Wednesday, November 22, 2006

3rd Quarter Pension Peer Benchmarks

In measuring your portfolio performance it is informative to look at institutional trust universe medians as well as market benchmarks. Care should be taken in drawing comparative performance conclusions however because the size, fees, asset allocations and objectives of the median in these universes may be substantially different than yours.

For the third quarter 2006:
the ICC median Master Trust returned 3.4%. This universe includes 21,000 portfolios with an aggregate market value of approximately $1.7 trillion.

the Mercer(Mellon) US corporate Plan Sponsor Median Universe return was 3.9% for the third quarter. Asset allocations are not provided.

The Northern Trust Corporate Median Plan return for third quarter was 3.9%. This universe covers 300 large institutional plans with over $550 Billion in assets.

Tuesday, November 21, 2006

REITS as an Investment Option

The $200 Billion government Thrift Savings Plan (TSP)recently concluded they would not add a separate Real Estate Investment Trust or REIT fund as a program option. The following criteria were used to make this determination:
  • Is it a major asset class not currently offered as an investment option?
  • What financial benefits could participants expect from participating in the new fund?
  • Is the fund tied to indexes that could be used for the investment?
  • Are peer plans adding such funds?
The program further declined separate investments in non-U.S. bonds, value and growth stock funds, emerging markets stocks, TIPS and commodities for not meeting all the criteria.
The TSP is unique in scale and composition so these criteria may not fit all Plans. It does however, provide a nice illustration of the kind of prudent decision making process fiduciaries should adopt in developing their investment line-ups.

Monday, November 20, 2006

Fiduciary WMD

"derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal" Warren Buffet

The global financial system has become more competitive and efficient as a result of extraordinary innovation in risk transfer products. The investment derivatives market has grown in size and complexity, driven by the demand for more sophisticated risk hedging as well as higher returns. Retirement plans and hedge funds have been the primary drivers. Retirement plans are taking a larger role in these markets to meet return objectives and fund managers/hedge funds are taking a larger role to post attractive returns and remain competitive and profitable.

The Bank for International Settlements reports that the notional amount of all outstanding OTC derivative contracts was $370 trillion at June 30, 2006, 24% higher than at the end of 2005 and 4 times larger than in 2000. Credit default swaps increased by 46%, interest rate derivatives grew by 24%, foreign currency contracts grew by 22%, while equity and commodity contracts grew by 17% and 18% respectively. The “net” market risk of these contracts, after accounting for offsetting exposures, increased 3%. This was a less astounding $10 trillion.

Being reasonably informed is a much harder task in derivatives than in other parts of the capital markets, especially in the OTC markets which are largely unregulated. Derivatives can be used for speculation or risk reduction. Speculation can be extremely risky because derivatives employ high risk leverage. Using derivatives to hedge portfolio exposures is less risky, though instability in correlations can create unintended risks. The DOL provided guidance on a fiduciary’s responsibilities for direct investments in derivatives.
“Investments in derivatives are subject to the fiduciary responsibility rules in the same manner as are any other plan investments. Thus, plan fiduciaries must determine that an investment in derivatives is, among other things, prudent and made solely in the interest of the plan's participants and beneficiaries. In determining whether to invest in a particular derivative, plan fiduciaries are required to engage in the same general procedures and undertake the same type of analysis that they would in making any other investment decision. This would include, but not be limited to, a consideration of how the investment fits within the plan's investment policy, what role the particular derivative plays in the plan's portfolio, and the plan's potential exposure to losses”.
Indirect derivative investments require fiduciaries to;
“obtain, among other things, sufficient information to determine the pooled fund's strategy with respect to use of derivatives in its portfolio, the extent of investment by the fund in derivatives, and such other information as would be appropriate under the circumstances”
Investment fiduciaries need to understand the unique risks (market, credit, operational, liquidity and legal) and opportunities posed by investment derivatives since they have the ultimate responsibility for determining if they are being suitability utilized for their plan and participants. What might have been a prudent due diligence process for derivatives a few years ago would certainly not be sufficient today. Fiduciaries should be especially aware that the current low yield environment motivates fund managers to amplify risk to improve returns.

The mind numbing complexity of the current generation of derivatives can easily disguise speculative activity and the endemic risks of derivatives for which plan fiduciaries can be held responsible.

Thursday, November 16, 2006

Fiduciary Decisions

Investment fiduciaries under ERISA will be judged based on their decision making processes. It is their conduct not the outcome of their decisions that matter most. Decision making is central to human activity yet there are many impediments to a good fiduciary decision making process. Human behavior in the face of uncertainty, group decision dynamics, time and resorce constraints and information asymmetry can can hinder good decisions.

The first decision fiduciaries must make tackle is...are they appropriately skilled and positioned from a time and resources perspective to make investment decisions? ERISA requires them to be or to seek counsel from those who are. Not critically addressing this most fundamental decision may stand out as a primary reason why plans and participants are underperforming, why poor investment products proliferate and why conflicts of interest still pervade the retirement investing industry. Oversimplifying investment decisions or avoiding them altogether generates fiduciary liability.

Robert Rubin
made some thoughtful comments on decision making that are relevant to fiduciaries:

"recognizing that all decisions are about probabilities rather than certainties should lead us to uncover and engage with the full array of complexities around making the best decisions"

"each alternative possible outcome is not a simple, single effect, but the net effect of tradeoffs between competing considerations"

"often, decision-makers faced with a situation where all choices are bad, react by not deciding. That, however, is a decision in itself, and often the wrong decision"

"reality is complex, and recognizing complexity and engaging with complexity was the path to best decision-making"

Wednesday, November 15, 2006

Over-engineering Target Retirement Funds

Single asset class investment funds are the investment equivalent of blunt objects. They provide basic though limited value when utilized on a standalone basis. Their potential value is unlocked when combined with other asset class investments. The leading target retirement funds do a reasonable job of combining asset classes in an efficient way and also provide a simple method for matching investments to investors. These products fit many investors generally though few specifically. Competent individual investment advice provides the greatest potential for optimizing asset mixes in a way that best suits the unique appetites and circumstances of each investor.

Though building customized target retirement funds may make sense in certain cases, the cost, effort and added fiduciary liability incurred in over-engineering these products might be better spent in the delivery of consistent and comprehensive personalized investment advice to retirement plan participants. In providing participant tools for retirement, it may be more effective for plan sponsors with a good pile of “rocks” to provide “nail guns” instead of “hammers”.