How Consultants Can Retire on Your Pension

By Gretchen Morgenson and Mary Williams  Walsh, New York Times

Nine years ago, William Keith Phillips,  a top stockbroker at Paine Webber, met with  the trustees of the Chattanooga Pension Fund  in Tennessee to pitch his services as a consultant.  He gave them an intriguing, if unusual, choice.  They could pay for his investment advice directly,  as pension funds often do, or they could save  money by agreeing to allocate a portion of  its trading commissions to cover his fees.  Under a commission arrangement, Mr. Phillips  told the trustees, the fund would be less  likely to incur out-of-pocket expenses, leaving  more money to invest for its 1,600 beneficiaries.

Seven and a half years later, Chattanooga's  pension trustees discovered just how expensive  that money-saving plan had been. According  to an arbitration proceeding they filed against  Mr. Phillips, the agreement cost the fund  $20 million in losses, undisclosed commissions  and fees. And since 2001, Chattanooga has  had to raise nearly $3.7 million from taxpayers  to keep the $180 million fund fiscally sound. 

The Chattanooga trustees fired  Mr. Phillips in 2003 and, last October, filed  arbitration proceedings against him, UBS Wealth  Management USA, formerly the Paine Webber  Group, and his new firm, Morgan  Stanley. The case, which is pending, accuses  the consultant of, among other things, fraud  and breach of fiduciary duty. The commission  arrangement was central to the problem because  it put Mr. Phillips's interests ahead of his  client's, the fund said in its complaint. 

"The very important and in many ways  unique relationship that a pension fund board  has with its consultant is based on trust,"  said David R. Eichenthal, finance officer  and chairman of the general pension plan for  the city of Chattanooga. "To the extent  that Phillips breached that trust, we thought  it was important for the pension fund to do  everything possible to hold him accountable  for the results."

Pension experts say the Chattanooga case  is hardly rare among retirement funds. The  Securities and Exchange Commission is concerned  enough about conflicts of interest among consultants  who advise pension funds on asset allocation,  selection of money managers and other investment  matters that it is conducting an industrywide  inquiry. The results of the S.E.C.'s investigation  are expected soon, and enforcement actions  may follow.

Aubrey Harwell, a lawyer for Mr. Phillips,  declined to make him available for this article.  Mr. Harwell said: "No. 1, these are allegations  and not proven facts. And No. 2, the performance  during the days that Keith Phillips was consulting  were well beyond the benchmarks." Details  of the commission arrangement, he added, were  fully disclosed to the pension fund. But this  is not the first time a pension client has  sued Mr. Phillips. In 2000, the Metro Nashville  Pension Plan filed an arbitration based on  similar accusations. That arbitration was  settled two years later, with UBS paying $10.3  million to the pension fund.

As financial services conglomerates have  added a wide array of operations in recent  years, the possibility of conflicts of interest  has also grown. And nowhere are the conflicts  more potentially lucrative - and more obscure  - than in the management of pension assets. 

"Recommendations to pension funds regarding  asset allocation, money manager selection  and securities brokerage policies are frequently  driven by undisclosed financial arrangements,"  said Edward A. H. Siedle, president of Benchmark  Financial Services Inc., in Ocean Ridge, Fla.,  and a former lawyer for the S.E.C. "Pensions  often accept that poor investment performance  is attributable to unfortunate investment  assumptions when, in fact, more sinister forces  were at work. Investment performance often  is compromised as the result of conflicts  of interest, undisclosed financial arrangements,  excessive fees and fraud."

An estimated $5 trillion sits in thousands  of pension funds across the nation, run for  the benefit of private company, state or municipal  workers who rely on the funds for retirement  income. Some funds are huge, with billions  of dollars under management, and are overseen  by a board of finance professionals. Many,  however, are tiny, with just a few million  dollars invested. These funds are often run  by volunteers less versed in the ways of Wall  Street.

Pension fund boards typically hire a consultant  to advise them on investment strategies and  the hiring of money managers. Problems can  crop up when these pension consulting firms,  which have a fiduciary duty to the fund, put  their own interests first.

Just as pension funds come in many sizes,  so, too, do the consulting firms that serve  them. Some are one-person operations while  others work within a large financial-services  firm. Among the biggest companies in pension  consulting are Mercer Inc., a unit of Marsh  & McLennan, and Callan Associates, a privately  held company based in San Francisco.

