Mutual Funds
SEC Should Modify Proposed Regulations to Address Some Pension Plan Concerns Gao ID: GAO-04-799 July 9, 2004Mutual fund investments represent more than 20 percent of Americans' pension plan assets. Since late 2003, two abusive trading practices in mutual funds have come to light. Late trading allowed some investors to illegally place orders for funds after the close of trading. Market timing allowed some investors to take advantage of temporary disparities between the value of a fund and the value of its underlying assets despite stated policies against such trading. The Securities and Exchange Commission (SEC) has proposed regulations intended to stop late trading and reduce market timing. We were asked to (1) report on what is known about how these practices have affected the value of retirement savings of pension plan participants, (2) describe the actions taken by SEC and the Department of Labor (DOL) to address these practices, and (3) explain how plan participants may be affected by SEC's proposed regulations.
The cost of late trading and market timing to long-term investors in mutual funds is unclear; however, it does not appear that these abuses affected pension plan participants more than other investors. While individual instances of abusive trading may not have had a noticeable effect on the value of funds held by long-term investors, the cumulative effect of such trading may be significant. Among 34 brokerage firms surveyed by the SEC, more than 25 percent reported instances of illegal late trading at their firms. However, numerous fund intermediaries that are not regulated by the SEC may also have permitted late trading. Trading abuses can be difficult to identify because, among other reasons, fund brokers aggregate the transactions of their clients and often do not share details of individual transactions with mutual fund companies. Ultimately, the effect of trading abuses on the savings of plan participants and other long-term fund shareholders is a function of which funds they invested in and for how long. SEC and DOL have taken steps to address abusive trading in mutual funds, and SEC has proposed regulations that aim to stop late trading and curb market timing. SEC and DOL are investigating these trading abuses, and SEC has already reached several settlements. DOL has issued guidance to pension plan sponsors and other plan fiduciaries on how they can fulfill their legal requirements to act "prudently" and in the best interests of plan participants who invest in mutual funds. To stop late trading, SEC has proposed that all fund transactions be received by mutual funds or designated processors before 4:00 p.m. eastern time in order for investors to receive the same day's price. To curb short-term trading, including market timing, SEC has proposed regulations that would impose a 2-percent fee on the proceeds of fund shares redeemed within 5 business days of purchase. DOL is not involved in the process of drafting these regulations because it does not regulate mutual funds, but it is considering how the proposals would affect pension plans. To the extent that SEC's proposed regulations stop late trading and market timing, they would benefit long-term mutual fund investors; however, the new rules could also affect such investors adversely, and pension plan participants more than others. The new regulations are expected to increase costs (e.g., for technology upgrades) that would be passed on to long-term mutual fund investors. In addition, plan participants could be distinctly affected by the late trading proposal because it creates potential complications in processing certain transactions unique to pension plans (e.g., loans). Further, the market timing proposal may result in plan participants paying fees intended to deter market timing, even when there is clearly no intent to engage in abusive trading. SEC officials told us that they are considering changes and alternatives to the proposed regulations that would address these concerns.
RecommendationsOur recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.
Director: Team: Phone:GAO-04-799, Mutual Funds: SEC Should Modify Proposed Regulations to Address Some Pension Plan Concerns
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Report to the Subcommittee on Oversight, Committee on Ways and Means,
House of Representatives:
United States General Accounting Office:
GAO:
July 2004:
MUTUAL FUNDS:
SEC Should Modify Proposed Regulations to Address Some Pension Plan
Concerns:
GAO-04-799:
GAO Highlights:
Highlights of GAO-04-799, a report to the Subcommittee on Oversight,
Committee on Ways and Means, House of Representatives
Why GAO Did This Study:
Mutual fund investments represent more than 20 percent of Americans‘
pension plan assets. Since late 2003, two abusive trading practices in
mutual funds have come to light. Late trading allowed some investors to
illegally place orders for funds after the close of trading. Market
timing allowed some investors to take advantage of temporary
disparities between the value of a fund and the value of its
underlying assets despite stated policies against such trading. The
Securities and Exchange Commission (SEC) has proposed regulations
intended to stop late trading and reduce market timing. We were asked
to (1) report on what is known about how these practices have affected
the value of retirement savings of pension plan participants, (2)
describe the actions taken by SEC and the Department of Labor (DOL) to
address these practices, and (3) explain how plan participants may be
affected by SEC‘s proposed regulations.
What GAO Found:
The cost of late trading and market timing to long-term investors in
mutual funds is unclear; however, it does not appear that these abuses
affected pension plan participants more than other investors. While
individual instances of abusive trading may not have had a noticeable
effect on the value of funds held by long-term investors, the
cumulative effect of such trading may be significant. Among 34
brokerage firms surveyed by the SEC, more than 25 percent reported
instances of illegal late trading at their firms. However, numerous
fund intermediaries that are not regulated by the SEC may also have
permitted late trading. Trading abuses can be difficult to identify
because, among other reasons, fund brokers aggregate the transactions
of their clients and often do not share details of individual
transactions with mutual fund companies. Ultimately, the effect of
trading abuses on the savings of plan participants and other long-term
fund shareholders is a function of which funds they invested in and for
how long.
SEC and DOL have taken steps to address abusive trading in mutual
funds, and SEC has proposed regulations that aim to stop late trading
and curb market timing. SEC and DOL are investigating these trading
abuses, and SEC has already reached several settlements. DOL has issued
guidance to pension plan sponsors and other plan fiduciaries on how
they can fulfill their legal requirements to act ’prudently“ and in the
best interests of plan participants who invest in mutual funds. To stop
late trading, SEC has proposed that all fund transactions be received
by mutual funds or designated processors before 4:00 p.m. eastern time
in order for investors to receive the same day‘s price. To curb short-
term trading, including market timing, SEC has proposed regulations
that would impose a 2-percent fee on the proceeds of fund shares
redeemed within 5 business days of purchase. DOL is not involved in the
process of drafting these regulations because it does not regulate
mutual funds, but it is considering how the proposals would affect
pension plans.
To the extent that SEC‘s proposed regulations stop late trading and
market timing, they would benefit long-term mutual fund investors;
however, the new rules could also affect such investors adversely, and
pension plan participants more than others. The new regulations are
expected to increase costs (e.g., for technology upgrades) that would
be passed on to long-term mutual fund investors. In addition, plan
participants could be distinctly affected by the late trading proposal
because it creates potential complications in processing certain
transactions unique to pension plans (e.g., loans). Further, the market
timing proposal may result in plan participants paying fees intended to
deter market timing, even when there is clearly no intent to engage in
abusive trading. SEC officials told us that they are considering
changes and alternatives to the proposed regulations that would address
these concerns.
What GAO Recommends:
GAO recommends that the SEC Commissioners adopt modifications or
alternatives to the proposed regulations that would prevent pension
plan participants from being more adversely affected than other
investors.
In its response to GAO‘s draft report, SEC agreed with GAO‘s analysis
and noted that it is considering modifications to the proposed
regulations.
www.gao.gov/cgi-bin/getrpt?GAO-04-799.
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Barbara Bovbjerg at (202)
512-7215 or bovbjerg@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Mutual Fund Trading Abuses Affected Pension Plan Participants but the
Extent Is Unclear:
Regulators Are Taking Actions to Address Abusive Mutual Fund Trading:
Most Plan Participants Could Benefit from SEC's Proposed Regulations
but Face Greater Costs than Other Investors:
Conclusions:
Recommendations for Executive Action:
Agency Comments:
Appendix I: Objectives, Scope, and Methodology:
Appendix II: Alternative Proposals to Eliminate Late Trading:
Appendix III: Comments from the Securities and Exchange Commission:
Figures:
Figure 1: Path of Mutual Fund Transactions1:
Figure 2: Comparison of Fund Net Asset Value with and without Market
Timing:
Figure 3: Mutual Fund Defined Contribution Plan Assets by Type of Fund:
Figure 4: Potential Complication with Loan Transaction if Dollar Amount
Is Specified:
Figure 5: Potential Complication with Loan Transaction if Number of
Shares Is Specified:
Figure 6: Assessment of a Redemption Fee for an Exchange Transaction:
Abbreviations:
DOL: Department of Labor:
ERISA: Employee Retirement Income Security Act of 1974:
NSCC: National Securities Clearing Corporation:
OCC: Office of the Comptroller of the Currency:
SEC: Securities and Exchange Commission:
United States General Accounting Office:
Washington, DC 20548:
July 9, 2004:
The Honorable Amo Houghton,
Chairman:
The Honorable Earl Pomeroy:
Ranking Minority Member:
Subcommittee on Oversight:
Committee on Ways and Means:
House of Representatives:
Mutual funds represent a significant portion of Americans' retirement
wealth, with 21 percent of the more than $10 trillion in pension plan
assets now invested in mutual funds. These funds are particularly
popular in defined contribution plans,[Footnote 1] because they allow
investors to pool their savings with those of other investors so that
they may benefit from professional investment management and
diversification, among other things. Most defined contribution plan
assets in mutual funds are allocated to funds that invest in America's
equity markets and thus serve as an important source of capital for
investment in the economy. Furthermore, while broad stock market
indexes fell 22 percent in 2002, continuing contributions into defined
contribution plans sustained some of the demand for stocks and may have
helped prevent even greater declines in their value.
