Report of the Working Group on Guidance in Selecting and Monitoring Service Providers

November 13, 1996

The Working Group on Guidance in Selecting and Monitoring Service providers presents its interim report and recommendations to the 1996 ERISA Advisory Council.

I. THE WORKING GROUP'S PURPOSE AND SCOPE

The 1996 Advisory Council on Employee Welfare and Pension Benefit Plans created a Working Group on Guidance in Selecting and Monitoring Service Providers. The Working Group was charged with studying and making recommendations concerning the need for, appropriateness and form of guidance to plan sponsors and fiduciaries in the Selection and Monitoring of Service Providers.

The 1996 Working Group determined that its study would focus on welfare plans as well as pension plans. The Working Group also determined that its study should take place over the course of two years. After reviewing the universe of common service providers (see below), the Working Group concluded that, unless it focused its inquiry, the large variety of service providers would preclude a thorough evaluation of this topic.

The Working Group concluded that, the first year, the study would focus primarily on pension plans with an emphasis on the selection and monitoring of investment managers, investment consultants and bundled service arrangements for small 401(k) plans. The Working Group chose this approach based on testimony that the decisions involving investment management were likely to have the most significant impact on plan participants. The Working Group recommends that this study continue for a second year, to focus primarily on service providers to welfare plans.

The Working Group decided to review general principles and industry practices in the selection and monitoring of service providers that could be determined from the specific areas studied. Preliminary conclusions and recommendations would be reported after the first year and modified, as appropriate, after the second year of the study.

The need for discussion on this topic was reinforced by the work of the 1995 Advisory Council's Working Group on Real Estate Investments. Among its recommendations, the 1995 Real Estate Working Group recommended:

The Department of Labor should explore the feasibility of developing and disseminating a publication which simply details the duties of fiduciaries as they relate to plan investments in real estate.

Further study of the issues of plans with less access to sophisticated real estate expertise is warranted.

These recommendations were based on testimony before the 1995 Real Estate Investment Working Group that Trustee Guidance and education was necessary so that trustees better understand their potential liability, especially trustees of small and medium sized trusts.

II. WORKING GROUP PROCEEDINGS

The Working Group received oral and written testimony at a series of public hearings. The Working Group also received and discussed research and material from public sources that related to the topic of study.

At the meeting on May 7, 1996, the Working Group discussed the various types of service providers that might be retained by both pension and welfare plans (see page 1). The Working Group acknowledged that different selection and/or monitoring procedures might be appropriate for different types and sizes of plans and with respect to different types of service providers. However, the Working Group determined that it would attempt to identify general principles that apply to the selection and monitoring of various service providers by different types of plans.

The Working Group decided to look at the practices and problems with specific providers and industries. From both the industry practices and the gaps in those practices, the Working Group would provide suggestions both with respect to those areas in which guidance would be helpful and the nature of the guidance. The Working Group would also attempt to identify sources of information for fiduciaries concerning the practices and/or qualifications of specific service providers.

At the hearing on June 18, 1996, Marc Machiz, Associate Solicitor of Labor, Plan Benefit Security Division, reviewed the cases brought by the Department of Labor concerning fiduciary misconduct in the selection and monitoring of service providers. Jack Marco, Marco Consulting, testified concerning practices of both investment managers and investment consultants.

At the hearing on July 16, 1996, the Working Group heard testimony concerning the procedures for selection and monitoring of investment managers and codes of conduct from the perspective of corporate plans, public plans and foundations. The witnesses were Joseph P. Craven of Putnam Investment Company and Carter F. Wolfe from the Howard Hughes Endowment. Barry Mendelson, Senior Special Counsel in the Investment Management Division of the Securities and Exchange Commission, testified concerning procedures, practices and information sources to aid fiduciaries in the selection and monitoring of mutual funds and investment advisors.

The hearing on September 10, 1996, focused on issues and procedures with respect to bundled service arrangements, including investment management services, often provided to small 401(k) plans. The Working Group heard testimony from Leonard P. Larrabee, III Assistant General Counsel, the Dreyfus Corporation, representing the Pension Committee of the Investment Company Institute and from Edmond F. Ryan, Senior Vice President, Defined Contributions Operations Department for Massachusetts Mutual Life Insurance Company.

At its meeting on October 9, 1996, the Working Group discussed the testimony and written material received and the Working Group's preliminary conclusions.

The Working Group held a public teleconference on November 4, 1996, to discuss its draft report.

A list of the Exhibits and written material received can be found in Sections IV and V. A summary of the oral testimony can be found in Section VI.

III. FINDINGS AND RECOMMENDATIONS: PENSION PLANS

The testimony and case law concerning service providers indicate that some form of easily accessible educational material would be useful for both large and small plans. Not only are plan fiduciaries faced with the substantial requirements of due diligence in the selection and monitoring of service providers, but in the case of investment managers, fiduciaries also face the difficult task of understanding and evaluating the risk in the underlying investment proposed by the provider.

Many of the problems with respect to service providers arise because the responsible plan fiduciary either does not understand his role and responsibility in the selection and monitoring of service providers or exercises poor judgment because he does not have experience or an appropriate source of information concerning legal requirements and industry practices. The Working Group heard testimony that many of the cases also involve an element of self-dealing.

Although the case law indicates that a large portion of the cases involve small to medium sized plans and Taft-Hartley plans, the misunderstandings and poor judgment based on lack of information also affect larger plans. However, in the case of single employer defined benefit plans where the sponsor is ultimately responsible for funding the plan benefits, or where plan assets are not at issue, the financial consequence of poor selection and monitoring of service providers tends to fall on the sponsor. In many such cases, it appears that problems with service providers are borne directly by the plan sponsor.

Therefore, the Working Group concludes that educational information would be useful to fiduciaries of plans of all sizes but would particularly benefit fiduciaries of small and medium size plans.

The Working Group acknowledges the concern expressed by Marc Machiz in his testimony that any form of guidance carries with it both the promise of improving practice among the weaker segments of the industry as well as the danger of inducing undue complacency if the Guidance is too formulated, sets too low a standard or is insensitive to the wide variations and circumstances that plan fiduciaries face. However, the Working Group concludes that information could be developed for fiduciaries based on clearly defined general principles of fiduciary conduct and industry practices that would serve as a resource to the industry and not provide a refuge for those who would willfully disregard their responsibilities. The majority of the Working Group does not believe that new legislation or regulation is required.

Educational material is needed and is appropriate for both small and large plans in the form of sponsor and fiduciary education. However, educational material will be most useful to small and midsize plans. While educational material will not change the behavior of those who would act in their own self interest and/or with deliberate disregard of their fiduciary obligations, it can still have an impact to discourage such activity by equipping others to recognize and object to improper conduct.

The Working Group collected a wealth of valuable information on this topic. This information has been categorized by subject in Sections IV and V of this report. The oral testimony of witnesses has been summarized in Section VI. In order to make this information more accessible, the Working Group recommends that the Department of Labor develop and disseminate educational materials to plan sponsors, participants and service providers that include the following information:

A plain language description of the duties of fiduciaries with respect to selection and monitoring of various kinds of plan service providers, including the Department's views on the importance of maintaining a written record of the due diligence process and of disclosing potential conflicts to plan participants (see Sections IV and V).

An explanation of the legal effect of a plan fiduciary's delegation of responsibilities to various service providers including the ongoing duty to monitor and evaluate the performance of the service providers selected by the fiduciary (see Section IV).

An explanation of the ability of a fiduciary to rely on the advice of service providers (see Section IV).

Examples of questions a fiduciary should ask or procedures a fiduciary should follow in connection with the selection and monitoring of service providers (see Section V).

Sources of information concerning various types of service providers (see Section IV).

