Wednesday, August 26, 2015

Chicago's Huge Pension Conflicts?

Matthew Cunningham-Cook of the International Business Times reports, At Chicago Pension Fund, Questions Raised On Conflicts of Interest:
Chicago pension officials wanted to know where to deposit the $11 billion that the city’s teachers had saved for their retirement benefits, so they turned in 2014 to the outside consulting firm they’d hired for financial advice. Such consultants are employed to provide guidance that's expected to be impartial -- not shaped by private business relationships that might make its recommendations less than objective.

So when the firm, Callan Associates, told pension trustees at a February meeting to give the cash to a bank called Bank of New York Mellon (BNY), the board’s trustees agreed to follow the advice. What they were not told at that meeting, however, is that BNY pays Callan for both general consulting services and financial education programs.

Those payments, say financial experts, represent an inherent conflict of interest. They effectively strip consultants like Callan of their objectivity by giving them an incentive to push their pension clients to use banks that are paying the consulting firms, the experts say.

Government regulators and auditors have in recent years raised concerns about undisclosed business relationships between financial institutions and consultants who are supposed to provide objective counsel. Auditors have documented lower investment returns at pension funds that rely on consultants with divided loyalties.

In Chicago, the conflicts could prove particularly costly for the city’s taxpayers and 63,000 educators. That’s because the bank Callan recommended, BNY, is a Wall Street behemoth that has repeatedly faced law enforcement action for skimming money from its clients. In fact, just after Chicago handed over teachers’ money to the bank, BNY agreed to pay more than $700 million to settle federal charges against it for defrauding its pension fund clients. Callan had previously faced sanctions from the Securities and Exchange Commission (SEC) for failing to disclose to clients that it was getting payments from BNY Mellon in exchange for referring brokerage business.

Callan did not respond to International Business Times' questions about its financial relationships. In its marketing material and financial disclosure documents, the firm has said, "We are independently owned and operated with interests that are precisely aligned with those of our clients.”

Ted Siedle, a former SEC attorney, said he sees no alignment of interests for Callan clients.

“It’s clear that Callan has conflicts of interest, and it’s likely those conflicts have an adverse effect on performance," he told IBTimes.

Feds Taking ‘A Careful Look’

In recent years, conflicts of interest in the shadowy world of finance have drawn increased attention from regulators and policymakers. In the wake of the financial crisis, lawmakers uncovered evidence that banks were pushing clients into investments that the banks themselves were betting against. That prompted deeper concerns about conflicts of interest and ultimately led the U.S. Labor Department to propose a rule mandating that financial advisers to individual investors provide advice that is solely in the interest of their clients.

But while the department has considered a similar rule for those advising pension funds, such an initiative has not moved forward.

In the absence of such a regulation, Rep. George Miller, D-Calif., sent a letter to the Department of Labor in 2014 saying the agency needs to "take a careful look” at conflicts of interest with pension consultants. In response, Phyllis Borzi, the Labor Department official in charge of regulating pensions, said the department was “committed to addressing" such conflicts in regard to pensions.

Evidence of conflicts has been mounting. In 2005, the SEC surveyed 24 major investment consultants and found that 13 had significant conflicts of interests that they had disclosed to investors. One of those firms investigated was Callan Associates. Using the findings of the SEC’s 2005 review, the Government Accountability Office (GAO) later found that pension funds that used conflicted consultants had 1.3 percent lower rates of returns than those that did not. As of 2006, those consultants were helping manage $4.5 trillion of assets.

If the GAO’s estimates are accurate, conflicted consultants cost pension funds $58 billion in unrealized returns every year.

Controversies surrounding financial conflicts of interest have periodically generated headlines.

In 2004 , Mercer, a major consultant, was criticized for receiving money from asset managers it recommended to pension funds, specifically in Santa Clara, California. In 2009, Consulting Services Group was criticized in an investigation for recommending that the pension fund of Shelby County, Tennessee, invest in its own hedge fund, which paid large fees to the company. In 2013, New York's Superintendent of Financial Services Benjamin Lawsky subpoenaed documents from 20 of the largest investment consulting firms, reportedly to evaluate their potential conflicts of interest (the results of Lawsky’s investigation have not yet been made public).

Most recently, in December 2014, IBTimes reported that the San Francisco pension fund's consultant, Angeles Investment Advisors, was pushing the city to allocate 10 percent of its portfolio to hedge funds but did not disclose that its own firm reserves the right to collect additional fees from pension clients when those clients invest in hedge funds. Angeles was later fired by the pension fund in favor of a company that claims to have fewer conflicts of interest.

‘The Bank Was Stealing’

In Chicago, where the teachers pension fund trustees are both educators and appointees of Mayor Rahm Emanuel, questions about conflicts of interest were not about investments. Instead, they were about which bank should get the lucrative contract to receive and disburse the pension fund’s $11 billion in assets.

In February 2014, when Callan recommended that pension trustees choose BNY for these so-called custodial services, Callan’s representatives did not explicitly tell pension trustees of their firm’s relationship with BNY or the 2007 SEC enforcement action against the consulting firm. Callan’s 2013 report on Chicago’s private equity investments did briefly mention the firm’s business with BNY, but pension trustees interviewed by IBTimes said they were unaware of the relationship.

At the February meeting, Callan also did not mention any of the ongoing legal issues related to BNY Mellon and its performance as a custodian for pension funds, even though the bank was just then the subject of law enforcement scrutiny. Indeed, one month after Chicago’s gave BNY the deal for custodial services, BNY agreed to pay $714 million to settle claims against it for bilking its pension fund clients by manipulating the rate at which pension funds’ currency holdings are traded internationally.

