As a follow-up to my January 12, 2017 announcement about retirement plan risk management education with the Professional Risk Managers’ International Association ("PRMIA"), I am delighted to announce a co-presenter for the March 2, 2017 learning event. Distinguished economist Dr. Lee Heavner will join me to talk about hedging techniques, the valuation of derivatives and structured products and the monitoring of investment-related risk as part of "Use of Derivatives in Pension Plans." Click here to read Lee Heavner’s impressive bio as a managing principal and financial expert with Analysis Group, Inc. Dr. Heavner and Dr. Mangiero have worked on multiple investment disputes and are the authors of "Economic Analysis in Fiduciary Monitoring Disputes Following the Supreme Court’s ‘Tibble’ Ruling" (Bloomberg BNA Pension & Benefits Daily, June 24, 2015).

Session Two will convene from 10:00 am EST to 11:15 am EST live this Thursday. If you cannot make it in real time, the event can be downloaded for later viewing. It is the second event of four CPE-qualified events. Speakers will examine risk management for retirement plans from both a governance and economics perspective. Topics to be discussed include the following:

  • Current usage of derivatives by retirement plans for hedging purposes;
  • Financially engineered investment products and governance implications;
  • Fiduciary duties relating to monitoring risks and values of derivatives and structured products; and
  • Suggested elements of a Risk Management Policy Statement.

Join us for this talk about an important issue – risk management for retirement plans!

I’m delighted to work with the Professional Risk Managers’ International Association ("PRMIA") in delivering four (4) educational webinars about retirement plan risk management. According to its website, PRMIA is a "non-profit professional association" with forty-five chapters in various countries around the world. Click to download the PRMIA brochure for more information about membership. I hope you will join us in February and March for what should be an exciting and timely quartet of live events. If you cannot attend in real time, the webinars will be archived for later use. See below for details.

           Lead Instructor: Dr. Susan Mangiero, AIFA®, CFA®, CFE, FRM®, PPC™

                               Thursdays from 10:00 – 11:15 am EST / 3:00-4:15 GMT
                                       February 23 | March 2 | March 9 | March 16

                                                     A Virtual Training Series

This series consists of four webinar lectures, each one delivered with the goal of providing actionable information that can be used by the audience right away.

With approximately $100 trillion in global assets under management, retirement plan fiduciaries and their attorneys and advisors face numerous challenges in the aftermath of the worldwide credit crisis that began in 2008. Market volatility, investment complexity and compliance with new accounting standards and government mandates, alongside a strident call for better accountability and transparency, are a few of the pain points that keep pension executives up at night. Litigation and regulatory investigations are on the rise. As a result, enlightened pension decision-makers are turning their attention to risk management technology and techniques as a way to mitigate economic, legal and operating trouble uncertainties. Those who ignore the adverse impact of longer life spans, statutory capital requirements, binding financial statement reporting rules and broader fiduciary duties are destined for trouble. In some countries, trustees may be personally responsible for poor plan governance and may have to pay participants from their own pockets.

Who Should Attend

This series should be of interest to a broad range of financial and legal professionals since poor governance and/or too few resources being devoted to pension risk management within a fiduciary framework can (a) force benefit cutbacks for participants (b) lead to a ratings downgrade which increases a sponsor’s cost of capital (c) force a plan sponsor to come up with millions of dollars (pounds, euros, etc.) in cash for contributions (d) result in a costly lawsuit and/or regulatory enforcement (e) thwart a merger, acquisition or spin-off and/or (f) cause a sponsor to be out of compliance with financial and statutory reporting requirements.

Both senior-level decision makers and staff members can benefit from viewing this series of webinar lectures. Representative titles of likely audience members include: • Directors of the board • CFOs, treasurers, controllers and VPs of finance • Members of a sponsor’s pension investment committee • Pension consultants • Pension advisors • Pension and securities attorneys • Pension and securities regulators • Rating analysts • Financial journalists • Derivatives traders • Executives with derivatives and securities exchanges • ERISA, municipal and sovereign bond and D&O liability insurance underwriters • International, U.S. federal and state lawmakers • Think tank researchers • Industry associations • Chambers of Commerce in various countries • Economists who cover demographic patterns and • Risk management students.

Session One (February 23, 2017): Establishing Risk Management Protocols for Defined Benefit Plans and Defined Contribution Plans

Session One examines risk management for retirement plans from both a governance and economics perspective. Topics to be discussed include the following:

  • Procedural prudence and the costs of ignoring fiduciary risk;
  • Risk management differences by type of retirement plan;
  • Industry norms and pitfalls to avoid;
  • Role of Chief Risk Officer, investment committee members and in-house staff; and
  • Suggested elements of an Investment Policy Statement.

