Rcanes, I'm not sure I'll get a response...

I’m not sure I’ll get a response…

I am enrolled in a financial management course this semester. Our instructor works for a pension fund as a derivatives specialist, trading fixed income securities, for a large for bank in Japan (not really Japan, but I am trying as much as possible to hide this instructor’s identity and employer). I asked her to comment on how the principal agent problem arises in the derivatives division at that bank. The instructor acts for the benefit of an institutional investor, presumably managing pension funds for public plans.

The Department of Labor supervises pension fund investment practices according to ERISA provisions, requiring those investors to act in the best interests of the beneficiaries. This can lead to a conflict of interest. Imagine a pension fund manager, voting one way, corporate management, the other; imagine further that no middle ground existed on the issue at hand and pension fund managers decide, somewhat flippantly, that if you can’t beat the corporate managers with risk assessments, then join them in failing to effectively minimize the risk of loss. Say, there is an asset bubble developing and the board further decides the CEO should carry out a particular policy. So fund begins managing the pension without effectively taking account of all kinds of risks. The results: the bubble deflates; individuals do not retire as they anticipated, or decide to retire with 30% of their investment eaten away by gross misconduct on the part of pension fund management; increased unemployment rates among college graduates who would have entered the work force if retirements were executed as initially scheduled; tax increases for underfunded pension funds, etc.

(For an excellentreview of pension fund risk management, please read. Pension Risk Management:Derivatives, Fiduciary Duty, and Process by Mangiero @ http://www.pensionriskmatters.com/uploads/file/PRM%20Survey%20Report-Final_101008%282%29.pdf

This researcher surveyed 161 pension funds U.S. and Canadian sponsors seeking to:

(1) understand why and how pension plans employ derivative instruments, if used at all;

(2) identify what plan sponsors are doing to address investment risk in the context of fiduciary responsibilities; and

(3) assess if and how plan sponsors vet the way in which their external money managers handle investment risk, including the valuation of instruments which do not trade in a ready market.

The participant’s responses were interesting. In answering broad questions, a majority of those surveyed described themselves as doing the right things to manage investment, fiduciary and liability risks; however, answers to subsequent questions that delved further into the risk procedures and policies were less than ideal. This research does not support the claim that pension risk management is currently addressed on a comprehensive basis by the plans represented in the sample.)

My question relates back to the days before FASB adopted FAS 158, a statement issued because defined benefit plans failed to communicate the funding status of those plans in a complete and understandable way.

Why, if pension fund managers acted in the best interests of shareholders, would they follow corporate policies that seemed to cause such destruction, in hypothetical scenario I described above the sidebar or parenthesis?

Clearly, I do not have the expertise and background knowledge of what exactly goes on between the corporate and pension fund management and the boards, but intuition can get me to a general observation of what occurs-a principal-agent problem. In no way, do I seek to minimize this instructor’s job. I am sure she performs well on the job.

I am only trying to understand the environment in which this principal/agent problem takes place because I am in an institution of higher learning. It would be nice to LEARN.