The Working Group also recommends that the 1997 ERISA Advisory Council continue the work on this topic with a focus on service providers to welfare plans.

IV. EXHIBITS AND WRITTEN MATERIAL RECEIVED

A. Selection and Monitoring Criteria

Procedures for Selecting Investment Managers Appendix A to consent decree in Arizona State Carpenters Pension Trust Fund, et al. v. Miller, et al.

Procedures for Monitoring Investment Managers Appendix B to consent decree in Arizona State Carpenters Pension Trust Fund, et al. v. Miller, et al.

Department of Labor Regulation 29 CFR § 2550.404a-1 Investment Duties, and the preamble thereto, 42 FR 54122.

Letter from Olena Berg, Assistant Secretary for Pension and Welfare Benefits Administration, to Honorable Eugene A. Ludwig, Comptroller of the Currency, concerning the Department of Labor's views with respect to the utilization of derivatives in the portfolio of pension plans subject to the Employee Retirement Income Security Act.

Labor Department Interpretive Bulletin No. 94-2 Relating to Written Statements of Investment Policy, Including Proxy Voting Policy or Guidelines, 29 CFR 2509.94-2.

Labor Department Interpretive Bulletin No. 95-1 on Plan Selection of Annuity Provider, 29 CFR 2509.95-1.

Labor Department Interpretive Bulletin No. 96-1 Relating to Investment Education, 29 CFR 2509.96-1.

B. Cases on Fiduciary Responsibility and Liability for the Selection and Monitoring of Service Providers; Fiduciaries' Reliance on Service Providers:

• Donovan v. Mazola, 716 F.2d 1226 (9th Cir. 1983)

• Donovan v. Tricario, 5 EBC 2057 (SD Fla. 1984)

• Brock v. Robbins, 830 F.2d 640 (7th Cir. 1987)

• Benvenuto v. Schneider, 678 F. Supp. 51 (ED NY 1988)

• McLaughlin v. Bendersky, 705 F. Supp. 417 (ED IL 1989)

• Morgan v. Independent Drivers Association, 15 EBC 2515 (10th Cir. 1992)

• In Re: Unisys Savings Plan Litigation, 74 F.3d 420 (3rd Cir. 1996)

• Glaziers and Glassworkers Local 252 Annuity Fund v. Newbridge Securities, Inc., 20 EBC 1697 (3rd Cir. 1996)

C. Conflicts of Interest and Compensation

Code of Ethics and Standards of Professional Conduct for financial analysts, Association for Investment Management and Research (AIMR).

Investment Management Consultants Association (IMCA) Standards and Practices for the Professional Investment Management Consultant, received Nov. 1, 1996.

"Firm Views on Soft Dollars," Institutional Investor

Investment Manager Questionnaire, The Marco Consulting Group

Contract language concerning other compensation, The Marco Consulting Group

Eugene B. Burroughs, "Checklist of Elements for Inclusion in Investment Policy Statement," Investment Policy Guidebook for Trustees, International Foundation of Employee Benefit Plans, Brookfield, WI, 1995.

Presentation of Joseph P. Craven, Outline and Exhibits:

Summary of MASTERS' Investment Policies and Procedures

Request for Proposal for Investment Management Services, The Commonwealth of Massachusetts

Disclosure Statement, The Commonwealth of Massachusetts

Massachusetts State Teachers' and Employees' Retirement Systems Trust, Manager Search, Manager Analysis

Howard Hughes Medical Institute, Standard Operating Policy and Procedure Manual, Conflict of Interest Policy

Written Testimony of Barry Mendelson including Article on "How to Find a Qualified Financial Planner."

D. Information and protection available from the Securities and Exchange Commission:

"Invest Wisely: Advice from Your Securities Industry Regulators," Securities and Exchange Commission, 1994.

"Ask Questions - Questions You Should Ask About Your Investments...and What To Do If You Run Into Problems", Securities and Exchange Commission

"Invest Wisely: An Introduction to Mutual Funds," Securities and Exchange Commission, 1994

"What Every Investor Should Know," Securities and Exchange Commission, 1995

"Investor Fraud and Abuse Travel to Cyberspace," Investor Beware, Securities and Exchange Commission, 1996

"Consumers' Financial Guide," Securities and Exchange Commission, 1994

"How To Avoid Ponzi and Pyramid Schemes," Securities and Exchange Commission

"Information For Investors," Collection of Fact Sheets from the Securities and Exchange Commission

V. EXAMPLES OF QUESTIONS A FIDUCIARY SHOULD ASK.

The following are examples of questions which fiduciaries may consider in hiring and monitoring the performance of a service provider. Given the wide range of plan needs, it is impossible to provide a complete list of questions which will be applicable to all plans and all circumstances. Nevertheless, the Working Group believes that the following are representative of the types of questions to which fiduciaries should seek answers to satisfy their obligations as fiduciaries under ERISA.

A. ISSUES FOR FIDUCIARIES WHO ARE HIRING A SERVICE PROVIDER

What service or expertise does the plan need? Is the service or expertise necessary and/or appropriate for the functioning of the plan?

Does this service provider propose to provide the service that is necessary or appropriate for the plan?

Does this service provider have the objective qualifications to properly provide the service that is necessary and/or appropriate for the plan? Generally, the fiduciary should seek the following information that will vary with the type of service provider being retained:

• business structure of the candidate

• size of staff

• identification of individual who will handle the plan's account

• education

• professional certifications

• relevant training

• relevant experience

• performance record

• references

• professional registrations, if applicable

• technical capabilities

• financial condition and capitalization

• insurance/bonding

• enforcement actions; litigation

• termination by other clients and the reasons

4. Are the service provider's fees reasonable when compared to industry standards in view of the services to be performed, the provider's qualifications and the scope of the service provider's responsibility?

5. Does the plan have a conflict of interest policy that governs business and personal relationships between fiduciaries and service providers and among service providers? Does the plan require disclosure of relationships, compensation and gifts between fiduciaries and service providers and among service providers?

6. Does a written agreement document the services to be performed and the related costs?

B. ADDITIONAL ISSUES WHEN HIRING AN INVESTMENT MANAGER

1. Does the Plan have a Statement of Investment Policy? Some or all of the following issues may be addressed by a Statement of Investment Policy:

(See Department of Labor Interpretive Bulletin 94-2.)

Evaluation of the specific needs of the plan and its participants

Statement of investment objectives and goals

Standards of investment performance/benchmarks

Classes of investment authorized

Styles of investment authorized

Diversification of portfolio among classes of investment, among investment styles and within classes of investment

Restrictions on investments

Directed brokerage

Proxy voting

Standards for reports by investment managers and investment consultants on performance, commission activity, turnover, proxy voting, compliance with investment guidelines.

Policies and procedures for the hiring of an investment manager

Disclosure of actual and potential conflicts of interest

2. What is the position to be filled? Why is the Plan hiring an additional investment manager? Is the Plan replacing a terminated manager with a manager of the same investment style or hiring an additional manager with a different investment style? Is the hiring of this manager consistent with the Statement of Investment Policy?

3. Does the Investment Manager have the objective qualifications for the position being filled? (See questions concerning qualifications above.) Does the candidate qualify as an investment manager pursuant to ERISA section 3(38)?

4. How does the investment manager manage money? What is the manager's performance record and how does the manager achieve his performance? What are the risks of the investment manager's style and strategy compared to other styles and strategies? Do you understand what the manager does and the risks involved? Is this risk level acceptable in view of the return? How do this manager's investment style and strategy fit into the portfolio as a whole? (See Department of Labor Regulation 29 CFR § 2550.404a-1 Investment Duties and Letter from Olena Berg, Assistant Secretary for Pension and Welfare Benefits Administration, to Honorable Eugene A. Ludwig, Comptroller of the Currency concerning the Department of Labor's views with respect to the utilization of derivatives in the portfolio of pension plans subject to the Employee Retirement Income Security Act.)

