Reaching for returns

U.S. public pension plans are facing an unprecedented crisis with an estimated shortfall of $1.378 trillion needed to pay benefits to retirees. Most pension funds have taken on higher-risk investments to seek increased returns. The rise and fall of the Dallas Police and Fire Pension System because of these non-traditional investments provides a cautionary tale with important lessons for CFEs.

In December 2016, the Dallas Police and Fire Pension System (DPFP) was teetering on the brink of collapse. Heavy investment losses left the fund only 45 percent funded, and the fund’s consultant projected it would be insolvent in 15 years. News of the losses caused police and firefighters to retire in droves and withdraw their Deferred Retirement Option Plan accounts in lump sums. The fund’s trustees had asked the city of Dallas for an immediate contribution of more than $1.1 billion, which Dallas Mayor Michael S. Rawlings and City Council member Lee Kleinman said threatened to bankrupt the ninth-largest city in America. (See Dallas Stares Down a Texas-Size Threat of Bankruptcy, by Mary Williams Walsh, The New York Times, Nov. 20, 2016.)

The disaster in Dallas can be traced back to the DPFP’s aggressive push for higher investment returns. Beginning in 2004, the fund reduced its allocations to traditional public stocks and bonds in favor of non-traditional investments, particularly in real estate development. By 2014, more than 56 percent of DPFP assets were invested in non-traditional assets, which increased from 15 percent in 2004.

The DPFP managers’ strategy initially appeared to be a huge success. The industry publication Money Management Letter named the DPFP “Mid-Sized Public Plan of the Year” in 2009. The Texas Association of Public Employee Retirement Systems recognized the fund in 2011, 2012 and 2013 as one of the top-performing pension systems in Texas for its 20-year average returns. (See TEXPERS’ Report on the Asset Allocation and Investment Performance of Texas Public Employee Retirement Systems, Texas Association of Public Employee Retirement Systems, March 26, 2012, March 5, 2013, April 4, 2014.)

But many of these investments ultimately failed to deliver. The fund invested about $149 million in ultra-luxury homes in Hawaii, Utah, Colorado and Arizona, but later its administrator reported it had lost about $60 million on the ventures. They paid $97 million for 2,650 acres of land in Napa Valley, California, to develop a luxury golf resort, but the project stalled in the face of local opposition and lawsuits. (See Dallas police-fire pension fund has $400 million bet on luxury real estate, by Steve Thompson and Gary Jacobson, Dallas Morning News, Feb. 17, 2013.)

In downtown Dallas, the fund’s $200 million luxury high-rise condominium — the Museum Tower — sparked concern and outrage. Managers at the nearby world-renowned Nasher Sculpture Center said the intense sunlight beaming from the Museum Tower’s 42-story glass façade had damaged the center’s delicate artwork and burned the plants in its garden. (See Dallas Museum Simmers in a Neighbor’s Glare, by Robin Pogrebin, The New York Times, May 1, 2012.)

Rumors and controversies had long swirled around the fund and its investment strategy. After the trustees hired a new executive director in 2015, the fund revealed that it lost $545 million on its investments between 2013 and 2015. Dallas hired the auditing and consulting firm Deloitte to perform a review, which found that $772 million of the fund’s non-traditional real estate investments were at risk of overvaluation because of improper valuation methods. (See Review of Dallas Police-Fire Pension Confirms Overvaluation of Real Estate, by Steve Thompson, Dallas Morning News, Jan. 21, 2015.)

The FBI raided the offices of the fund’s main outside real estate advisor in April 2016, and the trustees were later informed that a federal grand jury had been convened. The U.S. Securities and Exchange Commission (SEC) reportedly had also opened an investigation. (See Federal Grand Jury Probes Dallas Police and Fire Pension Fund, by Steve Thompson, Dallas Morning News, Jan. 20, 2017.)

On Dec. 30, 2016, Dallas Mayor Michael Rawlings asked the Texas Ranger Division of the Texas Department of Public Safety to begin a criminal probe into the causes of the losses at the Dallas Police and Fire Pension Fund. (See Dallas Mayor Calls for Criminal Probe of City’s Police and Fire Pension System, by John R. Emshwiller and Heather Gillers, The Wall Street Journal, Dec. 30, 2016.)

