Guest Article

The Imprudent "Asset-Silo" Approach to Pension Portfolio Investing, Monitoring, and Performance Measurement

By Herbert A. Whitehouse. Herb Whitehouse is currently in-house legal counsel for a Florida corporation. He has unique combination of fiduciary and funding policy experience -- as an attorney, as Chief Fiduciary Officer for an investment consulting firm, as an in-house fiduciary investment committee manager for a large Fortune 500 corporation, and as the in-house International benefits consultant of a large public employee labor union.

Portfolio skills and experience are central to pension plan investing. But it is not uncommon for investment consultants to provide what can best be described as merely pretend portfolio investment services. Because of this, investment fiduciaries (boards of trustees in the public sector) often settle for consultants whose practice discipline is focused on selecting active managers and actively managed mutual funds. The portfolio, and portfolio asset allocation, is not managed with respect to the plan's funding policy needs and objectives; and even the monitoring and measuring function is focused, not on the portfolio, but on the performance of discrete asset class silos against straw-man index fund benchmarks.

Every pension investment fiduciary deserves better than that. One task, above all others, is central to prudent pension investment oversight. That task is to ensure that a plan's investment policy, the execution of that policy, and the measurement of portfolio policy performance is explicitly ordered with respect to furthering a pension plan's funding policy.i This requires a focus on the portfolio. It is the volatility and return of the overall portfolio that needs to drive both investment policy development and performance measurement. An apt analogy, provided by the CFO of one well known company in Florida, is that five superstars don't make a winning basketball team. The players not only need to be managed; but they need to be selected for their potential for working together. So if you are a CFO or another member of a pension fiduciary committee, whether for a defined contribution or defined benefit plan, who regularly sits down to quarterly investment performance meetings that are focused on asset class silos, then you need to read on.

The default governance structure under ERISA calls for a trustee with exclusive authority to manage pension portfolios.ii In the private sector, this trustee will be a corporate trustee with the experience and skills needed to create and manage efficient investment portfolios. But the needs and objectives of each pension plan are different. Accordingly, the investment policies of each plan must be explicitly aimed at furthering that plan's unique needs and objectives.iii

Some pension investment fiduciaries, perhaps especially local government pension fiduciaries, miss the mark on this central focus to pension investment oversight.iv These fiduciaries, when they are governed by ERISA, violate ERISA and applicable Department of Labor (DOL) regulations by failing to develop investment policies to further their plan's funding policy objectives. Of course, local government pension fiduciaries are also be subject to the universal fiduciary standards pursuant to common law principles, state statutes that reflect these same principles, or even directly reference and incorporate ERISA. In any case, this central fiduciary practice standard is ignored only at great risk to public employees, retirees, and taxpayers.

One mistake made by some local government pension fiduciaries is to think that the pension plan's actuary sets the funding policy when it determines the Actuarially Required Contribution.v This mistake, and the related failure to develop investment policies around meeting real funding policy objectives, is the reason that several large local government pension plans in Florida -- plans that were regularly making their actuarially required contributions -- recently saw their funding ratios fall from 100% all the way to 0% for active employee liabilities.vi

An actuary determines actuarially required contributions with reference to a fixed earnings assumption, as well as the assumption that there will be no variability in those earnings for five or six decades. In fact, until recent GASB changes, public sector actuaries determined pension liabilities using an earnings assumption even for the purpose of discounting (measuring the present value) liabilities for which no plan assets existed. But the reason ERISA and fundamental fiduciary practice standards require that investment policies further funding policy objectives is precisely because investment risk and volatility exists in the real world. An investment policy will (or should) ratchet risk up or down depending on confidence level objectives set by the plan for maintaining and/or increasing its funding ratio.

When a plan's named fiduciary (board of trustees in the public sector) sets its investment policy without explicit reference to short, intermediate, and long-term funding policy objectives, that fiduciary is per se imprudent. The fiduciaries for these plans violate a central fiduciary practice standard by not establishing funding policy objectives. Moreover, for these fiduciaries and their investment consultants, determining the risk and volatility of alternative asset allocations is at best incidental to the creation of an investment policy. In plans that are not governed by fundamental fiduciary practice standards, portfolio volatility objectives are not set, and the performance of the plan's investment consultant is not regularly measured against any portfolio volatility objectives.