U.S. Attorney Preet Bharara, who brought the federal charges against BNY, said at the time that public pension funds "trusted the bank to be honest about the financial services it was providing and to deal with them fairly.” But, charged Bharara, BNY "and its executives, motivated by outsized profits and bonuses, breached this trust and repeatedly misled clients” about the currency rates they were charging their clients. Specifically, prosecutors said, the bank got the best currency exchange “rates for itself, gave its customers the worst or close to the worst rates, and kept the difference for itself.”

The federal investigation and lawsuit had been ongoing since 2011 but went unmentioned by Callan in its recommendations. At the time of the settlement, the New York Times reported that a BNY Mellon employee had been quoted in an email asking if it was “time to retire after raping the custodial accounts.”

The $714 million paid by BNY Mellon is negligible, however, compared with estimates provided by investigator Harry Markopolos, who first blew the whistle on the scam in 2011. In an interview with King World News, reported by Business Insider, Markopolos placed the scale of damages far higher -- at more than $2 billion. 
IBTimes asked Chicago teachers pension staff members if they had been informed about Callan’s conflict of interest with BNY Mellon and if they are concerned that such a conflict may have encouraged Callan to avoid mentioning the problems surrounding BNY’s custodial services. The fund’s executive director, Charles Burbridge, said that he has “not had the opportunity to look into the issues."

BNY Mellon declined to comment in response to questions from IBTimes. In a statement in March, the bank declared that it is pleased to put the “matters behind us, which is in the best interest of our company and our constituents.”

Finance experts question whether pension funds should continue to trust their money with BNY Mellon.

“It's hard to see how any fiduciary can keep doing business with BNY Mellon after these revelations,” Susan Webber, principal of Aurora Advisors, a financial consulting firm, said. “BNY Mellon flagrantly misrepresented its foreign exchange trading practices to customers. Consistently reporting the worst or nearly the worst price of the day to clients means the bank was stealing.”

For Siedle, the former SEC attorney, Chicago’s relationship with its consultant and decision to deposit retirees’ money in BNY is a cautionary tale that should prompt action.

“With the nationwide attack on defined-benefit pensions,” he said, “it is now more urgent than ever that Chicago teachers and other pension funds across the country launch independent investigations into how conflicts of interest have affected their portfolio.”
Ted Seidle, the pension proctologist, is absolutely right, now more than ever U.S. public pension funds need to scrutinize their relationships with external consultants, hedge funds, and of course private equity and real estate funds. They all want a piece of that multibillion dollar public pension pie but trustees need to uphold their fiduciary duty and make sure they're is proper alignment of interests.

As far as BNY Mellon, they were caught overcharging pension funds on foreign exchange transactions but I've got news for you, this type of stuff goes on all the time especially in unregulated currency markets. Big banks and custodians are always trying to screw their clients on F/X trades and to a certain degree, clients know this and allow it (there is a certain give and take in F/X markets but banks and clients need to be reasonable or else they get a very bad reputation and nobody will trade with them).

But as far as Callan Associates, one of the big consulting shops in the U.S., it should have disclosed that BNY pays Callan for both general consulting services and financial education programs. Failure to disclose this is grounds for termination of its contract with Chicago's pension fund.

When I was investing in hedge funds a long time ago, I'd always use a legal side letter to cover ourselves as much as possible from operational risk or any other negative surprises. Even then, it wasn't always foolproof.

I'm shocked at how sloppy some contracts are nowadays. It should clearly stipulate that failure to disclose serious conflicts of interest will mean termination of a contract and heavy fines and penalties.

Importantly, these conflicts of interest aren't just going on in Chicago, they're going on all over the United States where lack of proper pension governance means the entire public pension fund system is vulnerable to investment consultants fraught with conflicts of interest.

Of course, some consultants are better than others and are offering truly independent and outstanding advice, but for the most part it's been and continues to be a miserable failure and it's costing these U.S. public pensions billions in performance and fees.

And Chicago's pension woes don't end with consultants' conflicts. A report recently uncovered that teacher pension perks are not uncommon across Illinois:
Hundreds of school districts across Illinois cover either all or most of their teachers’ retirement contributions.

The issue is in the spotlight as Illinois’ largest district is in the middle of tense contract negotiations and the cash-strapped district is seeking help from legislators.

The Chicago Tribune reports thousands of teachers get a better deal than Chicago teachers.

Some districts, including in suburban Wheeling, say picking up pension costs helps keep them competitive. Some unions have also argued it’s a cost saver because if the money was paid as a salary it would be subject to payroll tax.

Mayor Rahm Emanuel wants teachers to pay the full contribution. The cash-strapped district has paid most of the 9 percent contribution. The Chicago Teachers Union argues that amounts to a pay cut.
I have a question for these public-sector unions: what planet do they live on? Have they not heard of shared risk for their pension plan? They should follow Ontario Teachers' Pension Plan and implement it immediately along with the governance that has allowed it to become one of the best pension plans in the world.

As far as Illinois, it's a pension hellhole and I don't just blame the unions for this sorry state of affairs. Just like in other states, its government has failed to top up its public pensions, which is why pension deficits keep growing. Record low interest rates aren't helping either and wait till deflation hits pensions and decimates them.

Below, the market's dramatic selloff was difficult and uncomfortable but merely "choppy seas" for long-term investors. Chris Ailman, CIO of the California State Teachers' Retirement System (CalSTRS), recently spoke on CNBC stating "we're going to ride this out." They don't have much of choice but listen to his comments as to why the long run is the only thing that matters for pensions.

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