In September 2003, the New York State Attorney General alleged that
some mutual fund companies had allowed some investors to engage in
abusive trading practices that hurt the savings of long-term investors,
including pension plan participants. Several investors and mutual fund
companies have since settled their cases with both federal and state
authorities. One type of abusive trading, known as "late trading,"
allows certain investors to submit orders illegally for fund
transactions after the close of the financial markets in New York (when
mutual funds usually calculate their share prices) and still receive
the same day's price per fund share.[Footnote 2] Late traders were able
to purchase or redeem (sell back to the fund) shares in reaction to
news, such as corporate earnings announcements, that were released
after the markets closed. Such news would often affect the next day's
closing prices of fund shares, and thus late traders were able to
profit by quickly trading in and out of funds and acting on information
before other investors. The second type of abusive trading, known as
"market timing," is not illegal but may be used by investors to take
advantage of temporary disparities between the value of a fund and the
values of the underlying assets in the fund's portfolio. These pricing
disparities can occur frequently in certain funds such as those that
invest in international markets where securities stop trading hours
before American mutual funds typically calculate their net asset
values.
Both late trading and market timing impose costs on long-term
shareholders. For example, when short-term traders purchase and redeem
mutual fund shares, all investors share in the costs of fund managers
buying or selling shares of securities held in the fund's portfolio.
Many mutual fund companies state in their fund prospectuses that they
discourage market timing and may assess fees that are transferred to
the fund if shares are sold within a certain period of time following a
purchase of fund shares. However, some fund companies allowed certain
investors to engage in market timing despite such language in their
fund prospectuses.
The Securities and Exchange Commission (SEC), which regulates the
nation's securities markets and mutual funds, has recently proposed
regulations that are intended to stop late trading and reduce market
timing. The Department of Labor (DOL) is not involved in the process of
drafting the proposed late trading and market timing regulations
because it does not regulate mutual funds. However, it is considering
how the regulations would affect defined contribution plans, which
frequently invest in mutual funds. The proposed regulations aimed at
eradicating late trading would significantly change current industry
practices in receiving and processing transaction requests from
investors. Since many of the cases of late trading involved orders
submitted through intermediaries not regulated by SEC, the proposed
amendments would require that all fund transactions be received by
mutual funds or designated processors (also regulated by SEC) before
the market closing time of 4:00 p.m. eastern time to receive the same
day's price.[Footnote 3] The proposed regulations intended to curb
short-term trading, including market timing, would require mutual funds
to impose a 2-percent fee--known as a redemption fee--on the proceeds
of shares redeemed within 5 business days of purchase. Given the
potential changes that would occur as a result of these new regulations
and the importance of mutual funds to the retirement savings plans of
millions of American workers, you asked us to:
* report on what is known about how market timing and late trading have
affected the value of retirement savings of defined contribution plan
participants,
* describe what actions SEC and DOL have taken to address late trading
and market timing, and:
* explain how defined contribution plan participants are likely to be
affected by SEC's proposed regulations.
To determine how late trading and market timing have affected
retirement savings in defined contribution plans, we reviewed academic
studies about the effects of these practices on the values of mutual
funds. We then compared this information with data from mutual fund
companies and record keepers on how defined contribution plan
participants allocate their retirement savings among mutual funds to
assess their exposure to abusive trading practices. We also interviewed
representatives of mutual fund companies, plan record keepers, and SEC
officials to determine if they had any information about how late
trading and market timing have affected the values of specific mutual
funds. To learn about the regulatory actions taken by SEC and DOL, we
interviewed agency officials and reviewed SEC's proposed regulations
and DOL's guidance to plan sponsors on how to respond to late trading
and market timing. To determine how defined contribution plan
participants and service providers might be affected by SEC's proposed
regulations, we reviewed comment letters to SEC and interviewed SEC
officials, representatives of mutual fund companies, plan record
keepers, and employers. While mutual funds are common investment
choices in many types of retirement savings plans, our analysis focuses
on defined contribution plans because individual employees decide how
to invest their retirement savings and thus they bear the risks of
changes in the value of their accounts. We conducted our work between
March 2004 and June 2004 in accordance with generally accepted
government auditing standards. Appendix I describes the scope and
methodology of our work in greater detail.
Results in Brief:
The cost to long-term investors in mutual funds of late trading and
market timing is unclear, however it does not appear that these trading
abuses affected pension plan participants more than other investors.
While costs of individual instances of abusive trading may not have had
a noticeable effect on the value of fund shares held by long-term
investors, the cumulative effect of such trading may be significant.
Studies of late trading and market timing have yielded varying
estimates of their cost to long-term fund investors. These differing
results are one indication of the difficulty of measuring the extent
and cost of late trading and market timing. Among 34 brokerage firms
surveyed by SEC, including some of the largest in the nation, more than
25 percent reported instances of illegal late trading at their firms.
However, one SEC official told us that the SEC views these survey
results as conservative estimates of the extent of late trading,
because there are numerous fund intermediaries that are not registered
with and regulated by SEC who may also have allowed late trading to
occur. The extent of market timing is also difficult to measure because
fund intermediaries usually aggregate their clients' fund transactions
and do not necessarily share individual account information with mutual
fund companies. Abusive trading appears to have varied among funds, in
part because some funds went to greater lengths than others to try to
prevent market timing. Ultimately, the effect of late trading and
market timing on the savings of retirement plan participants and other
long-term fund shareholders is a function of which funds they invested
in and for how long.
SEC and DOL have each taken steps to address abusive trading in mutual
funds, and SEC has proposed regulations that aim to eradicate late
trading and curb market timing. SEC investigations have led to
settlements that, among other things, require those who engaged in
abusive trading to return money to funds where late trading and market
timing took place. In addition to its enforcement activities, SEC
adopted new mutual fund disclosure requirements. DOL, meanwhile, has
issued guidance to pension plan sponsors on how they and other plan
fiduciaries can fulfill their legal requirements to act "prudently" and
in the best interests of plan participants in offering investment
options in their defined contribution plans. To stop late trading, SEC
has proposed that all orders for fund transactions be received by
mutual funds or designated processors, who are regulated by the SEC,
before 4:00 p.m. eastern time in order to receive the same day's price
(the "Hard 4" proposal). According to SEC officials, this rule would
effectively eliminate opportunities for late trading by fund
intermediaries, where many cases of late trading took place. To address
market timing, SEC's proposed regulations would impose a 2-percent
redemption fee on the proceeds of fund shares redeemed within 5
business days of purchase. On the basis of comment letters and
discussions with representatives of mutual funds and fund
intermediaries, SEC officials are considering modifications and
alternatives to these proposed regulations. DOL is not involved in the
process of drafting the proposed late trading and market timing
regulations because it does not regulate mutual funds. However, it
anticipates assisting plan sponsors and record keepers on issues
relating to how the final regulations affect defined contribution
plans, which frequently invest in mutual funds.
While SEC's proposed regulations could both benefit and create new
costs for all long-term mutual fund investors, defined contribution
plan participants could be more adversely affected than other long-term
investors. All long-term investors in mutual funds, including plan
participants, would benefit if the proposals result in a cessation of
late trading and a reduction in market timing. However, to comply with
the requirements of SEC's proposed regulations, mutual fund companies
and fund intermediaries, including plan record keepers, are expected to
incur costs, such as for upgrading their information systems. Many of
these costs would likely be passed on to investors, plan participants,
and plan sponsors. Plan participants would be distinctly affected by
the late trading proposal because it creates potential complications
for the processing of certain transactions unique to defined
contribution plans, such as loans. For example, defined contribution
plan participants sometimes borrow from their retirement savings, and
plan record keepers need to know the value of the participant's shares
at the end of the day to be sure that the participant gets the amount
requested and that the request complies with the rules of the pension
plan. If record keepers had to submit orders to withdraw shares before
share values are determined, as SEC's proposed rule would require,
participants could receive incorrect loan amounts and in some cases the
loan amount could be greater than allowed by the pension plan rules.
The market timing proposal could result in plan participants paying
fees that are intended to deter market timing, even on certain
transactions, such as occasional transfers between funds to meet an
investor's investment objectives, for which clearly no intent to engage
in abusive trading exists. While SEC attempted to address these
potential negative effects by including certain exceptions to the
application of the redemption fee, there are still some cases in which
a plan participant could be charged such a fee. Therefore, SEC
officials have told us that, as of this writing, they are considering
modifications or alternatives to the proposed regulations that would
prevent these problems from occurring.
Given the significant role that mutual funds play in retirement
savings, we are recommending that the SEC Commissioners adopt certain
modifications or alternatives to the proposed regulations that are
currently under consideration in order to prevent pension plan
participants from being more adversely affected than other investors.