One year later, no criminal charges had been filed, as the investigations and lawsuits over the events at the DPFP continued. But Dallas taxpayers must now pay an additional $25 million to $40 million each year to shore up the DPFP under the rescue plan passed by the Texas legislature in May 2017. Dallas police officers and firefighters face benefit cuts, along with contribution increases averaging 91 percent. As a result, Dallas is struggling to recruit replacements for resigning and retiring officers.

Moody’s Investors Service downgraded the city’s bond rating during the crisis, which resulted in increased borrowing costs for future projects. The near-collapse of the DPFP has had a major impact on the business climate and quality of life for the citizens of Dallas, Texas. (See Dallas Mayor and Police Officers End Their Retirement Row, by Heather Gillers, The Wall Street Journal, May 26, 2017.)

Public pensions pressure state and local governments

Long-simmering problems with the funding of pension plans now threaten to overwhelm many governments’ financial resources. State and local funds are estimated to need between $1.378 trillion and $3.846 trillion to fulfill the promises made to retirees and current employees. Overburdened taxpayers are on the hook for any shortfalls in investment returns and contributions.

Public pension funds are usually “defined benefit” (DB) plans, which promise certain payment amounts to beneficiaries over their retirement years. Member contributions, taxpayer contributions and investment returns fund DB plans. For DB plans, governments might call upon taxpayers to cover investment losses and underperformance to prevent any shortfalls in funding for benefits.

In contrast, most private-sector plans are “defined contribution” (DC) or 401(k) plans, funded by matching employer and employee contributions. Employees in private-sector DC plans make their own investment choices from the options offered by the plan, and they bear the risk of investment losses.

Public-sector DB pension plans are under increasing pressure to achieve higher investment returns for several reasons. First of all, public pension plans are underfunded. A 2017 Hoover Institution study of 649 public pension systems found that cities and states reported unfunded liabilities of $1.378 trillion under Governmental Accounting Standards Board (GASB) standards. (See Hidden Debt, Hidden Deficits: 2017 Edition, by Joshua D. Rauh.)

The Hoover report also found that governmental pension fund unfunded liabilities total $3.846 trillion when recalculated on a market value basis. Wilshire Consulting looked at 131 public pension plans and found that, on average, they had only 69 percent of the assets needed to pay benefits to retirees as of June 30, 2016. (See 2017 Report on State Retirement Systems: Funding Levels and Asset Allocation, June 26, 2017.)

Secondly, interest rates have fallen in the last decade, from an average of 7.60 percent on U.S. Treasury bonds in December 2006 to 4.36 percent in December 2016. These lower interest rates have increased the present value of plan liabilities, while decreasing the cash flows from fixed income investments needed to fund payments to beneficiaries.

Finally, pension plan investments overall have fallen short of earning the 7.5 percent to 8 percent returns that most funds have adopted as required to fulfill pension promises. Although large U.S. pension systems overall performed well in 2016, the three-year annualized returns for many funds are still below the required returns, according to consultants at NEPC. (See Strong returns nice, but aren’t expected to last, by Randy Diamond, Pensions & Investments, July 7, 2017.) The losses incurred during the 2008 financial crisis worsened the problem and motivated pension plans to look for ways to improve investment performance while protecting against sudden, sharp stock market declines.

Pension funds move to non-traditional investments

The DPFP is just one of many public pension plans that have turned away from traditional pension plan investments in publicly traded stocks and bonds in the last decade and sought higher returns. An April 2017 report from the Pew Charitable Trust reported that the 73 largest state-sponsored pension funds averaged a 25 percent allocation to alternative investments as of FYE 2014, ranging from a high of 56 percent to a low of zero percent for two funds. (See State Public Pension Funds Increase Use of Complex Investments, The Pew Charitable Trusts, April 12, 2017.)

Non-traditional, alternative, complex and high-yield investments (or “NACHY investments”) offer higher expected returns for pension funds in exchange for assuming more risk. These investments are only available to “qualified institutional buyers” with assets of more than $100 million, called QIBs, such as pension funds, which are presumed to be capable of bearing the higher risk. [See the Glossary of non-traditional, alternative, complex and high yield (NACHY) investment vehicles and asset classes at the end of this article.]

