Litigation against pension sponsors and managers is skyrocketing, and some think it may be only the tip of the iceberg.
Such is the momentum that the president of Pension Governance LLC, Susan Mangiero, this week is launching pensionlitigationdata.com, a Web site that will contain information on the 1,500 lawsuits currently pending against those managing and overseeing pension plans. "We're adding about 300 new cases each quarter," Ms. Mangiero says. "More than 90% of these cases allege fiduciary breach, meaning that decision-makers are accused of not doing their job properly."
Combined with the increased amounts of money being poured into alternative investments by pension plans, college endowments, and other not-for-profit organizations, the development of new accounting standards and a possible change to allow individuals to sue pension funds is causing high anxiety among those who have the ultimate responsibility for these funds ó and rightly so. The insidious spread of the subprime mortgage debacle is bringing this simmering issue to a boil. The American Institute of Certified Public Accountants issued an interpretation in summer 2006 that for the first time held fund trustees and executives, not their consultants or managers, responsible for the contents of their portfolios. That is, the fund sponsor was ultimately expected to understand, and to sign off on, the fund's investments, to agree with the valuation methodology, and to monitor the investments.
Some liken this shift in responsibility to the requirements under Sarbanes-Oxley that the CEO personally sign off on company financial statements. On the one hand, it is absurd to think that the CEO has himself investigated every number presented on the income statement. On the other, the authorities wanted to make it plain that he is ultimately responsible. Really, how many corporate pension fund officials have any idea how collateralized debt obligations should be valued, or what a mortgage-backed security is worth? "The reality is that the fiduciaries don't have the education or the experience to understand or to look behind the numbers," litigator Stephen Rosenberg of the McCormack firm in Boston says. Without a doubt the spreading subprime mortgage debacle will spotlight this mismatch of talent versus accountability. Across the country, investors of all stripes are realizing that investments they thought were risk-free have embedded subprime exposure.
Consider the story last week about the run on a state-managed investment fund (called Local Government Investment Pool) in Florida. Local government entities were in effect storing excess tax revenues in this fund, which purportedly invested the money in low-risk, short-term money market instruments. However, it turned out that some of the money was in short-term debt backed by mortgages, and had been issued by the kind of off-balance-sheet vehicles that today are unable to secure financing, and are therefore in serious trouble.
The investors in the fund, which included school boards and county governments, started to pull their money out of the fund, only to have it closed down by state officials who evidently were concerned about its solvency. This situation is by no means unique. The point is that numerous investors will no doubt find many banks and money mangers to sue once the dust settles on the subprime crisis, but for the first time, the tables will be turned. The pension plan sponsors, who historically have been eager to jump on companies and money managers that have failed to live up to expectations, will now be on the front line.
Historically, individuals were not allowed to sue pension funds, but the Supreme Court recently heard arguments that might lead to this approach being overturned. Because firms specializing in class-action lawsuits have historically made their living by representing pension funds in suits against money managers, they have been reluctant to sue the plan sponsors themselves. A matter of knowing which side the bread is buttered on.
However, that could change if the Supreme Court finds in favor of James LaRue, the plaintiff in the suit recently argued before the justices involving mismanagement of his 401(k) plan.
For Wayne Miller, head of Denali Fiduciary Management, which consults with industry on retirement plan governance, this new accountability is way overdue. Denali provides corporations with a training course in fiduciary responsibility, an area Mr. Miller says is woefully underserved. Mr. Miller is not complimentary about most corporations' attitudes about their pension programs. He says most don't pay enough attention to the funds' management, in part because the people in charge of overseeing the funds are protected by fiduciary liability insurance.
Indeed, such insurance exists and has increased steadily in price, reflecting the anticipated surge in litigation. According to Advisen Ltd., a New York firm monitoring such data, premiums have increased to .03% of plan assets for a midcap company last year, from .012% of assets in 2002.
"Everybody in the game is protected except the pensioner," Mr. Miller says. He says he sees frequent instances of conflicts of interest, as well as good old-fashioned incompetence.
"A lot more sunshine needs to be shed in this area," Mr. Miller says. "We thought the Enron collapse would have more of an impact, but it has not."
This increased accountability could dampen institutional enthusiasm for alternative investments. The prospect of higher returns has encouraged endowments and pension funds to raise the portion of their assets invested in private equity and hedge funds in recent years, fueling the growth of those industries. As the risk profile of some of these investments becomes more obvious, such institutions may think twice about further increases. Those in charge have arguably taken on greater risk in making these commitments, as such investments are often less easy to value and more complicated. In a piece published by Moody's Investors Service last March, the author noted that "the appropriate commitment of resources to manage alternative investments, in terms of cost, time and expertise, may be beyond the capacity of some smaller endowments."
Until now, the risk/return tradeoff has been mainly theoretical. As the losses in mortgage-related securities increase, and blame is put on those responsible for the funds, the balance becomes personal.