Session  Two (March 2, 2017): Use of Derivatives in Pension Plans

​Session Two looks at how derivatives are used by retirement plans, whether directly or indirectly. Topics to be discussed include the following:

  • Current usage of derivatives by retirement plans for hedging purposes;
  • Financially engineered investment products and governance implications:
  • Fiduciary duties relating to monitoring risks and values of derivatives; and
  • Suggested elements of a Risk Management Policy Statement.

Session Three (March 9, 2017): Liability-Driven Investing and Other Types of Pension Risk Transfer Strategies

Session Three examines the reasons why the number of pension restructuring deals is on the rise, especially in the United States and the United Kingdom, and the type of transactions being done. Topics to be discussed include the following:

  • Nature of the pension risk transfer market and various approaches being utilized;
  • Regulatory considerations for fiduciaries in selecting an annuity provider;
  • Action steps associated with implementing a pension risk transfer; and
  • Case study lessons learned.

Session Four (March 16, 2017): Service Provider Due Diligence

Session Four looks at the growth in the Outsourced Chief Investment Officer (“OCIO”) and Fiduciary Management markets and explains service provider risk. Topics to be discussed include the following:

  • Fiduciary considerations of delegating investment responsibilities to third parties;
  • Risk mitigation practices for selecting and monitoring vendors such as asset managers and advisors;
  • Types of lawsuits that allege fiduciary breach on the part of third parties and related regulatory imperatives; and
  • Identifying warning signs of possible vendor fraud.

Fee: Fee includes access to all four live sessions (75 minutes each), access to the recorded session for 60 days, and digital program materials.

  • Sustaining Members: $355.00
  • Contributing Members: $395.00
  • Free/Non-Members: $465.00

Registration: You may register for this course by clicking on Register at the bottom of the page. For questions regarding registration please contact PRMIA at training@prmia.org.

Cancellation: A refund (less a 15% administration fee) will be made if formal notice of cancelation is received at least 48-hours prior to the date of the first session. We regret that no refunds will be made after that date. Substitutions may be made at no extra charge.

Important Notice: All courses are subject to demand. PRMIA reserves the right to cancel or postpone courses at short notice at no loss or liability where, in its absolute discretion, it deems this necessary. PRMIA reserves the right to changes or cancel the program. PRMIA will issue 100% of registration refund should cancelation be necessary.

CPE Credits: This webinar series qualifies for 6 CPE credits subject to certain rules about required attendance. Email webinars@prmia.org for more information about obtaining continuing education credits.

About the Presenter:

Dr. Susan Mangiero is a forensic economist, researcher and author. With a background in finance, modeling and investment risk governance, Susan has served as an expert on numerous civil, criminal and regulatory enforcement actions involving corporate retirement plans, government retirement plans, hedge funds, private equity funds, foundations and high net worth individuals. She has been engaged by various financial service organizations to provide business intelligence insights about what institutional investors want from their vendors. As founder of an educational start-up company, Susan raised capital from outside investors, created a fiduciary-focused content library and developed a governance curriculum for institutional investors and their advisors. Prior to her doctoral studies, Susan worked at multiple bank trading desks in the areas of fixed income, foreign exchange, interest and currency swaps, financial futures, listed options and over-the-counter options.

Susan Mangiero is a managing director with Fiduciary Leadership, LLC. She is a CFA® charterholder, Professional Risk Manager™, certified Financial Risk Manager®, Accredited Investment Fiduciary Analyst®, Certified Fraud Examiner and Professional Plan Consultant™. Her award-winning blog, Pension Risk Matters®, includes nearly 1,000 essays about investment risk governance and has well over a million views. She is the creator and primary contributor to a second blog about investment compliance at www.goodriskgovernancepays.com. Susan is the author of Risk Management for Pensions, Endowments and Foundations. Her articles have appeared in multiple publications such as RISK Magazine, Bloomberg BNA Pension & Benefits Daily, Corporate Counsel, American Bankruptcy Institute Journal, Mergers & Acquisitions, Business Valuation Update, CFO Magazine and the Journal of Corporate Treasury Management.

Susan has testified before the ERISA Advisory Council and a joint meeting of the Organisation for Economic Co-operation and Development (“OECD”) and the International Organisation of Pension Supervisors (“IOPS”). She lectured at the Harvard Law School and addressed groups such as the American Institute of CPAs (“AICPA”) – Employee Benefits Section, Financial Executives International, and the National Association of Corporate Directors. She can be reached at contact@fiduciaryleadership.com or followed on Twitter @SusanMangiero.
 

I am delighted to share my recent article with readers of this pension blog. Entitled "An Economist’s Perspective of Fiduciary Monitoring of Investments" (by Dr. Susan Mangiero and published in Bloomberg BNA Pensions & Benefits Daily, May 26, 2015), I wrote this article in the aftermath of the May 18 Tibble v. Edison decision by the U.S. Supreme Court.

A central thesis is that "ongoing oversight is an exercise in risk management" and that "[r]isk management is a never ending process." The article emphasizes the importance of (a) examining multiple risk factors and not relying on performance numbers alone (b) understanding the presence of financial leverage (should it exist) (c) clarifying the role of a service provider when an outside party is used and (d) letting participants know about the type of monitoring being done by an investment committee.