In recent years, however, Wall Street firms  have played an increasingly large role in  the world of pension consulting. Merrill Lynch,  Smith Barney and Morgan Stanley are all big  in this field.

The potential for conflicts is greatest at  firms with brokerage or trading operations,  pension authorities say, and it almost always  involves how the consultants are compensated. 

The trouble is, much of a consultant's pay  can be hidden from view. The Chattanooga complaint  said Mr. Phillips and his colleagues controlled  and manipulated the information given to the  pension board, keeping it in the dark about  excessive fees and conflicts inherent in the  recommendations they made to the fund. Mr.  Phillips's reports on the pension fund's performance  were misleading, the complaint said, because  they did not take into consideration all of  the fees and commissions it paid.

Only when the Chattanooga board began considering  rival consultants to advise it in 2002 did  Mr. Phillips acknowledge the conflicts of  interest in his previous arrangement with  the pension fund, the complaint said. Arguing  that the Chattanooga board should keep him  on, Mr. Phillips said that under a new agreement  conflicts would be removed, according to the  complaint, and that there would be "full  and fair disclosure of all brokerage practices  and relationships." Money manager recommendations  would be "based upon performance rather  than revenue," he said, according to  the complaint.

Mr. Phillips ultimately lost the Chattanooga  account to the Consulting Services Group of  Nashville, an independent consultant with  no brokerage firm operations.

A spokesman for UBS said that the firm believes  the case has no merit. "We are defending  ourselves vigorously," he said.

A Morgan Stanley spokeswoman said: "The  Chattanooga Pension Board was a sophisticated  and knowledgeable investor that was advised  by its own counsel about all aspects of its  relationship with us. Morgan Stanley acted  properly and is confident that the board's  claims will be rejected by the arbitrators." 

The compensation of consultants is so complex  because it can come from many sources. "There  are more ways for people to be compensated  in the financial business than most people  realize," said Joseph Bogdahn, principal  of Bogdahn Consulting L.L.C., an independent  consultant in Winter Haven, Fla. "The  only way that you can determine if your consultant  is truly independent is to audit their tax  returns and their financials."

Mr. Bogdahn said he recommends that pension  fund trustees ask their consultants to open  up their books to show how they are paid,  and by whom. He says he makes his financial  statements available to his clients.

Because they have a fiduciary duty to their  clients, consultants are required to disclose  any potential conflicts of interest in their  operations. But when they have affiliations  with firms that conduct trades for the pension  funds they advise, these relationships can  undermine the fiduciary duty. Some consultants  try to get around this by hiring money managers  who agree to direct their trades through the  brokerage firm with which the consultants  are affiliated.

Arrangements like the one in Chattanooga  are the most common method used by pension  consultants to ensure that commissions will  go to them. In their contracts, they require  the pension funds to pay their fee through  commissions on trades steered to their brokerage  units. This is known as directed brokerage,  commission recapture or a soft-dollar arrangement.

Ultimately, pension experts say, the commissions  steered to the brokerage firm in such an arrangement  are often worth far more than the upfront  fee that is typically quoted by the consultant  for his services. Pension fund trustees do  not always receive a full accounting of the  transactions and the commissions they generate.  So the trustees do not know how much more  they are paying as a result of the arrangement. 

For example, during its years with Mr. Phillips,  Chattanooga wound up paying his firm $2 million  in commissions and cash payments, an average  of $270,000 annually. If it had paid the upfront  fees quoted by Mr. Phillips, the fund would  have paid $154,000 a year, on average, the  lawsuit said. As a result of the commission  arrangement, Mr. Phillips and his colleagues  misappropriated more than $870,000 in undisclosed  and unjustified fees, according to the complaint. 

When consultants steer trades to a particular  firm, a pension fund can pay dearly in other  ways, too. Money managers are supposed to  provide best execution - the most favorable  price - on their clients' trades. But when  a brokerage firm is guaranteed to receive  most or all of a fund's trades, it need not  work as hard on the execution of those trades  as a firm that is competing for the business.  Execution costs can skyrocket.