In its response to our draft report, SEC agreed with our analysis and
noted that the commission staff is considering modifications to the
proposals that should mitigate certain circumstances that could
adversely affect pension plan participants (SEC's comments are
reproduced in app. III).
Background:
Mutual funds are structured so that each investor in the fund owns
shares, which represent a percentage of the fund's investment
portfolio, and investors share in the fund's gains, losses, and its
costs. Mutual fund families offer investors multiple funds from which
to choose, each with its own level of risk and investment objective,
such as international equities or U.S. government bonds. Investors may
usually exchange assets between funds within a fund family at any time.
Recent investigations of mutual fund trading by the SEC and some state
attorneys general have revealed cases of abusive trading practices.
Mutual funds have proven to be a vehicle for abusive trading for a few
reasons, such as:
* Inefficient pricing of certain funds. Mutual funds typically
determine their net asset values once a day, based on the prices of
their underlying securities at 4:00 p.m. eastern time. For funds
invested in equities that trade on international stock exchanges, the
most current prices for those underlying assets may be as much as 15
hours old and thus not reflect more recent information that may affect
the prices of those assets. When the prices of underlying securities do
not reflect the most current information that is likely to affect their
price, opportunities are created for arbitrage, or profitably
exploiting price differences of identical or similar financial
instruments, usually over a short time period.
* Free fund exchanges. Abusive market timing sometimes took place
because investors took advantage of the fact that fund families often
allow their fund shareholders to purchase, redeem, or exchange funds at
no cost for a specific transaction. Normally, investors may redeem
their shares on any business day.
* Difficulty of identifying trading abuses. In many cases trading
abuses were committed by investors who purchased and redeemed fund
shares through intermediaries, who are not required to share
information about their clients' transactions with mutual fund
companies. Most funds are sold via intermediaries such as broker-
dealers, banks, and pension plans.
To simplify and reduce the costs of mutual fund transactions,
intermediaries collect orders throughout the day and then aggregate all
the transactions they receive for a particular fund. Those
intermediaries that are licensed as broker-dealers may net, or match,
purchase and redemption orders for the same funds among their own
clients. In a simplified example, if one investor were to purchase 15
shares of fund A, and another investor were to redeem 10 shares of fund
A, at the end of the day the intermediary would simply transmit one
order to purchase 5 shares of fund A--the net result of the day's
orders. Intermediaries then transmit the net results of aggregate
transactions to the mutual fund companies, where intermediaries hold
omnibus accounts representing the collective shares of their clients.
Mutual fund companies generally do not have information about the
identities and specific transactions of the individual investors in
intermediaries' omnibus accounts. Intermediaries have contact with
their clients, such as defined contribution plan participants and other
individual investors ("retail investors"), and control access to
information about their trading activity. Because intermediaries do not
typically share this information with mutual funds, the fund companies
often cannot discern whether these investors are frequently trading in
and out of their funds.
Mutual fund intermediaries accept purchase and redemption orders
throughout the day and are required to stop accepting trades at 4:00
p.m. eastern time for those transactions that will receive the same
day's net asset value. According to SEC rule 22c-1 under the Investment
Company Act of 1940, purchase and redemption orders submitted by
investors to a fund or fund intermediary before the fund next
determines its net asset value (usually at 4:00 p.m.) must be executed
at that next-computed net asset value. Presently, intermediaries are
allowed to aggregate orders after 4:00 p.m. and submit them as omnibus
account transactions later in the evening for settlement to mutual fund
companies, either directly or via their transfer agents[Footnote 4] or
the National Securities Clearing Corporation (NSCC), an SEC-registered
clearing agency.[Footnote 5] An intermediary or mutual fund that allows
investors to engage in late trading could therefore aggregate orders
received both before and after 4:00 p.m. and process them as if they
had all arrived before 4:00 p.m. Figure 1 illustrates the process of
how orders for mutual fund transactions are transmitted from investors
and plan participants to mutual fund companies.
Figure 1: Path of Mutual Fund Transactions:
[See PDF for image]
Note: Many mutual fund companies act as their own transfer agents,
while other funds hire transfer agents to keep records on their behalf.
Mutual fund companies may act as plan record keepers and only offer
proprietary mutual funds to plan participants; thus, plan participants
sometimes submit orders directly to mutual fund companies.
[End of figure]
Most employers that sponsor defined contribution plans contract out the
various administrative tasks of plan record keeping to companies that
have expertise in the administration of plans or investments. Pension
plan record keepers keep track of day-to-day transactions for each plan
participant's account. The record keeper is responsible for
transactions such as crediting accounts with employee and employer
contributions, processing changes in participant-directed investment
allocations, updating account values (usually each business day) to
reflect changes in the values of mutual fund shares held by each plan
participant, and acting as a mutual fund intermediary when participants
make exchanges between funds. When a plan participant sends the record
keeper a request for a transaction, such as for a loan, the record
keeper must determine whether the request can be approved in accordance
with federal tax and pension laws and the rules of the company's
pension plan. In addition, record keepers may function as the primary
source of plan information and customer service for plan participants.
Pension plan sponsors often hire a mutual fund company or a plan record
keeper to administer their defined contribution plans. Plans
administered by a record keeper frequently offer an "open-architecture
plan" that permit participants to invest in mutual funds offered by a
variety of mutual fund companies. The record keeper itself may be one
of these companies, insofar as some companies that are primarily record
keepers also offer their own proprietary mutual funds. Plans
administered by a mutual fund provider will typically include
investment choices offered by that mutual fund provider, and may or may
not offer funds of other mutual fund companies. In recent years, open-
architecture plans have become more common among defined contribution
plans.
Mutual funds are subject to SEC registration and regulation, and are
subject to numerous requirements established for the protection of
investors. Mutual funds are regulated primarily under the Investment
Company Act of 1940 and the rules and registration forms adopted under
that act. The 1940 act grants SEC broad discretionary powers to keep
the act current with the constantly changing financial services
industry environment in which mutual funds and other investment
companies operate. The primary mission of the SEC is to protect
investors, including pension plan participants investing in securities
markets, and maintain the integrity of the securities markets through
extensive disclosure, enforcement, and education. In addition to
regulating mutual funds, SEC also regulates some of the intermediaries
that act as brokers of mutual funds, such as retail broker-dealers and
certain pension plan record keepers. However, fund intermediaries that
are not registered as broker-dealers are outside SEC's jurisdiction.
For example, insurance companies are regulated by state authorities,
banks are regulated by the Office of the Comptroller of the Currency
(OCC) and other bank regulators, and pension plan administrators are
regulated by DOL. These regulators are required to perform a number of
oversight functions--for example, OCC examines the safety and soundness
of certain types of banks--therefore, identifying infractions of SEC
trading regulations is not the focus of their regulatory activity.
Pursuant to the Employee Retirement Income Security Act of 1974
(ERISA), DOL enforces reporting and disclosure provisions and fiduciary
responsibility standards of private employer-sponsored pension plans.
While ERISA does not provide specific guidance regarding the steps a
plan fiduciary may or should take with regard to late trading and
market timing, ERISA established the broad fiduciary requirements
relating to private pension plans and was designed to protect the
rights of plan participants and their beneficiaries.[Footnote 6] ERISA
Section 401(b)(1) of Title I provides that a plan which invests in a
security issued by an investment company registered under the
Investment Company Act of 1940, such as mutual fund shares, is only
investing in the "security" or shares of that investment company and
not in the underlying assets of the investment company. The asset of
the plan is the issued security, not any of the assets held by the
investment company. Therefore, under ERISA, DOL does not regulate the
activities of an investment company.
Mutual Fund Trading Abuses Affected Pension Plan Participants but the
Extent Is Unclear:
The cost to long-term mutual fund investors of late trading and market
timing is unclear, however it does not appear that these trading abuses
affected pension plan participants differently than other long-term
investors. While costs of individual instances of late trading and
market timing may not have a noticeable effect on the value of fund
shares held by long-term investors, the cumulative effect of abusive
trading may have been significant. Studies of late trading and market
timing have yielded varying estimates of their cost to long-term fund
investors. The extent of abusive trading appears to have varied among
funds, in part because some funds went to greater lengths than others
to try to prevent trading abuses. Ultimately, the effect of late
trading and market timing on the savings of retirement plan
participants and other long-term fund shareholders is a function of
which funds they invested in and for how long.
