VideoAs the mutual-fund probe widens, 401(k) plan sponsors are taking a hard look at an industry long regarded as a reliable workhorse for individual retirement plans. That image has taken quite a beating since September 3, when New York State Attorney General Eliot Spitzer announced a $40 million settlement agreement with Canary Capital Partners LLC—a hedge fund that obtained special trading privileges with several mutual-fund families, including Bank of America's Nations Funds—and launched an investigation into fund practices. And as the charges and allegations of late-trading and market timing (quick "in and out" trades that exploit loopholes in the way fund shares are priced) have mounted, employers are scrambling to figure out how the fallout will affect their plans.
"We're trying to gather facts," says Terry McClain, CFO of Valmont Industries, whose 3,200 U.S. employees have some $185 million invested in its 401(k) plan. First on McClain's agenda is to reassure Valmont's employees that their plan assets are safe, he says. Second is determining whether the managers of the offered funds have adequate safeguards in place to protect against corrupt practices. As to whether or not Valmont employees have been cheated, McClain can't "say definitely." But, he adds, "it's being investigated."
Like McClain, other plan sponsors are concerned about the implications for 401(k) plans. If the practices being investigated are found to be widespread, plan participants may be being robbed of billions of dollars in retirement savings. Investors are hurt by market timers, for example, because every time a trade is made in a mutual fund, fees are incurred that come out of fund assets. Frequent trading also deflates the net asset value of a fund for all remaining investors. "In short, while individual shareholders may profit from engaging in short-term trading of mutual-fund shares, the costs associated with such trading are borne by all fund shareholders," the Securities and Exchange Commission wrote in its civil action against two former Putnam Investments portfolio managers.
Those costs, along with the potential for missed profits, are also raising fiduciary concerns. It seems unlikely that plan sponsors can be held liable for improper activities in mutual funds that have occurred up until now. But Mercer Bullard, a professor of securities law at the University of Mississippi School of Law, notes that after the Nations Funds revelations, companies are "on notice" that they can be held liable from now on.
Courses and Recourses
Not surprisingly, the most immediate employer reaction has been to abandon the worst offenders. For example, within two days of charges being brought against the Putnam managers, the treasurer of the Commonwealth of Massachusetts recommended that Putnam be ousted as a manager of the state's employees' pension funds.
While it is too early to tell how many companies will take such a drastic step, Geoff Bobroff, president of Bobroff Consulting Inc., of East Greenwich, Rhode Island, believes sponsors should at least determine whether fund problems are pervasive or isolated instances of loss of control. For example, plan sponsors should ensure that funds have some safeguards in place—either fair-value pricing or the imposition of redemption fees—to discourage market timing, says Bobroff. They should also be asking about relationships between brokers and advisers—how funds are being placed and what payments are being made to brokers for what purposes.
That lesson is not lost on McClain. "We review our funds regularly," he says. But from now on, he adds, the company's review committee will be asking additional questions, such as, "What kind of controls does the fund have on [market timing]? What brokers does the fund use? and What kind of surveillance is in place to detect frequent trading?"
Companies should also consider the possible drawbacks before dumping a fund, according to Gary W. Howell, a partner with law firm Gardner Carton & Douglas. A fund's problems could be temporary, and, once resolved, that fund could again become a worthy investment, he wrote in a recent article. And given how widespread the allegations are—market timing or late trading is at issue in half of the 88 fund families the SEC is investigating—a sponsor has to figure out how to replace any funds it removes, says Bobroff.
Sponsors whose employees have already been hurt will also have to weigh legal action. Steven G. Schulman, a partner with Milberg Weiss Bershad Hynes & Lerach LLP, for example, is already pressing sponsors to become lead plaintiffs in class-action suits to recover beneficiaries' lost earnings. "Regulators have limited time and energy, and can't create full restitution for everyone," says Schulman. But 401(k) sponsors are in a good position to help ensure that the fullest-possible restitution is obtained, he says. In fact, Ann Combs, the U.S. Assistant Secretary of Labor, recently noted that plan sponsors may "ultimately have to decide whether and how to participate" in such suits as their fiduciary response to the scandals.
McClain says that Valmont might consider a class-action suit if it determined that its employees had lost a substantial amount of money, and that the money could not be recouped through a voluntary settlement. "If it is a matter of millions in the scheme of billions that some manager took, I'd hope the management company would make it up in reduced fees," he says. "If the market value lost is in the billions, then you'll have class actions all over the place."
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