Testimony Before the ERISA Advisory Council
Working Group on Select Issues of a Procedurally Prudent
President & CEO
Fiduciary Counselors Inc.
Good morning. I’m Nell Hennessy, President & CEO of Fiduciary Counselors Inc., a
registered investment adviser that acts as independent fiduciary for ERISA plans. Thank
you for the invitation to testify to the Working Group about prudent fiduciary procedures
for defined benefit plans and for participant-directed defined contribution plans that
utilize the “safe harbor” of ERISA §404(c) (“404(c) Plans”).
As I understand it, the Working Group this year is focused on two questions:
• Whether defined benefit plan investment policies, strategies, and monitoring
effectively show the timing and distribution of cash flows and the payment of
• Whether investment options, participant education as to the investment options
and the ability to change the investment options are properly and effectively
communicated in participant-directed plans.
I’m going to focus my remarks primarily on the defined benefit issues, but I will touch on
some of the issues you raised with respect to 404(c) Plans.
Investment Policies. Almost all defined benefit plans of any size have an investment
policy. The function of an investment policy for a defined benefit plan is generally to
identify the long-range asset allocation strategy for the plan and criteria for selecting and
evaluating investment managers or investment funds. The long-range asset allocation
strategy may or may not be tied explicitly to the timing of benefit payment cash flows.
However, fiduciaries in setting their investment policies take into account the liquidity
needs of the plan to pay benefits in the near term.
Increasingly, defined benefit plan fiduciaries have been shifting from a strategy
designed to achieve a particular rate of return to an investment strategy that takes into
account asset-liability modeling to achieve an asset mix that is likely to minimize
volatility in funded status. The recently-enacted Pension Protection Act is likely to create
additional pressure to shift assets away from equities to bonds. This is likely to reduce
volatility in funding but at the expense of the long-term returns. After the United
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Kingdom adopted similar legislation, U.K. pension schemes shifted their asset allocations
towards bonds and away from equities. This increased demand for long-duration bonds to
defease liabilities drove bond yields down.
In the debate over the Pension Protection Act, Administration officials indicated that
pension plan fiduciaries have been “gambling” by investing in equities and suggested that
they should behave like insurance companies, which are required by law to invest in debt
instruments. Based on this rhetoric and the volatility created by the new funding rules,
pension fiduciaries are likely to respond by shifting toward bonds and other liability-
driven investment strategies (“LDI”). LDI strategies typically involve matching liabilities
with bonds using interest rate swaps and other synthetics to increase the duration of a
plan’s bond portfolio.
Like all fads, this one comes at a cost. Over the long-term, stocks consistently
outperform bonds. Earlier this year, I looked at the Ibbotson data, which dates back to
1926. Over the last 80 years, equities outperformed high-grade bonds in all but three 20-
year periods; in 2 of them the difference was less than .4%. If large defined benefit plans,
with their long-term liabilities, can’t take prudent risks, who can? Whatever the
Department of Labor does, it should not force plans into asset liability matching of LDI
strategies that will reduce long-term returns.
Time horizons. Investment policies for defined benefit plans generally provide
time horizons for evaluating investment performance both for choosing new managers
and in monitoring existing managers. Investment performance is generally compared
over 3-, 5- and 10-year periods by comparison with managers with similar investment
objectives and styles. This performance is used as a screening mechanism to identify the
pool of potential managers, whose performance is then examined more closely to select
new managers, or to identify existing managers who should be put on a watch list. These
quantitative measures are usually combined with a qualitative analysis of the managers,
investment strategies and particular investments. Different investment strategies go in
and out of favor, perform better or worse in different market cycles, or take longer
periods to pay off. Thus, a manager might be placed on a watch list based on comparative
performance during a pre-determined period specified in a plan’s investment policy but
still be retained by that plan because the plan’s fiduciaries determine that the manager’s
strategy is likely to pay off in the long run.
Fees. Performance is generally measured net of management fees since that is
what the plan earns. Comparing fees alone may be misleading, since higher fees could be
justified by higher performance. By comparing net return, plan fiduciaries can evaluate
whether they are likely to be getting their money’s worth.
Disclosure of performance net of investment fees is particularly important in
participant-directed plan since the participants have to make those decisions. In the
respect, the simplified fund prospectuses permitted by the SEC are more effective than
the traditional long-form prospect, in part because few participants are likely to read the
legalese in the traditional prospectus. Laying this information out in easy to compare
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fashion, which most large plans do, assists participants in making decisions among the
investment options in their plans.
Alternative investments. Alternative investments are certainly appropriate for
large defined benefit plans with sophisticated investment personnel or outside advisors.
The term “alternative investments” covers a wide range of very different asset
classes including real estate, venture capital, private equity funds, distressed debt, timber,
oil & gas, LBOs, commodities and hedge funds. Some alternative investments involve
clear investment strategies (e.g., real estate, timber, oil and gas, distress debt). Others
cover such a broad spectrum that they can only be understood by examining the
underlying assets in the investment vehicle. For example, commodities include both
physical commodities (crop futures, fuel futures, metal futures, chemical futures) and
financial instruments such as bond futures and currency futures. The term “hedge funds”
has been used to describe so many different investment strategies that it has now lost its
original meaning and come to refer to any unregulated investment vehicle. In discussing
the recent collapse of the Amaranth hedge fund, because of large commodities losses, a
seasoned commodities dealer was quoted as saying “The larger ramifications is that
people should stay out of hedge funds unless they can stay very close to them and watch
them closely.” While this same advice could be given about most investments, the
unregulated nature of many alternative investments makes them particularly dangerous
for unsophisticated plan fiduciaries.
Which ‘alternative investments’ are acceptable ERISA investments for defined
benefit plans? All of them are appropriate strategies if properly managed as part of a
diversified portfolio. One danger is the lack of transparency so that plan fiduciaries do
not have access to information about the underlying investments. Another danger is the
risks in unregulated or less regulated markets may not be understood in the same way that
the risks of diversified stock and bond portfolios are understood.
Which ‘alternative investments’ are acceptable ERISA investment options for
participant-directed defined contribution plans? Probably few of them, given the lack of
investment sophistication of most participants. Real estate and distressed debt are seen in
larger funds. Other alternative investments, particularly those limited to sophisticated
investors, should not be included in the line up for participant directed unless the
participants are sophisticated investors. Alternative investments certainly could play a
role in a balanced option, where there the investment manager is making the investment
decisions and understands the risk/reward trade offs.
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