A letter sent to a public pension client  last January by Rittenhouse Asset Management  Inc., a money manager in Radnor, Pa., described  the matter succinctly: "Because we trade  through your advisor, we have not selected  broker-dealers or negotiated commission rates  for your account and cannot actively ensure  that directed brokerage terms are in your  continuing best interests. Although cost is  only one component of best execution analysis,  many directed brokerage accounts pay effective  rates of commissions that are higher than  client accounts that do not have directed  brokerage arrangements."

Rittenhouse said it made this disclosure  because industry practices were changing and  the firm wanted to remind its clients of their  specific arrangements.

The potential for conflicts is driving some  pension fund trustees to switch to independent  consultants who have no brokerage firm affiliations  and are therefore not tempted to ask money  managers to steer trades to them. Michael  Brown is a battalion chief of the fire department  in Dania Beach, Fla., and a member of the  police and fire pension board; the funds had  $22.6 million in assets as of last December.  For many years, the board employed Merrill  Lynch Consulting Services in Jacksonville,  Fla., as its pension consultant. But earlier  this year, the board replaced Merrill with  an independent consultant that did not have  a brokerage unit in its operations.

"I think they did a good job,"  Mr. Brown said, referring to Merrill. "But  a lot of stuff had come out over the last  year with reference to your big corporate  money managers and consultants being at the  same company. We thought it would be a better  idea to have an independent consultant." 

Merrill Lynch Consulting Services in Jacksonville  counts almost 100 pension funds in Florida  as its clients. At the end of 2003, they included  the $80 million fire and police funds of Cape  Coral, the $40 million police fund of Fort  Myers, the $26 million police fund of Miramar  and the $27 million fire and police funds  of Vero Beach.

Pension consultants sometimes recommend that  their smaller clients buy mutual funds. What  a pension's trustees may not realize is that  their consultant can receive compensation  from the mutual fund companies on these trades. 

In 2000, at the advice of Merrill Lynch Consulting,  the city of Sunrise, Fla., put $10.4 million  of its pension assets into three international  mutual funds with similar stock holdings.  The pension fund bought shares worth $3.7  million in one fund, $3.1 million in the second  and $3.6 million in the third.

Merrill Lynch Consulting received commissions  of 1 percent on each purchase from the mutual  fund companies. But mutual funds often discount  their commissions on larger trades, so if  the fund had put all $10.4 million into one  of the international mutual funds, Merrill  Lynch Consulting would have received 0.69  percent.

"Sunrise, not Merrill Lynch, selected  the money managers from recommendations we  provided," said Mark Herr, a Merrill  spokesman. "During the five years we  provided consulting services, Sunrise finished  in the top quartile or quintile for results  when compared to its peers."

Brokerage commissions are not the only source  of revenue for many pension consultants. They  also receive payments from money managers  who attend annual conferences at luxurious  resorts set up by the consultants. The conferences  are billed as opportunities for money managers  to meet pension plan officials, but critics  describe them as pay-to-play mechanisms. They  contend that the money managers recommended  by consultants to pension funds tend to be  only those who paid to attend the conferences.

Earlier this year, CRA RogersCasey, an investment  consultant in Chicago, held two conferences,  one at the American Club in Kohler, Wis.,  near two famous golf courses, and the other  at the Kingsmill Resort in Williamsburg, Va.  Celebrities often appear at CRA RogersCasey  conferences: past speakers have included Gen.  H. Norman Schwarzkopf; James Carville, the  political consultant; and Robert B. Reich,  the former secretary of labor. The cost to  attend varies. At the conferences this year,  "new members" paid $40,000 while  return guests were charged $35,000 to $37,500. 

Money management firms that have attended  past conferences of CRA RogersCasey include  AIG Global Investment, Citigroup Asset Management,  Strong Capital Management, Putnam Investments  and Bear Stearns Asset Management.

Matt McCormick, director of marketing at  CRA RogersCasey, said that it would continue  to sponsor conferences. "Our clients  tell us that they add value," he said.  "They tell us they have a very good comfort  level that there is no impact or influence  on our independent advice."

Earlier this year, Mercer said it would stop  conducting conferences. Callan Associates  said it was continuing to hold its meetings.  "An important part of our business model  is educating all clients on their fiduciary  responsibilities," a Callan spokeswoman  said.