Abusive Short-Term Trading Imposes Costs on Long-Term Shareholders:
When some investors are allowed to frequently buy into a fund to
benefit from its short-term increases in value and sell shares to avoid
its decreases in value, there is a three-fold negative impact on the
fund's long-term shareholders:
* Costs increase. Abusive trading generates greater transaction costs
because fund managers have to more frequently buy or sell shares of the
underlying securities in the fund's portfolio to match demand for fund
shares.[Footnote 7]
* Investment returns usually decline over time. Abusive trading usually
results in lower investment returns over the long term when fund
managers hold a greater percentage of the fund's assets in cash. Fund
managers often increase the percentage of fund assets held in cash in
order to accommodate short-term traders' redemptions of shares without
having to engage in cost-generating transactions of buying and selling
shares of the fund's underlying securities. Over the long term,
investments in cash have yielded lower investment returns than stocks
and bonds.[Footnote 8]
* Gains are diluted. If short-term traders purchase fund shares and
redeem them before their money can be invested in the fund's portfolio,
they share in increases in the fund's value, resulting in long-term
shareholders receiving a smaller share of these gains--a dilution of
fund gains. Conversely, short-term traders can often avoid losses by
redeeming fund shares before their value decreases, resulting in long-
term investors sharing in a higher proportion of the fund's decrease in
value. Figure 2 demonstrates the dilution effect of abusive short-term
trading on long-term shareholders.
Figure 2: Comparison of Fund Net Asset Value with and without
Market Timing:
[See PDF for image]
Note: The figure shows how a hypothetical mutual fund is affected by an
increase in its portfolio assets with and without market timing. In
this example, a market timer invests $1,000 in the fund on day 1 before
a 10 percent rise in the value of the securities held by the fund. On
day 2 the market timer redeems the shares, yielding a reduction in the
fund's net asset value compared to its value without a market timer
transaction. The example assumes that the portfolio manager is unable
to invest the market timer's cash and thus that amount does not help
increase the fund's gain when the market rises.
[End of figure]
While a short-term trader can earn large returns from late trading or
market timing, the costs of such trades are generally imposed on a
large population of shareholders and therefore have a relatively small
effect on each individual investor. As shown in the example in figure
2, market timing reduces the net asset value of a share from $10.90 to
$10.89, or less than 0.1 percent. However, abusive short-term trading
on a large scale and over a period of years could cost long-term
shareholders, such as plan participants, more significant percentages
of their assets.
Extent of Mutual Fund Trading Abuses Is Unclear:
Efforts to quantify the total extent and cost of late trading and
market timing have yielded varying results. One academic study found
evidence of late trading in 15 of a sample of 50 international funds,
and in 12 of a sample of 96 domestic equity funds between 1998 and
2001.[Footnote 9] On the basis of these samples, the study estimates
that during 2001, late trading diluted the gains of the average long-
term shareholder in international and domestic equity funds by 0.05 and
0.006 percent, respectively. We were unable to identify other studies
on the extent of late trading, though representatives of a mutual fund
trade association that we spoke with believe that these estimates are
too high. Market timing also appears to have been most prevalent in
international equity funds, according to both academic studies and
representatives of mutual fund companies we spoke with. Studies show
that the most profitable market timing strategies involved trading in
and out of international equity funds. Other funds that were used for
market timing were small and midsize company domestic equity funds and
some types of bond funds. According to one study, market timing has
more negatively affected long-term shareholders than late
trading.[Footnote 10] Among the seven studies about market timing we
reviewed, estimates of its cost ranged from averages of 0.32 to 2.3
percent of assets per year in international equity funds.[Footnote 11]
The differences in the estimated costs of market timing vary depending
on which data and methodology were used by the researchers. These
variations also indicate the difficulty of definitively calculating the
extent of mutual fund trading abuses and their effect on long-term
investors.
The extent of late trading and market timing is very difficult to
measure because these practices can be hard to identify. Many cases of
late trading occurred at the fund intermediary level, when orders were
illegally accepted after 4:00 p.m. and given the same day's price when
they were combined with orders accepted before 4:00 p.m. Among 34
brokerage firms surveyed by SEC, including some of the largest in the
nation, more than 25 percent reported instances of illegal late trading
at their firms. However, one SEC official told us that SEC views these
survey results as conservative estimates of the extent of late trading,
particularly because there are numerous intermediaries that sell mutual
funds, including a significant percentage that are not registered with
and regulated by SEC. In one case of late trading, SEC brought charges
against Security Trust Corporation, a national bank association, for
allowing Canary Capital Partners, a hedge fund, to submit trades after
the close of the market and receive same day pricing.[Footnote 12]
Security Trust then aggregated these illegal transactions with
legitimate retirement plan transactions and submitted orders after 4:00
p.m. that appeared to be legal to fund companies. Security Trust
Corporation has been closed by federal regulators. According to SEC
officials, audits of past transactions cannot identify many instances
of late trading because late traders often submitted orders before 4:00
p.m. and then were allowed to cancel those orders after the market
closed. Canceled orders were then destroyed, which left no record of
the illegal trading.
Market timing can also be difficult to identify because, among other
reasons, the omnibus accounts of intermediaries obscure individual
account transactions. Therefore, mutual fund companies cannot identify
the frequency at which an individual investor is exchanging money
between funds. SEC has alleged that one intermediary's methods included
(1) forming and registering two affiliated broker-dealers through which
the intermediary could continue to engage in market timing without
detection, (2) changing account numbers for blocked customer accounts,
(3) using alternative registered representative numbers for registered
representatives who were blocked from trading by mutual funds, (4)
using different branch identification numbers, (5) switching clearing
firms, and (6) suggesting that customers use third-party tax
identification numbers or Social Security numbers to disguise their
identities.
Effect of Mutual Fund Trading Abuses on Plan Participants Varies:
Retirement plan participants would have been affected by late trading
and market timing just like other long-term investors if they were
shareholders in funds where these trading abuses occurred. Since
trading abuses appear to have been concentrated in international equity
funds, those plan participants that invested in such funds would likely
have been affected by late trading and market timing.[Footnote 13]
However, even among investors in international equity funds, some were
probably affected more than others because some mutual funds have
successfully reduced market timing by employing various tools such as
fair value pricing, redemption fees, and other penalties against
frequent traders.[Footnote 14] According to news reports and SEC
officials, some plan sponsors have responded to mutual fund trading
abuses by reassessing the investment options they offer to their plan
participants, and in some cases have removed implicated funds from
their offerings. Nonetheless, some funds that tried to stop market
timing could still have been used by abusive short-term traders who
traded via intermediaries. Most of the assets of plan participants were
not affected by market timing in international equity funds because, as
shown in figure 3, less than 10 percent of all plan assets were
invested in international equity funds.
Figure 3: Mutual Fund Defined Contribution Plan Assets by
Type of Fund:
[See PDF for image]
Note: Hybrid funds invest in a mix of equity and fixed-income
securities.
[End of figure]
According to a study by the Investment Company Institute, international
equity funds make up less than 10 percent of total defined contribution
assets in mutual funds.[Footnote 15] However, according to two of the
nation's largest pension plan record keepers, at least 19 percent of
plan participants, for whom they keep records, invest at least part of
their retirement savings in international equity funds. Furthermore,
any individual investor may allocate his or her plan assets very
differently from the average.
Market timing can also harm plan participants if a plan sponsor fails
or refuses to limit a participant's market timing. In pension plans,
even where a fund company becomes aware of a participant that is
engaged in harmful market timing, the fund's ability to restrict only
the participant, and not the entire plan, may be limited because the
shares of all participants are held in the record keeper's omnibus
account. If a plan sponsor fails or refuses to act to stop a
participant engaged in market timing, a fund has few means with which
to stop the market timer, except for perhaps restricting access to the
fund for all the plan's participants. According to representatives of
one mutual fund trade association we spoke with, plan sponsors have
sometimes been reluctant to impose redemption fees or trading
restrictions on plan participants for fear that they may be sued for
fiduciary violations.
Regulators Are Taking Actions to Address Abusive Mutual Fund Trading:
SEC and DOL have each taken steps to address abusive trading in mutual
funds, and SEC has proposed regulations that aim to eradicate late
trading and curb market timing. SEC has been investigating and has
settled several cases of abusive trading in mutual funds and has
recently adopted new mutual fund disclosure requirements. DOL,
meanwhile, is conducting its own investigations and has issued guidance
to pension plan sponsors that covers, among other things, their
responsibilities to ensure that they are offering prudent investment
options to plan participants. SEC's proposed regulations on late
trading would amend the rule that governs how mutual funds price and
receive orders for share purchases and redemptions. To try to curb
market timing, a separate SEC proposal would require mutual funds to
impose a 2-percent redemption fee on the proceeds of shares redeemed
within 5 business days of purchase.
SEC and DOL Have Taken Steps to Enforce and Clarify Existing Laws under
Their Respective Jurisdictions:
SEC has already settled some cases of late trading and market timing
abuses with mutual fund companies, hedge funds, and brokers. Though
market timing is not illegal, SEC has charged fund companies with
defrauding investors by not enforcing their stated policies of
discouraging or prohibiting market timing, as written in their
prospectuses. Some institutions have been fined hundreds of millions of
dollars, and part of this money will be returned to long-term fund
shareholders who lost money from these abusive trading practices.
Furthermore, SEC has permanently barred some of the individuals at
these companies from future work with investment companies and is
seeking disgorgement and civil penalties against them.[Footnote 16] SEC
officials told us that more enforcement actions are pending.