A trustee or a fiduciary investment committee that does not ignore fundamental fiduciary investment practice standards will, working together with its investment consultant, select investment manager combinations that consistent with a desired level of confidence that the plan's funding ratio will be maintained within an acceptable range, and/or, especially for underfunded plans, improve over time.vii

The consequences of using investment consultants who do not have the skills, practice discipline, or inclination to manage portfolio risk with respect to funding policy objectives can be catastrophic for plan participants.viii Some observers believe that the risk of catastrophic pension failure is limited to public pension plans that do not make actuarially required contributions. This is definitely not the case. A part, but by no means all, of this risk has been illustrated by ten large Florida municipal pension plans whose plan sponsors made their actuarially required contributions from October 1, 2001, through September 30, 2010.ix

The argument that funding ratios are not as important as the ability of the plan sponsor to pay for the increased actuarially required contributions that will result from this kind of funding ratio decline misses the point. There has always been a risk that a plan sponsor will not be able to support higher pension contributions. But now that many pension public pension plans, even those making actuarially required contributions, have substantial recurring negative cash flows, the risk from investment volatility can be even greater. Recovery from a substantial investment loss, or from a series of annual investment losses, is just that much harder when plan assets are declining regardless of investment returns. And so, because cash flow expectations vary from plan to play, because the risks and expectations for a local government's income becoming constrained vary, and because the demand for government services and the necessary active payroll costs to support those services can also vary…

...both funding ratio volatility risk and the risk that a given pension plan can, or should, tolerate will materially vary from local government to local government.

That is why prudent investment policies are always developed in support of each plan's unique funding ratio needs and objectives.

Footnotes
i ERISA § 402(b)(1) ("Every employee benefit plan shall...provide a procedure for establishing and carrying out a funding policy and method consistent with the objectives of the plan and the requirements of this subchapter...") Emphasis added.
ii ERISA § 403(a) ("[T]he trustee or trustees shall have exclusive authority and discretion to manage and control the assets of the plan, except to the extent that -- (1) the plan expressly provides that the trustee or trustees are subject to the direction of a named fiduciary who is not a trustee, . . . or (2) authority to manage, acquire, or dispose of assets of the plan is delegated to one or more investment managers. . .").
iii Cf., Whitehouse, Herbert A., The Use of ERISA § 3(38) Investment Mangers in Plans Offering Mutual Fund Investment Options to Participants (April 15, 2011). SSRN update to Chapter 16 of NEW YORK UNIVERSITY REVIEW OF EMPLOYEE BENEFITS AND EXECUTIVE COMPENSATION -- 2007, LexisNexis Matthew Bender, 2007. Available at SSRN: http://ssrn.com/abstract=1811085 .
iv Ibid., § 1.06 THE CRITCAL ROLE OF THE FUNDING POLICY IN FIDUCIARY INVESTMENT MANAGEMENT ("One easy screen for a named fiduciary, whether of a defined benefit or defined contribution pension plan, to apply in the fiduciary's evaluation and selection of an investment advisor is to determine where the plan's funding policy fits into the advisor's advice. An advisor whose routine practice is not oriented toward constructing an investment portfolio for achieving the plan's funding policy target and objectives does not understand pension fiduciary investing. [Footnote reference. The same as fn i, above.] Despite this fact, there are many investment advisors, perhaps especially in the public sector, who provide advice to plan fiduciaries without any reference at all to the plan's funding policy, and seemingly without any recognition that such a concept is part of pension plan management.")
v In the public sector, the trustee takes on a role that is very much akin to the role of the named fiduciary committee in the private sector. Public sector plans use corporate custodians to hold the assets of the pension plan; but an appointed board of trustees establishes the plan's investment policy and selects the investment managers or mutual funds to implement that policy. Of course, under either the named fiduciary committee governance structure, or the board of trustee variant in public sector plans, these investment fiduciaries typically retain a professional investment consultant with a level of skill and practice discipline that needs to be comparable to that of a professional corporate pension trustee.
vi See Whitehouse, Herbert A., Fiduciary Accountability for Managing Funding Ratios in Florida's Local Government Pension Plans, or "You've got to be Very Careful if You Don't Know Where You're Going, Because You Might Not Get There", Yogi Berra, (May 27, 2013). Available at SSRN: http://ssrn.com/abstract=2270527 .
vii Importantly, the focus on portfolio risk and return is not something that can be established using index fund benchmarks while the actual investments managers selected are various active managers and active management approaches. Cf., 29 CFR §2550.404a-1(b) (A fiduciary must analyze whether each "particular investment . . . is reasonably designed, as part of the portfolio . . . to further the purposes of the plan….)." In fact, the primary theoretical advantage to combining various active manager and active manager investment strategies is not just to beat the individual benchmarks of the portfolio components -- especially, straw man benchmarks -- but to maximize portfolio return for the managed level of portfolio volatility that a particular combination of these strategies can offer.
viiiWhile this article is focused on defined benefit plans, the adverse impact on plan participants from a lack of a portfolio focus by plan fiduciaries is even more significant in defined contribution plans. See op. cit., Whitehouse, Herbert A., ("§ 1.10 CONCLUSION ("The paradigm shift that is developing in the defined contribution world is one that involves the twin principles of investment delegation and a focus on the portfolio. In no way is this development radical. In fact, the new paradigm essentially brings to the defined contribution world the long established governance principles of the defined contribution fiduciary's elder brother, the defined benefit fiduciary.")
ix Op.cit., Whitehouse, Fiduciary Accountability for Managing Funding Ratios in Florida's Local Government Pension Plans, or "You've got to be Very Careful if You Don't Know Where You're Going, Because You Might Not Get There."

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