In addition to real estate, these investments include private equity/leveraged buyouts, hedge funds, structured products, distressed and high-yield credit, private credit/private placements, agriculture and infrastructure.

Fraud risk assessments for pension funds should expand to include evaluation of investment forensic risk.

NACHY investments have higher market risks than traditional stocks and bonds for several reasons. They consist of highly complicated combinations of risk exposures, contractual rights, ownership structures and distribution provisions. Use of leverage, or borrowed money, magnifies the size of both potential gains and potential losses. NACHY investments are typically private partnerships with very limited disclosure. They’re often structured to exist for years, and barriers to exit make it difficult or impossible to sell or redeem until specific dates. This illiquidity contributes to the many inherent difficulties in valuation of these investments. As sophisticated investors, QIBs are expected to look after their interests with little regulatory oversight.

What’s ‘investment forensic risk’?

The DPFP case illustrates that NACHY investments are not only subject to the higher investment market-related risks but also to “investment forensic risk” (IFR). IFR is my firm’s term to describe the potential for disputes over allegations of misrepresentation, mismanagement or other misconduct relating to institutional investments.

CFEs, attorneys and regulators can expect to encounter more situations involving losses in NACHY investments in the future because of the widespread use of these investments by public pension funds. Understanding IFR will assist in the early stages of evaluation in these situations to determine if predication exists for further investigation.

Disputes involving institutional investments often are very different from other types of fraud cases. Suppose an investment advisor, without any authorization, wires money from his client’s bank account into his personal account in the Cayman Islands and alters account statements to conceal the transfer. Their actions would clearly fit the definitions of embezzlement and forgery. Once the activity is discovered and documented, there’s little question that the conduct is fraudulent.

In contrast, most institutional investment disputes arise over situations that aren’t nearly so clear-cut. Management might have arguably authorized and agreed to the questioned investments perhaps without being fully aware of all of the ramifications. Fraud examiners require specialized expertise to analyze the evidence and consider if the losses resulted from fraud or other misconduct as opposed to market conditions or management mistakes.

Institutional investment management cases feature sophisticated buyers and sellers, complex and interrelated transactions, extensive and complicated contracts and numerous outside professionals. These cases are usually difficult to understand and to explain. As a result, disputes involving institutional investors require substantial amounts of time and expert resources to determine whether anyone should be held accountable for fraud, a breach of duty or other misconduct — whether by civil litigation, prosecution or regulatory action.

IFR is a broader category than fraud risk because it includes any of the issues that could cause a dispute over institutional investment losses. IFR encompasses principal-agent conflicts of interest, which arise when an agent, to which a principal has delegated authority, puts their own interests ahead of those of the principal. Under many investment management contracts, but not all, agents are fiduciaries — bound by the highest obligation to act solely in the best interest of their clients. Pension funds engage numerous professionals, including internal and external investment managers, consultants, accountants, auditors, actuaries and custodians. IFR covers the potential for disputes over alleged misconduct by any of these parties. In the context of the Fraud Triangle, IFR relates to opportunities for situations to occur that can result in allegations of misconduct.

NACHY investments have higher IFR

IFR can exist in three elements of the investment management process for NACHY investments. First, individual securities, deals and contracts can be structured in a way that leads to disputes. For example, financially engineered instruments, including private-label, residential, mortgage-backed securities and collateralized debt obligations, were at the epicenter of the 2008 financial crisis, which caused litigation leading to $72 billion in settlements by 2014, according to NERA Economic Consulting. (See Credit Crisis Litigation Update, by Dr. Faten Sabry, Sungi Lee, Joseph Mani and Linh Nguyen, NERA.) High-yield/distressed debt, private credit, derivatives contracts and individual real estate investments fall into this first category.

Second, we can find IFR at the level of investment vehicles and portfolio strategies. This category includes hedge funds, private equity/ leveraged buyout funds, private credit funds, securities lending programs, asset-backed commercial paper conduits and certain real estate investment vehicles. For example, after the 2008 financial crisis, custodian banks (financial institutions that hold customers’ securities for safekeeping to minimize the risk of theft or loss) paid $343 million to settle lawsuits brought by institutional investors over losses in securities lending programs’ cash collateral investments in structured products, according to Pensions and Investments. (See Missouri fund scores big securities lending payout, by Arleen Jacobius, Pensions & Investments, May 29, 2017.)

