Who Needs Placement Agents, Anyway?
There really is no place in the pension boardroom for mercenaries.
Two weeks ago my column discussed the CalPERS governance scandal featuring $33,000 in reported campaign contributions to board members from a hired huckster who was paid $70 million for his glad-handing with the trustees and the former pension CEO.
Since then, the state treasurer and controller have scrambled with top fund officials to provide air cover for culpable board members by drafting legislation that would require "placement agents" to register as lobbyists. The board president has now endorsed this approach, which would include a prohibition on contingent fees (percentage-based payments for successful sales similar to class action and tort attorneys' fees). This week, the CalPERS board approved a policy to require disclosure of placement-agent fees by investment managers and also their campaign contributions.
Although these are positive steps, it's not enough. Until there are prohibitions on pension marketers making campaign contributions to board members and strict controls on contributions to anybody else involved in pension governance, the trustees can profit from their decisions to hire investment advisors. Requiring them to get a lobbying license almost makes it a laughable exercise unless there are explicit prohibitions embedded in the law. Otherwise the law would become a "license to steal."
Board members who accept such payola should be disqualified for voting on any issue that involves a campaign contributor and on any investment or contract/vendor decision remotely related. The proposed CalPERS legislation should include a provision similar to that as well.
Freedom of speech vs public interest: New York's approach. I realize there are constitutional issues regarding freedom of speech that make the campaign-contribution issue tricky. Part of the CalPERS governance problem stems from a prior court case on this issue. However, New York Attorney General Andrew Cuomo has crafted a bill that would limit campaign contributions by a qualified voter to a candidate's campaign to the $300 level -- what average people contribute as voters. That would be a reasonable place for California to start. I wouldn't worry that a qualified voter could buy favors on the pension board with a $300 contribution to the state treasurer. There are too many fish in the sea for that amount to make a splash.
In my previous column, I drafted public policy language that could curb these abuses through legislation or constitutional amendments. Knowing that legislative and electoral reforms are difficult to achieve, I spent the last two weeks thinking of other ways to achieve the same objectives. For public pension plans that want to pro-actively cure this cancer, here are some simple policy actions that could prevent the kinds of abuses that CalPERS has reportedly experienced.
1. Adopt a stiff internal code of ethics with sanctions. For instance, pension trustees who accept gifts or campaign contributions from retirement system investment advisors or service providers should be disqualified from office or suspended from voting on service providers. The code of ethics can also preclude trustees from meeting with service providers or their agents on an individual basis. This would require trustees and administrators at conferences to alert vendors that they are subject to such limitations, which is more difficult to do but can be accomplished. Of course, those vendors would have to register as lobbyists and in doing so would be notified of their obligation to refrain from individual persuasion and entertainment.
If necessary, I would design a "Don't lobby me" button for trustees to wear at pension conferences. Trustees will play less golf at the expense of private marketeers, and their dinners will be more general-purpose rather than the traditional hideaways reserved by marketeers for private wining-and-dining. Conference organizers will need to develop a new business model that relies less on vendor payments to gain access to individual trustees.
Yesterday, the CalPERS board president announced a proposal to adopt sanctions that could include censure for board members who violate a code of conduct. It's not clear from the media reports if his proposal would bar a member from voting, but I applaud his initiative as a welcome sign that he's now listening to the national chorus of criticism the CalPERS scandal has drawn. Other pension boards should discuss similar sanctions.
2. Provide a business code of ethics. There should be restrictions on activities by the investment advisors and service providers, restrictions that they must accept as an addendum to their engagement contract. This way, they would be compelled to terminate their engagement if the firm, its employees, its partners, or its agents make campaign contributions or violate other sections of the code. Hiring former employees or trustees would be prohibited for a specific time period.
3. Limit compensation for public-fund sales. There should be limits on sales commissions and third-party compensation to avoid the outrageous finder-fee stench of current practice. The California bill's prohibition against contingent compensation has merit, but it would create an un-level playing field that favors those working as inside salespeople. What we need here is moderation in the private sector with public trustee oversight.
I'd suggest an aggregate limit on non-salary or non-retainer compensation of 15 percent of first year revenue (advisory fees) with no more than 3 percent of revenue in excess of $500,000 (CPI adjusted) for variable, sales-driven compensation and an absolute dollar cap at something like $199,000 per engagement(and less in smaller plans). That still rewards a skilled marketer for presenting the advantages of an investment product to a large fund, but would immediately rule out the kind of flagrant largess and abuses that CalPERS allowed.