5. How does the investment manager measure and report performance? Does the process ensure objective reporting?

6. Is the investment manager a qualified professional asset manager? What is the investment manager's process to comply with the prohibited transactions provisions of ERISA?

7. What is the investment manager's process to insure compliance with the plan's investment policy and guidelines?

8. What is the investment manager's record with respect to turnover of personnel?

9. Has the manager's investment style been consistent?

10. Has the investment manager been terminated by plan clients within a relevant time period and why?

11. Has the ownership of the investment manager changed within a relevant time period and how will this affect the ability of the manager to perform the services needed by the plan?

12. What are the investment manager's fees? Are the fees reasonable in comparison with industry standards for the type and size of the investment portfolio? Does the fee structure encourage undue risk taking by the investment manager?

13. Does the investment manager have a personal or business relationship with any of the plan fiduciaries, or with another service provider recommending the investment manager? If a relationship does exist, how does it impact on the evaluation of the objective qualifications of the investment manager and the recommendation?

14. If the plan has adopted a directed brokerage arrangement with a broker affiliated with the plan's investment consultant, how does the investment manager determine when to use broker affiliated with the investment consultant? What are the per share transaction costs?

15. Does the investment manager have insurance which would permit recovery by the plan in the event of a breach of fiduciary duty by the investment manager? What is the amount of the insurance? Who is the insurance carrier?

C. ADDITIONAL ISSUES WHEN HIRING AN INVESTMENT CONSULTANT

What is the role of the investment consultant? Are the investment consultant's duties clearly stated in the Statement of Investment Policy and/or the contract with the Investment Consultant?

Does the Investment Consultant:

Monitor and advise concerning asset allocation

Monitor and advise concerning riskiness of investment strategies, styles and individual investment managers Monitor and advise concerning the performance and riskiness of

investments under the direct investment control of the fiduciaries

Monitor and advise concerning the compliance of the investment managers and direct investments with the Statement of Investment Policy and Investment Guidelines

Accept fiduciary responsibility in writing for all or some of the services it performs? Does the contract state specifically for which services the consultant accepts fiduciary responsibility?

3. Is the investment consultant's fee reasonable when compared to industry standards in view of the services to be performed and the scope of the consultant's fiduciary responsibility?

4. What are the investment consultant's performance measurement process and techniques including the performance data base used to evaluate the investment manager's performance? Do you understand the process? Are these processes and techniques appropriate?

5. Does the investment consultant have a personal or business relationship with any of the plan fiduciaries, or with one or more investment managers? Does the consultant receive compensation from investment managers either through the sale of services or through directed brokerage arrangements? If a relationship does exist, how does it impact on the evaluation of the consultant's recommendation of the investment manager?

6. What investment managers were recommended by the investment consultant in recent searches for other clients?

7. Does the investment consultant have insurance which would permit recovery by the plan in the event of a breach of fiduciary duty by the investment consultant? What is the amount of the insurance? Who is the insurance carrier?

D. ADDITIONAL ISSUES WHEN HIRING A BUNDLED SERVICE PROVIDER

Is the bundled service provider financially stable and committed to the defined contribution business for the long term?

What is the bundled service provider's track record for delivering accurate and timely record keeping, and other administrative services, and insuring regulatory compliance?

Does the bundled service provider offer a wide range of investment options that will allow participants to make appropriate asset allocation decisions and achieve their investment objectives?

Has the bundled service provider demonstrated the ability to generate superior investment performance over time?

Does the bundled service provider have the administrative capability to provide assistance with employee enrollment, investment education and ongoing plan communication?

Does the bundled service provider have knowledgeable and dependable service representatives available to consult with plan participants?

Has the plan sponsor been provided with advance written disclosure indicating the expenses and commissions, if any, that the bundled service provider will receive?

Are the bundled service provider's expenses reasonable in relation to the level of services provided?

Has the plan sponsor received sufficient information to make a true comparison of the services provided by the various bundled service arrangements available to select from?

What procedures or mechanisms are in place to assure that any mistakes that may be made by the bundled service provider will be disclosed to the plan sponsor and corrected?

Does the plan sponsor understand its role in monitoring the bundled service provider?

Has the bundled service provider disclosed in writing the capacity in which it is acting, and has the plan fiduciary acknowledged its understanding of this role?

Has the bundled service provider disclosed any potential conflicts of interests?

E. ADDITIONAL ISSUES IN MONITORING SERVICE PROVIDERS

Who is responsible for monitoring the service provider?

What is the process to monitor the service provider?

Are written reports provided by the service provider? With What frequency are the written reports provided?

Do the written reports describe the performance of the service provider as compared to the applicable written guidelines and/or contract?

Do the written reports provide sufficient information to adequately evaluate the performance of the service provider compared to benchmarks or industry standards?

Is there a process in place to either: (a) correct any non-conformance with guidelines/contract, benchmarks or industry standards; or (b) to terminate the service provider and retain a successor?

Has the responsibility for monitoring a service provider been delegated to an individual or another service provider?

If the responsibility to monitor a service provider has been delegated, has the individual or service provider to whom the delegation has been made accepted fiduciary responsibility in writing for the monitoring?

VI. SUMMARY OF TESTIMONY RECEIVED

Meeting of June 18, 1996

Testimony of Mr. Marc Machiz,

Associate Solicitor of Labor,

Plan Benefits Security Division

Mr. Machiz opened his testimony by saying that the perspective that he brought to the group's discussion was based upon his review of investigations and supervision of enforcement litigation. He stated that if he had to pick one part of the service provider universe where improper selection and lack of monitoring had the potential for causing the most harm to plans, it would be investment managers. He felt this because of the investment managers' direct control of plan assets.

Mr. Machiz went on to make the important point that not only are plan fiduciaries faced with the requirement of diligence in the selection and monitoring of providers, but that they also had the difficult task of understanding and evaluating the question of risk in the underlying investments proposed by the provider. In his view, in many cases, fiduciaries do not adequately understand and evaluate the investment risk. As examples of this last point, he cited the Arizona State Carpenters case and Lowen v. Tower Asset Management.

In evaluating an investment manager's performance, it is fairly simple to calculate the rate of return. It is more difficult to measure and appreciate the amount of risk involved in achieving that return. Trustees must also understand the investment manager's fee arrangements both in terms of ultimate cost to the plan and in terms of any incentive the fee arrangement gives the investment manager to take inappropriate risk.

Mr. Machiz made the point that a written statement of investment policy can be a useful tool in the selecting and monitoring of investment managers. He pointed out that in 1994 the Department had issued Interpretive Bulletin 94-2 that explained the use of such a statement and encouraged plan fiduciaries to adopt written statements of investment policy.

Interpretive Bulletin 94-2 also states that compliance with ERISA's prudence requirement requires maintenance of proper documentation of the activities of the Investment Manager and of the named fiduciary of the plan in monitoring the investment manager.

Mr. Machiz stated the Department's concern that trustees be aware, not just of the rate of return of an investment, but also the types of risks inherent in the rate. A greater risk should be rewarded with greater return. Some investments require a much higher degree of financial sophistication and expertise to understand the nature of the risks and potential returns. He said that the Department's concern concerning fiduciaries' awareness of risk could be seen in the Letter of Guidance released with the Comptroller of the Currency, Statement on Derivatives, March 28, 1996.

Concerning the focus of the Working Group, Mr. Machiz cautioned that the prospect of official guidance carries with it the promise of improving practice among the weaker segments of the industry as well as the danger of inducing undue complacency if the guidance is too formulated, sets too low a standard, or is insensitive to the wide variations and circumstances that plan fiduciaries face. He said that the Department would rely on the Council's wide practice experience to instruct them on the value and risks of proceeding with guidance.

