Managing Risk While Investing For Governmental Retirement Plans

Serving governmental retirement plans is viewed as attractive by many providers, simply due to the sheer size and stability of the clientele, but one ERISA attorney warns there may be unexpected risk that comes along with such arrangements. 

During a recent conversation with PLANADVISER, George Michael Gerstein, counsel with Stradley Ronon Stevens & Young, made the frank observation that “there seems to be a significant and even increasing amount of fiduciary investment risk that exists in governmental plans that is not being addressed.”

“Think of state retirement systems like CalPERS or Texas Teachers,” Gerstein says. “These governmental plans have really a lot of money to invest and strong liability demands on that money, and so they are enthusiastically pursuing things like alternative investments, greater use of derivatives, and other areas and transactions that can, quite simply, go awry if they are not properly approached.”

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Gerstein believes there is lasting confusion arising from the fact that these big state-run plans are not subject to the Employee Retirement Income Security Act (ERISA)—they are expressly carved out in fact.

“But this cannot be taken as these plans having free reign to invest however they please,” Gerstein warns. “They are all subject to state law—and these state laws vary tremendously. Some are very strict and lay out very specific requirements as to how state money can be allocated. A certain fund might have a restriction that it cannot invest in more than, say, 10% real estate, for example. Many have at least some restrictions on certain vehicles or transactions.”

The real challenge for service providers is the fact that some of these restrictions have been passed in “old, obscure laws that have not, frankly, been thought about for some time by anyone.”

“And so it’s not hard to imagine the kind of challenge I’m talking about and that I’m seeing more and more in practice,” Gerstein continues. “Say, if the plan I mention above has 8% of its assets in real estate today and a consultant comes in an pitches an attractive new investment that would push it to 10.5% real estate, or even 10.1% real estate. The investment professional and the sponsor may believe they are making/receiving a prudent recommendation but in fact the consultant is recommending their client break the law.”

This line of thinking should serve as a warning to sponsors, Gerstein says, “but generally they are going to know what they can and cannot do with their money. It more so applies to cases, say, where the plans have delegated some amount of investment authority to an outside professional. It is always possible that an outside manager will be unaware of some more or less obscure restriction—especially if nobody thinks to warn them, which can happen a lot more easily than you might expect.”

NEXT: Getting ahead of the problem 

According to Gerstein, there have been cases in which “well meaning but unwitting managers,” providing various services, fail to appreciate the risk that they are taking on serving these plans. The risk can result in many unfortunate consequences—anything from inappropriate transactions being ordered unwound, with fines, through to full-fledged fiduciary breach litigation naming individuals and alleging personal liability.

Something else to consider is that any legal challenges emerging will be tried in the local court system, “and you will see providers get dragged in front of very unfavorable jury pools in most situations.” As Gerstein puts it, “you will not find it easy to defend yourself if the local pension is accusing you of wrongdoing or negligence.”

In dealing with clients on the buy side and the sell side of this issue, there is some emerging awareness about these issues, Gerstein concludes. “But it’s really not a major focus, because everyone thinks of ERISA and the fact that these plans aren’t subject to ERISA. But these plans are still subject to state laws that are very similar to ERISA.”

In fact, some states have essentially incorporated ERISA’s prohibited transaction provisions directly into their own laws over the years, but they may leave out some or all of the accompanying federal exemptions that allow ERISA plans to even operate in the real world (i.e., under Department of Labor policing) without getting totally locked up by potential conflicts of interest.

“So the grounds are there for this issue to really become significant in some places,” Gerstien concludes. “Of course, this is all manageable with diligence and care. You need to know what you’re up against. Simply put, these plans present too much opportunity for providers to pass up, even with the risk.”

Majority of RIAs Planning on M&A in the Next Five Years

The motivation is growth, particularly boosting assets and revenues, expertise and clients, and ensuring that a succession plan is in place.

Seventy-six percent of registered investment advisers (RIAs) plan on a merger and/or acquisition (M&A) in the next five years, according to FA Insight’s Securing Your Firm’s Future survey. Sixty-one percent plan to acquire a solo adviser, 47% plan to buy a book of business, 42% plan to acquire a firm with multiple advisers, and 36% plan to merge with another firm.

Growth is the key motivator for these transactions, with 49% saying they are looking to increase revenue growth and 46% looking to boost asset growth. Twenty-four percent are looking to add more clients, and 21% are looking to expand into new markets.

However, RIAs are also looking forward to the practicalities of M&A transactions; 37% expect to realize economies of scale, 30% want to ensure that they have a succession plan in place, 21% want to round out their expertise, and 13% want access to new service capabilities.

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“For more than a decade, the industry was abuzz with talk of an impending M&A boom,” says Vanessa Oligino, director of business performance solutions at TD Ameritrade Institutional, parent company of FA Insights. “After a few false starts, it now appears the trend is finally about to take hold.”

While 76% of RIAs of all sizes are planning on an M&A in the next five years, that increases to 100% of firms generating $4 million to $8 million in revenue.

There were 77 M&A deals among financial advisers in 2016, down from an all-time high of 85 in 2015, according to FA Insights. By comparison, there were only 43 in 2014, 48 in 2013 and 38 in 2012.

“Over the years, we found that one in four breakaway brokers chooses to join an existing RIA, rather than go out on their own,” says Scott Collins, TD Ameritrade Institutional director of broker independence. “Regardless of whether an adviser is joining a new firm or selling their practice, the right deal can benefit clients and create a business that might otherwise have taken years to build organically.”

FA Insights conducted the online survey of 234 RIAs in December, and followed up with interviews and focus groups.

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