In addition to its enforcement actions, SEC has issued guidance and new
regulations that address the negative impact of market timing on long-
term shareholders. In 2002, SEC issued guidance stating that mutual
funds may delay exchanges of shares from one fund to another in order
to combat market timing. Permitting delayed exchanges could deter
market timing, since market timers seek to effect transactions on a
specific day to take advantage of perceived market conditions. SEC also
issued new regulations in April 2004 that require mutual funds to
disclose the following information in their prospectuses:
* risks to shareholders of frequent purchases and redemptions of
shares,
* policies and procedures regarding frequent purchases and redemptions
of shares,
* circumstances under which they will use fair value pricing and the
effects of using fair value pricing, and:
* policies and procedures with respect to the disclosure of their
portfolio securities and any ongoing arrangements to make available
information about their portfolio securities.
Mutual funds must comply with these new regulations by December 5,
2004.
Separate from SEC's activities, DOL has also begun investigating
possible fiduciary violations at some large investment companies,
including those that sponsor mutual funds, intermediaries, and plan
fiduciaries. More specifically, DOL is determining whether any of
ERISA's fiduciary provisions were violated by offering investments in
funds that allowed late trading or market timing, and whether employee
benefit plans incurred any financial losses as a result. Among other
things, DOL expects to address:
* whether plan fiduciaries used pension plan accounts to facilitate
late trading or market timing of others,
* whether pension plans incurred losses as a result of fiduciaries
knowingly directing investments in mutual funds that permitted late
trading or market timing, and:
* whether plan fiduciaries appropriately monitored plan provisions
regarding market timing.
DOL also issued a statement in February 2004 suggesting that plan
fiduciaries review their relationships with mutual funds and other
investment companies to ensure that they are meeting their
responsibilities of acting reasonably, prudently, and solely in the
interest of plan participants. According to DOL, for those mutual funds
under investigation for trading abuses, 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. For funds that are not
under investigation, DOL suggested that fiduciaries review whether
funds have procedures and safeguards in place to limit their
vulnerability to trading abuses.
The DOL guidance also explains that if a plan offers mutual funds or
similar investments that impose reasonable redemption fees on sales of
their shares, this would, in and of itself, not affect the availability
of relief to the plan sponsor under Section 404(c) of ERISA.[Footnote
17] The guidance adds that reasonable plan or investment fund limits on
the number of times a participant can move in and out of a particular
investment within a particular period would not run afoul of
requirements under 404(c). However, the terms and conditions of the
plan regarding the imposition of fees and trading restrictions must be
clearly disclosed to the plan's participants and beneficiaries.
Representatives of mutual fund companies and plan sponsors have told us
that additional guidance on what actions plan sponsors may take to
prevent market timing by plan participants, without losing relief under
ERISA Section 404(c), would be helpful.
SEC Has Proposed New Mutual Fund Trading Regulations:
In addition to adopting new mutual fund disclosure requirements, SEC
has also proposed regulations to address late trading and market timing
abuses. In December 2003, SEC proposed amending the rule that governs
how mutual funds price and receive orders for share purchases or
sales.[Footnote 18] Since many of the cases of late trading involved
orders submitted through intermediaries, including banks and pension
plans not regulated by SEC, the proposed amendments would require that
orders to purchase or redeem mutual fund shares be received by a fund,
its transfer agent, or a registered clearing agency before the time of
pricing (usually 4:00 p.m. eastern time). SEC officials explained to us
that given their resources, they cannot examine all intermediaries that
accept order information for mutual fund shares. Thus, to lower the
risk of additional late trading abuses, it would be necessary to reduce
the number of fund intermediaries with the authority to verify the time
that orders are received.
To stem market timing, SEC proposed a new rule in March 2004 to require
mutual funds to impose a 2-percent redemption fee on the proceeds of
shares redeemed within 5 business days of purchase.[Footnote 19]
According to the proposal, the proceeds from the redemption fees would
be retained by the fund and would become a part of the total assets
managed on the behalf of the fund's shareholders. The imposition of a
mandatory redemption fee is intended to serve two purposes: (1) to
reimburse a fund for the approximate costs of short-term trading in
fund shares, and (2) to discourage short-term trading by reducing its
profitability. SEC is aware that the redemption fee by itself is
inadequate for eliminating all profitable market-timing opportunities.
Therefore, fund companies may use additional measures to try to prevent
market timing. In addition, the proposal requires all fund
intermediaries, including plan record keepers, to share the details of
each client's transactions with mutual fund companies. On at least a
weekly basis, intermediaries would be required to provide mutual funds
with purchase and redemption information for each shareholder within an
omnibus account to enable the fund to detect market timers and ensure
that redemption fees are properly assessed. Presently, those
intermediaries that are not under the jurisdiction of SEC cannot be
required by SEC to share individual account information with mutual
fund companies. The proposal also allows for certain exceptions to the
application of the redemption fee, such as for unanticipated financial
emergencies, and for redemptions of $2,500 or less if the fund chooses
to adopt such a policy.
These proposals are part of an open regulatory process, and according
to SEC officials, SEC staff have reviewed over 1,400 comment letters
and met with various interested parties. SEC officials are considering
modifications to the proposals based on feedback from different parties
and will ultimately recommend a final set of proposals to the
Commissioners of the SEC. SEC also proposed new regulations that
address mutual fund boards' independence and effectiveness, fund
adviser compensation of broker-dealers that sell fund shares, and
mutual fund ethics standards.[Footnote 20] SEC officials told us that
these rules and others should help reduce abusive practices, such as
late trading and market timing, throughout the mutual fund industry.
DOL is not involved in the process of drafting the proposed late-
trading and market-timing regulations because it does not regulate
mutual funds. However, it is considering how the regulations would
affect pension plans and anticipates providing interpretative
assistance to plan sponsors and record keepers, as necessary, regarding
any ERISA issues in implementing SEC's final rules.
Most Plan Participants Could Benefit from SEC's Proposed Regulations
but Face Greater Costs than Other Investors:
SEC's proposed regulations on late trading and market timing would have
similar effects on pension plan participants and other investors, but
as they were initially written they would also have some effects unique
to defined contribution plan participants. To the extent that the
proposals would result in a cessation of late trading and a reduction
in market timing, plan participants, like other mutual fund investors,
would benefit. However, SEC's proposed regulations are expected to
create additional costs for mutual fund companies and fund
intermediaries, including plan record keepers; many of these costs are
likely to be passed on to investors, plan participants, and plan
sponsors. Plan participants could be distinctly affected by the late
trading proposal because it creates potential complications for the
processing of certain transactions unique to defined contribution
plans, such as loans. In addition, plan participants may pay fees
intended to deter short-term trading, including market timing, even on
certain transactions where there is clearly no intent to engage in
abusive trading.
Plan Participants Would Benefit from a Cessation of Trading Abuses:
To the extent that SEC proposals would result in a cessation of late
trading and a reduction in market timing, plan participants, like other
mutual fund investors, would benefit. SEC officials told us that the
Hard 4 proposal would virtually eliminate the possibility of late
trading through mutual fund intermediaries. Participants could also
benefit from the redemption fee proposal, as many short-term traders
are likely to be deterred from abusive market timing that imposes costs
on long-term investors. Furthermore, those who engage in market timing
would repay to long-term shareholders at least part of the costs that
they impose on them.
According to SEC officials, pension plan participants and other fund
investors would also benefit from increased confidence in the fairness
of the securities markets, knowing that these two types of abusive
trading practices were being minimized. Market fairness and the
promotion of investor confidence have long been goals of the SEC. The
persistence of late trading and market timing could undermine the
integrity of, and investor confidence in, the securities markets in
general and mutual funds in particular. SEC officials told us that not
acting quickly to address these abuses could have resulted in investors
withdrawing mutual fund investments and either looking for other
investment options or withdrawing from securities markets entirely.
New Regulations Are Expected to Impose Costs on Service Providers and
Investors:
SEC's proposed regulations on late trading and market timing are
expected to create additional costs for mutual funds and fund
intermediaries, including pension plan record keepers, which would
likely result in increased costs for all mutual fund investors, plan
participants, and plan sponsors.[Footnote 21] SEC's late trading
proposal could force intermediaries to require their clients, including
pension plan participants, to submit their orders for mutual fund
transactions prior to 4:00 p.m. eastern time. Pension plan
administrators anticipate that retirement plan participants who submit
orders through intermediaries would face cutoffs between 12:00 p.m. and
2:00 p.m. eastern time in order to allow pension plan record keepers
time to process purchase and redemption orders before submitting them
to the fund, its transfer agent, or NSCC. This earlier deadline for
submitting fund transaction orders to plan record keepers should not
significantly affect payroll transactions of fund shares because these
transactions are a function of the participant's payroll schedule and
not usually timed investment decisions made by the plan participant;
therefore, the change in price from one day to the next could either be
to the benefit or the detriment of plan participants as they purchase
or redeem shares at higher or lower prices. According to
representatives of two large mutual fund companies that we spoke with,
payroll transactions represent about 95 percent of the defined
contribution plan transactions that they process. However, some pension
plan administrators told us that in some cases of nonpayroll
transactions, they may not be able to process any purchase and
redemption requests the same day that orders are received. SEC
officials told us that implementation of computer system upgrades and
modifications to business processes would likely result in
intermediaries ultimately being able to accept orders until a time very
shortly before 4:00 p.m. eastern time. However, some intermediaries
told us that system upgrades and the communication of information to
investors, plan participants, and plan sponsors about new requirements
for submitting orders for mutual fund transactions could represent a
significant expense.
