The Securities and Exchange Commission's current examination of pension fund consultants is overdue. You might call the new scrutiny a shock-and-awe campaign.
First, there is the shock the SEC has allowed intimations of pay-to-play to remain unexamined for so long. Then there is the shock the SEC needs a crash education on consulting practices and how the business is conducted. Finally, there is the shock that few, if any, in the pension investment business ever formally advocated an examination of the potential conflicts and possible abuses.
As for the awe, that will depend on the findings of the SEC examination and what initiatives it provokes in terms of new rules for the industry, and any action against specific consultants.
The SEC examination could change the face of consulting. It should. Consultants should be required to more fully disclose any payments they receive from money managers, in hard or soft dollars, for any services they provide, whether for performance measurement, business consulting or education.
Of course, there would be no need for the SEC examination if pension plan sponsors had examined their consultants carefully over the years. Sponsors could have ended non-disclosure of potential conflicts, and avoided potential abuses long ago had they demanded their consultants act as fiduciaries, serving the best interest of plan participants.
But few sponsors have probed such controversial areas. Pension executives who have neglected to scrutinize their consultants about apparent conflicts might have failed in their fiduciary duty to participants. According to some in the pension investment industry, plan sponsors rarely ask such questions in requests for proposals, even though money from directed commissions belongs to the pension trust.
But not all sponsors are so negligent. In an RFP for a 1998 equity manager search, the Public School Retirement System of Missouri, Jefferson City, asked important questions of manager-consultant relationships. It asked, for example, that each money manager name the consulting firms, if any, from which it obtained investment performance reports, and the amounts the manager paid the consultants in soft dollars. J&W Seligman & Co., New York, for instance, reported paying $310,000 in soft dollars in 1997 to seven consulting firms, each named, for investment performance reports.
More recently, a KPMG Investment Consulting Group audit for the $1.3 billion fund of the Metropolitan Government of Nashville & Davidson County Benefit Board found inherent conflicts of interest, involving soft-dollar payments and directed brokerage, with PaineWebber Prime Investment Consulting Group, when it was the fund's consultant. That audit led to a $10.3 million settlement in 2002 by UBS PaineWebber, the successor firm, and its then-consultant William Keith Phillips.
Last year, an audit of the Hawaii Employees' Retirement System, which has a $7 billion fund, raised the issue of potential conflicts of interest at pension consulting firms that also consult with money management organizations.
The audit found that more than 85% of recommended money manager candidates and 100% of the managers chosen "have disclosed financial relationships" with Callan Associates Inc., the Hawaii fund's consultant. "While not technically representing a conflict of interest, the motivation to recommend these particular investment managers warrants close scrutiny," the audit noted.
Gary W. Findlay, executive director of the Missouri State Employees' Retirement System, Jefferson City, speaking of the SEC examination, said pension sponsors share some blame for the consultant conflicts.
Plan sponsors "generally insist on paying minimal amounts for consulting services yet expect consultants to be more knowledgeable about big-picture investment issues than we demand of any of our money managers," he told P&I. "We then pay money managers fees that are a substantial multiple of what we pay our consultants without acknowledging that our consultants are competing with money managers for talent."
Whether the SEC's examination finds illegal or unethical behavior, the SEC should start demanding consultants provide full disclosure to fiduciary clients of conflicts of interest, including non-pension sponsor sources of revenue.
All sponsors, not just the few who already do so, ought to finally demand such information of their existing and prospective managers. Disclosure shouldn't necessarily disqualify a manager or consultant, but a pension executive can evaluate the impact such conflict might have on performance, and deal with it accordingly. As consultant Stephen P. Holmes said in a Jan. 12 story on the subject, "Sunshine is the best disinfectant."