Pension consultants aren't the only ones  holding conferences where money managers can  hobnob with pension officials. Robert D. Klausner,  a lawyer at Klausner & Kaufman in Plantation,  Fla., whose firm provides legal counsel to  many pension funds in Florida and elsewhere  in the south, runs similar meetings.

Klausner & Kaufman's sixth annual client  conference was in March at the Hyatt Regency  in Fort Lauderdale, Fla. Among the eight companies  that paid to sponsor the 2003 conference were  Merrill Lynch and Davis Hamilton Jackson &  Associates, a money manager based in Houston  that Merrill often recommends to its pension  clients.

According to documents detailing the various  advisers to police and fire pension funds  in Florida, Mr. Klausner's firm provides legal  advice to 19 funds. Twelve of them employed  Davis Hamilton as a money manager, or Merrill  Lynch Consulting as a consultant, or both.  Mr. Klausner did not return calls seeking  comment.

Davis Hamilton appears often among the pension  fund clients of Merrill Lynch Consulting,  even though the firm has produced less-than-stellar  returns in recent years. Davis Hamilton has  managed the Lake Worth Police Officers' Pension  Fund, for example, and for the six years ending  in 2003, it beat its benchmark index only  one-third of the time. For the year ending  2003, the police fund's overall return, including  both stocks and bonds, ranked in the bottom  26 percent of the peer group used by Merrill. 

A trustee at a public fund in Florida, who  asked for anonymity because he feared reprisals  from the firms involved, said his fund is  advised by Merrill Lynch and has employed  Davis Hamilton. Although the money manager's  performance has been lackluster in recent  years, this trustee said Merrill Lynch continued  to recommend that the pension fund retain  Davis Hamilton. The trustee said he was concerned  that Merrill's support of Davis Hamilton had  to do with the fact that Davis Hamilton steers  "virtually all" of the pension fund's  trades to Merrill.

Davis Hamilton did not return calls seeking  comment. Merrill's spokesman said: "We  do not require any client or any manager to  direct its trades to us. The choice always  belongs to the client."

The Merrill spokesman added: "We don't  pay to play. We don't have conflicts of interest  that injure or work against our clients. We  fully disclose our fees face up on the table.  The only reason we do well is because we provide  excellent work for our clients."

Trustees of the city retirement system in  San Diego are in a battle over the practices  of Callan Associates, one of its consultants.  Diann Shipione, a volunteer trustee and a  financial adviser, has called for the consultant's  resignation because of payments Callan has  received from money managers it has recommended  to the fund.

For example, Ms. Shipione said, one of the  money managers recommended by Callan had only  two full years of experience and a performance  ranking in the bottom 30 percent of its peers  nationwide. Only after she questioned the  recommendation did it emerge that Callan had  a significant economic relationship with the  money manager, she said.

Callan's spokeswoman said the performance  of the San Diego pension fund spoke for itself.  For the five years ended Sept. 30, she said,  "San Diego was in the top 1 percent of  our public fund universe and was in the top  third in each of those five years." She  added that in a typical year, less than half  the investment managers recommended by Callan  were its clients.

But Ms. Shipione said: "These pay-to-play  practices are systemic. A consultant's advice  should come in the form of an objective recommendation,  but in reality it may be the result of self-serving  economic gain. Pension trustees need information  about the business of investment consultants  and their sources of revenue. It would at  least give us information with which to test  the consultant's objectivity."

Indeed, among the documents requested of  pension consultants by the S.E.C. in its investigation  are a full accounting of the compensation  received by consultants, not only from their  pension plan clients, but also from the money  managers they recommend.

Mr. Siedle, who investigates money management  abuses on behalf of pension fund clients,  said these funds could be easily defrauded  because they had no procedures in place to  detect and prevent wrongdoing. "The greatest  threat to pensions today is the widespread  unwillingness to confront the truth about  how investment firms have profited at the  expense of funds and take corrective action,"  he said.

Gary Findlay, executive director of the Missouri  State Employees' Retirement System, said his  organization had tackled the problem of conflicted  consultants by using a consultant that receives  no revenue beyond the direct fees it charges  the fund.

"Our consultant has no relationship  with a broker dealer and they sell no services  to money managers," Mr. Findlay said.  "One of the things that we rely on from  our consultant is to provide us with guidance  on the basis of undivided loyalty. Their interests  are aligned with our interests only, and I  do believe that's what it's all about."