Third, IFR can arise from the actions of management, executives and professionals for the pension fund. In May 2016, the former CEO of the $290 billion California Public Employees Retirement System (CalPERS) was sentenced to 4½ years in prison after he pleaded guilty to conspiracy and fraud charges for accepting bribes, including $250,000 in cash, to influence CalPERS’ decision to invest $3 billion with a private equity firm, which enabled a placement agent to be paid $13 million in commissions. (See Former CEO of CalPERS is sentenced to prison for his ‘spectacular breach of trust,’ by Associated Press, The Los Angeles Times, May 31, 2016.)

Incorporate IFR in the fraud risk assessment process

Fraud risk assessments for pension funds should expand to include evaluation of investment forensic risk (IFR), because of the widespread use of NACHY investments and strategies by pensions, and the public policy impact of losses in these investments. As we’ve seen in the DPFP’s near collapse, these NACHY investments are subject to higher IFR, which is the potential for disputes over allegations of misrepresentation, mismanagement or other misconduct.

Because more than 97 percent of state-sponsored pension plans have NACHY investments subject to higher IFR, we can expect more questions and controversies to arise in the future. How should CFEs, attorneys and regulators view these situations? Where should we focus our attention at the first sign of possible trouble? Let's take a detailed look at the seven red flags of IFR, which will assist us in evaluating these situations and determining if we've predication to justify further investigation.

Seven red flags of investment forensic risk

CFEs are trained to look for specific risk factors that can become red flags when initially assessing possible fraud or misconduct. Focusing on these IFR red flags is valuable because we can observe them early in publicly available news and information sources soon after the initial revelation of possible controversies over investment losses. CFEs, attorneys and regulators can start by looking at the level and interaction of these risk factors as they begin to assess whether there is predication for further examination.

My firm has analyzed more than 1,260 disputes involving NACHY investments, and we've identified these seven IFR red flags for public governmental pension funds:

1. Information asymmetry.
2. Outsized expenses.
3. Centralized control.
4. Illiquid assets.
5. Confirmation bias.
6. Regulatory environment.
7. Moral hazard.

Information asymmetry

This exists whenever parties to a transaction have different levels of knowledge about a subject, which naturally results from divisions of labor and specialization in an advanced economy.

Outsized expenses are an IFR red flag, first, because they indicate the presence of higher-cost NACHY investments.

Information asymmetry is an inherent feature of financial markets and institutions. Pension funds seek to benefit from it by hiring and retaining professionals with specialized skills in various aspects of the investment process.

But information asymmetry is also a prerequisite for deception. In the U.S. financial services industry, federal laws, SEC rules and regulations, state and common law anti-fraud provisions, and professional standards all seek to restrain dishonesty and unjust enrichment — based upon the duties owed to, and the relationships among, various market participants.

In the pension fund context, information asymmetry exists among six groups of participants with a knowledge spectrum from highest to least:

Highest knowledge

• Originators/sellers such as underwriters, fund sponsors, financial engineers and real estate developers
• Investors/buyers, such as external investment managers and internal pension fund investment staff
• Professionals, such as consultants, accountants and actuaries
• Boards of trustees, which might be non-investment professionals
• Beneficiaries of pension funds

Least knowledge

• Taxpayers/guarantors of pension funds

The complexity and opacity of NACHY investments makes information asymmetry a critically important IFR red flag for many reasons. Originators/sellers and investors/buyers might have compensation incentives based on short-term valuation and risk metrics, which are in conflict with the longer-term interests of beneficiaries and taxpayers. Originators/sellers and investors/buyers might also negotiate restrictive contracts or might advocate for state laws that limit information disclosures. (See Look Who's Coming to Private Equity's Defense on Fee Secrecy, by Neil Weinberg and Darrell Preston, Bloomberg,com, Aug. 25, 2016.)

In the middle of the spectrum, professionals usually focus on aggregate and summary information as inputs to their processes and might generally accept the data that originators/sellers and investors/buyers provide them as a given.

When the pension's board of trustees is comprised of non-investment professionals such as beneficiaries and politicians, IFR increases. After the Texas legislature approved the rescue plan for the DPFP in May 2017, Dallas Mayor Rawlings was able to appoint six veteran investment management executives to make up the majority of the DPFP board of trustees, taking an important step to reduce the future IFR of information asymmetry.

