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Time to expand audits

Once Congress gets past the fiscal cliff and takes steps to solve the country's long-term debt problem, it should turn its attention to strengthening the integrity of both defined benefit and defined contribution retirement plans.

In this it should be joined by the Department of Labor's Employee Benefits Security Administration and the Pension Benefit Guaranty Corp.

Strong, reliable retirement plans can help employees offset any reductions in Social Security that might result from steps to deal with the nation's long-term debt.

One issue needing attention is the use of limited-scope audits of retirement programs, which has long been a concern among some in government and in private practice.

In a report Sept. 28, the Office of Audit of the Office of Inspector General of the Department of Labor said it is a problem that the Employee Retirement Income Security Act allows limited-scope audits and a major obstacle to ensuring the integrity of assets through audits.

The valuation of plan assets “has implications for defined contribution and defined benefit plans,” according to the report.

“One concern for a defined benefit plan is that overstating asset value could place a plan at risk of unknowingly being underfunded. Alternatively, if a value is too low, it would give rise to excessive deductible plan contributions. For a defined contribution plan, a proper valuation is essential to determine” participant assets.

Plans increasingly use limited-scope audits. In 2010, some 70% of plans, accounting for $3.3 trillion of assets, used limited-scope audits, up from 46%, accounting for $520 billion, in 1987, the report said.

In all, some 84,000 plans filed audited financial statements with the EBSA, representing $5.7 trillion in assets in 2010, according to the report, using the latest data available.

“ERISA allows limited-scope audits, which means the auditor does not need to audit plan asset information if the assets are held and certified by certain financial institutions,” according to the report. “Since the auditor does not test asset information certified by the financial institution, the auditor disclaims an opinion on the plan's financial statements, providing no assurances to participants or beneficiaries on the reliability of the plan's financial statements.”

The new Congress taking office in 2013 should seek to eliminate the exemption and require full audits of pension programs.

But the task might not be easy to accomplish. The DOL Office of Inspector General's Office of Audit has long recommended the change. EBSA, while it agrees with the recommendation, has made no proposal to Congress.

Standard audits will add to plan sponsor costs, but it is a necessary cost. No company would operate without a complete audit of its corporate operations. It should not do so for its defined benefit and defined contribution plan assets, whose combined value is often a significant fraction of, and sometimes exceeds, the market capitalization of the company. Full audits provide for better control. What gets measured gets managed. Plans invested only in publicly traded equities and fixed income might call for an exemption in any legislation.

Full audits would contribute to confirming or correcting valuations, especially of alternative investments. Valuing investments has become more challenging as pension funds have increased their allocations to alternatives, so better audits have become more imperative.

These investments include hedge funds, private equity funds, real estate, timberland, infrastructure, mortgage- and other asset-backed securities, distressed debt, and swaps and other derivatives strategies. These generally are hard-to-value assets for which market prices are not readily and publicly availably.

Audits could help prevent trouble that could lead to disputes and even lawsuits on asset valuations, whether from participants or with investment managers. Without better audits, financial statements could mislead shareholders on critical corporate obligations pertaining to plan assets and funding levels.

On the defined benefit side alone, the looming all-time-high deficit the PBGC recorded in its recently released annual report raises concerns about terminated plans. It is essential for the PBGC to get an accurate count of the assets in plans it has assumed, and the impact that any fiduciary breaches had on the plans' costs and investment performance.

Rigorous audits have the potential to uncover inaccurate asset valuations and breaches of fiduciary duty in terminated plans, the correction of which could increase the PBGC's assets and reduce its costs, both of which have repercussions for active plan sponsors and all participants.

The PBGC's growing unfunded obligations for terminated plans means costs likely will rise for corporate sponsors as the PBGC seeks to raise premiums to help finance its deficit. Higher premiums add to reasons corporate sponsors want to stop providing defined benefit pension plans.

The PBGC needs to do all it can to ensure it doesn't get shortchanged when it assumes the assets of terminated plans if it is to avoid a potential taxpayer bailout, provoked by political pressure of participants left without PBGC-covered pensions.

To its credit, the PBGC in October sought to strengthen its asset-valuation expertise by naming Philip R. Langham director of its benefits and payments department. His duties include hiring experts to help get better valuations on assets of terminated pension plans PBGC assumes.

The change was prompted by reports from the PBGC Office of Inspector General revealing serious flaws by the PBGC and contractors involved in asset valuations of terminated pension funds assumed by the agency, including those of United Airlines and National Steel.

In pursuit of alleged fiduciary breaches in investments, the PBGC is involced in a case pending on behalf of Saint Vincent Catholic Medical Centers Retirement Plan in the 2nd U.S. Circuit Court of Appeals, New York, against Morgan Stanley (MS) Investment Management Inc. The plan, which had assets of $345 million, was terminated and taken over by the PBGC in 2010. The case accuses MSIM of breaching its fiduciary responsibility, alleging it “irresponsibly concentrated” some fixed-income assets, causing the plan to sustain a $25 million loss, which would not have occurred “had MSIM invested in a portfolio with characteristics similar to the benchmark, as required under the plan investment guidelines.”

Taken together, better audits and valuations as well as investigations of allegations of fiduciary breaches will help make defined benefit and defined contribution plans more secure, bolster the PBGC and bring greater accountability to fiduciaries.

But the job will be easier if Congress gives it help by revising the appropriate sections of the Employee Retirement Income Security Act.

This article originally appeared in the January 7, 2013 print issue as, "Time to expand audits".