climate, asset liability management will likely gain prominence. Asset liability optimization and strategies such as duration matching and portable alpha may over time replace asset only optimization as industry best practice. We suspect 2006-08a is one step in defining practice in this new direction for pension plans.

Interestingly, a large segment of the asset management industry now serving plans has little competency in liability analysis or asset liability management. Because of the entrenched asset only optimization practice and with minimal growth opportunity in the defined benefit plan space, industry wide transition to these new strategies will be slow and primarily deployed by the largest plans.


Thursday, October 12, 2006

401(k) Fees - Documented or Defendant

There couldn't be a better time to ask your service provider to help you document how your employer/employees 401(k) dollars are being spent. Take a minute to familiarize yourself with Plan fees using these resources;DOL Plan fees , 401khelpcenter Collected Wisdom on Plan Fees,or CIEBA Plan Fees , then send a request like this to your 401(k) service provider.

Dear Service Provider,

Pension plan fiduciaries are responsible for selecting and monitoring both their plan service providers and the investment options that are made available to their plan participants. Responsible plan fiduciaries must ensure that the compensation paid directly or indirectly to their service provider is reasonable, taking into account the services being provided to the plan as well as other fees or compensation received by the provider in connection with the investment of plan assets.

The Department of Labor has consistently taken the position that plan fiduciaries must obtain sufficient information regarding fees or other compensation that service providers receive related to the plan's investments and then must make an informed judgement as to whether the service provider's compensation is reasonable.

Recent litigation has placed renewed emphasis on these fiduciary responsibilities and the attendant demand for full disclosure and transparency of all Plan fees, expenses and revenues received by any Plan service provider. Therefore, we request you complete the attached fee disclosure worksheets for the XYZ 401(k)Plan as of September 30, 2006.

The intent of the attached DOL Fee Disclosure Worksheets , or ASPPA Fee Disclosure Worksheet or 401khelpcenter Annual Service Provider Disclosure Worksheet is to confirm the hard dollar fees paid directly by either Plan participants or the Plan sponsor and to identify any additional soft dollar or intermediary fees which your organization may receive related to your service or investment relationship with the Plan. The completed worksheets should reflect the total actual or estimated fees for the Plan and any revenues which your organization receives related to your servicing relationship with the Plan.



Tuesday, October 10, 2006

Landmark Agreement - No Investor Left Behind!

Per today's new release "Attorney General Elliot Spitzer announced a landmark agreement that will set new national standards for transparency in the marketing of retirement products and provide compensation to each of more than 50,000 teachers in upstate New York".

"Under today’s settlement, ING has agreed to set a new industry standard for retirement product disclosure by providing a simple cover-page summary of all the costs of each plan it offers. This disclosure will include a chart demonstrating the impact that these costs have on long-term investments. On this disclosure page, ING will also explain that mutual fund managers often pay ING to have their funds appear on the menu of options offered to investors." The "landmark" 1 page disclosure appears below.

Important Facts About [Name of Product]
This retirement product is not free. ING and the funds offered in the product charge various fees and expenses. Many fund companies pay ING in return for being offered as investment options, as well as for the recordkeeping and related services ING provides. Funds are selected based on the revenue they pay to ING and on ING’s ssessment of their quality and cost. Both ING and the mutual fund companies seek to make a profit from the product. Any fees that you pay as part of your retirement plan will have an impact on your savings over time. An investor in this product pays ING and the fund companies an average of __% of his or her account balance every year. The table below shows the impact of the average fee on the account of an investor who saves $__ at the beginning of each year over a twenty-year period, assuming that the investment portfolio (before fees) increases by 7% per year
YearEOY Bal. Without FeesEOY Bal. With Average Fees

Total impact of average fees = $


Putting the Conflict Back into Advice

Beginning in 2007 the Pension Protection Act (PPA) provides a prohibited transaction exemption for fiduciaries to provide investment advice to plan participants. Historically, sponsors have not wanted to take on the fiduciary exposure related to advice provision. Money managers have preferred to maintain their investment arrangements with plan sponsors rather than focus on plan investment advice, since the potential conflicts inherent in providing both of these services created a prohibited transaction under ERISA.

The PPA advice provisions, presumably cognizant of the self dealing potential associated with money management firms providing advice covering their own products, allows only 2 kinds of investment advice arrangements; those incorporating a level fee structure or those generated by an objective computer model. Both these exemptions have been recognized in a case specific way by the DOL prior to the PPA. The SunAmerica letter dealt with computer generated advice models while the Country Trust Letter dealt with fee leveling.

