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What Action is the Department of Labor Taking to
Protect America's Retirement Security in the Wake of the Ongoing Mutual
Fund Industry Scandals?
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March 29, 2004
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Thank you, Mary (Barneby, FWA President and First VP of
UBS), for that kind introduction. I am pleased to be here today to talk to
the Washington Briefing of the Financial Women’s Association (FWA).
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I realize that this conference is the direct result of a
demand by your members for a window on the Washington policymaking process.
Well, judging from the line up of speakers on your agenda, you have clearly
met that demand!
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I also want to commend you, Martha (Goss/Co-Chair of
Washington Briefing), for your hard work in setting up this important
conference. As the leading national professional organization for women in
finance, I know the allegations of scandal in the mutual fund industry –
and the legislative and regulatory response they have set off – are of
great interest to you.
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It's hardly surprising that troubles in the mutual fund
industry have attracted 24-7 media coverage for the past year. According to
the Investment Company Institute, nearly 50% of all U.S. households own at
least one mutual fund, up from fewer than 31% as recently as eight years ago
and only about 6% in 1980. This rise in the “investor class” has changed
our economy and precipitated intense congressional and political scrutiny.
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Thirty-six million U.S. households invest in mutual funds
through employer provided retirement plans. This accounts for one-third of
all investments in mutual funds. Quite clearly, problems in mutual funds are
problems for retirement plans – problems that we at the Labor Department
must address.
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In spite of its popularity – or maybe, because of it
– the mutual fund industry is facing intense scrutiny. But, there is a
window of opportunity to restore investor trust. And, the government must
respond with strong but sensible regulation.
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Today, I want to talk about the impact of late trading,
market timing, and excessive fees on the retirement plan participants that
the Department is pledged to protect.
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Most of the 8,000 mutual funds in the U.S. are serving
investors well. But a number of bad actors have put the investor, the
industry, and to some extent, the economy, in a tough position.
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President Bush has proposed six specific steps to spur
economic growth, create jobs, and build employer and consumer confidence.
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We need to make health care more affordable, reduce the
burden lawsuits place on our economy, ensure an affordable, reliable energy
supply, streamline regulations and reporting, and continue to seek new
markets for American products abroad.Finally, the President wants to enable
families and business to plan for the future with confidence. A major
component of economic security is retirement security. Our commitment is to
implement policies that help American workers and their families retire with
confidence.
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Private sector pension plans invest $700 billion dollars
in mutual funds, representing 18% of all investments by such plans. Most
Americans who invest in a 401(k) or some other type of retirement plan have
their contributions automatically deducted from their paycheck on the
presumption that, somewhere a fund manager is looking out for their best
financial interest. Unfortunately, this is not always the case.
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Last year state and federal authorities began unraveling
a scandal revealing questionable and potentially illegal practices at the
largest mutual funds. Plan fiduciaries – the persons responsible for
making investment decisions – are understandably concerned about how they
should react to the current turmoil surrounding mutual funds.
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While the SEC focuses on securities fraud cases, DOL’s
role is to enforce the provisions of the Employee Retirement Income Security
Act, or ERISA, regarding the mishandling of retirement plan assets. The
Department acts through my agency, the Employee Benefits Security
Administration, or EBSA. EBSA doesn’t have direct authority over mutual
funds because, under ERISA, the assets of a mutual fund are not “plan
assets.” However, affiliates of the mutual fund may act as fiduciaries to
retirement plans, bringing them under our jurisdiction. And, ERISA-covered
pension plans are significant investors in mutual funds. In addition, common
and collective trusts sponsored by banks and other institutions do not have
the same exception in ERISA. They do hold plan assets and thus are subject
to ERISA’s fiduciary rules.
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While the SEC regulates the internal operations of mutual
funds and disclosures associated with the purchase and sale of shares, DOL
deals with retirement plans that invest in these funds. Anyone who exercises
discretionary authority or control over the management of a plan or its
assets, or gives investment advice for a fee, is a fiduciary under ERISA and
must act prudently and solely in the interests of the plan’s participants
and for the exclusive purpose of providing promised benefits. Plan sponsors,
brokers, investment managers, and advisors are all potentially subject to
ERISA’s fiduciary rules if they meet this functional test.