Mr. Machiz noted that if you looked at the full range of the Department of Labor's litigation, there are a tremendous number of cases involving small to medium-sized plans. The small plans' cases usually had a self-dealing tinge to them and there was not really a selection and monitoring service provider aspect to them.

He also noted that a significant portion of the cases about selection and monitoring service providers involve Taft-Hartley plans. He noted, however, that the reasons for this probably having nothing to do with where the service provider problems arise. In the case of single employer defined benefit plans, sponsors are ultimately responsible for funding the benefits regardless of the performance of the investment manager and other service providers. The sponsor must pay the money to fund the plan sooner or later. If the sponsor discovers a problem, he simply fires the investment manager or other service provider.

Mr. Machiz commented that investment manager's sales pitches to trustees generally included little discussion regarding risk and this was usually confined to a few sentences in which the trustees were assured that the manager had figured out how to out-perform the market while taking risks less than the market at large. When we look at the cases, we see fiduciaries who have a service provider -- either an investment consultant or the investment manager -- who is giving the fiduciaries updates on how the plan is performing but really no assessment of the underlying risk of the portfolio. Another issue for trustees is whether the consultant hired to do performance tracking has been hired to perform the right service for the plan. Will the performance consultant give an assessment of the risks in the portfolio and not just performance numbers.

In response to a question, Mr. Machiz responded that the theme of overpayment for services showed up in a number of the Department's cases. Overpaying for services by either not doing competitive bidding or taking other steps to ascertain the correct price for services shows up often in welfare plan cases. In investment cases the issue is usually not the fee but the way services were provided. His sense is that fees for investment managers tend to be fairly competitive. In the Department's cases, the investment managers got their profit on the other end by investing in investments in which they owned an interest. Once an investment manager has discretion over the plan assets, the potential for making himself wealthy comes not so much from charging a few extra basis points for management but from abusing the power that's been given to him, whereas with a welfare plan's contract administrator oftentimes the price at which services are provided is the abuse itself. In the case of other service providers, the pricing is really a different problem than the quality issues that are the focus of investment manager cases.

Mr. Machiz said that his feeling is that service provider abuse cases are the result of ignorance and with plan fiduciaries being "too cozy" with service providers. A formal process for selecting and monitoring makes it more difficult to rely on inappropriate factors. However, he stated his view that there is virtually no process that with enough will and ingenuity can't be fixed. However, to the extent problems are the result of ignorance and not the fact that the decision makers are "ethically challenged," guidance and education can attempt to address this.

Mr. Machiz also discussed other potential areas of service provider abuse. He discussed the selling of insurance to the plan by the administrator and inadequate disclosure of commission income. He also mentioned the potential for conflict of interest when the investment performance monitors are also in the brokerage business. How much does the brokerage income influence whom they recommend? It is something that the Trustees need to be aware of and question.

Mr. Machiz agreed that one of the more difficult issues facing trustees in retaining service providers was to always be sure that the scope of the engagement was appropriate for the type of advice that needed to be given. It's a serious problem, particularly when the plan fiduciary is not an expert in the particular area (that is why the fiduciary is, in fact, hiring the service provider in the first place). Fiduciaries need to know enough to ask the right questions and to enter into an agreement with the service provider where the scope of the engagement is appropriate. If the scope is too broad, the plan may overpay. On the other hand, if the scope is too narrow it may not accomplish the goal the fiduciary set out to accomplish by retaining the service provider in the first place. Mr. Machiz agreed with these points and again noted the importance of a formal written statement of investment policy.

However, Mr. Machiz noted in response to questions concerning investment guidelines that neither the statute nor regulations required them. In addition, the specificity of the Guidelines affected their utility in limiting investment managers and managing investment risk. He looked to the Working Group for recommendations concerning investment guidelines.

In response to questions regarding whether accountants could become more useful in highlighting investment problems before they became serious, Mr. Machiz said that in his experience, if you try to talk to accountants about issues of prudent investing, they tell you that this is not their area of expertise and that you are looking at the wrong service provider.

In response to a question about counsel's role, Mr. Machiz said that he believed that counsel's role was a very delicate role. He said that he believed that counsel had a responsibility to advise the named fiduciary who was making the decisions about the need to put procedures in place to make sure that there is appreciation of risk. He pointed out that counsel should advise that there be adequate processes in place so that if the fiduciary is ever questioned about why did they hire this manager, why did they conclude that this manager should continue to be retained, that it can be adequately justified.

In response to a question about the possibility of having portfolios under Department guidelines, Mr. Machiz responded that there already exist a Department prudence regulation which people tend to forget about. He pointed out that it talks in terms of taking into account the risks and returns in the context of the entire portfolio. The regulation suggests that we're not going to tell you that there's any kind of investment that is absolutely forbidden, but you have to consider that investment in terms of its function in the portfolio. The Department has been very sensitive to not limiting the investments from which fiduciaries could choose. However, if there is a type of investment for which no one really understands the risk characteristics, the prudent thing might be for the fiduciary to wait until the risk characteristics of the investment are understood.

Mr. Machiz noted that the Exhibits on Selecting and Monitoring Service Providers that were part of the consent order in the Arizona Carpenters Case were negotiated by the Department of Labor in the specific context of that litigation. They did not go through a general policy review since there was not concern for universal applicability. Therefore, they should be looked at as potentially instructive but not as any kind of final and definitive view of the Department on what trustees should be doing.

Testimony of Mr. Jack Marco,

Marco Consulting Company

Chicago, Illinois

Mr. Marco stated that he had been an investment consultant for about 19 years. He said that his company helps trustees establish investment guidelines, hire money managers, evaluate performance, vote proxies. The company does not actually manage money for the trustees.

He pointed out that even with Association for Investment Management Research (AIMR) standards that have been published about the way money managers should present numbers, this still does not prevent some people from displaying numbers in a way that makes them look good. It makes them look better than they really are. For example, he recently evaluated a money manager who claimed that he had beaten the index over a period of time. However, the time periods listed ended in March. When he evaluated their numbers on an annual basis, they had failed to beat the index in seven out of ten years. The AIMR standards do not prevent this type of manipulation.

He also pointed out that in hiring a money manager, a plan should be wary about working from a published list of top performers or trade publications. He gave an example of investment manager who was on the top of a list but when Mr. Marco investigated, he found that this investment manager was a small bank, had only a small amount under management and had one good year. In another case, an investment manager who was on probation with Mr. Marco's client for his poor performance was rated highly by a publication. When he called the manager he was told that the publication was given the performance of a very specialized investment product they offer and which is very different from the investment product they provide most of their clients. However, this distinction was not noted in the publication.

He noted that fiduciaries of large plans can be unsophisticated with respect to investments. They may be just as easily misled by information as their small plan counterpart since they are not in the investment business. In addition, in the case of larger plans, egos may get in the way of seeking expert information.

Mr. Marco pointed out that his firm regularly monitors the performance of hundreds of money managers. However, in the case of a new manager, his firm has a 15-page questionnaire that they have the money manager fill out about the money manager. They asked for performance information from the inception of the money management form. He pointed out that it was important that his company get raw information regarding the money manager's performance and not composites put together by some marketing person at the money management firm. It is the job of the marketing person to create a composite that makes the money manager look good. His company then does a proper analysis of the numbers including analysis of the individual accounts managed to note variations in performance.

Mr. Marco said that other important things to look for when hiring a money manager are turnover of personnel in the firm, turnover of clients, style changes, ownership changes and litigation.

He noted that it was very difficult for fiduciaries, who are not in the investment business, to know what questions to ask, get all of the relevant information and evaluate it. Therefore, he feels that fiduciaries should go to a professional to help them select investment managers because it is a very difficult process to do correctly on their own.