The topic of this article readily lends itself to at least one lengthy book as there is a considerable amount to say. I am co-writing a sequel article with fellow economist, Dr. Lee Heavner.

If you are interested in discussing investment fiduciary monitoring as relates to trustee training, compliance or dispute resolution, please email contact@fiduciaryleadership.com.

According to survey results provided in "Pension Plan De-Risking, North America 2015" (published by Clear Path Analysis and sponsored by Prudential Retirement), "pension risk management remains a principal concern for many plan sponsors." This should come as no surprise. Low interest rates, longer lifespans and anemic funding levels are a few of the concerns cited by the fifty-one senior professionals who answered questions. Half of the respondents agree that implementing a risk management strategy sooner than later makes sense, with one out of four individuals indicating an intent to transfer risk to an outside insurance company in 2015. Three out of four survey-takers "believe that movement in interest rates will impact their decisions to implement a liability driven investment strategy, or to execute a bulk annuity transaction." When asked about the use of alternatives such as hedge funds, fourteen percent replied that they currently use and seek to increase. One third currently allocates to alternatives and two percent look to introduce. Assuming that a respondent can only answer this question once and that there is one survey-taker per pension fund, this means that there is roughly a fifty-fifty split when it comes to including alternatives as part of a defined benefit plan investment portfolio.

If true that lower interest rates may discourage some plan sponsors from fully transferring risk to a third party insurer via a buy-out but they nevertheless seek to more actively manage pension risks, one could logically expect a greater use of a strategy such as Liability-Driven Investing ("LDI"). To the extent that LDI frequently entails the use of derivatives, those plan sponsors in favor of LDI may want to take note of a recent move by the U.S. Securities and Exchange Commission ("SEC"). As I just posted to my investment risk governance blog, certain registered funds could soon be asked to publish a considerable bounty of data about how they price securities, characteristics of trading counterparties and the specific use of derivative instruments. See "SEC and Asset Manager Disclosures About Use of Derivatives" (May 21, 2015). Sometimes an LDI strategy can include an allocation to alternatives. Post Dodd-Frank, lots of alternative fund managers are registering with the SEC. Connecting the dots, plan sponsors that use LDI and/or invest in alternatives are likely to benefit from enhanced disclosures made by asset managers.

Even those sponsors that decide on a risk transfer of some type other than LDI will soon be impacted by reporting mandates. In "Employers must disclose pension de-risking efforts to PBGC," Business Insurance contributor Jerry Geisel explains that data regarding lump sump arrangements will have to include answers to questions such as those listed below:

  • How many plan participants "not in pay status" were offered a chance to switch from a monthly annuity to the lump sum payout?
  • How many plan participants "in pay status" were given a choice?
  • What was the number of participants who made the choice to take a lump sum?

In its filing with the Office of Management and Budget ("OMB"), the Pension Benefit Guaranty Corporation ("PBGC") writes that "de-risking" or "risk transfer" events "deserve PBGC’s attention because (among other things) they lower the participant count and thus reduce the flat-rate premium and potentially the variable rate premium." Fewer dollars being paid for this last-resort insurance "have the potential to degrade PBGC’s ability to carry out its mandate…"

Given the complexities of managing pension risks and the regulatory changes underway, you may want to attend the May 27, 2015 educational webinar entitled "Pension De-Risking for Employee Benefit Sponsors: Avoiding Litigation and Enforcement Action." I hope you can join us for a lively and topical event.

Seeking to accomplish a goal without having the right tools can result in frustration and possible failure. One solution is to get outside help when needed as long as the party being hired is knowledgeable and independent. Otherwise, what looks like a solution could quickly become a problem. Applied to ERISA plans, trouble might take the form of costly and time-consuming enforcement and/or litigation. Over the last few years, that reality has set in for more than a few employers.

Recognizing the importance of abiding by good governance principles, several of us agreed to speak as part of an educational webinar on April 8, 2015 about fiduciary tools, pitfalls and lessons learned. Sponsored by fi360 and entitled "ERISA Litigation and Enforcement: The Role of the Independent Fiduciary and Best Practices for Financial Advisors," this webinar joined Attorney Tom Clark (Counsel with the Wagner Law Group), Dr. Susan Mangiero (Managing Director with Fiduciary Leadership, LLC) and Mitchell Shames, Esquire (Partner with the Harrison Fiduciary Group) to address the (a) use of an independent fiduciary (b) clarifying what an outside vendor should be doing and (c) avoiding legal and economic landmines that have revealed themselves in prominent court cases and regulatory examinations.