The flat or level fee model requires that the fees received by the fiduciary advisor are not dependent on the investment selections made. What is not specified in the PPA is whether the fee leveling relates specifically to the individual providing advice or also to the advisor's employer or a member of a controlled business group. Consistent with the old ERISA advice exemptions, the PPA legislation may have been drafted to prohibit any advisor from qualifying under this exemption should either they or any member of their employer or controlled group benefit from differential fees. On the other hand, there is opinion that this was not the intent of the legislation. From our perspective, the most critical piece of the PPA advice provision remains subject to interpretation or subsequent technical correction.

The large insurance and investment firms are lobbying for a technical correction to the langauge which would clearly contain the fee leveling requirement to the individual or registered rep level. Should they prevail, this would be a major directional change in ERISA. It would also represent a monumental business opportunity for the large money manager/retirement plan providers to capture individual account relationships, profit from them while in a qualified plan and retain them as they rollover post retirement.


Six Early Lessons from Amaranth

Noted commodities expert Hilary Till, Research Associate with the EDHEC Risk and Asset Management Research Centre and Principal of Premia Capital Management, finds in a paper titled EDHEC Comments on the Amaranth Case, Early Lessons from the Debacle
"that the fund employed a Natural Gas spread strategy that would have benefited under a number of different weather-shock scenarios. These were economically defensible, although the scale of their position-sizing relative to the capital base clearly was not. Using a returns-based analysis to infer the sizing of positions, it is found that the Amaranth’s energy portfolio likely suffered an adverse 9-standard-deviation event on the Friday (September 15th) before the fund’s distress became widely known."

Tuesday, October 03, 2006

2006 Public Pension Fund Survey

The 2006 Public Pension Fund Survey is an online compendium of key characteristics of most of the nation’s largest public retirement systems. A key objective of the Survey is to increase the transparency of the public pension community and pension funding levels, providing a factual and objective basis on which to discuss many issues related to retirement benefits for public employees.

The Survey presents 2005 FY data on public retirement systems that provide pension and other benefits for a combined 12.8million active (working) members and six million annuitants (retired members, disabilitants and beneficiaries). Combined, systems in the Survey hold in trust $2.26 trillion, invested in diversified portfolios of public and private equities, corporate and government bonds, real estate, cash, and other assets. The membership and assets of systems included in the Survey represent approximately 88 percent of the entire state and local government retirement system community. According to the U.S. Census Bureau, employees of state and local government comprise more than ten percent of the nation’s workforce.


Amaranth - Another Meteor Strikes Earth

An EDHEC study by research associate Hilary Till ,as reported in the FT, concludes that the natural gas market moves that decimated the Amaranth hedge fund were statistically less probable than those that ruined Long Term Capital, (similar to the probability of a meteor striking earth). However, the fund's "massive" position in natural gas derivatives virtually guaranteed disaster as the fund, without adequate capital, was forced to liquidate its holdings.

While the historical diversification and risk/reward opportunities in hedge funds can look attractive on a mean variance basis, as Jeremy Siegal points out, the risk in certain strategies can't be quantified regardless of the length of the historical analysis.


Monday, October 02, 2006

Schlichter, Bogard & Denton 401(K) ERISA Suit vs International Paper

Plaintiff law firm Schlichter,Bogard & Denton has filed ERSIA breach of fiduciary duty suits against at least 7 Fortune 500 employers; Lockheed Martin, General Dynamics, United Technologies Corp, Bechtel Group, Caterpillar Inc, Exelon and International Paper. These plans collectively have more than 400,000 employees in their 401(k) plans.

We took a closer look at the International Paper (IP) complaint to understand the specific claims and to highlight possible exposures for other Plans. The IP plans had about $4.3 billion in assets and $666 million in IP stock ending 2005 according to their 10-K filing.

Overall, the complaint charges breach of fiduciary duty for allowing excessive fees and incomplete disclosures to Plan participants. The relevance of these suits to the rest of us is that the alleged breaches pertain to fairly common industry practices such as; master trust account structures, revenue sharing and generalized fee and performance benchmarking.

Master Trust Structure Understates Disclosed Fees
Master trust structures are widely used in the 401(k) industry to provide multiple employers or related groups with a common trust to facilitate uniform administration of the assets of multiple plans and multiple investment managers. According to the complaint, this structure understates Plan expenses reflected in information available to participants. For instance, certain master trust specific expenses, while being taken out of fund net asset values are not explicitly detailed in Plan regulatory filings. These expenses are included in Master Trust filings, though these are presumably not readily available to plan participants.