However, Mr. Marco suggested that his own field, investment counseling, had some problems of its own. He pointed out that they were totally unregulated and unsupervised by anybody. He suggested that if an investment consultant was receiving a fee from a money manager, and that money manager is hired, that is a problem. He did not suggest regulation, but suggested that some sort of required disclosure to clients be required.

Mr. Marco explained that for an investment manager to get a new account is tremendously profitable. They really do not have to do much additional work to service a new account except prepare a report and attend some meetings. They do not have to do more research; they just buy bigger blocks of securities. Since it is so profitable to add clients, investment managers will do almost anything to get new business, including trying to influence the people who advise the fiduciaries in their decisions -- the investment consultants. Therefore, he feels that if an investment consultant has some connection to a money manager or is receiving some compensation from a money manager, the consultant's advice should be suspect. He suggested that if a fiduciary hires a consultant with some connection to a money manager, that the fiduciary may want to stipulate at the beginning of the process that the related firm may not be considered to be hired.

Mr. Marco stated his opinion that one of the biggest problems in the industry is investment consultants doing business with money managers -- selling services, doing brokerage, anything that involves compensation. In this situation, the consultant has two employers -- they are working for the fiduciaries and they are working for the money manager that they are supposed to be evaluating or recommending. Mr. Marco felt that fiduciaries should inquire of their consultants concerning compensation from money managers. He feels consultants should be required to disclose what revenue they receive from money managers. Fiduciaries can then make up their minds concerning the objectivity of the consultant's recommendations.

In response to a question, Mr. Marco acknowledged that for very small plans, under $10 million, it was usually cost prohibitive for them to go hire a consultant. He thought that these plans should stick with pooled funds where they would be much better off since the performance numbers are more reliable. However, Mr. Marco noted that fiduciaries can end up investing in inappropriate pooled investment vehicles.

In response to a question, Mr. Marco pointed out that unless a consultant claimed to be an investment advisor or a licensed broker, there were no regulations. Investment Advisors are regulated under the Investment Advisory Act.

When asked if there were a self-regulating organization for investment consultants, Mr. Marco said there was one called the Investment Management Consultants Association (IMCA). Upon investigation, he found the organization to be loaded with broker consultants. When he talked with them about joining, he said that he would join if the organization would simply say you cannot do business with the other side. Let consultants be consultants and not sell services to money managers. He felt this would totally wipe out their membership.

Mr. Wood asked if Mr. Marco thought some sort of disclosure for plan sponsors or fiduciaries might not be a good idea. Perhaps an annual statement that they receive no compensation or any benefit, side benefits from any relationship they have with either investment managers, custodians, consultants, or service providers. He wondered if this might be particularly good for the ethically challenged. Mr. Marco said that he did not think that it would hurt, however, anybody that's going to do that has a much bigger problem than just hiring a manager.

In response to a question concerning the questions he would ask if hiring an investment consultant, Mr. Marco stated that he would ask about experience and qualifications, potential conflicts of interest -- what businesses is the consultant in besides consulting -- technical capabilities, measurement techniques -- what kind of data bases are used for performance, communications and references.

In response to a question, Mr. Marco stated that contracts with consultants should require them to acknowledge fiduciary responsibility. Many consultants will not sign anything that says they are a fiduciary.

Meeting of July 16, 1996

Joseph P. Craven,

Senior Vice President

Putnam Investments

Boston, Massachusetts

Based on his prior experience, Mr. Craven stated the ultimate goal for plan sponsors and trustees in selecting and monitoring investment managers is to have in place formalized written decision-making policies and procedures. Investment policies and procedures should be (1) consistent with the fiduciary responsibilities of plan sponsors/trustees, staff and investment consultants; and (2) give plan sponsors/trustees the best opportunity to select and retain investment managers who will serve the long- term needs of the plan and its participants.

In hiring investment managers, Mr. Craven stressed the importance of trustees observing five criteria. The first criterion is for plan sponsors/trustees to have a working knowledge of the specific needs of the plan and its participants. Plan needs include determining investment goals, risk tolerances, staffing levels and conducting investment manager oversight. Needs of the plan will determine its investment structure and asset allocation. A plan's asset allocation should determine types of investment managers evaluated for hire.

The second important criterion is for all policies and procedures involved in the hiring of investment managers be put in writing. Unless policies and procedures are written, there will always exist substantial opportunity for misunderstanding. Written procedures should be specific to plan's individual needs, and utilize a format clearly understood by all plan sponsors/trustees. Plans should consider utilizing a request for proposal (RFP) format to make the selection process as fair as possible. All selection criteria for hiring managers should be determined before a search is initiated.

The third criterion is for plan sponsors and trustees to gather as much information as possible to help them make informed decisions. Trustees can utilize consultant databases and other reference sources to evaluate managers performance numbers. All client and professional references should be carefully screened and critically analyzed.

The fourth criterion is to require full disclosure of all potential conflicts of interest between investment managers and plan sponsors/trustees, staff, and investment consultants. Investment manager candidates should complete a disclosure statement revealing all financial relationships between their firm and all other parties doing business with the pension plan. The fifth criterion is to carefully evaluate information provided by investment managers before making a selection. Each step in the selection process should be carefully documented in writing should it be needed for later reference.

Mr. Craven testified that monitoring investment managers is as much a fiduciary duty for plan sponsors/trustees as selecting them. He recommended that plan sponsors/trustees consider four important points in the monitoring process. The first point is every pension plan should have clear and understandable written investment guidelines applicable to each class of investment managers. The guidelines should clearly state all restrictions and limitations placed on each class of investment managers.

The second important point is that investment managers' compliance with investment guidelines be closely monitored by either internal staff or an investment consultant. Investment managers failing to stay within established guidelines should be dealt with immediately. Mr. Craven's third point covered the different types of due diligence required over different time periods. Investment manager compliance with written guidelines should be evaluated at least quarterly, while investment managers performance against peers can be performed on a less frequent basis.

The difficulty of investment manager oversight and compliance was the last point made by Mr. Craven. Plan sponsors/trustees should have either adequate internal staff or an investment consultant to closely monitor investment managers. Mr. Craven suggested smaller pension plans need fewer managers and should utilize less complex asset allocation. Software packages are now commercially available to help plan sponsors/trustees monitor investment managers' compliance. Software packages may be an attractive alternative for plan sponsors/trustees who are unable to afford hiring internal staff or an investment consultant.

In closing, Mr. Craven stated plan sponsors/trustees must remember they are dealing with funds belonging to plan participants and not their own money. Consequently, plan sponsors/trustees must sometimes pass up appealing investment opportunities not meeting long-term needs of the pension plan.

Carter F. Wolfe

Howard Hughes Endowment

In selecting investment managers, Mr. Wolfe stated it was critical for plan sponsors/trustees to establish clear investment guidelines as a first step. In drafting investment guidelines, plan sponsors/trustees should consider three important points. The three points are: (1) choosing the relevant index for each class of investment manager; (2) determining the amount investment managers are expected to exceed their index; and (3) determining how much risk plan sponsors/trustees are willing to tolerate in order for managers to exceed their indexes.

In choosing the types of managers to be hired, plan sponsors/trustees can utilize either individually managed accounts, commingled funds, or mutual funds. Smaller plans have difficulty justifying individually managed accounts because of the higher management fees and are better off selecting commingled funds or mutual funds. In addition, plan sponsors/trustees may choose between active and passive management styles by managers. Mr. Wolfe's recommendation was small and medium-size plans should utilize passively managed index funds to invest plan assets. Index fund management fees are lower than their actively managed counterparts. Because of lower management fees, index fund managers cannot afford to market and entertain plan sponsors/trustees.