Information asymmetry means that taxpayers/guarantors might have limited ability to understand how a pension fund's activities might trigger their obligations to increase their contributions to the pension fund. For example, the city of Dallas' Chief Financial Officer Jeanne Chipperfield formally requested information on Nov. 4, 2013, from the DPFP on its alternative investments in connection with the scheduled state-mandated audit. But the DPFP refused to provide the documents to the city and stated that the information requested about the fund's alternative investments wasn't within the scope of the required audit. (See Feud over Dallas police-fire pension audit threatens to boil over, by Steve Thompson and Gary Jacobson, The Dallas Morning News, Jan. 2014.)

On Jan. 16, 2014, Chipperfield sent a letter to DPFP "respectfully demanding" the information the city had requested earlier. After extensive negotiations, the DPFP later reached a deal with attorneys for the city of Dallas to provide documents to a fund trustee, who was also a Dallas City Council member. Deloitte's subsequent review of that information showed that the fund valued real estate investments using improper techniques.

Outsized expenses

Fees and expenses reduce the returns earned by pension funds on their investments. Public pension funds with NACHY investments pay much higher fees on those assets than they pay on traditional stocks and bonds. For example, an equity index fund that tracks the overall return on the stock market incurs fees of about .01 percent to .02 percent of assets. In contrast, standard fees for hedge funds, private equity and real estate funds are much higher, with management fees starting at 1 percent to 2 percent of assets. In addition, managers of NACHY investments are paid performance bonus fees of 20 percent to 30 percent of the amount that the pension fund earns on the investment, if returns are more than a rate specified in the contract, which is called "carried interest."

Managers of NACHY investments are able to charge high fees because pension fund investors expect these managers to have unique and exceptional skills, and the ability to deliver extraordinary returns in excess of those available in less expensive investments. However, a Maryland Public Policy Institute study found that the 10 state pension funds which paid the highest fees and expenses in 2014 earned lower investment returns than the 10 funds that paid the lowest fees. (See Wall Street Fees and Investment Returns for 33 State Pension Funds, The Maryland Public Policy Institute, July 28, 2015.)

Outsized expenses are an IFR red flag, first, because they indicate the presence of higher-cost NACHY investments. According to a Jan. 29, 2013, Dallas Morning News report, in 2011, the $3.6 billion DPFP paid $32 million in investment management fees, or .89 percent, compared to $13.2 million, or .48 percent, in fees paid by the $2.75 billion Dallas Employees Retirement Fund, which had only 8 percent allocated to alternative investments. (See "Pension Board Spent $1 Million on Traveling Globe," The Dallas Morning News, Jan. 29, 2013, reprinted in Money Management Letter.)

Secondly, public pension funds reported $10 billion in investment-related expenses in 2014, but many funds don't disclose, track or monitor the additional 20 percent to 30 percent performance bonus fees retained by investment managers. Pew estimates that these undisclosed investment fees mean that investment expenses could be 40 percent higher than reported, or $4 billion in additional fees paid annually. (See State Public Pension Funds Increase Use of Complex Investments, by Greg Mennis, The Pew Charitable Trusts, April 12, 2017.)

Thirdly, the SEC reported that it found serious deficiencies in the area of fees and expenses during its examinations of 150 private equity firms. Andrew J. Bowden, director, SEC Office of Compliance Inspections and Examinations, said in a 2014 speech, "When we have examined how fees and expenses are handled by advisors to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time."

Bowden cited instances of inappropriate and improperly disclosed expenses, as well as hidden, improperly disclosed and excessive fees charged to investors. (See Spreading Sunshine in Private Equity, by Andrew J. Bowden, May 6, 2014.)

Centralized control

Publicly traded companies are large organizations with numerous executives, managers and employees directing and handling its operations. In contrast, NACHY investments are typically in smaller, privately held entities in which management has an ownership stake, along with other investors. NACHY investments are often built around the vision, expertise, contacts and marketing abilities of a founder and the management team. The management team's track record in previous deals is a major influence on institutional investors' demand for subsequent offerings.

