Lessons From Madoff

Unlikely. And this is the first important lesson learned in today’s volatile markets: as much as we want to hold the bad guys accountable, they rarely make good for the financial loss or suffering caused to their victims.

Another important lesson learned from the Madoff debacle is that fraud is very difficult to uncover, as by its very definition, fraud is not meant to be uncovered. Fraud may be in your portfolios, and it may not be. In any event, those that perpetrate fraud do not want to get caught and likely expend a greater amount of time, effort and money than those trying to catch them. The perpetrators are also usually smarter and nimbler, and thrive in an environment lacking any laws that demand ethics and integrity.

The tale of Madoff defies most logic because we have a system that promotes the order of law, and demands ethics and integrity. Yet crazier things have happened and in greater magnitude. Take capital markets, for example: crowd psychology propped up by subprime greed all based on wooden nickels, lending money to NINAs (No Income and No Assets) who could not by any reasonable measure possibly pay back the loan. In my view, this is nothing short of wide-scale fraud.

The reality is, it happened and it got past every check the system provides for investors, including pension plans. Who can we blame when so many parties failed to perform their duties?

So what do we do now? Do we seek and embrace more regulation or look for ways to improve plan governance by becoming fraud-sniffing fiduciaries? With markets and the nationalization of major global companies today, do we really want Big Brother running things and putting more and more regulation into place?

Probably not, because these solutions are like trying to systematically uncover fraud. Chances are, you will not find it, and so the pay-off just isn’t there. However, we can look at the lessons learned from today, take a deep breath and get a sense of the best way forward.

Lesson No. 1: If pension plans are the victims, how do we go about making plans whole? The frank answer is that what has been lost for some plans may never be made back. Some plans may become whole again someday, but no plan will ever be the same. Some will fail because the sponsor is unable to maintain it, some will convert to defined contribution (DC) and some may change into a target benefit plan being recommended by the Ontario Expert Commission on Pensions.

Lesson No. 2: Is trying to uncover fraud analogous to trying to uncover return opportunities these days? Uncovering fraud may be a very difficult exercise, like trying to find alpha: it may not even exist, so it’s difficult to know when to stop looking. A better use of time may be to focus on the liabilities side of the asset/liability equation—less exciting but equally important to asset return, and more predictable and capable of de-risking.

We have had three major market downturns in the last 10 years: Long-Term Capital Management, which blew up in the late ’90s, the tech wreck in the early 2000s and the current credit crunch. If this is a peek at the future of investing, then volatility appears to be increasing, which suggests that it may be prudent for de-risking strategies to become a core function for plan sponsors to evaluate.

To sum up, capital markets and plan circumstances call for priority management. Ferreting out fraud may be metaphorically seeking alpha, and increased governance expectations are akin to not being able “to see the forest for the trees.” Tangible matters that plan sponsors can reasonably predict and control should be the focus until more resources can be dedicated to those adverse deviation events that are infrequent and unpredictable, but ultimately severe.

Peter Arnold leads the Canadian Investment Consulting Practice for Buck Consultants, an ACS Company. He is responsible for the development and delivery of all investment and defined contribution consulting services in Canada.

If you’d like to comment on this story, click here.