If you missed the event, email contact@fiduciaryleadership.com for a copy of the slides. Click here to download the written transcript. Edited for clarity (and because the audio file is spotty in some places), this fourteen page document lays out cornerstone concepts and includes suggestions for plan sponsors and the advisers who serve them. These include, but are not limited to, the following:

  • The outsourced fiduciary market is growing in the United States and elsewhere.
  • When an outside party is hired by a plan sponsor, it is critical to specify responsibilities and contract accordingly. When an "expectations gap" exists, some critical tasks may be left wanting or not addressed at all.
  • When multiple fiduciaries are in place, a plan sponsor must ensure that a central person or team is adequately coordinating the efforts of all fiduciaries.
  • The newly proposed Conflict of Interest rule is predicted to materially change the landscape of fiduciary relationships between plan participants and retirement advisers.
  • A fiduciary status may exist due to either a contractual agreement or by virtue of the functions assumed by an individual or organization.
  • ERISA litigation is getting more attention these days, with a particular focus on fees, use of proprietary funds, revenue-sharing and disclosure of compensation paid to investment consultants, advisers and asset managers.
  • Demonstrating procedural prudence in part depends on what others in the industry are doing (or not doing as the case may be) and whether actions make sense for a given plan.
  • A renewed focus on disclosure and transparency is in the works according to comments made by the U.S. Department of Labor.
  • An independent fiduciary can be engaged for a singular transaction or for a task that continues over a long period of time.
  • An independent fiduciary can be engaged by either a defined contribution plan or defined benefit plan or both.
  • When there is a perception or reality of a conflict of interest, it may be prudent for an independent fiduciary to be engaged. The participants pay for said party because the independent fiduciary works on behalf of the participants.
  • The concept of co-fiduciary status is important and should be paid heed by any adviser who has an ERISA plan as a client.
  • Before delegating duties (to the extent allowed) to a third party, a plan sponsor should decide what financial issues should be vetted. Liquidity, the use of leverage by asset managers and asset allocation are a few of the many topics that a delegated fiduciary could be asked to measure, monitor and manage.
  • A fiduciary audit can be extremely helpful as a tool for identifying areas of improvement for an ERISA plan sponsor.

It may be no surprise that over 500 people registered for this educational webinar about fiduciary foibles. After forty years since its inception, ERISA remains a force that cannot be ignored.

During a catch-up conversation, a now-retired colleague told me how much money he was making by trading options. Based on several recent articles, it seems that he is not alone in looking to Wall Street instruments in hopes of an income boost or a way to hedge uncertainty. In "Retail Investors Flock to Derivatives for Income and Safety" (TheStreet.com, October 31, 2014), senior reporter Dan Freed describes a growing trend in trading options and futures, with growth rates that exceed the level of purchases and sales of stock. On November 3, 2014, the Options Clearing Corporation reported a 22.32 percent rise in total equity and index option volume in October 2014 from one year earlier, "the second highest monthly volume on record behind the August 2011 record volume of 554,842,463 contracts" or a year-to-date volume of 3,673,768,194 contracts.

Reuters journalist Chris Taylor describes the average options trader as 53 years of age, citing Options Industry Council statistics that put nearly thirty percent of those who trade options at between "the ages of 55 and 64." However, in "New baby boomer hobby: trading options" (July 9, 2013), even retirees with a high net worth are cautioned to educate themselves about the downside of leverage. Mary Savoie, Executive Director of the Options Education Program, talks about the free resources made available by the Options Industry Council.

Critics counter that formal training cannot replace experience and that retirement assets should be invested with a long-term goal in mind, especially for those individuals with a low net worth. What they may not realize is that numerous retirement plans are chockablock with exposure to derivatives in the form of investment funds that trade swaps, options and futures. In mid-September of this year, Bloomberg reporters Miles Weiss and Susanne Walker wrote that then PIMCO senior executive and co-founder of the Pacific Investment Management Company Bill Gross "sold most of the $48 billion of U.S. Treasuries held by his $221.6 billion Pimco Total Return Fund (PTTRX) in the second quarter, replacing them with about $45 billion of futures. In "SEC Preps Mutual Fund Rules," Wall Street Journal reporter Andrew Ackerman (September 7, 2014) cites a concern on the part of the U.S. Securities and Exchange Commission about the use of derivatives by certain mutual funds and could seek "to limit the use of derivatives in mutual funds sold to small investors, including both alternative funds and certain ‘leveraged’ exchange-traded funds, volatile investments that use derivatives to double or even triple the daily performances of the indexes they track…" 

Over the years, I have traded derivatives, valued derivatives, reviewed financial models, created hedges and stress tested deals for compliance purposes. Throughout that time, the global markets continue to grow, attesting to their popularity. Earlier this summer, the Bank for International Settlements measured the over-the-counter derivatives market as having expanded to outstanding contracts with a value of $710 trillion at yearend 2013, up from $633 trillion in a single year.

Whether singular derivative transactions are appropriate for any one individual plan participant depends on a number of factors. Suffice it to say, derivative instruments are here to stay. It would be incorrect to underestimate the ubiquitous nature of derivatives. Besides asset managers who use derivatives, there are plenty of structured products that layer in derivatives with traditional equity or fixed income securities.