Some pension plan record keepers told us that adoption of the Hard 4
proposal would put intermediaries at a competitive disadvantage if they
were unable to modify their systems so that plan participants would be
able to submit orders until 4:00 p.m. (or just before then). They
argued that investors, including plan participants, have grown
accustomed to ever-increasing rates of change in global financial
markets and that plan participants want the flexibility to move their
money at a moment's notice, without having to wait a day for the
transaction to be completed. Indeed, on some of the stock market's most
volatile days there have been increases in the percentage of plan
participants who exchange money between funds. As a result of this
demand, plan record keepers fear that they would not be able to compete
with mutual fund companies, who offer their own funds and record-
keeping services to pension plans and could therefore allow plan
participants to submit orders until 4:00 p.m.[Footnote 22] Officials of
one mutual fund company that also serves as a record keeper expressed
concerns that plan participants may demand alternative investment
products to mutual funds if they were to no longer be able to place
orders for fund transactions until the market closing time. However,
according to information from two of the nation's largest mutual fund
companies, the vast majority of plan participants do not make more than
one exchange between mutual funds during the course of a year.
The redemption fee proposal would also create new costs for mutual
funds and their intermediaries. SEC has noted that the costs to a
fund's transfer agent to store the shareholder information and track
the trading activity may be significant and those costs may ultimately
be passed on to investors. In some cases, the transfer agent would have
to upgrade its record-keeping systems. Commenting on the information-
sharing requirement in the proposed redemption fee rule, some plan
record keepers that we spoke with explained that it would be
inefficient to have transaction information of individual investors
stored by both plan record keepers and fund transfer agents.
Representatives of one mutual fund company told us that record keeping
would be most efficient if intermediaries were only required to share
transaction information about individual investors upon the request of
mutual funds.
The redemption fee proposal would also increase costs for fund
intermediaries who would have to upgrade any systems that are currently
unable to either transmit individual shareholder data to mutual fund
companies or track transaction patterns of individual accountholders.
Many intermediaries have stated that the costs of these technology
upgrades would be substantial and would likely be passed on to mutual
fund shareholders who invest through intermediaries, including pension
plan participants. However, estimates of these costs depend to some
extent on the flexibility of systems that intermediaries currently
employ.
Some fund intermediaries have argued that SEC should establish a
uniform schedule for redemption fees in order to keep the cost of
tracking the transactions of individual investors and assessing
redemption fees to a minimum. Mutual fund company representatives,
however, have told us that because funds vary in characteristics such
as investment objective and investor turnover, funds have different
needs for cost recovery and market timing deterrence. For example, an
international fund might need higher redemption fee amounts and longer
holding periods to discourage market timing. Therefore, they say,
mutual fund directors should have the flexibility to set redemption fee
terms that they feel would best achieve these goals and protect long-
term investors.
SEC's Hard 4 Proposal Could Complicate Certain Pension Plan
Transactions:
Pension plan record keepers note that SEC's Hard 4 proposal would
present complications for the processing of certain transactions that
are unique to pension plans, such as participant loans, which are held
by about 20 percent of 401(k) plan participants, according to three
large plan record keepers.[Footnote 23] Record keepers told us that to
process a loan request, a plan record keeper must know the value of the
mutual fund shares held by the plan participant to determine how many
shares must be redeemed, and from which funds, to meet the
participant's request and comply with various rules governing loan
transactions. Currently plan record keepers process loan transactions
after the net asset values of mutual fund shares have been calculated,
which is after 4:00 p.m., and then submit a redemption order for a
specified number of dollars or fund shares or a percentage of the
participant's total plan assets.[Footnote 24] Under the Hard 4
proposal, record keepers would have to transmit redemption orders for
loan transactions before they could know the net asset value of a
participant's shares in different funds; therefore, according to record
keepers, they would likely use the prior day's share prices to estimate
either the number of shares to be redeemed or the amount of money to be
withdrawn from each fund owned by the participant. Because mutual fund
share prices usually change from one day to the next, the submission of
a redemption order could result in either the participant receiving
more or less money than requested or a violation of plan rules that
specify the order in which shares may be redeemed. For example, many
plans require participants to first redeem those mutual fund shares
that were purchased with their own contributions before redeeming
shares that were purchased with employer contributions.
Figures 4 and 5 demonstrate the potential problems that may arise with
loan transactions were the Hard 4 regulations to be adopted as
originally proposed.
Figure 4: Potential Complication with Loan Transaction if Dollar
Amount Is Specified:
[See PDF for image]
[End of figure]
Figure 5: Potential Complication with Loan Transaction if Number of
Shares Is Specified:
[See PDF for image]
[End of figure]
SEC's Proposed Redemption Fee Rules Could Impose Fees on Plan
Participants when Not Intended:
Despite SEC's proposed measures to limit the application of the
redemption fee, SEC's redemption fee proposal may in certain
circumstances penalize plan participants for certain transactions that
could not be construed as attempts to engage in market timing. Plan
participants do not control the timing of payroll transactions of fund
shares, since plan sponsors and record keepers process these
transactions. The transaction of purchasing fund shares in a
participant's plan does not necessarily occur on the same day that an
employee receives a payroll deposit in the bank, and therefore plan
participants may not know when additional fund shares are purchased on
their behalf. Occasionally plan participants rebalance the allocation
of their plan assets among their different mutual funds, transfer
retirement savings from one fund to another, or take a loan from their
plan. In some cases, these participant-directed transactions may occur
within 5 days of a payroll purchase of fund shares, and in some of
these cases the plan participant would pay a redemption fee of 2
percent on the most recent payroll purchase of fund shares, despite the
fact that there was no intent to engage in abusive market timing. The
SEC's proposed rule has attempted to address these situations by
limiting the application of the redemption fee by (1) mandating a
"first-in, first-out" method for determining redemption fees, (2)
allowing funds to not collect redemption fees on proceeds of $2,500 or
less (de minimis exception), and (3) limiting the rule's holding period
to 5 days, thereby targeting the most egregious circumstances of
excessive trading.[Footnote 25] Nonetheless, some funds may choose not
to apply the de minimis exception; therefore, in some cases,
participants could still end up paying redemption fees. Usually, a 2-
percent redemption fee on the last payroll purchase of fund shares
would not amount to more than a few dollars. However, plan sponsors and
administrators have argued that it would be unfair to penalize plan
participants when there is clearly no intent to engage in abusive
trading.
Figure 6 illustrates how a plan participant could be assessed a
redemption fee for transferring the balance of one fund to another.
Figure 6: Assessment of a Redemption Fee for an Exchange
Transaction:
[See PDF for image]
Note: The proposed rule's de minimis provision permits funds to forgo
the assessment of a redemption fee if the value of the shares redeemed
is $2,500 or less.
[End of figure]
In our most recent discussions, SEC officials told us that as of this
writing, they are considering modifications to both the Hard 4 and
redemption fee proposals to address the concerns cited above. SEC
officials are also considering alternatives to the Hard 4 proposal (see
app. II for discussion of two such alternatives) and are actively
talking with mutual fund companies and fund intermediaries about the
feasibility of these other options.
Conclusions:
Pension plans play a significant role in the financial markets of the
United States as a primary vehicle for investing savings in the
economy, and the use of mutual funds in pension plans often gives
participants a great deal of choice about how they allocate their
savings. Because late trading and market timing have negatively
affected pension plan participants and other long-term investors, we
support SEC's efforts to stop these abusive practices. However, in
certain circumstances, some pension plan participants may be more
adversely affected by SEC's proposed regulations than other mutual fund
investors if they were to be adopted as proposed. Amending the proposed
regulations to mitigate these potentially negative effects on pension
plan participants, as SEC staff are now considering, seems a sensible
approach. Without such changes, pension plan participants could face
complications with certain transactions that are unique to pension
plans and be assessed fees when they would clearly not be engaging in
abusive trading.
Recommendations for Executive Action:
Given the significant role that mutual funds play in retirement
savings, we are recommending that the SEC Commissioners adopt certain
modifications or alternatives to the proposed regulations that are
currently under consideration in order to prevent defined contribution
plan participants from being more adversely affected than other
investors.
Agency Comments:
We provided a draft of this report to SEC and DOL. We obtained written
comments from SEC, which are reproduced in appendix III. SEC agreed
with our analysis and noted that the commission staff is considering
modifications to the proposals that should mitigate certain
circumstances that could adversely affect pension plan participants.
SEC and DOL also provided technical comments, which we incorporated as
appropriate.