Plan sponsors and trustees cannot depend solely on investment managers' historical performance in selecting managers. Mr. Wolfe discussed a Cambridge Associates chart showing how investment market conditions change and how few investment managers maintain performance at highest levels due to changing market conditions. First-quartile performing managers in the first five-year period may easily be performing at third-quartile levels in the second five-year period and vice versa.

Mr. Wolfe stated plan sponsors/trustees should remember the three "Ps" of investment manager selection. The three "Ps" are (1) philosophy of the firm; (2) people qualifications; and (3) performance numbers. Plan sponsors/trustees should evaluate an investment management firm's philosophy for a good fit with the plan's asset allocation. A key question for plan sponsors/trustees to ask is: Has the firm's investment philosophy stayed consistent over time. People qualifications include researching key staff members backgrounds and qualifications. Plan sponsors/trustees should inquire into: How much turnover is there among key staff members? How is the firm owned? Are compensation packages in place to retain key staff members? Who are the firm's clients and how long have they been associated with the investment management firm?

Once investment managers are selected, plan sponsors/trustees must decide how to compensate the investment managers for their services. There are two types of investment manager fees, fixed and performance-based fees. Performance-based fees are much more complex and difficult to calculate. Consequently, performance fees are not as widely used as fixed fees. Another difficulty for plan sponsors/trustees in negotiating fees is the difficulty getting industry-wide comparable data on investment management fees.

Mr. Wolfe advised plan sponsors/trustees to concentrate in three areas to effectively monitor investment managers. First, plan sponsors/trustees should ensure investment managers are complying with written investment guidelines and terms of their individual contracts. The second area was monitoring turnover of key personnel within the investment management firm. Effective due diligence was the third area mentioned by Mr. Wolfe and should involve at least one on-site visit to each investment manager annually.

On the subject of investment consultants, Mr. Wolfe recommended plan sponsors/trustees not let investment consultants pass their account to a junior consultant who has less experience. When selecting an investment consultant, plan sponsors and trustees should interview all clients furnished as references.

Lastly, Mr. Wolfe said he was unfamiliar with the practice of investment consultants selling informational products to investment managers.

Barry Mendelson,

Senior Special Counsel in the Investment Management Division

Securities and Exchange Commission

When selecting a mutual fund, a Plan sponsor should consult a number of sources. First, the sponsor should thoroughly review the Fund's prospectus. The prospectus contains information about the mutual fund's investment objectives, risk profile, fees and expenses and past performance. In addition, plan sponsors should consult a fund's statement of additional information or SAI that contains more detailed information about the mutual fund than is found in the prospectus. An SAI is available from a mutual fund upon request.

Plan sponsors can obtain even more information about a mutual fund by reviewing its most recent annual and semi-annual reports to shareholders. These reports list all of the fund's portfolio holdings and give past performance information. The itemization of a mutual fund's portfolio holdings gives valuable insight into the fund manager's strategy and philosophy.

In addition, plan sponsors should consult third-party source material. For example, Morningstar publishes reports covering approximately 3000 stock and bond funds. More importantly, the reports contain an analyst's discussion of the fund and a risk analysis of the fund's portfolio using Morningstar's risk rating system that has become the standard in the industry. In addition to Morningstar, Lipper Analytical Services also publishes reports that track fund performance and fees.

Fund sponsors should consider visiting the offices of the mutual fund. Speaking with the portfolio manager can lead to insights into the fund's investment strategies. Sponsors should also speak to the mutual fund's administrative personnel to find out what special services that fund may be able to provide to the plan.

A plan sponsor should also carefully review the risks associated with investment in a mutual fund. As part of a general review of mutual fund disclosure requirements, the SEC is examining what can be done to improve the discussion in the prospectus of risk and allow investors to gauge more accurately a fund's overall risk profile.

Sponsors should pay particular attention to information about sales charges and operating expense. Expense is particularly important because every basis point of expense lowers the fund's return.

Sponsors should check to see how long the current fund manager has held his or her position.

Plan sponsors often select investment advisory firms to be responsible for investing some or all of the plan's assets. Generally, a firm or individual that provides investment advice for a fee must register with the SEC and comply with the Investment Advisors Act. A fundamental element of the Investment Advisors Act is that the investment advisor owes its clients a fiduciary duty and, therefore, must act solely in their best interests. It is integral to this fiduciary duty to require full and fair disclosure of all material information. Therefore, the Investment Advisers Act requires and advisor to furnish each prospective client with a written disclosure statement containing: the types of advisory services, the fees its charges, the types of securities with respect to which the firm provides advice, the methods of investment analysis used by the firm, any affiliations with other securities professionals, whether the firm makes securities transactions for advisory clients, a current financial statement, the educational and business background of the key employees and any legal action taken against the firm's employees.

Mr. Mendelson noted that the law does not require any educational or business standards in order to register as an investment advisor. Anyone can register so long as they disclose the required information. Therefore, plans sponsors must carefully check the credentials of an advisor before hiring him or her. For this reason, sponsors may want to hire an advisor who has been certified or accredited by a private organization.

Since information in an advisor's disclosure brochure is very general in nature, sponsors must obtain specific information about how the advisor intends to invest the plans' assets and the fees it will charge. Sponsors should ask not only about the advisor's direct compensation but also about indirect compensation such as soft dollar arrangements and compensation to affiliated broker dealers. Sponsors should also ask for past performance information and references.

Plan sponsors may engage the services of an investment consultant to assist in the selection of mutual funds for the plan. Depending on the services it provides an investment consultant may be required to register as an investment advisor. In any event, sponsors should ask whether the Investment consultant or anyone affiliated with the consultant will receive any remuneration of any kind other than the fee paid by the plan as a result of the consulting arrangement.

Many of the same sources of information consulted before selecting an investment fund or advisor should be consulted to monitor the fund or advisor after selection. These should be reviewed to determine how the fund has performed compared to the market generally.

The investment advisor is required to notify clients of any material change in the advisory relationship. Finally, the sponsor should arrange with periodic meetings with the advisor to discuss the management of the plan's assets.

Mr. Mendelson noted that the mutual funds were only required to report their holdings twice a year but that fiduciaries may wish to check on the fund's portfolio on a more frequent basis.

Under the securities laws, investment consultants who provide advice concerning particular investments are required to register. If a fiduciary wants to protect the plan he or she can insist that the consultant be registered. He felt it was more important for the fiduciary to find out about the consultant's credentials, get references and find out if the consultant is receiving compensation from any source other then the pension plan.

Mr. Mendelson stated that under the Investment Advisors Act of 1940 any one who gives personalized investment advice for compensation is an investment advisor under the act.

With respect to fees for mutual funds, Mr. Mendelson comments that many funds will waive the load for pension plan investments or plan investments over a particular amount. Therefore, there is no need for a plan to pay a load since there is a universe of funds out there that will make the same investment management services available without a load.

Mr. Mendelson noted that the SEC could examine an investment advisor who fails to disclose a conflict of interest.

Mr. Mendelson discussed in general terms the current proposals of the SEC to require better disclosure of the risk of an investment fund. The change would be in the nature of disclosure with respect to the current portfolio rather than with respect to potential investments.

Mr. Mendelson commented that a similar disclosure project was not needed for investment advisors because they were fiduciaries under ERISA and, therefore, had an obligation to recommend only investments that are suitable for their clients. A decision of the United States Supreme Court from the 1960s--SEC v Capital Gains Bureau, Inc.-- states expressly that anyone who is registered as an investment advisor is a fiduciary.

