Pension sponsors whose funds invest in alternative asset classes should heed the recent warning from the Department of Labor's Boston regional office.
James Benages, director of that office, said in a letter sent to at least one pension plan sponsor according to a Pensions & Investments report that plan fiduciaries must have a process in place to independently value alternative assets.
A process which merely uses the general partner's established value for all funds without additional analysis may not insure that the alternative assets are valued at fair market value, the letter reportedly said. If you take proper corrective action, then the department will not bring a lawsuit with regard to these issues.
Pension plan fiduciaries face a dilemma when they invest in alternatives, or so-called hard-to-value assets. They bear responsibility and accountability for the investments, yet they cannot independently account for the value of each alternative investment in their portfolios.
It would be virtually impossible for them to independently value alternative assets under the current practices typical of managers, who often restrict access to the details of investments to prevent disclosure of competitive information.
Even if the necessary details were available, it would be extremely expensive, if not prohibitive, for pension fiduciaries to value each investment.
In fact, even among investment professionals there is no agreement on how to value alternatives. Identical hedge fund portfolios, for instance, could be valued differently by different managers.
Independent valuation is an incendiary issue that could ignite lawsuits for breaches of fiduciary duty, if the issue is left to smolder without attention and assets prove widely misvalued.
Despite a frightening perception that valuation is out of a sponsor's control, the issue shouldn't cause trouble for plan executives who already carry out careful due diligence.
Some pension executives, however, have been negligent about due diligence, in particular in checking for conflicts of interests involving consulting firms and soft-dollar arrangements. Such laxity can lead to investing with underperforming, high-cost managers and can spill over to inattention regarding alternative investments.
The valuation issue is growing in importance as alternative investments including venture capital, other private equity, real estate, timberland, hedge fund strategies, derivatives, swaps, etc. become a larger share of pension funds' asset allocations. The 200 largest corporate plan sponsors averaged 15% of their assets in alternatives as of last Sept. 30, up from 8.2% 10 years earlier, according to P&I data.
The ERISA Advisory Council will examine the alternatives valuation issue at its Sept. 11 meeting, a discussion planned since May.
The Financial Accounting Standards Board also raised the question of plan sponsor obligations to obtain independent valuation of assets in its Statement 157, which took effect this year. It established a framework for valuation of a hierarchy of assets, from those widely traded with publicly quoted market prices to situations in which there is little, if any, market activity for assets, such as alternatives, according to the statement.
So why should pension executives bother investing in alternatives, risking fiduciary legal action? As fiduciaries, plan executives invest in alternatives for diversification advantages. In some cases, they invest in the strategies to reduce risk, while in other cases they invest in alternatives to add appropriate risk to increase expected return as the global market broadens into new institutional asset classes.
Because plan sponsors cannot independently value every alternative investment, the question is: On which entities can they rely to verify valuation? Investment advisers themselves? Auditors, custodians, or independent valuation experts and appraisers? The answer is every one of them.
Sponsors should already have in place an independent structure for evaluating investment managers through their due diligence process. And they shouldn't invest with managers that can't withstand such scrutiny. Pension trustees know they bear ultimate responsibility for failures in their system of due diligence.
As investments, such as alternatives, become more complex, plan executives must improve the sophistication of their due diligence processes. Unless they are willing to expend the resources to keep their processes equal to the complexities of alternatives, they shouldn't invest in them.