Stay tuned for more from the regulators about the usage of derivatives and asset management. In the aftermath of the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, rules about derivatives trading and clearing are changing the operational and technology landscape. Fund directors not already in the know are being urged to pay attention to the economic impact on fund activity when derivatives are used. Click here to download a good risk management checklist. It is part of a November 8, 2007 speech by Gene Gohlke, then Associate Director, Office of Compliance Inspection and Examinations, SEC. Entitled "If I Were a Director of a Fund Investing in Derivatives – Key Areas of Risk on Which I Would Focus," Attorney Gohlke addresses the panoply of due diligence considerations such as custody, pricing and valuation, legal, contractual, settlement, tax, performance calculations, disclosure, investor reporting and compliance. These are important knowledge areas for investors too.

I have been writing, training and consulting about the use of derivatives by pension plans for many years. There is no shortage of topics, especially in the aftermath of the Dodd-Frank Wall Street Reform and Consumer Protection ("Dodd-Frank") and the fact that pension investing and derivatives trading are significant elements of the capital markets. The OECD estimates the size of the private pension system in 2012 at $32.1 trillion. The Bank for International Settlements estimates the June 2013 global derivatives market size at $692.9 trillion.  

Given the importance of the topic of pension risk management and the evolving regulatory landscape, it was a pleasure to have a chance to recently speak with Patrick S. Menasco. A partner with Steptoe Johnson, Attorney Menasco assists plan investors, investment advisers and broker-dealers as they seek to navigate the laws relating to hedging, swaps clearing and much more. Here are a few of the take-away points from that discussion.

Question: Do the swaps provisions embedded in the Dodd-Frank legislation contradict the netting rules that are part of U.S. bankruptcy law?

Answer: No, the netting provisions of the Bankruptcy Code remain intact and should be taken into account in negotiating swap agreements. To the extent feasible, a performing counterparty wants to be able to net obligations in the event of a counterparty insolvency and default.

Question: Your firm obtained Advisory Opinion 2013-01A from the U.S. Department of Labor ("DOL") on February 7, 2013 regarding swaps clearing, plan assets and ERISA fiduciary duties. Explain the importance of identifying plan assets in the clearing context.

Answer: ERISA, including its prohibited transaction rules, governs "plan assets." Thus, it is critical to determine whether margin posted by a plan in connection with swaps clearing and the swap positions held in the plan’s account are considered "plan assets" for ERISA purposes. Among other things, Advisory Opinion 2013-01A gives comfort that (1) margin posted by the investor to the clearing agent generally will not be considered a plan asset for ERISA purposes and (2) clearing agents will be able to unilaterally exercise agreed-upon close-out rights on the plan’s default without being deemed a fiduciary to the plan, notwithstanding that the positions are plan assets.

Question: The headlines are replete with news articles about swap transactions with pension plans that could be potentially unwound in the event of bankruptcy. Detroit comes to mind. Should non-pension plan counterparties be worried about a possible unwinding in the event of pension plan counterparty distress?

Answer: Yes and no. The case in Detroit (which is currently on appeal) illustrates the risk that, notwithstanding state or local law to the contrary, federal bankruptcy judges may disregard the legal separation between municipal governments and the pension trusts they sponsor, treating those trusts as part of the estate. This may present certain credit and legal risks to the trusts’ swap counterparties, although the Bankruptcy Code’s swap netting provisions may mitigate some of those risks. I doubt that we will see anything similar to Detroit in the corporate pension plan arena because ERISA not only recognizes, as a matter of federal law, the separate legal existence of such plans, but also affirmatively prohibits the use of plan assets for the benefit of the sponsor. Separately, many broker-dealers negotiate rights to terminate existing swaps upon certain credit events, including the plan sponsor filing for bankruptcy or ceasing to make plan contributions.

Question: How does Dodd-Frank impact the transacting of swaps between an ERISA plan and non-pension plan counterparties such as banks, asset managers or insurance companies?

Answer: Dodd-Frank does a number of things. For one, it adds a layer of protection for ERISA and government plans (and others), through certain "External Business Conduct" standards. Generally, these standards seek to ensure the suitability of the swaps entered into by the investors. Invariably, swap dealers will comply by availing themselves of multiple safe harbors from "trading advisor" status, which triggers various obligations relating to ensuring suitability. Very generally, these safe harbors seek to ensure that the investor is represented by a qualified decision-maker that is independent of, and not reliant upon, the swap dealer. Under protocol documents developed by the International Swaps & Derivatives Association ("ISDA"), the safe harbors are largely ensured through representations and disclosures of the plan, decision-maker and swap dealer (as well as underlying policies and procedures).

Question: Dodd-Frank has a far reach. Would you comment on other relevant requirements?

