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March 8, 2004
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Thank you, Bob (Kurucza w/Morrison & Foerster LLP) for that kind introduction. I am pleased to be here today to address the Washington Forum of the U.S. Institute. I realize this is a critical time for the asset management industry as you make the transition from the “investment” bubble to what may appear to be an impending “regulatory” bubble.
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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 precipitated intense congressional and political scrutiny as well.
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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 and you in the industry 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 fees on the retirement plan participants that the Department is pledged to protect. Then I will touch briefly on defined benefit plan reform and the President’s plan to strengthen 401(k) plans.
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Many 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.
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Finally, and of particular relevance to this audience, the President wants to enable families and business to plan for the future with confidence. A major component of economic security is retirement security. And we have to work together to help American workers and their families retire with confidence.
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Which is why we are here today: 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. Last year, however, state and federal authorities began unraveling a scandal revealing that 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 ERISA pertaining to the mishandling of retirement plan assets. The Department doesn’t have authority over mutual funds because, under ERISA, the assets of a mutual fund are not “plan assets.” However, ERISA-covered pension plans are significant investors in those funds.
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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? 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, we 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 that they discharge their duties prudently. The exercise of prudence in this context requires a careful, deliberative process. In this regard, 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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Late trading and market-timing abuses may extend to mutual funds and pooled investment funds beyond those currently identified by Federal and state regulators. For this reason, plan fiduciaries will need to consider whether they have sufficient information to conclude that such funds have procedures and safeguards in place to limit their vulnerability to abuse.
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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 raised 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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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. 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 who 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” solution, trades must be received by 4 p.m. at the fund company unless intermediaries are certified by the SEC to have the following protections in place:
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Electronic Audit Trail - orders would be sequenced and time-stamped at each step of the process, ensuring that the order was received before 4 p.m. and was not tampered with after it was received. Executive Certification - intermediary executives would certify that procedures to prevent illegal late trading were in place and working. Independent Audits - all entities handling mutual fund transactions would be audited by an independent auditor. Enhance SEC Jurisdiction - all entities handling mutual fund transactions would submit to SEC jurisdiction (not all do today). Enhanced Compliance Surveillance Tools - Robust compliance and surveillance tools would be in place, with the SEC providing guidance (based on its investigations over the past few months) as to the kinds of suspicious trading patterns or other signs warrant further scrutiny.
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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. 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.
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We are focusing on investment companies and banks that offer 401(k) services to plans more than 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 any real problems here but we have an obligation to look.
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Another ERISA fiduciary concern currently in the news is the fees issue.
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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.
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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 vehicle. Many plan service providers offer “bundled fee” arrangements where a number of different services, including recordkeeping, are packaged together and the plan is charged a single fee. 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, as you know, “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, it 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 through 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 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 on 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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Let me switch gears for a moment and talk for a few minutes about current legislative proposals designed to shore up retirement plans. The Administration is committed to ensuring that defined benefit plans continue to be a viable option for employers and workers. But to accomplish this, we must address the level of underfunding in the defined benefit system as a whole and work to preserve the integrity of the PBGC, which protects the pensions of approximately 44 million workers and retirees participating in over 31,000 private sector defined benefit plans.
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Last July, the Administration released an initial set of proposals designed to improve accuracy in measuring and reporting pension funding. First, we proposed to improve the accuracy of pension liability measurement to reflect the time structure of each pension plan’s benefit payments. This would be accomplished by measuring a plan’s liabilities using a yield curve of highly rated corporate bonds to calculate the present value of the future benefits.
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Second, we proposed better disclosure to workers, retirees, investors and creditors about the funded status of pension plans -- which will improve transparency and create incentives for better funding.
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Third, we proposed safeguards against underfunding, such as requiring financially troubled companies with below investment grade debt and highly underfunded plans to immediately fund or secure additional benefits or lump sum payments.
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Fourth, we committed to developing proposals for additional reforms to protect workers’ retirement security by improving the funded status of defined benefit plans.
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Our reform efforts continue to focus on policies that encourage employers to make benefit promises they can afford and to fund the benefit promises they make. In 2003, the House passed H.R. 3108, which provides for two years of a corporate bond interest rate to replace the current-law Treasury rate.
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The Senate recently approved an amendment to H.R. 3108, to provide funding relief from the Deficit Reduction Contribution (DRC) for single employer plans and funding relief for multiemployer plans. Final action requires a conference between the House and Senate to resolve differences between the two bills. The Administration supports the two years of interest rate relief as proposed in H.R. 3108. However, Secretary Chao, along with the other PBGC board members, Secretary Snow and Secretary Evans, have expressed to the Congress that they would recommend that the President veto a bill that that would significantly further exacerbate systemic pension plan underfunding.
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On the issue of long term defined benefit plan funding reform, the Administration continues to work on crafting a solution that will get pension plans better funded without increasing the risk of corporate bankruptcies. Our goal is to simplify, improve the transparency, and reduce the volatility of the funding rules while targeting those firms that pose the greatest threat to their workers and retirees and the PBGC. This is a tall order but we are closing in on it.
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In the meantime, corporate sponsors are responding to increased contribution requirements by changing their asset mix to more closely match liabilities and, in some cases, freezing plans or considering termination. We must work together to develop a sensible set of rules that allow defined benefit plans to thrive without putting workers, retirees, and the taxpayer at risk.
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With respect to defined contribution plans, the President has proposed allowing employees to divest company stock after three years, requiring quarterly benefit statements, and increasing access to professional investment advice - these reforms were passed by the House and are pending in the Senate.
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Let me say a quick work about investment advice. As you know, current ERISA law has barriers that prevent investment firms from providing individual investment advice to workers about their own funds. As a result, millions of rank and file workers do not have the information and advice necessary to make sound investment decisions to enhance their long-term security and independence. The Department made significant progress when we clarified that independent advice, even when offered in connection with an investment advisor, did not violate ERISA. But we continue to believe that the investment advice legislation is necessary both to expand the number of options available to workers and to remove the fear of liability from plan sponsors so that they make advice services available.
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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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