The Securities and Exchange Commission, in proposing to ban pay-to-play at public pension funds, missed tackling a huge related issue. It also should look at the power of consultants and the subtle pay-to-play they generate in the investment management community through money managers buying services from them.
Arthur Levitt Jr., chairman of the SEC, said his staff will draft a rule to prohibit pay-to-play at public pension funds. It will be designed to ban money management organizations from making political campaign contributions to officials at the public funds that make decisions to select the investment advisers.
Pay-to-play in the public fund arena and managers buying services from consultants represent weaknesses in the system of selecting investment advisers to manage pension funds. But can you blame the manager for paying, if that is how the system works?
The consultant case is more troubling because relationships between consultants and money managers are not even as transparent as political contributions money managers make to public fund officials. A whole lot of money is paid to consultants by managers, and consultants are a lot more powerful than a typical public fund trustee. Yet there is no disclosure.
Consultants often have immense influence on asset allocation and the hiring and firing of money managers. True, the advice of consultants comes in the form of recommendations, but trustees often adopt that advice, trusting in its objectivity.
One must ask how objective can that advice be when consultants, while paid by pension fund sponsors, also seek revenue from money managers for services such as performance measurement, seminars or marketing and product development.
For some consultants, services provided to managers have become a significant source of revenue.
This purchase of services by managers from consultants seems to be a form of pay-to-play. At least, managers seem to believe the purchases are necessary to get into search databases or search finals, although the consultants deny it.
At the very least, there is an apparent conflict of interests.
To evaluate the objectivity of consultants in recommending managers, pension executives need information about the business of consultants and their sources of revenue.
Few sponsors have asked managers to detail their consultant relationships in search questionnaires. That should change.
When pension executives do manager searches, they should know from their consultants what revenues, and for what services, the consultants get from the managers they recommend.
A few pension funds have been aggressive about seeking information about such business relationships, because they discern the potential conflicts of interests. One of these vigilant funds is the Missouri State Employees' Retirement System, Jefferson City.
Gary W. Findlay, the system's executive director, suggested a few months ago that consultants should provide data on possible conflicts. He suggested asking consultants, in simple questionnaires, to note the percentage of their revenue that comes from plan sponsor consulting, services to money managers, money management and brokerage from other than soft-dollar services to sponsors.
In a search last year, the Missouri Public School Retirement System asked managers for information about investment performance reports they obtain from consultants with soft dollars. The issue: Do managers need so many performance reports from so many different consultants? Are managers paying to play?
Pension executives should ask their consultants to report how much revenue they have received in the previous 12 months from each of the managers recommended. More disclosure of this kind might force consultants to decide in which business they want to be. It would at least give pension clients information with which to test the consultants' proclaimed objectivity.
As a matter of principle, we hesitate to advocate an SEC regulation for the consultants. Pressure ideally should come from sponsors. The way to resolve the potential consultant conflicts is for plan sponsors to ask the right questions of their consultants.
Consultants must not only be free from real conflicts of interests, they also must appear to be free from conflicts.