Few winners here.                                                          Photographer: John Gurzinski/AFP/Getty Images
Few winners here.                                                          Photographer: John Gurzinski/AFP/Getty Images

In September 1974, Congress passed a law aimed at ensuring that U.S. companies could fulfill the vast pension promises they had made to millions of employees. Forty years later, that law is greatly in need of reinterpretation.

Known as the Employee Retirement Income Security Act, the law has been widely hailed as a success. It created standards for managing private pension funds that professionalized their operations -- and that public pension funds, which invest on behalf of government employees, have also chosen to adopt.

In 1978, though, the Labor Department made an adjustment that has had vast consequences. Responding to political pressure and influenced by new academic thinking on portfolio theory, it reinterpreted the so-called prudent-man rule of fiduciary duty. Fund managers would be judged not on the risk of their individual investments, but on the risk profile of their investment portfolio as a whole.

The result was that the pension funds, which had long been limited to safe assets such as corporate bonds and Treasury securities, could put some money into riskier investments such as stocks and venture capital -- on the assumption that diversification, both by asset class and within each asset class, would reduce risk in the broader portfolio.

Unfortunately, over-reliance on the power of diversification has led fund managers to be less attentive to the hazards of particular investments. Consider two examples: private-label mortgage securities, which are issued without government guarantees, and private-equity partnerships, which acquire public companies with the aim of restructuring them and selling at a profit.

Seduced by AAA ratings, fund managers often ignored the extraordinary complexity of mortgage securitizations, which typically involve hundreds of pages of documents defining the circumstances under which different investors get paid or suffer losses. As a result, they failed to notice some significant pitfalls.

For one, the contracts governing the securities gave an outsized, badly conflicted role to the mortgage servicer, responsible for interacting with borrowers and passing payments along to investors. Because the servicers were often the same banks that had made other loans to the borrowers, and because they could make more money by foreclosing than by fixing troubled loans, they had strong incentives to act against the investors' (and the borrowers') best interests.

The evidence is overwhelming that servicers abused their powers. They gave their own loans preference in making modifications and when counseling borrowers on what to pay first. They increased their profits by precipitating foreclosures and by forcing borrowers to buy insurance. They skimmed extra fees from money that they were supposed to pass on to investors.

Such abuses made the housing crash far worse than it should have been, and left badly burned investors wary of ever buying private-label securities again. As a result, nearly six years after the crisis, the mortgage market remains on government life support.

In private equity, too, pension-fund managers closed their eyes to conflicts of interest among the people to whom they were entrusting their money. The Securities and Exchange Commission has recently uncovered widespread illegal and undisclosed investor charges as well as serious compliance deficiencies at private-equity companies. It attributed the problems to lopsided partnership agreements in which the limited partners -- investors such as pension funds -- gave the general partners too much leeway for abuse (for more on the subject, see my blog).

Under the 1974 act, the Labor Department has the authority to change the way pension funds invest. It should, for example, restrict permissible assets to those with a minimum of a full business cycle of historical performance data, so managers can adequately assess the risks. It might even consider prohibiting investments that are too risky, or in funds that don't use independent third parties to value their assets. During the 2008 crisis, investors complained that the in-house valuations provided by private-equity funds were too high given the sharp decline in stock markets.

Pension funds should also demand more information about fees, and set limits -- an effort that the Labor Department could support by imposing restrictions on the total level of non-performance-based fees and expenses. Understanding the fees that private-equity funds charge is still difficult, because they don't itemize all the compensation they take from the fund and its portfolio companies. The government needs to require full transparency here as well as bar certain types of charges. Some private-equity funds, for example, have the authority to pass on fines for regulatory violations to investors -- a practice that shouldn't be allowed.

The original premise of the prudent-man rule was that pension-fund managers needed to operate as if their clients were widows and orphans. Sadly, experience has shown that the managers are often as vulnerable to exploitation as the people on whose behalf they are investing. A few changes would help ensure that they do their homework better.

To contact the writer of this article: Yves Smith at yves@nakedcapitalism.com

To contact the editor responsible for this article: Mark Whitehouse at mwhitehouse1@bloomberg.net.