Answer: Separately, Dodd-Frank imposes various execution and clearing requirements on certain swaps. These requirements raise a number of issues under the prohibited transaction rules of ERISA and Section 4975 of the Internal Revenue Code. Exemptions from those rules will be needed for (1) the swap itself (unless blind) (2) the execution and clearing services (3) the guarantee of the trade by the clearing agent and (4) close-out transactions in the event of a plan default. This last point presents perhaps the thorniest issue, particularly for ERISA plan investors that direct their own trade swaps and thus cannot avail themselves of the Qualified Professional Asset Manager ("QPAM"), In-House Asset Manager ("INHAM") or other "utility" or "investor-based" class exemptions. The DOL expressly blesses the use of the QPAM and INHAM exemptions in the aforementioned Advisory Opinion 2013-01A, under certain conditions. Senior U.S. Department of Labor staff members have informally confirmed that the DOL saw no need to discuss the other utility exemptions (including Prohibited Transaction Class Exemption ("PTCE") 90-1, 91-38 and 95-6) for close-out trades because they assumed they could apply, if their conditions were met.

Question: Is there a solution for those ERISA plans that direct their own swap trading?

Answer: It is unclear. There are only two exemptions, at least currently, that could even conceivably apply: ERISA Section 408(b)(2) and Section 408(b)(17), also known as the Service Provider Exemption. The first covers only services, such as clearing, and the DOL has given no indication that it views close-out trades as so ancillary to the clearing function as to be covered under the exemption. In contrast, the Service Provider Exemption covers all transactions other than services. But it also requires that a fiduciary makes a good faith determination that the subject transaction is for "adequate consideration." If the close-out trades are viewed as the subject transaction, who is the fiduciary making that determination? The DOL’s Advisory Opinion 2013-01A says that it isn’t the clearing agent. Thus, to make the Service Provider Exemption work, you have to tie the close-out trades back to the original decision by the plan fiduciary to engage the clearing agent and exchange rights and obligations, including close-out rights. That argument has not been well received by the DOL, at least so far.

Many thanks to Patrick S. Menasco, a partner with Steptoe & Johnson LLP, for taking time to share his insights with PensionRiskMatters.com readers. If you would like more information about pension risk management, click to email Dr. Susan Mangiero.

When I worked on several swaps and over-the-counter options trading desks, there was always a lot to do in order in order to properly set up a program with an end-user. Sometimes this involved in-person training of a board or asset-liability management committee or otherwise authorized persons who had made an organizational decision to employ derivatives. Credit limits had to be vetted, decisions about collateral had to be made and master agreements were negotiated and signed. Throughout the process, everyone was mindful that big money was at stake and that getting the preliminaries finished on time, with diligence and care, was both crucial and important. The key was (and still is) to plan ahead for a worst case scenario wherein a contractual counterparty cannot or will not perform. Should that occur, the remaining party would likely seek to unwind or offset a given position rather than allow a bad situation to linger. A valuation of the over-the-counter derivative instrument in question, such as an interest rate swap, would be determined and mutually agreed upon. Contractual terms such as the rate of swap exchange, time remaining and the quality and quantity of collateral posted by either or both counterparties would typically be used to determine the amount of money owed by the non-performing entity. An agreement as to when "non-performance" commenced would be yet another factor. In a dispute situation such as a lawsuit, damages might be part of the calculation.

Sounds straightforward, right? Well, things are seldom simple, especially when one counterparty is in financial distress. When a counterparty owes money but cannot pay on a given date or has insufficient monies to settle a swap as part of a buyout, the remaining counterparty has to look to the underlying collateral, consider litigation and/or negotiate for some type of remuneration. Legal decisions can complicate things. Consider the situation with Detroit.

On January 16, 2014, Judge Steven W. Rhodes, U.S. Bankruptcy Court for the Eastern District of Michigan, opined that a $165 million payment to UBS and Bank of America to end certain interest rate swaps was too much money to outlay right now. Refer to "Detroit bankruptcy judge rejects $165M swaps deal with banks" (Crain’s Detroit Business, January 16, 2014).

By way of background, these over-the-counter derivative contracts were related to the issuance of pension obligation bonds. The objective at that time was to protect the Detroit issuer (and taxpayers by extension) from higher funding costs if interest rates climbed. By having a swaps overlay, the bank counterparties were to pay Detroit if rates increased above a specified level. Conversely, lower rates would obligate Detroit to make periodic swap payments to the banks involved.

Reporters Nathan Borney and Alisa Priddle describe a 2009 effort to collateralize the swaps with casino-related revenue in "Detroit bankruptcy judge denies proposal to pay off disastrous debt deal" (Detroit Free Press, January 16, 2014). They add that this move was aimed at avoiding "an immediate payment of $300 million to $400 million on the swaps, potentially violating the Gaming Act" since interest rates had not risen. According to "Detroit continues talks with banks after canceling swaps truce" (Bloomberg, February 7, 2014), the swaps have a monthly price tag of about $4 million, "have cost taxpayers more than $200 million since 2009" and are being questioned by the city with respect to their "legitimacy."

