The costs of conflicts of interest in investment consulting might be quantified in a case involving the Metropolitan Government of Nashville and Davidson County Benefit Board and PaineWebber Prime Investment Consulting Group, regarding its work as consultant.
An audit by KPMG Investment Consulting Group, New York, in March 2000 found the metropolitan board for the some $1.6 billion fund "has established an investment consulting arrangement with inherent conflicts of interest, then has relied exclusively on the consultant for advice to manage Metro's pension investments...Metro's investment consultant is not independent and has provided the board with misleading information, resulting in board decisions that generated higher commissions."
"The root cause of this problem," the audit states, stems from the way the board compensated PaineWebber. "Instead of directly paying PaineWebber a fixed fee to provide the board with independent investment advice, PaineWebber is compensated indirectly through a `soft dollar' arrangement where they earn brokerage commissions from Metro's investment managers directing trades through PaineWebber."
The KPMG audit, in one example, states, "PaineWebber misquoted an investment industry expert in a manner that would have left the board with the impression that the expert did not recommend passive investing, when in fact the expert did....Had the board in 1996 invested the applicable portion of the portfolio in index funds, Metro's pension fund would have earned $60 million more than it actually earned through December 1999 being invested actively as PaineWebber advised."
The audit pointed out, in describing the incident, that "fewer commission dollars are generated (by passive investing) than with an active fund."
Two years after the audit, Metro authorities are still evaluating its implications; they are reluctant to talk about what, if any, action they might take.
"We have not sued PaineWebber at this time," said Karl F. Dean, director of law. He said he couldn't discuss the matter further. "This is something we are still evaluating," he added.
After the audit, the fund dropped PaineWebber.
Paul R. Marrone, director-media relations, UBS PaineWebber Inc., the new name of the organization since its acquisition by UBS AG, wouldn't comment on the audit or the status of the matter.
The audit, in part, details how PaineWebber dominated equity trading. "Although the domestic equity investment managers are contractually obligated to trade at the lowest rates," the audit states, "95.8% of domestic equity trades for the year ending June 30, 1999, went through PaineWebber. Eight managers placed 100% of trades through Paine Webber, three managers placed over 85% ... and one manager placed over 55%.
"Had the domestic equity managers executed trades at the lowest rate, the fund would have saved an estimated $305,000 in commissions during the year ending June 30, 1999, and PaineWebber would have still earned their contracted fee."
The metro government seems to be giving this matter the deliberation it deserves. The matter in general underscores the risk pension sponsors take when they depend on objective advice in the presence of potential conflicts of interest. One wonders what the experience has been with other pension fund clients of PaineWebber, or what disclosure PaineWebber has made to regulators about the cause for complaint in Nashville.