Meeting of September 10, 1996

Edmond F. Ryan

Senior Vice President, Pension Management

Massachusetts Mutual Life Insurance Company

Mr. Ryan prefaced his remarks by stating that he is familiar with the range of bundled products offered by the service provider community to 401(k) plans as a result of his twenty-three years of experience within the pension industry. His comments focused on the bundled product offered by MassMutual in the small employer market place, which is fairly representative of bundled products offered by the insurance industry.

Mr. Ryan made the important point that although the legal standards for selecting service providers does not vary depending upon whether a 401(k) plan is small or large, what makes sense does vary. The fixed cost of establishing and maintaining a plan is a far more significant issue for a small employer. Additionally, the administrative burden and complexity of maintaining a 401(k) plan is a bigger issue for small employers. While large employers often have fully staffed Human Resources and Treasury Departments, and many even have internal investment units, small employers rarely have this expertise in house. Consequently, they need a higher level of guidance and assistance.

Claims by small businesses that they do not maintain retirement plans because they are too costly and complicated are made manifestly clear when one looks at coverage rates relative to plan size. The Department of Labor estimates that almost one half of private sector workers--51 million people--do not have retirement plans. While over 80% of large companies with over 1000 employees offer plans; less than 25% of small companies, which are defined as having fewer than 100 employees offer plans.

According to Mr. Ryan, the bundled service provider approach provides small employers with a response to both the cost and complexity hurdles to plan coverage. A bundled product can provide an employer that sponsors a small plan with an array of valuable plan features previously available only to large plans, all at a reasonable cost. The bundled approach also prevents any gaps or overlaps in service that might otherwise result when multiple service providers are involved. While it makes sense for large employers to have multiple service providers, the bundled approach makes sense for small employers and provides them with a realistic opportunity to provide important retirement benefit to their workers.

Mr. Ryan noted that providing services to the defined contribution market is a very competitive business. Since 1982, when there were only a handful of competitors in the full service 401(k) market place, more and more service providers, including insurance companies, banks, third party administrators and employee benefit consultants, have entered the highly concentrated 401(k) provider market place. Several years ago mutual funds began to focus on the burgeoning 401(k) market as well. This ever increasing competition, coupled with advances in technology and a movement toward more wide spread benefits outsourcing have forced the leading companies to upgrade the quality of their bundled services without increasing fees. Service providers have enhanced their technological capabilities and resources and can now provide daily valued funds, daily valuation participant record keeping systems, 800 telephone numbers for participants to access account information and online employer access to plan and participant information. These technological innovations in plan administration and record keeping allow bundled service providers to respond to the demand for more comprehensive and integrated outsourcing of benefit plan administration.

On the investment side, providers need an array of funds covering the entire risk-return spectrum. Mr. Ryan noted that the Department of Labor's promulgation of Regulation §404(c) accelerated this trend by encouraging employee-directed defined contribution plans to offer a broad range of investment alternatives. When the Department published its regulation in 1992, it insisted on a minimum of three covariant funds. Today, a typical bundled 401(k) client has up to eight funds. Greater investment choice and opportunity for diversification have produced a need for more and better investment education tools and counseling for plan participants. Mr. Ryan commended the Department for its recent release of Interpretive Bulletin 96-1, which will encourage employers to provide additional financial educational materials without incurring the risk of becoming a fiduciary under ERISA.

Market data demonstrates that plan sponsors across all segments of the 401(k) market increasingly prefer these reasonably priced bundled products, Mr. Ryan noted. For example, a recent study found that the number of large defined contribution plans, (those with more than 1,000 participants,) using a single vendor for plan services increased to 59% in 1995 from 37% in 1989. Mid-size plans dramatically increased their use of bundled service to 62% in 1995 from 46% in 1989. The move toward bundled services was also dramatic among small plans, which increased single vendor usage to 70% in 1995 from 62% in 1989.

Mr. Ryan stated that, in his experience, plan sponsors who purchase a bundled package of investments and administrative services have seven essential expectations. The first essential client expectation of a bundled service provider is financial stability, with a commitment to the defined contribution business for the long term. Studies confirm that prospective purchasers of a full service product rate financial stability as the single most important vendor selection criteria. This is reasonable since retirement plans by their very nature represent a long term financial commitment by employers to their employees. Therefore, prudent plan sponsors should inquire about the financial stability and experience of the service provider, and this is information the service provider should readily disclose.

The second essential expectation is timely and accurate compliance and record keeping services that reduce the plan sponsor's work load and save time and money. Mr. Ryan testified that an essential ingredient of any successful defined contribution program is the strength and flexibility of its administrative service capabilities. The track record of a vendor's ability to deliver the basics, accurate and timely record keeping, regulatory compliance and other administrative services, should be an absolutely crucial consideration for a plan sponsor when selecting a full service product.

A quality provider recognizes that small employers most often lack fully staffed human resource and benefit areas to manage their 401(k) plans, and strive to provide a competitive, state-of-the-art array of services in order to minimize the administrative burdens placed on the employer. The following services are now the rule for most 401(k) bundled products: (1) A daily valuation record keeping system should be able to process all withdrawals, including hardships, terminations, and retirements, as well as participant loans, and have the capacity to ensure that participant records always total to plan level records for all investment funds. (2) The record keeper should withhold federal and state income taxes from distributions made to participants and beneficiaries, and prepare IRS tax information forms. (3) Current information should be routinely available via an interactive voice response system. Through these systems participants can access account information using a toll free 800 telephone number and obtain information that is updated on a daily basis. (4) Comprehensive participant loan services should be available to assist the plan sponsor in the day-to-day administration of loans. (5) Detailed, yet easy to understand, reports should be made available to the plan sponsor summarizing the plan related activity that has occurred. (6) To ensure that participants know how their contributions are being invested and how their investments are performing, written participant account balance statements should be provided to participants on as frequently as a quarterly basis.

The third essential expectation is an investment manager which has demonstrated the ability to generate superior investment performance over time and which offers a wide range of investment options that will achieve plan participants' investment objectives. Plan sponsors demand that the investment options available under a bundled product be diverse and produce competitive rates of return, because employees' ultimate retirement benefits will be based on investment performance.

Mr. Ryan noted that one of the great challenges facing plan sponsors is getting participants to make rational investment decisions for retirement. Many Americans make little or no provision for their retirement security during their working years. Even those that have made the crucial decision to begin investing for retirement often select overly conservative investments that weaken their retirement security because of low rates of return or are inconsistent with their investment objectives and risk profiles. This is especially true in today's 401(k) environment, where more and more plans allow participants, rather than plan fiduciaries, to make their own investment selections. Consequently, a bundled service provider must provide education and assistance to participants planning for retirement and making asset allocation decisions.

The fourth essential bundled 401(k) client expectation is an administrator that assists with employee enrollment, investment education and ongoing plan communication. To achieve maximum value and high levels of participation, the plan must be recognized, understood and appreciated by employees. Small employers, who typically do not have a sophisticated human resource organization, rely heavily on the employee communication services provided under a bundled product to achieve that potential by assisting in the development of an effective employee communication program. An effective employee communication program should include the basics on investment education, and provide participants with a means for assessing their risk tolerance as well as designing alternative asset allocation strategies which provide them flexibility to meet individual return objectives and risk tolerance.

Investment education and retirement planning information for employees can take the form of written material, video tapes, computer software, and periodic group education sessions as well as one-on-one conversations with pension professionals. Mr. Ryan noted that because retirement planning concepts and terminology may be complicated for some employees, educational materials should be designed to appeal to all levels of investment sophistication in accordance with Interpretive Bulletin 96-1

The fifth essential client expectation is an administrator that helps interpret the laws and regulations and keeps their plan in compliance as the legal environment changes. Compliance with government regulations is paramount to a 401(k) plan's existence and plan design and ongoing regulatory compliance are critical parts of a bundled program. Most bundled service programs include prototype plan documents. They are flexible, comply in form with IRS regulations, and economic to use since they save the plan sponsor time and money on qualification filings and ongoing compliance. A typical bundled service program assists plan sponsors in drafting Summary Plan Descriptions, completing Form 5500s and keeping their plans in compliance with the operational requirements of the Internal Revenue Code through testing services.