Numerous questions come to mind and will no doubt be raised as the banks and city officials continue to talk or the attorneys take over, should litigation ensue. The list includes, but is not limited to, the following:

  • Who had the authority to commit Detroit to the swaps trades? Click to view an interesting visual put together by the Detroit Free Press and entitled "Were The $1.44-Billion Pension Deal And The Pledge Of Casino Tax Revenue Legal?" (September 14, 2013).
  • Were any of the recommending swaps agents subject to a conflict of interest, as has been suggested by The Detroit News?
  • What was the due diligence carried out by city officials before the swaps were put in place?
  • How were the collateral-related terms decided and by whom?
  • How were swap interest rate triggers determined?
  • Was there an independent party in place to regularly review the quality and quantity of posted collateral?
  • What role did the internal and external auditors play with respect to oversight of the reporting of the swaps and related bond financing?
  • Was there an appreciation that rising rates would mean a payment by the swap banks to the city and that this inflow could have been used to offset the higher cost of variable rate debt?
  • Who undertook the analysis of the effectiveness of the swaps as a hedge against rising rates and was the hedge deemed likely to be protective?

There are lessons to be learned aplenty about swaps, contractual protection, collateral valuation, oversight, authority and much more. No doubt there will be much more to say in future posts.

According to the Bank for International Settlements, the notional amount outstanding, as of June 2013, of global over-the-counter derivatives exceeded $692 trillion. Interest rate swaps reflect the largest category at about $425.6 trillion. Given the jumbo size of this market, it is no surprise that regulators have demanded more transparency about the mechanics of the global swaps market, including reporting to regulators and the public dissemination of reported information. It is also no surprise that regulators have demanded what they deem to be risk-reducing measures such as the clearing of these instruments and collateral collection. With the promulgation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), numerous market participants are now required to clear their swaps. Click here to learn about the three categories of organizations that are required to adhere to swap clearing and trade execution requirements under Section 2(h) of the Commodity Exchange Act (“CEA”). Given the complexity of the prevailing swaps-related rules and regulations as well as the evolving nature of these mandates, any educational insights are welcome.

As an economic consultant, trainer and expert witness who regularly does work in the pension risk management arena and author of Risk Management for Pensions, Endowments and Foundations, I was delighted to have a chance to get comments about this important topic of swaps clearing and trade compliance from Davis Polk attorneys Lanny A. Schwartz and Gabriel D. Rosenberg. Mr. Schwartz is a partner, and Mr. Rosenberg is an associate in Davis Polk’s Trading and Markets practice. Besides the questions and answers provided below, and acknowledging that there is a lot to learn about swaps-related compliance, readers may want to download "Are You Ready? New Swap Trading Requirements For Pension Plan Asset Managers" (August 2013) by Attorneys Schwartz and Rosenberg, in conjunction with BNY Mellon.

Question: What is your motivation for writing about this topic as well as offering educational webinars?

Answer: We continue to receive numerous inquiries from swap market participants, many related to clearing. Swaps dealers were the first to have to demonstrate compliance with Dodd-Frank’s swaps clearing mandate in March of last year. Most asset managers were required to clear specified types of interest rate swaps and credit default swaps as of June 2013. Other entities, including ERISA plans, had a deadline of September 2013.

Question: What areas have you identified as requiring more time and attention?

Answer: We are still mid-stream in terms of implementing a wide array of rules. Compliance is not a simple “check the box” exercise. Some swaps are now subject to mandatory clearing, but this is a relatively small part of the universe in terms of instruments traded in the market. Trading on a regulated futures exchange or swap execution facility is currently voluntary. Margin requirements are not yet final. Documentation requirements are similarly critical and require significant attention.

Question: What is a qualified independent representative and why is that important to an asset manager that has pension plan clients?

Answer: Before a swap dealer can act as an advisor to a pension plan regarding swaps, which in this context means making customized recommendations, the plan manager must verify that the pension plan has a qualified independent representative ("QIR") in place. A QIR is an agent of a Special Entity (such as a corporate or public pension plan) that is knowledgeable and independent of any swap dealer counterparty.

Question: It sounds like there is a large amount of due diligence that must be carried out by swaps dealers, asset managers and end-users such as pension plans, respectively. Would you elaborate?

Answer: You are correct that each category of swap market participant has a large amount of due diligence to carry out in order to ensure that they are compliant with Dodd-Frank’s trading, clearing and other provisions. Swap dealers will generally require counterparties to adhere to one or more of the International Swaps and Derivatives Association (“ISDA”) protocols and other documentation as relevant to their activity. For example, suppose Big Bank X is a leading dealer of swaps and has been approached by Global Asset Management Firm Y to handle its trades on behalf of various end-users such as pension plans of Fortune 500 companies. Before Big Bank X will speak in detail about swaps with Global Asset Management Firm Y, it generally will need to make sure it has proper documentation in place. Unless Global Asset Management Firm Y can demonstrate adherence (or enters into alternative documentation developed by the swap dealer, Big Bank X will generally not transact with them.