Although most pension funds hire external managers for NACHY investments, pension funds might manage some of these investments internally — specifically real-estate investments. For example, an in-depth Feb. 17, 2013, investigative report by The Dallas Morning News revealed that many of the DPFP's luxury real estate development projects were managed internally or by an outside management firm that happened to be located in the same building as the DPFP headquarters. (See "Dallas police-fire pension fund has $400 million bet on luxury real estate," by Steve Thompson and Gary Jacobson, The Dallas Morning News, Feb. 23, 2013.)

Centralized control might enable owner/managers to generate exceptional returns, but it's also an IFR factor. For one example, owner/managers might hire, contract with and set the compensation for partners, affiliates and professional service providers with whom they might have undisclosed relationships. In the private equity field, the SEC's Bowman said in his 2014 speech that its examinations found instances of insufficient disclosure relating to payments to certain consultants.

Illiquid assets

Liquidity refers to the ease of converting assets into cash. Stock exchanges such as the New York Stock Exchange and the NASDAQ provide liquidity through specialists and market makers that hold inventories of stocks and post prices at which they will buy or sell. In the bond market, U.S. Treasury bonds are the most liquid instrument because the Federal Reserve designates major banks as primary dealers and so are required to participate in auctions of U.S. Treasury bonds and to post real-time prices.

In comparison, NACHY investments are subject to varying degrees of illiquidity. For example, certain mortgage-backed structured products are registered securities, but their complexity and customization make matching of buyers and sellers more difficult.

Hedge funds are private entities that usually restrict customer redemptions to designated periods. Private equity funds are also privately held with investors often committed to the fund for five to 10 years. Pension funds have long invested in core commercial real estate, such as office buildings, which requires substantial time and extensive negotiation to structure purchase or sale transactions.

Valuation is one issue with illiquid assets. Because continuous, comparable arms-length transaction data might not be available, valuation might be based on estimates, assumptions and model-generated prices. Illiquid assets are an IFR red flag because their valuations can diverge from economic reality. This IFR increases when information asymmetry and centralized control red flags are also present and when the regulatory environment doesn't require external audits or independent oversight.

For example, the Dallas Morning News in its February 2013 story was the first to report that some of the DPFP's real estate holdings were valued at cost or the amount invested rather than using market valuations. Nearly two years later, Deloitte's January 2015 report on its review of the fund confirmed the improper application of accounting standards for asset valuation.

Confirmation bias

Confirmation bias is the tendency for decision-makers to seek out and accept information that validates their previous decisions and commitments, and to disregard information that suggests their decisions are wrong.

Behavioral finance expert Daniel Kahneman, in his book Thinking, Fast and Slow (Farrar, Straus & Giroux), has identified confirmation bias as part of humankind's built-in mental processing system. In some personal situations, these mental shortcuts might be harmless. But in the investment realm, as well as in other business and professional contexts, faulty decisions based on confirmation bias can have serious and long-lasting consequences.

Here's a simple recipe for negative outcomes when pension funds are making decisions about NACHY investments: 1) disregard problems in the investment rationale 2) ignore downside risks and probabilities 3) fail to consider complete and updated information.

Confirmation bias is an IFR factor that might not be apparent when suspicious losses in NACHY investments are first discovered. One earlier observable indicator of problematic confirmation bias is any attempt to take action against those who raise questions about a pension fund's investments. On Dec. 11, 2015, the Dallas Morning News reported that Dallas City Council member and DPFP Trustee Scott Griggs, who'd earlier raised questions about the fund, was the subject of a "forensic trace" investigation by an attorney for the Dallas Police and Fire Pension Fund using an outside consultant. (See Records: Police/fire pension attorney paid for 'forensic trace' on Dallas councilman Griggs by Steve Thompson, The Dallas Morning News, Dec. 10, 2015.)

In another incident, DPFP trustees considered "censuring" Dallas City Council member Phillip Kingston for comments he made to the media about the fund's Museum Tower investment, according to a March 30, 2016, story in the Dallas Observer. (See Police and Fire Pension Fund Should Be Ashamed of Going After Kingston, by Jim Schutze, Dallas Observer, Mar. 30, 2016.)

Regulatory environment

NACHY investments are generally designed to be lightly regulated because they're privately held and only large institutions can purchase them. As I've said, these qualified institutional buyers are expected to have the ability to intelligently analyze and monitor investments.