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What is the practical implication of being a fiduciary
under ERISA? Simply put, plan fiduciaries must act thoughtfully and
undertake a process to determine what, if any, action they should take to
protect plan participants. On February 18, the Department issued guidance to
assist fiduciaries in determining whether plan investments in mutual funds
and other pooled investment vehicles are, or continue to be, appropriate for
their plan. The guidance also addressed steps that plan fiduciaries might
take to limit the potential for market timing in their plans. I would like
to take a moment to summarize several of the key points from this guidance.
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As significant investors in mutual funds, plan
fiduciaries, understandably, are concerned about the impact of reported late
trading and market-timing abuses on their plans and the steps that should be
taken to protect the interests of their plans’ participants and
beneficiaries.
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Although investors generally could not anticipate the
late trading and market-timing problems identified by Federal and state
regulators, plan fiduciaries nonetheless are now faced with the difficult
task of assessing the impact of these problems on their plans’ investments
and on investment options made available to the plans’ participants and
beneficiaries.
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As fiduciaries conduct their review, it is important to
remember that ERISA requires that they discharge their duties prudently. The
exercise of prudence in this context requires a careful, deliberative
process. Fiduciaries, in deciding whether to make any changes in mutual fund
investments or investment options, must make decisions that are as well
informed as possible under the circumstances.
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In cases where specific funds have been identified as
under investigation by government agencies, fiduciaries should consider the
nature of the alleged abuses, the potential economic impact of those abuses
on the plan’s investments, the steps taken by the fund to limit the
potential for such abuses in the future, and any remedial action taken or
contemplated to make investors whole. To the extent that such information
has not been provided or is not otherwise available, a plan fiduciary should
consider contacting the fund directly in an effort to obtain specific
information. Fiduciaries of plans invested in such funds may ultimately have
to decide whether to participate in lawsuits or settlements. In doing so,
they will need to weigh the costs to the plan against the likelihood and
amount of potential recoveries.
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Of course, the appropriate course of action will depend
on the particular facts and circumstances relating to a plan’s investment
in a fund. Plan fiduciaries should follow prudent plan procedures relating
to investment decisions and document their decisions. The guiding principle
for fiduciaries should be to ensure that appropriate efforts are being made
to act reasonably, prudently and solely in the interests of participants and
beneficiaries. Through our discussions with employer groups and other
members of the employee benefits community, we believe that most fiduciaries
are taking these issues seriously and are considering the available
information in attempting to fulfill their fiduciary duties.
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In an effort to address these concerns, plan sponsors and
fiduciaries have raised questions as to the steps that can be taken to
address market-timing by plan participants. In particular, questions have
been asked as to whether a plan’s offering of mutual fund or other similar
investments that impose reasonable redemption fees on sales of their shares
– or whether reasonable plan or mutual fund limits on the number of times
a participant can move in and out of a particular investment within a
particular period – would affect the safe harbor that protects plan
sponsors from liability for the investment decisions of individuals in
participant-directed plans.
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The guidance makes clear that both these approaches would
not, in and of themselves, violate the safe harbor, provided that any such
restrictions are clearly disclosed to the plan’s participants and
beneficiaries.
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As SEC Commissioner Cynthia Glassman has mentioned, in December of last year,
the SEC issued a proposed rule to combat illegal late trading, which has
come to be known as the “Hard 4 Close” proposal. Under the proposed
rule, all mutual fund orders would have to be received by fund companies by
Market Close (generally, 4 p.m. eastern time). The proposal also solicited
comments on an alternative, which would involve combining technological
solutions (such as time-stamping of when orders were received and creating
an electronic audit trail) with enhanced compliance procedures, including
independent audits, to ensure that illegal late trades are prevented.