The code should also preclude subsequently linked salary increases, general bonuses, profit-sharing, deferred compensation or follow-on retainers of more than 1 percent of revenue to be paid in later years. Compensation in excess of an excessive-payments threshold level for all individuals and third-party firms involved in marketing the account should be disclosed in private files that are held by the general counsel of the pension fund. This would assure confidential compliance with a reasonable total compensation level that each fund should establish. The full board should appoint a special review committee to examine these reports annually and report on compliance on a confidential basis. Excessive compensation should be penalized through refunds to the fund.
This kind of due diligence should be expected of every public pension fund with substantial assets. Investment consultants and professional associations can assist the trustees in developing these policies and setting appropriate limits.
4. Park the marketers with the investment consultant. To my way of thinking, third-party marketers ("placement agents") serve no real public purpose when they lobby individual trustees, the board or its investment committee. In the first place, placement agents don't usually fiddle with small municpal plans. They don't have sufficient assets or sophistication to even consider high-profile investment strategies that are commonly used by the jumbo pension plans. The private-equity and hedge fund firms, for instance, serve only the larger public pension plans. Meanwhile, the large pension plans retain professional consultants to help them screen vendors. So why on earth is it necessary for legitimate and competent investment advisors to a pension fund to hire a mercenary? All they need to do is to get in the door with the investment consultants whose business models require independence -- and cannot survive in this business if they sell favors to investment advisors.
The larger investment consultants -- the same firms that typically serve the larger public pension funds -- already have extensive staffs that research the alternative investment world, private equity, hedge funds, and other specialty advisors. Competent investment firms should be able to tell their story to the independent consultants, and if they pass muster professionally on the basis of their record and their organizational capabilities, they can then advance to the finals for board consideration.
Thus, the rules governing marketing should be pretty straightforward: Allow marketers to interface with the independent consultants (and possibly the internal investment staff) in pitching their firm's or a client firms' services. But the marketing should stop there. At the internal staff level, the marketing interface should be "just the facts, ma'am" and informational rather than promotional. Once the consultant has recommended consideration of that firm, then the presentations to the full board or its investment committee should include only the portfolio manager(s), the service team leader, and one of the firm's principals. Why do we need marketers at those meetings, when the primary interest and obligation of the decision-makers is to gather facts and not marketing spin?
Having sat on both sides of the table at finals presentations for 25 years, I can tell you that there is really no value added to the analytical process from marketeers that cannot be delivered by the key players I have identified above. And my perspective is shared by others who've watched this problem fester. Here's a recent quote from the Los Angeles Times in its summary of CalPERS problems: "'The fact of the matter is that investment-products salesmen should not be meeting the board members,' said Dave Elder, who chaired the California Assembly's public employees committee for a decade until retiring in 1992. Salespeople, he said, 'need to be meeting the investment staff. If the investment staff screws up, they can be fired.' "
5. Cut costs with tighter procedures. The third-party marketers have formed a self-interested association and hired their own lobbyist to promote their business model before the Securities and Exchange Commission and various state authorities. They won't like my proposals, which will cut their compensation dramatically. Nor will the high-end, pension-fund salespeople who collect fat commissions on sales under the current system. But if you ask the business managers and owners of the companies these folks represent, they all agree that marketing is a zero-sum game at the industry level.
The ever-higher spending on sales compensation to achieve competitive advantage is a deadweight cost on the investment industry, and can be reduced materially by the policies I have suggested above. I cannot name a single investment advisory business manager who would object to reform of the marketing protocols and a limit on sales-based compensation at the industry, state or plan level. Most of them would cheer the idea, although some will quibble about the details.
All it takes is a board resolution to make this happen. If trustees are reluctant to adopt such measures on pure principle, they should engage an expert to help them calculate the dollar savings to their plan of changing the business model and adopting a strict code of ethics. Once trustees see the numbers, the decision should be easy to make.
Pension and benefits professional associations should beef up their model codes of ethics and best practices for governance. Details need to replace platitudes. Trustees need concrete guidance. The International City/County Management Association does a superb job of providing concrete guidance and illustrations by supplements to its professional code of ethics, and a similar approach could benefit the pension community.