Unapplied and Undisclosed Revenue Sharing Arrangements
Revenue sharing arrangements (compensation transfers usually from asset managers to service providers) are commonly employed in the industry and can fund a substantial percentage of a plan's expenses. These arrangements are lightly disclosed and relatively unregulated by the DOL or SEC and were not addressed since they werent common practice when ERISA was drafted. The complaint charges that established revenue sharing arrangements were not utilized to offset hard-dollar plan costs – effectively making plan participants pay an unnecessary premium for services. In addition, the revenue sharing arrangements were not disclosed to Plan participants.

Revenue sharing arrangements are common in the industry and, like any tool, can be properly used or abused. These arrangements have been getting better disclosure at the sponsor level, though participant level disclosure probably lags. In the small 401(k) market, plans are largely “price-takers”. These Plans have less recourse in accepting revenue sharing arrangements and may be less informed and/or limit disclosure. A $4 billion Plan, on the other hand, can avoid undesirable revenue sharing arrangements and many generally practice better disclosure. According to the 2005/2006 Deloitte & Touche 401(k) Benchmarking Study, Plans with assets >$1Billion (mega plans) are more likely to fully disclose plan administration costs without any revenue-sharing or investment revenue offsets as well as disclose revenue-sharing arrangements and investment offsets (75 percent and 79 percent, respectively) compared to the national sample (63 percent and 67 percent, respectively). Revenue sharing arrangements in this segment that exceed costs of service are more likely to result in a fee credit (19%) than in the average. Avoiding the capture of available revenue sharing on behalf of plan partcipants could be a big fiduciary issue for IP. This case also point out the need for additional regulatory or legal clarity around common revenue sharing practices that impact many plans.

Misleading Fee Benchmarks
IP Plan fiduciaries allegedly compared their Plan investment expenses ratios to a Morningstar average including retail share classes (which include the impact of sales commissions/deferred charges etc). Use of the Morningstar Overall Fee Average is a favorite “head fake” used regularly in the asset management business to put distance between their fees and a peer mean.

Though this comparison may not be an example of discerning fiduciary benchmarking, the level of fund expenses, which were not disclosed in the complaint, should be substantially below this average, even after considering that they support some level of non-sponsor paid service provision in 401(k) plans. According to the Deloitte and Touche study, average fund expense ratios for mega plans should be 38% to 50% percent lower than in other segments.

Misleading Performance Benchmarks
The complaint states that “the performance and quality of the Plans investment options is, and has been quite poor”. Though no performance details were provided, the complaint argues that several fund benchmark changes, an incorrectly benchmarked S&P500 fund and an improperly scaled risk return exhibit provide evidence of Plan self-promotion and misleading performance.

Though actual performance data is critical to judging the merit of these charges, they don’t appear especially flagrant given practical imprecision in comparative performance analysis. The complaint seems very literal and naive in its assertions about what constitutes maket indicies and the absolute correlation of performance indicies to actual holdings. For instance, the complaint alleges the combination of an 80% MSCI EAFE and 20% S&P EMI EPAC (extended market index in the Euro Pacific region) is not a valid “market benchmark”. Only the facts can determine whether this composite matches the implemented investment strategy but composite benchmarks generally signal more sophisticated not less relevant benchmarking. The complaint alleges that benchmarking a large cap fund which held undisclosed securities “with risk levels incompatible with large cap investing” to the S&P 500 was misleading. Though this may be "literally" inappropriate, it is normative practice. Look at Growth Fund of America, a US large cap fund that includes 12% cash and 19% international equity. The complaints benchmarking example would probably require an extreme set of facts to be considered "misleading" beyond currently accepted fund categorizations.

Excessive Fees for the Employee Stock fund
This portion of the complaint reads like a “stock drop” suit where underperformance and participant risks are enumerated. However, in the end, the fiduciary violation charged is excessive management fees for what they regard as a “low cost” ( ie no-one manages the investments) option. Though the expenses weren’t detailed, unitized employer stock funds are expensive to manage because; the asset pool size is limited, daily pool liquidity must be managed, they often require one-off record keeping systems and processes and also represent legal exposure for the trustee/administrator. For this, firms levy higher investment management fees than comparable generic investment pools.

The IP complaint addresses several areas of industry practice which have developed beyond specifc regulatory or legal standards. The DOL has strenghtened fee disclosure requirements effective in 2008. Under the new Schedule C requirements Plans will have to provide more information about third-party financial relationships. Plans will have to identify all service providers that receive $5,000 or more from plan assets. At this point, Plan sponsors should focus on understanding and memorializing any revenue sharing arrangements. Request all service providers document their fee and revenue arrangements. Reviewing and documenting external fee comparables would be prudenta s well. Sponsors might also review participant disclosures and plan/trust documents to ensure comprehensive disclosure of all relevant fees and arrangements. To the extent employer stock is held in the Plan, review your goveranance and fiduciary monitoring protocol with ERISA counsel.