The Labor Department can help curb off-balance-sheet "soft-dollar arrangements" between public pension funds and their brokerage firms by detailing the hidden costs of that practice to lawmakers in all 50 states, former SEC Commissioner Steven M.H. Wallman recommended.
Even though the Department of Labor's pension office does not regulate public pension funds, Mr. Wallman said a report on soft dollars bearing the agency's imprimatur would merit reading by state legislators, especially if it documents how soft dollars can eat into a pension fund's returns by padding commission costs and resulting in less efficient trading.
In a typical soft-dollar arrangement, money managers (or sometimes the plan sponsors) receive investment research and other investment services from brokerage houses instead of rebated commission rates, in return for directing trades to them.
"Make it clear that legislators should step up to the plate and set aside money in hard dollars (for trading securities for the state pension fund) instead of hiding costs," Mr. Wallman said.
"Every other organization in the government runs on budgets, and the argument that this should be run off line, and should be able to create its own budget by churning stocks, suggests that the system needs to be revisited," he said.
Mr. Wallman, who left the SEC earlier this month, testified in September before the Labor Department's ERISA advisory council examining soft dollar arrangements. In a later interview, he expanded on that testimony.
The council is expected to publish its findings next month and make recommendations to the Labor Secretary.
Mr. Wallman suggests lawmakers would not resist increasing the budget for their pension fund's trading costs, especially if the states could recoup the savings at the end of the year from not using soft dollars.
"They can get the money back as a management expense. It's simple enough to create solutions at the state level, if they want to," he noted.
"People don't use soft dollars because they are allowed to, any more than you would ride a unicycle to get to work. The reason people are using soft dollars is because they want to hide those costs."
A example is the approximately $56 billion New Jersey Division of Investment, which uses soft-dollar rebates to pay for travel and conferences as well as investment research, Roland M. Machold, executive director, told the Labor Department's council in July.
Mr. Machold also testified how his pension fund's budget of $4.1 million "is small by any standard and the Legislature has not changed this appropriation in five years." Lawmakers have limited his fund's budget, he said, because they contend the fund should be able to recoup trading costs.
Mr. Machold said for years, he has tried without any success to get lawmakers to include research costs in the state's budget for the division, and has needed to rely on soft dollar rebates as a "necessary and critical supplement to the division's resources."