W. Scott Simon
The staff of the U.S. Securities and Exchange Commission issued a report on May 16
titled “Staff Report Concerning Examination of Select Pension Consultants.” The U.S.
Department of Labor, in coordination with the SEC, issued a fact sheet on June 1
titled “Selecting and Monitoring Pension Consultants: Tips for Plan Fiduciaries.” I
suggest that those of you who are investment advisors to 401(k) plans read both
documents to help you better understand the shell game played by many pension
consultants.
Here’s how that shell game is played. Many pension consultants market their services
(e.g., identify plan investment objectives, allocate plan assets, select money managers
to manage plan assets, select mutual funds as plan investment options, monitor the
performances of plan money managers and mutual funds, etc.) to sponsors of 401(k)
plans with the hope of becoming the designated “gatekeeper” to a plan.
The gatekeeper designation is important to a pension consultant that has won it at the
expense of its competition because it allows the consultant to exact a “toll” from a
money manager (including mutual fund families and brokerage firms) that seeks to
provide, for example, the mutual funds for a 401(k) plan’s investment options.
That toll is composed of money and other forms of compensation paid by the money
manager to the pension consultant–compensation in addition to the explicitly stated
consulting retainer paid by the sponsor of a pension plan to the pension. In fact, the
disclosed annual consulting fee paid to a pension consultant by the plan sponsor often
pales in comparison to the undisclosed toll paid to the consultant by money managers.
(Sometimes when the tolls are particularly high, the consulting fee is totally waived,
which makes it appear that the consultant is providing its services for “free.”)
So what are the services that pension consultants provide and what makes them so
valuable that trustees and other fiduciaries of pension plans (ultimately, though, usually
plan participants and their beneficiaries) must pay so dearly for them? Two services
identified by the SEC report include 1) “selecting mutual funds that [401(k)] plan
participants can choose as their funding vehicles” and 2) “monitoring performance of
money managers and mutual funds and making recommendations for changes.”
The first of these services provided by pension consultants involves searches to find the
“best” mutual funds (or money managers) for sponsors of 401(k) plans. While many
plan sponsors will admit in private that such exercises provide very little value, they
nonetheless fork over large amounts of money to pension consultants to conduct them.
They engage in this behavior for the simple reason that it is behavior their competition
engages in. The pension consulting industry has done an excellent job at inculcating a
herd mentality, to its benefit, among plan sponsors. In reality, though, many pension
consultants are just expensive numbers gatherers and survey providers.
Far too many pension consultants are given an annual contract for, say, $100,000 to
run their computers for a few seconds to produce a spreadsheet that gives investment
performance versus a peer group and a benchmark. Four quarterly reports and some
meetings on why the funds and/or managers did what they did–and voila!. That just
about sums up much of the pension consulting business. Value added? It sure is
difficult to think so.
There is an alternative for plan sponsors looking to save either their own money or the
money of their participants. In the latter case, as fiduciaries of their plans under the
Employee Retirement Income Security Act of 1974 (ERISA), sponsors have a legal
obligation to avoid unreasonable expenditures of plan assets. For a paltry $125, then,
they could buy a Morningstar.com subscription (in the interests of full disclosure: I swear
that I am not a commissioned salesman for Morningstar) and assign some junior staffer
in the finance department to spend four hours each quarter producing reports to salt the
files with information. It would take about 20 minutes to teach someone how to do it.
The only really hard part would be formatting all the information to make it look pretty.
All in all, it could probably be done for less than $1,000 (instead of $100,000) with the
same results.
The second service identified by the SEC report that pension consultants provide and
that I have focused on involves “monitoring performance of money managers and
mutual funds and making recommendations for changes.” Along with searches for the
“best” funds and managers, monitoring is the bread and butter of a pension consultant’s
existence. But the very oxygen that allows a pension consultant to exist is style drift.
Style drift is a phenomenon that occurs when a money manager picks stocks that differ
in style from the manager’s stock-picking style. Suppose that the manager of an active
mutual fund specializes in picking growth stocks, but in its efforts to outperform the
market, picks some value stocks instead. The manager has “drifted” outside its stated
investment style and stated investment objective of the mutual fund that it manages. A
prominent example of this phenomenon involves former Fidelity Magellan FMAGX
mutual fund manager Jeffrey Vinik, who, in attempting to beat the market in 1996,
changed Magellan from being a growth-and-income stock fund into one that held 20%
bonds and 10% cash.
Vinik was forced out by Fidelity for his mistaken bet on the future direction of the
market. That “mistake,” though, also provided a field day for pension consultants. Since
Vinik’s style drift led Magellan to underperform its benchmark, such consultants advised
plan sponsors (as part of their monitoring “service”) to replace Magellan with other
funds, thereby potentially generating additional revenue for the consultants. (By the
way, the language in the prospectuses of many active funds allows fund managers
considerable discretion to hold investments that differ from their respective investment
styles.) Style drift is the primary justification for the existence of many pension
consultants. By taking away the possibility of style drift in an investment product (i.e.,
index funds and asset class funds), you largely take away the usefulness of (and
justification for) retaining such consultants.
The SEC report examined 24 unnamed pension consultants that are also SEC-registered
investment advisors. Under the Investment Advisers Act of 1940, any such
consultant is a fiduciary to its clients. According to the U.S. Supreme Court case of
S.E.C. v. Capital Gains Research Bureau, Inc., (375 U.S. 180 (1963)), the Advisers Act
“reflects a congressional recognition of the delicate fiduciary nature of an investment
advisory relationship, as well as a congressional intent to eliminate, or at least expose,
all conflicts of interest which might incline an investment adviser [e.g., a pension
consultant]–consciously or unconsciously–to render advice which was not
disinterested.” An advisor owes its clients a duty of “utmost good faith, and full and fair
disclosure of all material facts” as well as an affirmative obligation “to employ
reasonable care to avoid misleading clients.”
Undisclosed tolls paid by money managers to pension consultants that are then shifted
to, for example, participants in 401(k) plans are most assuredly “conflicts of interest
which might incline an investment adviser [e.g., a pension consultant]–consciously or
unconsciously–to render advice which was not disinterested.” Because trustees and
other investment fiduciaries of retirement plans such as 401(k) plans are fiduciaries
under ERISA, they must be on the lookout for this shell game that is played by far too
many pension consultants.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. The author’s views expressed in this article do not necessarily reflect the views of Morningstar.