Question: What are some of the action steps that a pension plan must take?

Answer: A pension plan, whether a corporate ERISA plan or government employee benefits plan, must have an account with a Futures Commission Merchant (“FCM”) in order to enter into swaps trades that are subject to clearing. This requires diligence and negotiation of important documentation about the clearing relationship. Pension plans should also consider the trade-offs between using swaps and nearly equivalent futures contracts.

Question: Are there areas of vulnerability that need to be better addressed?

Answer: A firm needs to have people in place who are experienced and knowledgeable about Dodd-Frank, operational processing, legal documentation and the use of technology for data inputting and report generation. None of these areas are trivial and require care and diligence. Additionally, since things are in flux as new rules are being adopted, it is critically important for any swap market participant to stay abreast of compliance mandates.

Question: Headlines are replete these days with news about regulatory investigations and lawsuits about how London Interbank Offer Rates (“LIBOR”) are determined by quoting banks. Inasmuch as the majority of swaps are tied to some type of LIBOR fix, how is swaps trading likely to be impacted?

Answer: The increased scrutiny about LIBOR could result in increased regulatory interest in other indexes that are referenced by swaps.

Question: What is the role of external counsel versus the internal General Counsel?

Answer: It is critical for asset managers to develop an educational program that allows front, middle and back office professionals to understand what rules, policies and procedures need to be established and followed. External counsel can add value by explaining the ISDA Protocols and other documentation and compliance requirements to clients. An end-user’s General Counsel should make sure that everything is in place in order to comply with Dodd-Frank. Plenty of clients say they don’t even know where to start and feel overwhelmed.

Question: There is so much more to discuss. Readers should stay tuned for further updates. At the client level, it sounds like you will both remain quite busy.

Answer: Susan, we appreciate the opportunity to share our insights with readers of your blog. We urge everyone with a stake in good governance to pay attention and do whatever is needed to comply with Dodd-Frank’s swaps rules.

If this photo of senior ski fans is representative of the upward global trend in longevity, creators of derivatives could be on to something big. Deal count suggests that 2013 will be described as a banner year for banks and others types of financial companies as their respective corporate clients, in search of protection against the greying of their plan participants, took the plunge to get rid of risks they find difficult to manage. Financial News reports a December deal for 2.5 GBP between AstraZeneca and Deutsche Bank that "will cover the drug company against the risk that 10,000 of its former employees will live longer than expected." This follows a 1 billion GBP swap between Carillion and Deutsche Bank and a second transaction between BAE Systems and Legal & General, also in December 2013. See "A shot in the arm for longevity swaps" by Mark Cobley (January 6, 2014) for more details.

Certainly the topic is gaining importance in policy-making circles and at an international level. In December 2013, the Bank For International Settlements ("BIS") released an updated version of a study about longevity risk transfer markets. The product of the Joint Forum on longevity risk transfer ("LRT") markets, the report strongly encourages those with regulatory authority to carefully track the nature of deals being done and by which organizations as a way to gauge capacity to handle risks being transferred to the financial sector. Longevity risk exposures should be properly measured and attention should be paid to the extent to which "longevity swaps may expose the banking sector to longevity tail risk, possibly leading to risk transfer chain breakdowns." The study likewise notes the importance of supervisors to be able to evaluate whether those in possession of longevity risk have the "appropriate knowledge, skills, expertise and information to manage it."

These words of caution make sense, especially given the large amounts at stake. In its December 20, 2013 press release, the BIS cites estimates of the aggregate "global amount of annuity- and pension-related longevity risk exposure" as ranging between $15 and $25 trillion. Based on World Bank data, U.S. Gross Domestic Product for 2012 was $16.2 trillion. It was reported at $8.2 trillion for China and $5.9 trillion for Japan. The implication is clear. Get it wrong and it could mean big losses for a delicate global financial system that has had its share of risk management twists and turns. Click to access "Longevity risk transfer markets: market structure, growth drivers and impediments, and potential risks" (Basel Committee on Banking Supervision Joint Forum, December 2013).

As at least one major bank moves forward to develop a longevity derivative instrument that is meant to be traded, expect more news from insurance company and banking regulators about capacity, internal controls, assessment of risk, posting of capital and adequate disclosure about the transfer of large amount of longevity risks to financial intermediaries. Risk Magazine author, Tom Osborn, describes some of the impediments to a full-scale launch of the longevity transfer market, including limited disclosure about how transactions are priced, absence of a liquid index that would facilitate cost-effective hedging and avoid capital adequacy-related basis risk problems and questions about how exposures should be accurately modeled. Click to read "Longevity: Opportunity or flop?" (September 20, 2013).