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Most of the retirement services industry is strongly
opposed to the “Hard 4 Close.” They have strenuously argued that the SEC’s
proposal will create enormous disadvantages for participants investing
through retirement plans.
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The retirement services industry asserts that
intermediaries, such as third party administrators, will be forced to
cut-off trading in mutual funds much earlier than 4 p.m. in order to process
trades and ensure that they are delivered to fund companies by 4 p.m.
Retirement plan participants will see even earlier cut-off times because of
the additional administrative and regulatory obligations around retirement
plan transactions.
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As a result, unlike individual investors, participants in
401(k) plans will not be able to do a round-trip trade in a day, and may
have to trade at the next day’s price. Some retirement plan administrators
also argue that the “Hard 4” proposal unfairly favors large institutions
that offer proprietary funds.
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In response to the SEC’s request, some in the regulated
community have advanced an alternative they argue would provide certainty
that illegal late trading will be detected without disadvantaging the
retirement plan investor. Under the so-called “Smart 4” option, trades
must be received by 4 p.m. at the fund company unless intermediaries are
certified by the SEC to have an electronic audit trail, executive
certification, and other key protections in place.
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This alternative has been shared with the SEC and is
similar, although somewhat more fleshed out, to proposals being considered
in Congress. We share the SEC’s interest in developing a rule that will
protect all investors from fraud and market-timing while recognizing
legitimate concerns raised by the unique aspects of retirement plan
administration to the extent possible.
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EBSA is currently conducting its own review of practices
by mutual funds and other pooled investment vehicles, such as bank
collective trusts, as well as service providers and so-called “intermediaries”
to such funds, to determine whether there have been any violations of ERISA.
We are examining a sample of mutual fund and other financial service
providers to see whether activities such as market timing or illegal late
trading may have harmed retirement plan beneficiaries.
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Under ERISA, a mutual fund affiliate or other retirement
plan fiduciary that engages in or facilitates market timing or late trading,
causing losses to an ERISA covered plan, is liable to restore losses to the
plan. We are focusing primarily on investment companies and banks that offer
401(k) services to plans rather than on employers who run their own
retirement plans. We are looking for improper payments for directed
investments, and whether retirement accounts have been used to facilitate
market timing or late trading for clients.
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I should note that this review is exploratory and not the
result of specific evidence that investment professionals serving as
fiduciaries have engaged in improper or illegal activity. We don’t know
yet if there are significant problems here but we have an obligation to look
and we will take appropriate action if we discover abuses.
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Another ERISA fiduciary concern currently in the news is
the issue of fees.
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Under ERISA, fiduciaries have a legal obligation to
ensure that fees and expenses paid by its retirement plan are reasonable,
and to prudently select and monitor the investment options that it makes
available under its plan. This duty is ongoing, so the fiduciary must
monitor to determine that particular service providers and investment
options continue to be appropriate choices. Performance is only one element
in this analysis. Another is the reasonableness of the fees charged to the
plan.
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As you know, there are a variety of direct and indirect
fees that may be charged when plans invest in a mutual fund or other
collective investment vehicles. Many plan service providers offer “bundled
fee” arrangements where a number of different services, including record
keeping, are packaged together and the plan is charged a single fee.
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Additionally, an investment provider sometimes may
provide financial incentives such as 12b-1 fees or revenue sharing
arrangements to plan service providers such as brokers or consultants for
including that vehicle on the provider’s “platform” or making that
vehicle available as an investment option to its clients. This is sometimes
referred to as a “pay-to-play arrangement”. Finally, “soft dollar”
and directed brokerage arrangements are under increasing scrutiny, and there
are proposals to change or even abolish them.
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Plan fiduciaries have a duty under ERISA to act prudently
and in the interests of plans and participants when evaluating all service
arrangements, including bundled fee arrangements, soft dollar and directed
brokerage arrangements, to ensure that the aggregate of fees paid by their
plans are reasonable in light of the quality and level of services provided.
