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Subject to Failure

Recent scandals in the mutual-fund industry leave employers questioning the security of their plans.
Linda Corman, CFO Magazine
December 1, 2003

As 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."


Sharing Responsibility
At the same time, sponsors should shine the spotlight on themselves, says the University of Mississippi's Bullard. Putnam may be trying to absolve itself by saying "it's the plans' responsibility to minimize market timing," he explains. "But Putnam has a point: it's a shared responsibility." And the first step plans should take is to ask whether their participants have been engaging in timing and whether it is hurting other participants, he says.

The Profit Sharing/401(k) Council of America, in conjunction with Hewitt Associates, is currently devising methods to do just that, says council president David Wray. Three possibilities (which are already in use in some funds) are for plans to: (1) limit the number of trades allowed in a given period, (2) impose their own back-end loads on trades, or (3) institute minimal holding periods for trades of international funds, where most market timing occurs. Plan sponsors want to devise a solution that does not require them to confront individuals in their plans, says Wray. "The vice president of human resources or the CFO doesn't want this on his desk," he adds.

One company that has adopted internal controls is International Paper. Informed by its trustee about a year ago of frequent trading by some of its 68,000 401(k) participants (with $3.7 billion in assets), the company has adopted a "time-out" rule to control market timing, says Bob Hunkeler, vice president of investments. Under the rule, adopted November 1, a participant may not make more than one trade in a 48-hour period. Says Hunkeler: "We hope this [rule] will be enough to materially increase the risk of investment losses occurring abroad in the interim" to discourage quick trading.

Solving the problem of late trading, however, may involve some fixes that could hurt plan participants, according to the Profit Sharing/401(k) Council. For example, requiring plans to get their trades to fund companies by 3:59 p.m. daily would make unbundled plans—in which participants can hold funds from a variety of managers—less attractive than bundled plans, in which participants can own funds from only one manager. Because of the more-complex process of executing orders for unbundled plans, it takes longer to process trades, so orders would have to be made earlier in the day to meet the 3:59 p.m. deadline, says Wray.

The Problem of Fees
Reining in market timing and late trading may be only the first step in ensuring that employees get the returns they deserve, says Brent Glading, managing director of the Glading Group. More emphasis, he insists, should be placed on the excessive profits—up to 500 percent—that companies overseeing 401(k)s are making from management fees. "If [a plan sponsor] can recapture 35 basis points on assets and redirect that to participants, that could be worth a hell of a lot more to employees than companies [doing something] about certain trading practices," says Glading.

David Reiland, CFO of Los Angeles based Magnetek, whose 1,000 participants have approximately $35 million invested in the company's 401(k), agrees. "Market timing and late trades are a problem, but not a huge one in the long run," he says. "Sponsors should worry about consistency of style, overall fund performance, and expense ratio more than late trades," adds Reiland, who conducts a quarterly review of fund fees and performance. That review has been effective in deterring any trading problems, he says, because such activities could show up in outsized fees and poor performance.

Efforts such as Reiland's at Magnetek will probably intensify no matter how the current investigation turns out. And if nothing else, the probe will mean that the days when sponsors confidently left the husbanding of their employees' 401(k) plans to a once-untainted industry are now history.

Linda Corman is a freelance writer based in New York.

Birth of an Activist?
The Mutual-Fund Industry has long been criticized for not using its $7 trillion weight to reform market practices. But recent events are forcing it to adopt a new activism.

Shortly after the investigations came to light, for example, Fidelity Investments announced its support for eliminating the New York Stock Exchange's specialists system. Although the company has worked behind the scenes to reform the system, it was uncharacteristic for it to publicly promote its cause. In addition, the Investment Company Institute, the investment industry trade association, is lobbying for a board seat on the NYSE.

Such steps are not surprising, says Seth Taube, former SEC prosecutor and chairman of securities litigation at McCarter & English LLP, in Newark, New Jersey. "Institutional investors [including mutual funds] have realized they can't rely on Corporate America to regulate itself," says Taube. "There has been a movement by all institutional investors to take much more active roles."

In fact, Taube says he expects mutual funds to begin "showing up at annual meetings, exercising their proxies more independently, possibly getting together to appoint directors." Still, says Morningstar managing director Don Phillips, the most forceful step funds can take is to reward their portfolio managers for three-to-five-year performance rather than quarter to quarter.


In the short term, however, some experts say the industry may be too embattled to lead any reform. "Institutional investors bear much of the responsibility for the [recent] financial scandals, and the mutual-fund industry is the 800-pound gorilla in that group," says Mercer Bullard, a professor at the University of Mississippi School of Law. "But, mutual-fund firms are now much more concerned about policy abuses in their [own] companies." —L.C.




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