U.S. states that create public pension funds are also responsible for regulating them. State regulations cover areas such as governance, audit requirements, liability discount rates, allowable investments and investment disclosure. Several states changed their laws to facilitate NACHY investments, for example, South Carolina, which enabled these investments in 2007. Other states have provisions to protect certain information about private equity investments from public disclosure.

The regulatory environment can affect IFR in several ways. State laws that restrict disclosure of information on NACHY investments and fees result in increased IFR. The frequency of audit requirements also can increase IFR. In the Dallas case, Texas government code § 802.1012 provides that public pension funds are only subject to an "actuarial audit" every five years. The DPFP had been audited in 2008, so no external audits were required until 2013, despite the numerous questions raised about the operations of the fund during those five years.

Moral hazard

This is the increased incentive to engage in high-risk transactions that might occur when a third party will cover losses. The concept covers formal insurance policies, but also applies to any type of third-party guarantee or bailout, such as the taxpayer-funded Troubled Asset Relief Program bailout of major banks during the 2008 financial crisis.

In the Dallas example, the DPFP System's benefits are guaranteed by taxpayers under the Texas Constitution. According to the Center for Retirement Research at Boston College, 48 out of 50 states provide protections against reductions in pension benefits under their state constitutions or by other state laws.

The DPFP had the riskiest strategy of any pension fund because of its high allocation to alternative investments, according to research firm Preqin, Ltd. as reported by Bloomberg News. (See Once-Celebrated Dallas Pension Fund Runs Risk of Going Broke, by Darrell Preston, Bloomberg News, Aug. 15, 2016.)

After the DPFP revealed it had lost $545 million in high-risk real estate investments, it called upon the taxpayers of the City of Dallas for a $600 million contribution in August 2016, which by October had increased to a request for $1.1 billion in taxpayer funds, along with an additional $36 million to cover the Fund's operating expenses and investment fees. (See Dallas Police, Fire Pension Crisis Worsens, NBC/DFW, Oct. 14, 2016, and Dallas Police and Fire Pension Fund now wants city to pay $36M to keep the lights on, Dallas Morning News, Oct. 13, 2016.)

NACHY investments require new approach to fraud risk assessment

Many public pension funds have turned to NACHY investments and strategies, accepting higher investment risks in the expectation of earning higher returns necessary to meet their obligations. Losses in these investments can have a devastating impact on the ongoing viability of a pension fund. As we have seen in the DPFP story, these NACHY investments are subject to higher potential for disputes over allegations of misrepresentation, mismanagement or other misconduct.

In addition to the ongoing FBI, SEC and Texas Ranger investigations, the DPFP board of trustees has filed lawsuits against some of those involved in the debacle, including its former outside investment manager, a former investment consultant and former attorneys. (See Dallas Police and Fire Pension System sues investment advisors, former attorney, by Tristan Hallman, The Dallas Morning News, Sept. 2, 2017.)

Pension funds' demand for investments in NACHY assets and strategies shows no sign of abating. For example, between January 2017 and March 2017, private equity funds raised a record $62 billion in funds in North America and gathered $156 billion worldwide — the most money raised since 2007. (See Private equity is breaking records left and right as funds rake in money, by Leslie Picker, CNBC, April 6, 2017.) Given the huge amount of money that continues to flood into such complex, opaque and illiquid assets and investment vehicles, we're likely to see a new wave of controversies and fraud allegations rivaling those of the 2008 financial crisis.

CFEs and auditors can help pension fund beneficiaries and taxpayers by incorporating investment forensic risk into their fraud risk assessment process for pension plans. Recognizing and understanding the seven red flags of IFR will also assist CFEs, attorneys and regulators in evaluating whether losses in public pension plan's NACHY investments might justify further investigation to uncover evidence of possible misconduct or fraud.

Monique G. Harley, CFE, is a veteran institutional portfolio manager, analyst and strategist, and managing director of Speculare Forensic Consulting, LLC. Her email address is: mgharleycfe@speculareforensics.com.

Author disclaimer: The author does not express any opinion about the liability, guilt or innocence of any party mentioned in this article. She obtained the background information here from previously reported and publicly available sources, including the Dallas Morning News, The New York Times, The Wall Street Journal, investment industry publications and other media reports — any of which might be inaccurate or subject to change. The information in these articles is intended for educational purposes only.