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If a plan fiduciary does not have sufficient information
to compare service providers and make an informed decision, he or she should
request all relevant information from the service provider. The Department
posts on its Website a series of educational pamphlets on ERISA fiduciary
responsibilities, including fees, and a very useful tool developed by ABA,
ACLI, and ICI designed to provide employers with detailed information from
financial service providers comparing the services offered and fees charged.
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“Pay to play” and soft-dollar arrangements present
particularly difficult issues for plan sponsors and fiduciaries because of
the inherent conflicts of interest involved. With regard to “pay to play,”
if the financial service provider receiving these payments is itself a plan
fiduciary, the transaction violates ERISA’s prohibited transaction rules
[406 (b) 1, and 406 (b) 3] because the service provider is using its
fiduciary authority to increase its compensation. This is illegal
self-dealing.
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Even if the financial service provider is not a
fiduciary, it must still provide the plan sponsor or other designated
official sufficient information so that they can fulfill their fiduciary
obligations.
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For “soft dollars,” the plan fiduciary should know
and approve its investment manager’s arrangement. The fiduciary should
determine whether research and services being purchased with the plan’s
brokerage are worth the higher trading costs and that the broker has
provided the best execution of the trades. It is up to the fiduciary to make
this determination.
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Disclosure is equally important for plan participants
when they direct their own investments. Under ERISA, to the extent a
participant or beneficiary exercises free and independent control over the
assets in his or her individual account, fiduciaries of the plan are not
liable for any losses resulting from the participant’s investment
decisions. Without information, however, participants cannot exercise
control. And, without participant control, fiduciaries cannot escape
liability.
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For this reason, DOL regulations require that certain
information be furnished to plan participants and beneficiaries. Among the
information which the plan administrator is required to provide to the
participant is a description of any transaction fees and expenses which
affect the participant’s account balance in connection with purchases or
sales of interests in investment alternatives, such as commissions, sales
loads, deferred sales charges, redemption or exchange fees. Also, the
participant must be provided directly or upon request with a description of
the annual operating expenses of each designated investment alternative
which reduces the rate of return of the alternative, such as investment
management fees, administrative fees and transaction costs, and copies of
any prospectuses, financial statements and reports, and of any other
materials relating to investment alternatives available under the plan.
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A prospectus, prepared in accordance with SEC standards,
is a principal means of fee disclosure for many investment vehicles.
Proposals that would enhance transparency by requiring more complete and
clear disclosures of fees and expenses paid by investment vehicles would
help plan fiduciaries in discharging their ERISA responsibilities in a more
informed manner, and would assist participants in making more informed
investment decisions. We strongly support the SEC’s efforts in this area.
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Perhaps one of the beneficial side effects of the
unfortunate spate of corporate fraud and mutual fund scandals is a renewed
emphasis on good corporate governance and good plan governance. I hope that
the issues raised with respect to mutual fund practices have focused plan
fiduciaries – both plan sponsors and their fiduciary advisors – on the
important role they play in protecting plan participants and has provided a
necessary wake up call for people to take their fiduciary responsibilities
seriously. In the long run, a renewed focus on fiduciary responsibility will
benefit us all.
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The mutual fund practices that have been uncovered are
potentially harmful to plan participants and have broken a bond of trust
with the investing public. To the extent that they are illegal, the
responsible parties must be prosecuted to the fullest extent and ordered to
make restitution.
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But, we would have learned the wrong lesson if small
investors were to flee from mutual funds and collective investments as a
result of this scandal – to abandon the diversification and stability
offered by these funds in favor of shifting their retirement savings into
individual stocks, or worse, out of the market completely. Mutual funds and
collective trusts have truly democratized investing; confidence in these
vehicles must be restored and strengthened.
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The challenge before the Administration, the Congress and
the industry, is to implement the necessary changes in regulation and
business practices, and then work together to reassure the investor that the
problems have been corrected and their retirement savings are safe.
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Thank you for inviting me to be with you today. I’d be
happy to take a few questions.
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