Well before the mutual fund trading scandal dominated headlines, most mutual funds claimed in their prospectuses that so-called market-timing—short-term movement in and out of funds—was frowned upon. Moreover, those same prospectuses outlined steps that would be undertaken to preserve those interests.
Then, the scandal broke, bringing to the industry’s attention just how discretionary the application of those restrictions really was. With a backlash born of a guilty conscience, the mutual fund industry tried to get in front of the issue by taking an aggressive stand on the imposition of mandatory redemption fees—a stance initially adopted, but then softened, by the Securities and Exchange Commission (SEC) that allows, but does not require, registered open-end investment companies to impose a redemption fee on those short-term trades, not to exceed 2% of the amount redeemed.
Known as rule 22c-2, the new SEC regulation also requires most funds to enter into written agreements with intermediaries that hold shares on behalf of investors, such as broker/dealers and retirement plan administrators. In these agreements, where holdings typically are tracked in some kind of omnibus arrangement by the plan recordkeeper, all intermediaries must consent to provide funds with certain shareholder identity and transaction information at the funds’ request and carry out certain instructions from the funds.
The rule, as originally adopted, had a compliance date of October 16, 2006, but the SEC voted, in late September, to delay that. Now, the compliance date for entering into shareholder information agreements is April 16, 2007, and the date by which funds must be able to obtain information from intermediaries under those agreements is October 16, 2007.
However, as many financial advisers are discovering, some fund companies already have taken steps to implement the redemption fees on retirement plan transactions. Rob Kieckhefer, vice president at the Kieckhefer Group with RBC Dain Rauscher in Minneapolis, notes, “Most of the larger fund families we work with have already taken steps to implement the technology so that they can track redemptions.” Beyond having developed that capability, however, the current reality is that the application of the redemption fees has been left largely to the discretion of the fund complexes-and, for financial advisers, the results could be chaotic, to say the least.
Larry Goldbrum, general counsel for the SPARK Institute, the legislative arm of the Society of Professional Administrators and Recordkeepers, which represents firms that have been in the vanguard of implementing the changes mandated by 22c-2, says advisers need to understand how the rule will affect individual plans—participant transactions will be subject to greater monitoring, and all that information may be shared with mutual fund companies.
Communication is Key
“It is important for advisers to start talking to plan sponsors about the rule,” Goldbrum states. Advisers should be aware that plan sponsors do not yet seem to appreciate how limiting participant trading activities -or assessing a fee against their accounts-could create issues between them and employees. Nor do plan sponsors appear to be overly concerned about the costs of implementing Rule 22c-2, Goldbrum asserted, despite the reality that those costs-the monitoring and reporting costs, in addition to the actual redemption fees-almost certainly will be passed through to the plan and participants. Advisers should make sponsors and participants aware that the funds are imposing the rules, not the employer or the recordkeeper. “Participants need to know that, yes, it is your money, but you must abide by the fund rules,” Goldbrum says.
Jim O’Shaughnessy, a principal and co-owner of Sheridan Road Financial in Northbrook, Illinois, expects that advisers will see another significant effect when providing education. Participants will be confused about why the rules are different for different funds and why this restriction is being placed on them. “When the participants get upset, plan sponsors will get upset, and the adviser is just the bearer of the bad news,” he says. Plan advisers will have to comfort participants, who may see the costs of implementing the restrictions passed to them, and who may be concerned about what data about their account activity will be shared with fund companies. He also notes that different states have different privacy requirements that could make implementation complex.
Additionally, each fund family may have different redemption fee requirements, further complicating the education process, O’Shaughnessy points out. “We deal with hundreds or thousands of funds, and we’ll have to understand the rules for every fund we use,” he notes. Technical issues on transmitting transaction information sharing is not necessary for plan advisers to understand, Goldbrum says, but advisers do need to know how monitoring will be done, how each fund defines excessive trading, and participant restrictions imposed as a result of excessive trading. Those kinds of impacts already are influencing which funds advisers recommend. Chris Lee, senior vice president, Investments, at Wachovia Securities in Bloomington, Minnesota, says, “We are not adding any funds with restrictions longer than 90 days.” He goes on to note that they recently decided not to add a fund due to that restriction.
Advisers who give direction on investments could start looking at investments with a more plan-friendly approach to the monitoring requirements of Rule 22c-2, but this will take some research: “It is very hard for advisers to get information other than talking to funds about their rules and going to the SEC’s Web site and downloading white papers,” O’Shaughnessy notes.
The rule will require more due diligence, especially before client meetings, from advisers on the current state of redemption fees for each fund family, O’Shaughnessy says. Further, according to Goldbrum, many funds have not yet made a final decision on how they will enforce the rule. O’Shaughnessy points out that a consolidated list of fund families or funds that have a redemption fee attached to them and the monitoring time schedule they impose does not exist yet-but it surely would be a valuable tool going forward. Advisers do not have to simply acquiesce to the demands of the new rules, however. He said his mid-market clients and prospects are looking at mainstream providers with the most scale— mutual fund companies, insurance companies, and very large third-party providers—in order to utilize fund families to minimize the impact of the rule on the plan. O’Shaughnessy, who does not give specific fund recommendations, nonetheless helps sponsors consider different investment options. One client already has asked to exclude any funds that impose fees, he says. “The rule definitely is affecting fund choice and will become a much bigger factor in investment selection and monitoring in the future.” He says he has not seena move to exchange-traded funds (ETFs) and noted that not many product providers offer ETFs, but that they will “definitely be a vehicle to use in the future.” ETFs are not subject to the new redemption fee rules, nor are collective funds or group annuity contracts.
Additionally, there may be an opportunity for innovative plan designs to mitigate the problem. Chad Larson, senior vice president, Retirement Services at Denver-based Moreton & Company, notes that his firm has added an administrative restriction to plan processing for a particular account. “The restrictions allow only one participant-directed transfer every 30 days on each fund,” he says. “Ongoing contributions and scheduled rebalancing transactions are not affected. We have had overall acceptance of the transfer restrictions, and most employers have agreed with the intent of the restrictions,” he notes. Larson says that the participants have seemed to be much more accepting of a transfer restriction rather than a short-term trading penalty imposed upon participant accounts.
Regardless of what investment vehicles are used, O’Shaughnessy comments that Rule 22c-2 is intended to protect shareholders and retirement plan participants, and he hopes it ultimately does not become a detriment to the industry.
A plan sponsor speaks:
Our plan processed the first redemption fee on a participant just last week and, boy, is he unhappy. Our recordkeeper has been posting messages on quarterly statements since September 2004 to warn participants about the possibility of redemption fees being imposed. We sent a letter to all accountholders on June 30, 2005, specifying the funds that will impose redemption fees effective August 1, 2005; the amount of the fee as a percentage of the assets transferred; and the parameters under which they would be imposed (less than 90 days in most cases). Our recordkeeper programmed a “pop-up” to warn participants that their actions will result in a redemption fee. Our IVR has a warning and our phone reps relay a warning as well. Of course, this participant doesn’t read his statements or open any mail with the recordkeeper’s logo on it. He also commented that, in the world of numerous “pop-ups,” who reads them anymore?
What Advisers Should DoFind out and inform plan sponsors
1. When the rule goes into effect
2. What the funds will require—what each fund is using as a definition of active trading and whether participants will be subject to a redemption fee or transaction freeze or both
3. How the recordkeeper will implement the rule requirements