Mutual Funds: SEC Should Modify Proposed Regulations to Address Some Pension Plan Concerns
Published: 2004-07-09T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: 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.
section_title: What GAO Found
paragraphs: 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.

section_title: Letter
paragraphs: 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, 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. 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. 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.
subsections: section_title: Background
paragraphs: 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 or the National Securities Clearing Corporation  (NSCC), an SEC-registered clearing agency. 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.
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. 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.
section_title: Mutual Fund Trading Abuses Affected Pension Plan Participants but the Extent Is Unclear
paragraphs: 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.
subsections: section_title: Abusive Short-Term Trading Imposes Costs on Long-Term Shareholders
paragraphs: 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.
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.
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.
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.
section_title: Extent of Mutual Fund Trading Abuses Is Unclear
paragraphs: 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. 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. 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. 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. 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.
section_title: Effect of Mutual Fund Trading Abuses on Plan Participants Varies
paragraphs: 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. 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. 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.
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. 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.
section_title: Regulators Are Taking Actions to Address Abusive Mutual Fund Trading
paragraphs: 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.
subsections: section_title: SEC and DOL Have Taken Steps to Enforce and Clarify Existing Laws under Their Respective Jurisdictions
paragraphs: 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. 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    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. 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.
section_title: SEC Has Proposed New Mutual Fund Trading Regulations
paragraphs: 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.  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. 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. 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.
section_title: Most Plan Participants Could Benefit from SEC’s Proposed Regulations but Face Greater Costs than Other Investors
paragraphs: 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.
subsections: section_title: Plan Participants Would Benefit from a Cessation of Trading Abuses
paragraphs: 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.
section_title: New Regulations Are Expected to Impose Costs on Service Providers and Investors
paragraphs: 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. 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. 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.
section_title: SEC’s Hard 4 Proposal Could Complicate Certain Pension Plan Transactions
paragraphs: 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. 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. 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.
Plan rule violated (not all shares in fund were sold)
Participant receives less than requested (not enough shares available because of drop in price) 500.000 (2,500)
Estimated shares to be sold (Total shares held)
Estimated total to be withdrawn 800.000 (800) (+.25)
Outcome with overall dollar increase 700.000 (700) (-.25)
500.000 (2,500) (+.25)
800.000 (800) (-.25)
Outcome with overall dollar decrease  700.000 (700) (+.25)
500.000 (2,500) (-.25)
section_title: SEC’s Proposed Redemption Fee Rules Could Impose Fees on Plan Participants when Not Intended
paragraphs: 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. 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.  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.
section_title: Recommendations for Executive Action
paragraphs: 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.
section_title: Agency Comments
paragraphs: 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  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.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: Plan record keepers include broker-dealers and insurance companies.
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.
section_title: Appendix II: Alternative Proposals to Eliminate Late Trading
paragraphs: 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. 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. 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.
section_title: Appendix III: Comments from the Securities and Exchange Commission