Mutual Funds: SEC Should Modify Proposed Regulations to Address
Some Pension Plan Concerns (09-JUL-04, GAO-04-799).
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.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-04-799
ACCNO: A10879
TITLE: Mutual Funds: SEC Should Modify Proposed Regulations to
Address Some Pension Plan Concerns
DATE: 07/09/2004
SUBJECT: Brokerage industry
Employee retirement plans
Funds management
Mutual funds
Regulatory agencies
Retirement pensions
Securities regulation
Investments
Stocks (securities)
Abusive practices
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GAO-04-799
United States General Accounting Office
GAO Report to the Subcommittee on Oversight, Committee on Ways and Means, House
of Representatives
July 2004
MUTUAL FUNDS
SEC Should Modify Proposed Regulations to Address Some Pension Plan Concerns
GAO-04-799
Highlights of GAO-04-799, a report to the Subcommittee on Oversight,
Committee on Ways and Means, House of Representatives
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.
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 [email protected].
July 2004
MUTUAL FUNDS
SEC Should Modify Proposed Regulations to Address Some Pension Plan Concerns
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.
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
1
4 6
11
18
22 30 31 31
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 Transactions 9 Figure 2: Comparison of Fund
Net Asset Value with and without Market Timing 13 Figure 3: Mutual Fund
Defined Contribution Plan Assets by Type of Fund 17 Figure 4: Potential
Complication with Loan Transaction if Dollar Amount Is Specified 27 Figure
5: Potential Complication with Loan Transaction if Number of Shares Is
Specified 28 Figure 6: Assessment of a Redemption Fee for an Exchange
Transaction 30
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
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separately.
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,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
1Defined 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.
share.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
2This 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.
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.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
o report on what is known about how market timing and late trading have
affected the value of retirement savings of defined contribution plan
participants,
o describe what actions SEC and DOL have taken to address late trading
and market timing, and
o 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
3Types 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.
Results in Brief
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.
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
longterm 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
Background
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).
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
o 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.
o 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.
o 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 agents4 or the National Securities Clearing Corporation
(NSCC), an SEC-registered clearing agency.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.
4Mutual 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.
5NSCC 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.
Figure 1: Path of Mutual Fund Transactions
Source: GAO.
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.
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
brokerdealers 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.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:
o Costs increase. Abusive trading generates greater transaction costs
because fund managers have to more frequently buy or sell shares of the
6ERISA 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.
underlying securities in the fund's portfolio to match demand for fund
shares.7
o 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.8
o 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.
7Unlike 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.
8Over 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.
Figure 2: Comparison of Fund Net Asset Value with and without Market
Timing
Source: GAO.
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.
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 2001.9 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.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.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
9E. 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.
10Zitzewitz, 2003.
11W.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.
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.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
12The 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.
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.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.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.
13Investors 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.
14Fair 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.
Figure 3: Mutual Fund Defined Contribution Plan Assets by Type of Fund
1999 2002
Bond
Money Bond market
Hybrid Money market
International equity Hybrid
Domestic equity
International equity
Domestic
equity
International equity mutual fund (typically where market timing takes
place) Source: GAO, based on data from the Investment Company Institute.
Note: Hybrid funds invest in a mix of equity and fixed-income securities.
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.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
15The 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.
Regulators Are Taking Actions to Address Abusive Mutual Fund Trading
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.
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.16 SEC officials told us that more enforcement actions are
pending.
16Disgorgement is a remedy that requires a violator of federal securities
law to give back to investors money obtained as a result of the violation.
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:
o risks to shareholders of frequent purchases and redemptions of shares,
o policies and procedures regarding frequent purchases and redemptions
of shares,
o circumstances under which they will use fair value pricing and the
effects of using fair value pricing, and
o 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
o whether plan fiduciaries used pension plan accounts to facilitate late
trading or market timing of others,
o whether pension plans incurred losses as a result of fiduciaries
knowingly directing investments in mutual funds that permitted late
trading or market timing, and
o 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.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.18
Since many of the cases of late trading involved orders submitted through
intermediaries, including banks and pension plans not regulated by SEC,
17ERISA 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 S:2550.404c-1.
18Securities and Exchange Commission, Proposed Rule: Amendments to Rules
Governing Pricing of Mutual Fund Shares, Release No. IC-26288 (Dec. 11,
2003).
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.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
19Securities and Exchange Commission, Proposed Rule: Mandatory Redemption
Fees for Redeemable Fund Securities, Release No. IC-26375A (Mar. 5, 2004).
Most Plan Participants Could Benefit from SEC's Proposed Regulations but Face
Greater Costs than Other Investors
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 brokerdealers
that sell fund shares, and mutual fund ethics standards.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.
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.
20See (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, GAO-04-533T (Washington, D.C.: March
10, 2004).
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.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
21Mutual 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.
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.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
22Some 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.
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.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.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.
23A 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.
24Under 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.
Figure 4: Potential Complication with Loan Transaction if Dollar Amount Is
Specified
Source: GAO.
Figure 5: Potential Complication with Loan Transaction if Number of Shares Is
Specified
Source: GAO.
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.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.
25The 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.
Recommendations for Executive Action
Agency Comments
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.
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.
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.
Barbara D. Bovbjerg Director, Education, Workforce, and Income Security
Issues
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,1 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.
1Plan record keepers include broker-dealers and insurance companies.
Appendix I: Objectives, Scope, and Methodology
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.
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.
Appendix II: Alternative Proposals to Eliminate 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.1 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.2 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
1The 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.
2The 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.
Appendix II: Alternative Proposals to Eliminate Late Trading
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.
Appendix III: Comments from the Securities and Exchange Commission
Appendix III: Comments from the Securities and Exchange Commission
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