Glossary of non-traditional, alternative, complex and high yield (NACHY) investment vehicles and asset classes

NACHY investment vehicles

Hedge funds are private, pooled investment vehicles that investors use to engage in complex investment and risk management strategies to generate “alpha,” the industry’s term for higher returns than unmanaged market benchmarks like the S&P 500. Hedge funds might invest in virtually any tradable asset class, from stocks and bonds to futures, options and other derivatives, currencies and precious metals.

Strategies include hedging or risk-reduction strategies such as long-short equity and market neutral, as well as return maximization strategies such as merger, credit and convertible arbitrage, relative value strategies in fixed income securities, energy and real estate, and macro strategies in currency, metals and energy. Hedge funds typically use leverage, or borrowed funds, and might engage in short selling of securities to benefit from falling prices.

Private equity funds are private, pooled investment vehicles that invest in privately held companies. Private equity firms typically engage in leveraged buyout transactions in which they purchase an existing publicly traded operating company using funds borrowed from investors. The private equity fund and its investors manage the now-private company to maximize returns over a five- to 10-year horizon. Private equity firms might also provide venture and growth capital, and invest in distressed debt, private credit, real estate, infrastructure, energy/power production and other assets.

Securities lending programs are offered by custodian banks to their institutional investor clients to provide them with opportunities to earn additional income from their securities holdings. Custodian banks are major financial institutions that provide safekeeping, administrative and other services to institutional investors.

In a securities lending program, a pension fund loans securities to a borrower — typically a broker-dealer — and receives cash collateral from the broker-dealer of at least 100 percent of the market value of the securities lent. The pension fund lender pays the borrower a rebate — or fee — for the use of the cash collateral unless the securities lent are in high demand, in which case the borrower pays the lender a fee.

The custodian bank co-mingles the cash collateral from its clients and invests those funds in eligible short-term investments, which might include structured products. Earnings from the cash collateral are divided between the pension fund and the custodian bank on a predetermined basis — for example, 60 percent to the pension fund and 40 percent to the custodian bank.

NACHY asset classes

Real estate: Pension funds invest in real estate primarily to obtain higher yields than those available in fixed-income securities. Institutions invest in three risk categories of real estate: core, value-added and opportunistic. The least-risky core real estate sector consists of Class A established properties with long-term, stable and predictable cash flows from lease payments. Higher-risk value-added properties require renovation or redevelopment to increase lease rates. Opportunistic investments in speculative real estate development have the highest risk. Institutional investors might invest in real estate directly through private partnerships or publicly traded real estate investment trusts.

High-yield and distressed debt: Entities with non-investment grade ratings (rated BB/Ba or below by organizations such as S&P and Moody’s) issue high-yield bonds and loans. Distressed debt refers to bonds and loans of troubled entities that might be in default or bankruptcy. High-yield and distressed-debt strategies might also include derivatives such as credit default swaps and structured products such as collateralized debt obligations and collateralized loan obligations.

Structured products: Securities are created out of pools of assets that generate cash flows, such as residential or commercial mortgages. Underwriters issue bonds secured by the asset pool and engineer the distribution of cash flows from the pool to create series of securities with a wide range of different risk and return characteristics, which they designed to appeal to various types of investors. Structured products often include various types of derivatives. Structured products include residential mortgage-backed securities, commercial mortgage-backed securities and asset-backed commercial paper as well as collateralized debt obligations, collateralized loan obligations, structured notes and other products.

Derivatives: Investment contracts that provide for payments between parties based on or derived from stock market indexes like the S&P 500, interest rates, exchange rates, commodities like oil prices, or any combination of these or other factors.

Private credit/private placements: Privately negotiated loans by non-bank lenders, which might include secured and unsecured loans to both large and middle-market companies, and special situation loans to distressed companies or those involved in leveraged buyout transactions.

Infrastructure: Investments in domestic and international civil assets such as toll roads, power and wastewater treatment plants, pipelines, bridges and airports. Infrastructure investments might occur in partnership with governments and are primarily accessed through private partnerships.

Agriculture/farmland: Investments in farmland, timberland and permanent crops like nuts, grapes and citrus. Institutional investors might invest directly, through private partnerships or through publicly traded real estate investment trusts.