Unless you publicly announce its contents earlier, we plan no further
distribution until 30 days after the date of this report. At that time,
we will send copies of this report to the Commissioner of the SEC, the
Secretary of Labor, appropriate congressional committees, and other
interested parties. The report is also available at no charge on GAO's
Web site at [Hyperlink, http://www.gao.gov].
If you have any questions concerning this report, please contact me at
(202) 512-7215 or George Scott at (202) 512-5932. Other major
contributors include Gwen Adelekun, Amy Buck, David Eisenstadt,
Lawrance Evans, Jr., Cody Goebel, Marc Molino, Derald Seid, and Roger
Thomas.
Signed by:
Barbara D. Bovbjerg:
Director, Education, Workforce, and Income Security Issues:
[End of section]
Appendix I: Objectives, Scope, and Methodology:
To determine how late trading and market timing have affected pension
plan participants, we reviewed academic studies of how different types
of mutual funds were affected by these trading abuses and compared this
information with data about how defined contribution plan participants
allocate their retirement savings among different types of funds. In
addition, we asked various experts in the pension plan and mutual fund
industries for any information about the effect of mutual fund trading
abuses on pension plan participants. None of the representatives of
pension plan record keepers,[Footnote 26] mutual fund companies, and
officials from the Securities and Exchange Commission (SEC) and the
Department of Labor (DOL) were able to provide us an estimate of how
late trading and market timing affected plan participants.
We reviewed one study from 2003 on late trading, which estimated its
effect on the values of mutual funds. We also identified seven studies
done between 1998 and 2003 on market timing, four of which estimated
its effects on the values of different types of mutual funds. We
reviewed the methodologies used in these studies and found that they
are consistent with techniques that are generally accepted in the
academic literature. The estimates of the effects of late trading and
market timing on long-term shareholders should be interpreted with
caution because of data limitations, small samples that may not be
representative of the mutual fund sector, and assumptions that underlie
the estimates. However, we believe that these studies serve a useful
purpose in providing a general sense of the scale of late trading and
market timing. Furthermore, the variance in the results of these
studies illustrates the difficulty of determining the extent and
effects of late trading and market timing.
To assess plan participants' potential exposure to abusive trading
practices, we obtained data from two large pension plan record keepers,
two of the largest mutual fund companies (who are also plan record
keepers), and the Investment Company Institute on how defined
contribution plan participants allocate their retirement savings among
mutual funds. The information about asset allocations to different
types of mutual funds by plan participants was fairly consistent among
these studies. We reviewed the methodologies used in these studies and
the consistency of their data, and we found the studies to be
sufficiently reliable for the purpose of describing the average
allocations of pension assets of plan participants.
To explain the regulatory actions taken by SEC and DOL to address late
trading and market timing, we interviewed SEC and DOL officials and
reviewed documents from both agencies. To describe SEC's enforcement
actions, we reviewed congressional testimony by SEC's Director of
Enforcement and press releases from SEC and the New York State Attorney
General's office and interviewed SEC officials. To describe new
regulations either adopted or proposed by SEC, we reviewed the
regulations and spoke with officials from SEC's Investment Management
Division who have been involved in writing these regulations. To
describe DOL's enforcement actions, we reviewed documents sent to us by
DOL officials and interviewed these officials. To explain DOL's
guidance to plan sponsors on the duties of plan fiduciaries in light of
mutual fund trading abuses, we reviewed the guidance issued by DOL and
interviewed DOL officials. We also spoke with representatives of plan
sponsors, plan record keepers, and mutual fund companies to obtain
their opinions about DOL's guidance.
To determine how defined contribution plan participants and pension
plan service providers might be affected by SEC's rule proposals on
late trading and redemption fees, we reviewed numerous comment letters
submitted to the SEC. In addition, we interviewed representatives of
mutual fund companies, pension plan record keepers, officials from the
National Securities Clearing Corporation (NSCC), trade associations
that represent mutual funds, plan sponsors, pension actuaries and life
insurance companies, and officials from SEC and DOL. To assess how plan
participants could be affected by an earlier deadline for the
submission of mutual fund transactions, we reviewed information from
plan record keepers and mutual fund companies about the types of mutual
fund transactions that plan participants normally make during the
course of a year. In addition, we obtained information about the mutual
fund trading activity of plan participants in response to major events
that resulted in significant increases or decreases in the values of
major stock indexes.
We conducted our work between March 2004 and June 2004 in accordance
with generally accepted government auditing standards.
[End of section]
Appendix II: Alternative Proposals to Eliminate Late Trading:
While many mutual fund companies and intermediaries support SEC's goal
of preventing unlawful trading in mutual fund shares, they have raised
concerns about the Hard 4 proposal as a solution to illegal late
trading and have suggested alternative solutions. These concerns center
on the question of which entity or entities should be allowed to accept
orders until the market closing time of 4:00 p.m. eastern time to
receive the current day's fund price. One alternative solution, the
"Smart 4" proposal, seeks to maintain the flexibility intermediaries
currently enjoy of accepting fund orders until the market close and
then processing and transmitting them sometime after the market close.
A second alternative, the "Clearinghouse" proposal, would require all
mutual fund orders to receive an electronic time stamp at a central
location that would verify their time of receipt. All orders received
at the central clearinghouse by 4:00 p.m. would receive same day
pricing.
The Smart 4 proposal would require all companies that want to accept
orders until the market close, and process them thereafter, to adopt a
three-part series of controls: (1) electronic time stamping of all
transactions so all trades could be tracked from the initial customer
to the mutual fund company, (2) annual certifications by senior
executives that their companies have procedures to prevent or detect
unlawful late trading and that those procedures are working as
designed, and (3) annual independent audits. The Smart 4 proposal has
been advocated by most of the fund intermediaries that we spoke with.
Representatives of intermediaries told us that they should be given an
opportunity to prove that they can comply with the same policies and
procedures as mutual fund companies in accepting and processing fund
orders. Furthermore, many intermediaries assert that while SEC's Hard 4
proposal addresses intermediary processing of mutual fund orders, it
does not go as far in seeking to prevent late trading at mutual fund
companies. Currently, not all intermediaries are subject to SEC
jurisdiction; therefore, under the Smart 4 proposal, any unregistered
intermediary that forwards mutual fund orders to a fund company after
the market close would have to consent to SEC inspection authority.
However, SEC officials told us that they do not have the resources to
examine the numerous unregulated intermediaries they would have to
inspect to ascertain that adequate internal controls are in place to
prevent late trading. To date, the Smart 4 proposal has been revised a
few times, and representatives of retirement plan intermediaries told
us that they are working on developing a more robust network of
controls that would allow independent auditors to verify that
intermediaries are complying with the laws that prohibit late trading.
The Clearinghouse proposal would require all mutual fund orders to be
time-stamped electronically by an SEC-registered central clearing
entity before the market close to receive that day's fund price. The
clearing entity's time stamp would be considered the official time of
receipt of an order for a mutual fund transaction. The National
Securities Clearing Corporation is currently the only SEC-registered
clearing agency operating an automated processing system for mutual
fund orders.[Footnote 27] The Clearinghouse proposal would expand the
NSCC's role, capabilities, and capacity to handle all orders of mutual
fund transactions. Each mutual fund company and fund intermediary would
consider its technological capabilities and other factors in deciding
how to meet the requirement of submitting orders to the NSCC by 4:00
p.m. in order to receive same-day pricing.
By requiring that all mutual fund transactions be processed through the
NSCC, the Clearinghouse proposal seeks to ensure that companies that
offer their own mutual funds do not gain an advantage over
intermediaries that do not. By allowing record keepers to submit order
information to the NSCC in two phases, the Clearinghouse proposal, like
the Smart 4, would preserve the processing of fund transactions after
the market close. First, before the market close, mutual funds and fund
intermediaries would submit a fund order that must contain the
information essential to establishing the customer's intent.[Footnote
28] Some orders would require additional information not essential to
establishing intent. Under the Clearinghouse proposal, the additional
information could be submitted after 4:00 p.m. as long as the
submission establishing intent is received by the NSCC before 4:00 p.m.
One major concern surrounding the Clearinghouse proposal is that
intermediaries who do not currently use the NSCC's clearinghouse system
may face significant costs in upgrading their computer systems and
establishing a connection to the NSCC. SEC estimates that each year
approximately half of all mutual fund orders are submitted directly to
mutual funds through their transfer agents and the other half are
submitted to funds through the NSCC. Intermediaries and funds that do
not currently use the NSCC would have to either establish a direct
communications link to the NSCC or make arrangements with other mutual
funds or intermediaries who would be willing to transmit their orders
to the NSCC on their behalf. Some pension plan record keepers are
concerned that the costs of establishing a direct connection to the
NSCC would be unaffordable. Another concern about the Clearinghouse
proposal is that the NSCC may not be able to handle the concentration
of orders it would receive just prior to the market close. However, the
NSCC's analysis indicates that its current system capacity is
sufficient to handle the increase in transactions. Proponents state
that a benefit unique to the Clearinghouse proposal is that it would
allow plan record keepers and administrators to process plan
participants' requests for exchanges between different fund families on
the same day.
