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How Not to Get Madoffed

The Ponzi scheme allegedly orchestrated by Wall Street trader Bernard Madoff exposes the need for greater due diligence by all companies on the investments in their retirement plans.

January 9, 2009
Chuck Gallagher has a unique perspective on the Madoff scandal. In the mid-1990s, he served eight months in federal prison for plotting and executing his own Ponzi scheme. Now a business ethics and fraud prevention consultant, Gallagher says that any company thinking, "This wouldn’t happen to me" is dead wrong.

    "Fraud is like cancer; it needs fuel," he says. "In a down economy, fraud will be on the rise. [The time is] ripe."

    On December 11, Bernard Madoff, a Wall Street trader and former chairman of Nasdaq, was arrested for running a $50 billion Ponzi scheme. While only a handful of pension plans had money invested with Madoff directly or through hedge funds of funds that invested with Madoff, experts say the scandal unveils the need for greater due diligence by all companies on the investments in their retirement plans.

    "I don’t think that [employers] should be generally distrustful, but I do think [they] need to have a healthy skepticism," Gallagher says.

    News of retirement plans that invested with Madoff surfaced in the weeks following his arrest. Among them are Sterling Properties, a St. Louis-based real estate company that had a 401(k) plan that allowed employees to invest with Madoff. The Fairfield, Connecticut, pension plan also invested $42 million with Madoff.

    But these situations are few and far between, experts say.

    "This is going to have virtually no impact on 401(k) plans," says Weston Tomkins, a practice leader for Watson Wyatt Worldwide’s investment consulting branch. "Even its impact on defined-benefit plans is going to be very, very modest."

    However, the scandal does shed light on the need for employers to perform more due diligence of not only how the investments in their plans are performing, but of the managers of these investments, says Joe Nagenast, researcher and senior manager of Target Date Analytics and president of Turnstone Advisory Group, a Marina del Rey, California-based investment advisory firm.

    "Just because someone looks impressive, don’t drop the basics," he says. "If you can’t understand how a manager is making money and they won’t tell you, don’t invest with them."

    Specifically, the scandal exposes the need for employers to be diligent in reviewing hedge fund of funds in their retirement plans. Hedge fund of funds, which are essentially mutual funds that invest in hedge-like fund vehicles, have lately become more popular in the 401(k) industry. Tremont Group and Fairfield Greenwich Group, two firms that manage hedge funds of fund investments for institutional investors, invested with Madoff.

    Some experts argue that hedge funds, even through fund of funds, have no place in 401(k) plans. "It’s just not an appropriate investment," Tomkins says.

    These vehicles are particularly inappropriate in a 401(k) plan because the average employee doesn’t have the investment knowledge to understand these vehicles, Nagenast says.

    Also, hedge funds are often not transparent in terms of what they invest in, says Mike Griffin, hedge fund manager with Spectrum Global Fund Administration, a privately owned fund administrator based in Chicago. Hedge fund managers are often wary of sharing what they see as proprietary business tactics, Griffin says. Still, it’s not enough for employers to be blindly accepting of their strategies. Spectrum now provides daily return data for clients as part of an effort to be more transparent.

    Even companies that have advisors overseeing their retirement plans need to be diligent, Nagenast says. "An employer is never fully relieved of their fiduciary duty," he says.

    And if companies do have hedge fund of funds in their plans, they need to increase investment education for employees to make sure that they understand exactly how their money is being invested, says Matthew Tuttle, president of Stamford, Connecticut-based Tuttle Wealth Management.

    Companies also really need to make sure their money managers are doing the right things, he says.

    "Fund of funds really dropped the ball," Tuttle says. Clients were paying for a level of due diligence and institutional oversight that obviously didn’t take place when examining whether investing with Madoff was a smart decision, he says.

    Jeff Sklar, managing director of Bellmore, New York-based SHC Consulting Group, predicts that the scandal will cause an increase in government oversight of investments, particularly among private equity and hedge funds. Still, he says, "We can put in laws all we want; the problem is in enforcement."

    "I think this will cause employers to take a hard look at their portfolios," Sklar says.

    Despite the fact that Madoff’s returns were never truly outstanding, experts agree that there should have been a bump in the road at some point.

    And that in itself should have been a red flag, they say.

    After all, the experts say: If it looks too good to be true, it probably is.