Mercer Abandons Public Pension Plans

The Consultant Corner from aiCIO Magazine: As the consultant industry—an expensive, time-consuming, litigious space—continues to shift, one can't help wonder if other firms will follow Mercer's lead in a clustering effect, spurred by fear of being the last out. aiCIO Senior Editor Paula Vasan reports.

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In early June, investment consultant Mercer paid $500 million to settle a lawsuit brought by the Alaska Retirement Management Board. By doing so, it also raised a red flag for other large advisory firms looking to do business with American public pension funds.

The suit itself is rather juicy. Filed in 2007 and seeking as much as $2.8 billion for unfunded liabilities, the fund alleged that Mercer’s lack of oversight dampened the ability of the retirement system to fulfill its obligations to former public employees. As the state’s actuarial consultant, the fund claimed Mercer made a series of errors when it estimated the amounts that two of the state’s retirement plans needed to set aside for health care and pension benefits. Furthermore, Alaska’s board claimed Mercer executives were aware of the actuaries’ errors and concealed them. In a statement, Mercer admitted that its lack of transparency and its failure to disclose errors in its calculation was “a mistake in judgment.”

Mercer’s explanation for its departure from the public pension space, however, is muted. “It is prudent to assess the conditions outside the control of an investment consulting firm,” said company spokesman Charles Salmans in response to the firm’s subsequent decision to reevaluate its defined benefit (DB) investment consulting work for U.S. public sector plans. “Many public pensions now have a particularly severe funding problem,” he noted from his office in Midtown Manhattan, describing the gap that has emerged as a result of longer life spans, lower than expected public employee turnover, and differing accounting standards from the private sector. In some cases, the problems have grown over the years because politicians have offloaded the pension problem to the next administration. In a calculation of risk-versus-reward, the firm made the decision to withdraw from offering DB investment consulting services to U.S. public sector clients, affecting $240 billion in assets under advisement, a significant portion of the roughly $2.06 trillion in total for public DB pensions in America.

While the private pension market is governed by the Employee Retirement Income Security Act (ERISA), the public sector faces no such requirements, exemplified by the recent news of Pittsburgh’s pension crisis. Still hoping for a miracle, the city is working on finding a solution to its pension deficit and will need to pay up to $3.6 billion over the next 30 years to shore up its public pension fund if it fails to meet a state-required funding minimum by the end of the year. Perhaps not coincidentally, Mercer—which has provided investment-consulting services to Pittsburgh’s troubled pension plan since 2007—has recently come under fire from a wayward city Councilor and others within the city Administration, hinting at a lawsuit. This potentially political attempt to divert blame from the real issue—severe underfunding at public funds—illustrates Mercer’s concerns. “Pittsburgh is 27.5% funded; that would never happen in the private sector,” said a source intimately familiar with Mercer’s thinking, describing the backdrop behind the firm’s decision to flee the public U.S. market. “So, the reason for Mercer’s decision comes from their need to put limits of liability on their contracts. The sky can’t be the limit. They can’t let what happened with Alaska happen again.”

Mercer has had similar problems with other pension clients. In May 2009, the firm agreed to pay Milwaukee County $45 million to settle a negligence lawsuit filed by Milwaukee’s pension board. Mercer did not acknowledge it was at fault in the case. “They already have two examples—Alaska and Milwaukee—of when they went after Mercer because they have deep pockets,” the source said. He suggested that these suits were provoked by contingency fees for lawyers, who would garner business by touting the fact that it would cost nothing to sue a consultant in exchange for cashing in on a hefty part of the settlement. In Mercer’s case, while the Milwaukee settlement was $45 million, the contingency law firm reaped $15 million. Following the Alaska suit, lawyers profited from an even bigger payday, earning about $100 million of the roughly $500 million settlement. The incentive to sue is consequently significantly less for smaller shops, which have less sizeable insurance policies to cover the costs of liability. As a result, the source believes, big public pensions will soon no longer find large firms like Mercer willing to do business with them.

Mercer is not the first large consultant to abandon DB public plans in the U.S., but the firm’s recent decision to exit this space has put a spotlight on the industry, reflecting an effort among large firms to rid themselves of non-growth sectors as a means of managing their legal risk. As the consultant industry—an expensive, time-consuming, litigious space—continues to shift, one can’t help wonder if other firms will follow Mercer’s lead in a clustering effect, spurred by fear of being the last out. The new reality may well be that, as American public funds become further underwater, drowning in their deficits, both sides of the equation—the pension fund and the advisory firm—will be less willing to take responsibility and accountability for investment decisions.

One’s loss may be another’s gain. “I understand why it might make sense for some consultants to decide they no longer want to work with public defined benefit plans, but it doesn’t make sense for Callan,” said Greg Allen, President of independent institutional consulting firm Callan Associates, which works with large public funds. “Working with large pools of assets, public or private, involves a degree of risk and associated potential liability. One of the advantages of being a privately held firm is that we are in a position to analyze and manage these risks—through oversight committees and other rigorous processes— independent of considerations of how they might impact an outside shareholder.” He noted that, from the standpoint of a plaintiff’s lawyer, interest in litigation is driven partly by the size of the potential settlement and, therefore, the bigger the insurance policy, or the deeper the pockets of the parent company, the larger the potential settlement. Small firms with small policies are relatively unattractive targets, Allen said.

If big companies are more likely sued, small private firms may be the future of the market. Industry observers question whether EnnisKnupp, for example— bought by Hewitt and then by Aon, a global multinational insurance company with deep pockets—has magnified its potential liability, an unintended consequence of growth. EnnisKnupp, however, contends, that it will continue to serve the public fund system and compete for new mandates. “I believe that liability exists when you have poor procedures—and that’s not limited to the public pension marketplace,” said Stephen Cummings, Hewitt EnnisKnupp’s CEO. “My job is to make sure our business is risk-mitigated so that our company doesn’t get sued by clients—that sound processes and procedures are implemented.”

The final calculation is this: The Alaska lawsuit is a canary in the coalmine for large investment consultants. It is also clearly an opening for boutique firms looking to amass assets under advisement. What is unclear is whether this is good news for public pensions in America.