[End of section]
Appendix III: Comments from the Securities and Exchange Commission:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION:
WASHINGTON, D.C. 20549:
DIVISION OF INVESTMENT MANAGEMENT:
June 30, 2004:
Barbara D. Bovbjerg:
Director:
Education, Workforce, and Income Security Issues:
U.S. General Accounting Office:
441 G Street, NW:
Washington, DC 20548:
Re: GAO Draft Report (GAO-04-799):
Dear Ms. Bovbjerg:
Thank you for the opportunity to comment on the General Accounting
Office's draft report addressing market timing, late trading, and their
effects on pension plan participants' retirement savings. The report
assesses the impact that late trading and market timing have had on the
value of retirement savings of pension plan participants, describes the
actions taken by the Commission and the Department of Labor to address
these practices, and explains how plan participants may be affected by
the Commission's proposed regulations. I commend the GAO for its
thorough analysis of these very complicated, but important issues.
We share the concerns that GAO has identified in the draft report. In
particular, we agree that pension plans play a significant role in the
financial markets as a primary vehicle for investing savings in the
economy, and that late trading and market timing have negatively
affected pension plan participants and other long-term investors. As
the report noted, the Commission staff is considering recommending
modifications to the Commission's proposals that should mitigate
against certain circumstances that could potentially adversely affect
pension plan participants. In addition to evaluating comments on the
rule proposals, we have spoken with representatives from mutual funds,
insurance companies, and third party administrators and record keepers
for pension plans in order to ensure that the recommendations we make
to the Commission will effectively prevent abusive trading in mutual
fund shares while minimizing costs to investors.
Thank you again for this opportunity to provide comments to the GAO as
it prepares its final draft of the report.
Sincerely,
Signed by:
Paul F. Roye:
Director:
[End of section]
FOOTNOTES
[1] Defined contribution plans are one type of employer-sponsored
pension plan. Employee benefits are based on employer and/or employee
contributions and investment returns (gains and losses) on individual
accounts. Employees bear the investment risk and often control, at
least in part, how their individual account assets are invested.
According to the most recent Department of Labor information, most
private-sector pension-covered workers in the United States are covered
only by defined contribution plans.
[2] This report assumes, for convenience, that all funds price their
securities daily at 4:00 p.m. eastern time. Some funds, however, price
their securities more than once per day, and many funds price their
securities earlier than 4 p.m. eastern time.
[3] Types of intermediaries include broker-dealers, banks, insurance
companies, and pension plan administrators, all of which may provide
record-keeping services for pension plans. We refer to those that do as
plan record keepers.
[4] Mutual funds employ transfer agents to conduct record-keeping and
related functions. Transfer agents maintain records of shareholder
accounts, calculate and disburse dividends, and prepare and mail
shareholder account statements, federal income tax information, and
other shareholder notices.
[5] NSCC is currently the only clearing agency registered with the SEC
that operates an automated system, called Fund/SERV, for processing
orders for mutual funds and other securities. Fund/SERV provides a
central processing system that collects order information from clearing
brokers and others, sorts all the incoming order information according
to fund, and transmits the order information to each fund's primary
transfer agent.
[6] ERISA generally defines a plan fiduciary as a person who, among
other things, exercises discretionary control or authority over the
management of a pension plan or any authority or control respecting
management or disposition of its assets. Fiduciaries often include the
plan sponsor and the investment adviser.
[7] Unlike publicly traded corporate stock, the number of allowable
shares in a mutual fund are not finite, since shares may be created and
eliminated as investors purchase and redeem them.
[8] Over the short term, in a portfolio that is declining in value, a
greater cash position may help to limit the decline in the fund's net
asset value.
[9] E. Zitzewitz, "How Widespread Is Late Trading in Mutual Funds?"
Stanford Graduate School of Business Research Paper Series (2003). The
study notes that the existence of late trading in a mutual fund does
not necessarily imply that the fund itself colluded with late traders.
Many instances of late trading occurred among fund intermediaries.
[10] Zitzewitz, 2003.
[11] W.N. Goetzmann, Z. Ivkovic, and K.G. Rouwenhorst, "Day Trading
International Mutual Funds: Evidence and Policy Solutions," Journal of
Financial and Quantitative Analysis Vol. 36, No. 3 (2001); and E.
Zitzewitz, "Who Cares About Shareholders? Arbitrage-Proofing Mutual
Funds," The Journal of Law, Economics, and Organization Vol. 19, No. 2
(2003). These studies note that the effect of market timing varied by
type of international fund. Among these studies, four provided
estimates of the effect of market timing on the values of mutual funds.
The studies cited above include the minimum and maximum estimates of
the costs of market timing. See appendix I for more details.
[12] The term "hedge fund" generally identifies an entity that holds a
pool of securities and perhaps other assets that does not register its
securities offerings under the Securities Act and which is not
registered as an investment company under the Investment Company Act of
1940. Hedge funds are also characterized by their fee structure, which
compensates the adviser based upon a percentage of the hedge fund's
capital gains and capital appreciation.
[13] Investors outside of international equity funds may also have been
affected by market timing as some short-term traders exchanged money
back and forth between international funds and other funds. Aside from
money market funds, we were unable to determine which types of funds
market timers used. The value of money market funds should not have
been affected by market timing because they hold highly liquid assets
and are intended to maintain a stable value of $1.00 per share.
[14] Fair value pricing is a process that mutual funds use to value
fund shares (such as for assets traded in foreign markets) in the
absence of current market values. SEC requires that when market
quotations for a portfolio security are not readily available, a fund
must calculate its fair value.
[15] The Investment Company Institute is the national association of
the U.S. mutual fund industry. Its membership includes approximately
8,595 mutual funds (including about 400 fund families) and manages
about 95 percent of mutual fund assets in the U.S. mutual fund
industry.
[16] Disgorgement is a remedy that requires a violator of federal
securities law to give back to investors money obtained as a result of
the violation.
[17] ERISA Section 404(c) generally provides relief for plan
fiduciaries of certain individual account plans, such as 401(k) plans,
from liability for the results of investment decisions made by plan
participants and beneficiaries, under conditions specified in 29 CFR
§2550.404c-1.
[18] Securities and Exchange Commission, Proposed Rule: Amendments to
Rules Governing Pricing of Mutual Fund Shares, Release No. IC-26288
(Dec. 11, 2003).
[19] Securities and Exchange Commission, Proposed Rule: Mandatory
Redemption Fees for Redeemable Fund Securities, Release No. IC-26375A
(Mar. 5, 2004).
[20] See (1) Securities and Exchange Commission, Proposed Rule:
Investment Company Governance, Release No. IC-26323 (Jan. 15, 2004);
(2) Securities and Exchange Commission, Proposed Rule: Prohibition on
the Use of Brokerage Commissions to Finance Distribution, Release No.
IC-26356 (Feb. 24, 2004); and (3) Securities and Exchange Commission,
Proposed Rule: Investment Adviser Code of Ethics, Release No. IC-26337
(Jan. 20, 2004). For assessment of some of these proposals see U.S.
General Accounting Office, Mutual Funds: Assessment of Regulatory
Reforms to Improve the Management and Sale of Mutual Funds,
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-533T]
(Washington, D.C.: March 10, 2004).
[21] Mutual fund transfer agents and NSCC would also face increased
costs from implementation of the proposed regulations. Many of these
costs are likely to be passed on to the mutual funds and fund
intermediaries who use their services.
[22] Some plan record keepers and mutual fund companies have suggested
alternative regulations to the SEC's Hard 4 proposal. Appendix II
describes these alternatives and some of the concerns that have been
raised about them.
[23] A 401(k) plan is a common type of defined contribution pension
plan sponsored by a private sector employer that generally allows a
participant to make pretax contributions to an individual account.
Earnings on contributions likewise accumulate tax-free until the funds
are used.
[24] Under Internal Revenue Code Section 72(p), a loan from a qualified
plan to a participant or beneficiary will be treated as a taxable
distribution, unless the loan amount is the lesser of $50,000 or one-
half of the participant's defined contribution account balance.
[25] The first-in, first-out (FIFO) method would require that funds
determine the amount of any fee by treating the shares held the longest
time as being redeemed first, and shares held the shortest time as
being redeemed last. According to SEC, use of the FIFO method would
trigger redemption fees when large portions of an account are rapidly
purchased and redeemed (a characteristic of abusive market timing
transactions), but not when small portions of an account held over a
longer period are redeemed.
[26] Plan record keepers include broker-dealers and insurance
companies.
[27] The NSCC is a not-for-profit organization. Investment companies
that use NSCC's clearinghouse service pay an annual membership fee plus
17.5 cents for each transaction they submit to the NSCC.
[28] The information required to establish intent includes the
specification of the dollar value, amount, or percentage of fund shares
to be transacted; whether the order is a purchase or redemption;
identification information about the fund to be purchased or redeemed;
the shareholder's account number; and an order identification number.
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