Could your Client's Underperforming Pension be Related to it Advisor's CONFLICTS OF INTEREST?

Edward E. Sharkey

In May 2005, the SEC published the results of an unprecedented investigation of financial conflicts of interest in the pension consulting industry.1 The regulators found that conflicts of interest were pervasive. They referred some of the consultants for further investigation and enforcement, and they issued guidelines to pension trustees intended to identify and protect against such conflicts. They also asked consultants to change their business practices to prevent and mitigate the risks of conflicts of interest and to better disclose conflicts to pension clients. More than one year later, not much has changed in the management of pension plans.

Relative to the uproar that followed discovery of similar conflicts of interest in the insurance brokerage industry the year before, the reaction to the SEC’s findings was surprisingly calm. Thus far, no official action has been taken against any pension consultant. More troubling, plan trustees, who oversee more than three trillion dollars in private pension plan assets, do not appear to be addressing the real concerns expressed by the SEC. This is highly curious for one important reason: pension trustees who fail to identify and protect their plans from conflicted advisors could find themselves personally liable for any losses arising therefrom.

The Pension Consulting Industry

Pension consultants act as advisors to pension trustees. Consultants devise investment policy and allocations, recommend money managers, and monitor the managers’ performance. Some consultants focus exclusively on advising pension plans, charging a fee for their advice. Sponsors’ sensitivity to costs, however, makes this model less lucrative. More commonly, pension consultants are affiliated with firms that offer other products and services, such as brokerage, money management, and financial analysis. Frequently, such consultants offer their advisory services for “no fee,” asking only that the pension plan direct trades to the consultant’s affiliate broker. All pension consultants owe a fiduciary duty to their clients. They have a legal duty to act in the best interest of the client. They must provide unbiased advice, and they must disclose all information material to their clients’ decisions.

The SEC Investigation

The SEC found that the majority of consultants examined failed to honor this duty. Of the 24 consultants investigated, the SEC found that more than half earned money selling products and services to professionals hoping to do business with the pensions. More troubling, these consultants traded on their trusted relationship with their pension clients.

For example, the majority of the consultants hosted investment conferences, which they populated with pension clients by offering free tuition. The consultants then charged money managers to attend. Ten of the 24 consultants sold investment software to money managers, some of whom were found to purchase duplicate products from multiple consultants. The majority also had affiliated broker-dealers that enabled them to generate revenue with brokerage “commission recapture.” A few had referral arrangements with unaffiliated broker-dealers that they did not disclose at all. In those arrangements, the consultants directed pension clients to use the broker-dealer for commission-based trades. The broker-dealer paid kickback to the consultant based on the amount of commissions earned.

The SEC questioned whether pension plans were receiving “best execution” on their trades and whether they were overpaying for advisory services. Without capping commissions at the level of the consultants’ regular fees, the consultants could reap a windfall through directed commissions. The SEC also understated the obvious: that a “concern exists that these arrangements may provide an incentive for a pension consultant to recommend an active trading strategy, because the pension consultant may receive more money in commission payments.”

The SEC found that the consultants were not disclosing their financial arrangements and conflicts of interest to clients. Only one consultant made client-specific disclosures that it had sold products and services to the same money managers that it recommended to a pension plan. That consultant gave no information concerning the dollar amounts involved, thereby concealing the magnitude of its conflict.

Guidelines Issued by the SEC and Department of Labor

The harm that arises from these conflicts of interest can go unseen. Underperformance caused by the selection of an unsuitable investment policy or an unsuitable manager may not cause a plan to fail; the plan may simply lag. When a $100 million pension fund lags by two percent a year for five years, however, the losses are material. If the pension committee responsible for such a plan has been working with a reputable consultant, the underperformance usually will be written off as mere market fluctuation.

The SEC said they were not able to “fully analyze” the effects of the conflicts because of the way the consultants kept their records. Of the six consultants that kept records useful to the task, however, the SEC found that 50 percent recommended money managers who paid the money more frequently than those that did not.

The regulators issued guidelines to pension trustees concerning these conflicts of interest. The guidelines are aimed at helping trustees fulfill their fiduciary duty to manage pension plans and monitor service providers with prudence. Recognizing that trustees usually rely heavily upon pension consultants, the regulators created a series of questions that trustees must direct to their consultants to help assess the objectivity of the advice they are receiving.2

The questions focus on critical issues such as:

1. Whether the consultant has relationships with money managers that it recommends or maintains in a pool of managers for consideration by clients;

2. Whether the consultant receives payments from money managers it recommends;

3. Whether the consultant has procedures to address conflicts of interest or to prevent these payments or relationships from being a factor when it provides advice to pensions;

4. If the consultant allows plans to pay consulting fees using directed brokerage commissions, whether the consultant monitors the amount of commissions paid and alerts plans when consulting fees have been paid in full;

5. What steps the consultant uses to ensure that its plans receive best execution for securities trades;

6. Whether the consultant will acknowledge in writing that it has a fiduciary obligation as an investment adviser while providing the consulting services;

7. What percentage of the consultant’s clients use managers, investment funds, brokerage services or other service providers from whom the consultant receives fees.

One Year Later

As noted, regulators have not taken action against any pension consultant identified as breaching its fiduciary duty. In a December 2005 speech at the 14th Annual Public Fund Boards Forum, the Director of the SEC’s Office of Compliance Inspections and Examinations said that the SEC had followed up the investigation to determine what consultants were doing to address the problems identified. Its methodology? The SEC asked them.

Not surprisingly, consultants reported progress in evaluating, revising, and implementing changes to their procedures. This self-reporting should provide no comfort to trustees. Pension trustees have an independent fiduciary duty to act with prudence. In the hiring and monitoring of pension consultants, this duty unquestionably requires the independent evaluation and supervision of consultants.

One year after publication of the SEC’s report, there is little evidence that pension trustees are asking the hard questions of their consultants. This is a serious mistake. Ultimately, if a pension plan suffers losses due to tainted advice, the Department of Labor may or may not investigate and pursue the consultant. There is a much greater chance, however, that participants or sponsors will pursue claims against the trustees who failed to identify and avoid the conflict of interest.

Any committee that discovers, only after pointed questioning, that its consultant has a conflict of interest that was previously undisclosed is on notice that the consultant concealed material information when it was under a duty to disclose. Blind reliance on any subsequent statements by the consultant concerning their ability to manage the conflict, or concerning the lack of harm resulting from the conflict, would be questionable. A prudent committee should attempt to verify, independently, the nature and extent of the conflict, as well as whether the conflict harmed the plan.

In order to prudently manage their plans, pension committees need to know whether the advice they are receiving from consultants is tainted. Now that the regulators have expressly stated that conflicts of interest may be harming pension plans, the duty of prudence includes a duty to investigate, and, upon discovery of conflicts, a duty to determine any harm.

Endnotes

1. The full report can be found at http://tinyurl.com/hu6u8.

2. The full text of the questions can be found at http://tinyurl.com/ommd2.

Edward E. Sharkey is a lawyer who represents pension fiduciaries in the investigation and resolution of violations of the pension and securities laws. Questions or comments concerning this article or related issues may be directed to him at (301) 657-8184 or esharkey@ sharkeylaw.com.

AZ CPA – September 2006