The sixth essential bundled 401(k) client expectation is a consultant that provides personal attention from people who are knowledgeable and dependable. The ability for participants in plans sponsored by small employers to speak with a knowledgeable and dependable service representative is vital to ensuring plan sponsor satisfaction. A voice response system can be combined with personal assistance from customer service representatives to help keep participants informed about the plan and their accounts.

Mr. Ryan noted that while it is obvious that small plan sponsors who select a bundled product receive a level of services that was previously available only to the largest plans because of cost concerns, the services are valuable only if they are provided accurately and on a timely basis. A bundled program should operate with documented service standards and deliver service on time, accurately, and to specifications. The bundled service provider should establish stringent internal measurement goals and seek constant improvement.

The seventh essential bundled 401(k) client expectation is that expenses must be reasonable in relation to the level of services provided. A key consideration for the plan sponsor is the method for the payment of expenses. They can be paid by the plan sponsor, withdrawn from participants' accounts, shared by both the plan sponsor and the participant or paid from forfeitures. Most plans across all market segments provide for cost sharing by the plan participants and the sponsor company. All expenses should be fully disclosed to the plan sponsor in writing. Mr. Ryan brought to the Council's attention an article that appeared in the April 1996 edition of CFO entitled, Facing Up To Total Plan Cost. The article suggests there is a wide disparity in costs of bundled 401(k) service provider packages.

Mr. Ryan concluded his testimony by stating that he views the role of the bundled service provider as part business-part social engineer. Such organizations exist only because they can offer quality services at a reasonable cost and meet their profit objectives. He noted that he also takes pride in the fact that bundled service providers, like MassMutual, are the only reason small companies are able to offer 401(k) retirement plans to hundreds of thousands of employees.

Leonard P. Larrabee, III

Senior Counsel

The Dreyfus Corporation

Mr. Larrabee, an attorney with the Dreyfus Corp. spoke on behalf of the Investment Company Institute (ICI), and was accompanied by Catherine L. Heron, Vice President and Senior Counsel, and Russell Gaylor, Assistant Counsel, who coordinate pension activity at the ICI. Mr. Larrabee began his testimony by stating his definition of a bundled service arrangement. Such an arrangement is an integrated package of administrative and investment services from affiliated or unaffiliated entities that is offered to the defined contribution market as a single product. That definition covers a variety of programs. The most basic one would involve an integrated package of administrative and investment services offered by a single financial institution. Mr. Larrabee made the point that, in the last five years, strategic alliance programs have been developed as an alternative to traditional bundled arrangements. The difference is that instead of having one financial institution offering investment and administrative services as a coordinated, integrated product, two or more institutions band together to provide a complete package of administrative and investment services as a coordinated, integrated product.

Mr. Larrabee next stated that the distinction between an alliance program and the traditional bundled service arrangement has become blurred in that it is becoming more and more common for a financial institution that offers a traditional, "one stop shopping," product to open up its program to include outside funds within its own bundled program.

The bulk of Mr. Larrabee's prepared remarks were devoted to the types of services a plan and its participants receive when a plan sponsor decides to purchase a bundled package of services. They can potentially receive every type of service involved in the daily operation of a defined contribution plan such as investment products, trustee services, record keeping services, communication and educational materials, telephone voice response systems, and plan documentation and compliance services. In essence, a plan sponsor could contract with a bundled service provider to have all of its defined contribution needs addressed.

Mr. Larrabee next discussed the issue of selecting service providers and specifically addressed the concern that participants' interests may be compromised by a plan sponsor's desire for the administrative convenience afforded by bundled service arrangements. Mr. Larrabee felt such criticism is unfair, and made the point that the same types of processes and procedures that are followed in the unbundled context carry over to the bundled service arrangement. With respect to investment options, Mr. Larrabee stated that due to the large number of bundled service providers to select from, if a particular service provider does not offer competitive investment products, it will not survive.

According to Mr. Larrabee, participants' interests are served by the number of "participant friendly" features available in a bundled service arrangement, such as daily valuation of participant account balances coupled with the ability to make daily transactions. Mr. Larrabee noted that studies have shown that the ability of participants to trade on a daily basis actually leads to better investment decisions on the part of participants who tend to focus on investing for the long-term without having to worry about market volatility over the short-term. He also stated that the ability to make frequent transactions in a bundled arrangement leads to better allocation decisions by participants.

Investment education is another participant friendly service typically found in a bundled service arrangement. Mr. Larrabee noted that financial institutions and their personnel are experts in investment matters. Many of the innovative educational materials developed for participants in defined contribution plans evolved from the bundled service type of arrangement. In a bundled service arrangement, investment education materials are coordinated and targeted to the particular investment options available under the plan. Such materials are more effective in terms of educating employees and influencing their behavior than generic materials that may be used in an unbundled situation.

Mr. Larrabee made the point both in his testimony and in a question posed to him later that in a bundled arrangement the parties available to answer participant questions about investments available under the plan are registered representatives of the service provider. They are licensed and trained to answer any and all questions relating to securities and other investments available to plan participants. This is typically not the case in an unbundled arrangement where the answers to participant questions may be more scripted and less informative.

Mr. Larrabee concluded his remarks by stating that the reason bundled service arrangements -- whether they are in the form of the traditional one stop shopping arrangement or an alliance program -- are so popular and will continue to be so popular is that they are very responsive to the interests of the key players in a defined contribution plan, the plan participants.

In response to questions about the cost differential of bundled versus unbundled arrangements, Mr. Larrabee stated that he believes a plan sponsor tends to receive a better net price on a bundled arrangement, and that on a per participant basis, a bundled arrangement is more economical.

Custody and money management are handled by independent entities in a typical unbundled arrangement, and provide important cross-checks in the reconciliation of plan assets. Mr. Larrabee was asked to what extent do bundled service arrangements dilute this protection, and whether errors would be less likely to be reported to plan sponsors in a bundled arrangement. Mr. Larrabee responded that reconciliation procedures do take place in bundled arrangements, and that the potential for errors going unreported and uncorrected is not any greater or lesser in either arrangement. He and Ms. Heron stated that mutual funds, like banks and insurers, are highly regulated entities. They are regulated at both the federal and state level. There is no indication that the regulatory regimes are inadequate to deal with any mistakes or problems that arise, including any conflicts of interests between affiliated entities. Plan sponsors and participants receive numerous reports and statements. A mistake could potentially be found by a regulator, an auditor, a plan sponsor, a plan participant or by the service provider itself. Financial institutions take responsibility for the errors that they make. When mistakes occur, they are corrected so that participants are put in the position they would have enjoyed if the transactions were processed correctly when initiated.

VII. Members of the Working Group

Joyce A. Mader, Working Group Co-Chair

O'Donoghue & O'Donoghue

James O. Wood, Working Group Co-Chair

Louisiana State Employee's

Retirement System

Judith Mares, Chair of the Advisory Council

Mares Financial Consulting, Inc.

Glenn W. Carlson

Arthur Andersen LLP

Kenneth S. Cohen

Massachusetts Mutual Life

Insurance Company

Carl S. Feen

CIGNA Financial Advisors

Jim Hill

State of Oregon

Marilee P. Lau

KPMG Peat Marwick LLP

Richard McGahey

Neece, Cator, McGahey

& Associates, Inc.

Edward B. Montgomery

University of Maryland

Victoria Quesada

Attorney at Law

Zenaida M. Samaniego

Equitable Life Assurance

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