Question Air

By Fred Reish

401(k) fiduciaries have a big job: to help participants retire with enough money to pay for the basics of life over 20 or 30 years of retirement.

While doing that job, ERISA requires the “investment fiduciaries” (typically the committee members) to act carefully and skillfully--and knowledgeably. The fiduciaries are held to the standard of a knowledgeable investor--and not to that of a prudent layperson.

The first step in a prudent process is to investigate. Fiduciaries need to determine the information needed to make an informed decision, and then they need to gather that information. In a nutshell, fiduciaries need to ask the right questions--and get answers. Fortunately, fiduciaries do not need to create their own list of questions: The State of Maryland has developed a list of questions for the investment provider for its plans (www.reish.com/publications/pdf/maryland.pdf).

In this column (the first of two), I’ll list some of the Maryland questions and suggest preferred answers. I believe the suggested answers equal or exceed ERISA’s standards.

“Are there any current or pending litigation or administrative actions against the firm as a result of the fund investigation?”

Suggested answer: “No.”

Obviously, the preferred answer is that the fund has not been implicated in the scandals. However, if it has been, you want to know whether the violations were minor and technical or material and substantive. I suggest a follow-up question that asks implicated funds to describe the steps taken to avoid those problems in the future. Remember, the question is to an organization whose practices are under scrutiny; the burden is on it to prove its integrity and concern for your participants.

“Has the firm conducted an internal review to determine if excessive market timing and/or after-hours trading have occurred in the funds? If yes, what was the outcome of the internal review?”

Suggested answer: “Yes, an internal review was conducted. No late trading was discovered. Market timers were deterred by the rigorous implementation of procedures that have been in place for several years.”

Late trading is illegal. Any firm that accommodated late trading knew it was breaking the law. Market timing threatens the ability of your participants to get the full earnings on their investments. It is a form of skimming. Both late trading and market timing favor other shareholders (e.g., hedge funds) over your participants. It is difficult to interpret the prudent man rule in a way that would allow fiduciaries to invest in a fund that allows those practices.

However, people-—and organizations-—make mistakes. If your committee has asked the right questions, and received the right answers, to determine that an implicated fund management company has changed its ways, the committee may prudently include an implicated fund in the plan. However, you should look for fundamental change--and not just a BAND-AID.

“Has the firm terminated any employee in connection with the Trading Practice Investigations? Please provide information regarding any such termination.”

Suggested answer: “No, because there were none.”

Second suggested answer: “Yes, every executive, senior manager, investment manager and analyst who market-timed or late-traded, or who facilitated those activities by others, has resigned or been terminated.”

I realize that this is a harsh answer. However, the implicated funds need to send a message to their personnel, to 401(k) fiduciaries and to the public that they will not tolerate abuses of shareholder money. It is difficult for 401(k) fiduciaries to know if public statements by implicated mutual fund firms reflect fundamental change or are being made to placate critics. As a result, the actions of the management firms need to be loud and clear.

The key for responding to the mutual fund scandal is to insist on investing with managers of high integrity. Ask the questions; get the answers; then make the right decision for your participants.

© 2004 Article was reprinted, with permission, from Plan Sponsor magazine (July 2004). Copyright 2004 Asset International, Inc. All rights reserved.

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