Working with independent fiduciaries: Is it necessary?
Westminster Consulting exists to “promote a culture of fiduciary responsibility”; that is literally our trademark. Still, detractors argue, the traditional relationship which bypasses fiduciary experts with salesmen, stock-brokers, and non-fiduciary financial advisors has worked for years so why not continue with business as usual? These detractors concede that working with an independent fiduciary may be an ideal industry best-practice, or more efficient to work with an independent, unconflicted fiduciary advisor, but where is the harm really?
Avoiding Conflicts of Interest and Other Mismanagement
So, let’s investigate the impacts regarding conflicts of interest & other mismanagement. Our June 2013 article – “Improper Roles for Advisors” walked through the legal basis for using an independent fiduciary consultant. Our September 2013 article – “The Biggest Myth for Investment Consultants” – explicitly described the difference between independent fiduciary consultants or a conflicted consultant. However, we haven’t given details about the actual harm of using a salesman, who may have a conflict, as your consultant.
Before we examine the errors and impact, let us back up a moment and consider the capital market’s impact on institutional investment strategy. In the relatively strong market years leading up to the crash, good market returns shielded relative poor performance because absolute performance was strong. In other words, institutions are less likely to criticize underperformance against benchmarks if their rate of return is still above their long term target. However, since the financial crisis and economic weakening, the damage of using a salesman has become a little more obvious. The dissolution of rosy assumptions broke the habit of complacency, and disappointed investors began to scrutinize the impact of imperfect business practices to actual rates of return much more carefully. It turns out there are plenty of missed opportunities for improvement that are now being resolved with legal challenges.
The precepts of fiduciary responsibility are ultimately founded on legal precedent. There are a variety of court cases which define the boundaries of legal responsibility (e.g. - Tussey vs. ABB, Kraft vs. George, Bidwell vs. Universal Medical Center, Tibble vs. Edison) and the penalties for failure.
Harm to the Private Sector
Stress to a system exposes weakness. Given the great damage to financial markets in 2008 and 2009, corporate America actually weathered the storm fairly well and, it could be argued, that the dot-com era accounting scandals and resulting lawsuits (WorldCom, Enron) resulted in a wider appreciation for the fiduciary standard as well similarly well-intentioned enforcement efforts (i.e. – Sarbanes-Oxley). Thus, the testing – the proving – of corporate America resulted in a private sector which, while not immune from the effects of a coordinated global slowdown, has managed to endure it with laudable stability.
Of course, market forces continue to roil and any company which suffers undue secular and cyclical pullbacks will have to address its weaknesses. For example, Kodak’s secular reorientation from the chemical film business to digital imaging has not been painless and their weakness has ultimately resolved as bankruptcy, liquidations and lawsuits. Specifically in regards to their retirement plan, one lawsuit contended that the inclusion of Kodak company stock within the employee retirement plan was not vetted to the fiduciary standard and that the investment committee should have omitted the stock from the investment lineup.
Here’s another example: imagine for a moment that you work as a secretary at a nationally recognized investment management and recordkeeping firm. Your company custodies assets, creates investment products, and manages the accounts of other retirement plans all over the world, but you are just an office-worker. As an ordinary employee, you might not really care if the options in your 401(k) plan are made of investment products that your company created or not – your goal is simply a stable retirement. However, it is brought to your attention that your retirement options are made solely from mutual funds that were created in house. So you wonder: are these really the best options or is there some conflict of interest from the board that selected these funds for your retirement plan lineup?
That’s pretty much what happened. It is interesting to note that the presumptive experts in financial services – the financial industry – are embroiled in legal challenges despite their expertise. Several well known firms have both undergone challenges to their own retirement plan lineup. In September, Fidelity’s employees filed a class action lawsuit arguing that the company neglected its fiduciary duty by selecting in-house mutual funds. Similarly, Mass Mutual employees recently a filed lawsuit challenging the presence of group annuities made almost exclusively of in-house investment products in their retirement plan.
Harm to the Public Sector
Recent history has also provided us with a surprising number of municipalities which have struggled to demonstrate prudence in the wake of imperfect, arguably negligent, business practices.
Recall that the Employee Retirement Security Act (ERISA) was created to protect employee retirement funds with investment transparency and enforcement provisions (i.e. – employees have the right to sue for breaches of duty). ERISA, notably, did not cover public pensions (i.e. – governments and municipalities). Thus, despite the inherent reliability of public funding, public retirement systems are facing a disproportionate amount of stress and challenges in the post financial crisis world.
The difference in public and private management is not solely a difference of the adherence to fiduciary principles; the difference is structural as well. For example, public retirement assets are more likely to provide defined benefits (i.e. a pension plan) for employees while the private sector has been systematically replacing defined benefit plans with defined contribution plans – 401(k) plans - for the past 30 years. This structural difference is a key reason why the public plans bear a greater potential for mismanagement; the burden is more clearly borne by the institution, not the individual employees. However, the lack of procedural transparency and oversight, because of ERISA exclusions, could be a contributing factor to a number of public fund fraud and mismanagement scandals.
High profile bankruptcies in California and Detroit have exemplified these failures. Detroit’s bankruptcy, the largest Chapter 9 ever, has engendered more than 500 separate civil lawsuits of creditors, pensioners, and union employees, each with separate claims to a finite & ever-dwindling stream of city tax revenues. Not surprisingly, a variety of these cases allege mismanagement on behalf of the city and, given the diverse interests represented by the many plaintiffs, unwinding all the inherent conflicts of interest is truly a monumental task. With hundreds of separate cases, these lawsuits probably will not yield sufficient compensation for each of the pensioners, employees, bond-buyers or other creditors let down by the bankruptcy.
You Can’t Squeeze Blood from a Stone
The example of Detroit has inspired New York state regulators to proactively investigate the management of the New York State pension fund. More specifically, investigators are subpoenaing between their consulting firms, large and small, and investment managers, probing for corruption via quid-pro-quo recommendations, direct kickbacks, or other indirect compensation.
In the worst case scenario, the excessive damage to retirement plans, public or private, may prohibit the possibility of material restitution, particularly for companies or municipalities in bankruptcy proceedings. There simply may not be enough spare dollars to fulfill these obligations. As the saying goes, “you can’t squeeze blood from a stone”. Therefore, the incentive is higher for employees (or taxpayer advocates) to challenge lax business practices more quickly in the future, especially if the near-term market environment generates lackluster investment returns.
Potential plaintiffs have realized that breaches in fiduciary duty must be resolved early (before bankruptcy) to increase the chances for full restitution. This fact should inspire investment committees and retirement plan committees to become equally more proactive towards meeting their financial responsibilities.
In other words, fixing fiduciary lapses before they encourage a lawsuit should be a significant motivator for any investment committee or board member. There are solutions available to resolve conflicts of interest or other mismanagement problems, such as a fiduciary review, but it is up to responsible fiduciaries to address the issues proactively.
New York is Investigating Advisers to Pension Funds, Dealbook New York Times, Mary Williams Walsh
New York Investigating State’s Pension Advisors, NAPA-Net, Fred Barstein
Detroit nears Deadline to clear lawsuits in bankruptcy case, Detroit News, Brian O’Connor
Detroit in Context, Understanding Municipal Defaults and Bankruptcy, Nixon Peabody, Mark Berman