"a More Secure Retirement for Workers:Proposals for ERISA Reform"

House Committee on Education and the Workforce Subcommittee on Employer-Employee Relations

Statement of 
Investment Company Institute 

March 9, 2000

Table of Contents
I. Introduction
II. Mutual Funds and 401(k) Plans
III. Disclosure, Education, and Investment Advice
IV. Prohibited Transaction Exemption Process
V. Conclusion

I. Introduction

The Investment Company Institute ("Institute"),¹ the national association of the American mutual fund industry, appreciates the opportunity to submit this written statement regarding the Employee Retirement Income Security Act ("ERISA") to the Subcommittee on Employer-Employee Relations. Retirement savings are of vital importance to our nation’s future and the well-being of millions of Americans and must continue to be sufficiently managed and safeguarded.

This statement supplements the Institute’s March 9 testimony by providing a detailed discussion regarding the provision of investment advice, and makes additional recommendations regarding ERISA’s prohibited transaction rules, which were the subject of a hearing before the Subcommittee on March 10.

The passage of ERISA 26 years ago was a landmark event. Its goal was—and remains—to protect Americans’ pensions. To accomplish its goal, ERISA established new legal standards for retirement plan trustees and other plan fiduciaries. The core fiduciary and trust requirements of ERISA hold plan fiduciaries to the highest standards of loyalty and prudence and assure that plan assets remain segregated from corporate assets and protected against the claims of company creditors. These broad standards have fostered a safe, secure pension plan environment.

ERISA, however, presupposes the world of 1974. Our suggestions for amending the statute reflect the significant changes that have occurred since that that time, including the substantial growth of defined contribution plans, most notably, participant–directed plans, such as 401(k) plans, and a rapidly changing financial marketplace. We believe the changes to ERISA described below are necessary to assure that it continues to address adequately the needs of today’s pension plan participants and delivers the most effective and sound benefits possible to them.

The Institute recommends the following:

Amend ERISA so that retirement plan participants who direct the investment of their own retirement accounts can receive investment advice more easily; and

Amend the prohibited transaction exemption standards to ensure that retirement plans and their participants are afforded the same opportunities to use financial tools, services and products as are available to non-retirement plan investors.

Our statement addresses each of these recommendations in detail. As a preliminary matter, we provide certain background information on the role of the mutual fund industry in the retirement savings system, and particularly with respect to 401(k) plans.

II. Mutual Funds and 401(k) Plans

A. Role of the Mutual Fund Industry in Retirement Saving

The mutual fund industry has a long history of assisting people to save and invest for the long-term in retail mutual fund accounts, individual retirement accounts and employer-sponsored retirement plans. Of the 78.7 million Americans investing in mutual funds, 77 percent indicate their primary goal is to save for retirement.²

About 42 percent of all 401(k) plan assets are invested in mutual funds.³ Employees and employers find mutual funds to be well-suited for 401(k) plans, because they offer professional asset management, have diversified portfolios and reasonable, fully disclosed fees and expenses and are highly regulated under the securities laws. Because mutual fund shares are valued daily, they also offer participants the ability to identify accurately the value of their 401(k) accounts and reallocate their savings among the investment options available in their plans at any time.⁴ In addition to serving as investment vehicles for participants in 401(k) and other defined contribution plans, mutual fund companies also provide a full range of administrative services to these plans, including trust, recordkeeping and participant education services.

The mutual fund industry has a strong interest in assuring that participants in these plans are well-informed and that these plans work to their benefit.

B. Importance and Effectiveness of the 401(k) Plan

The growth in participant-directed defined contribution plans, such as 401(k) plans, has been a very significant change since the enactment of ERISA. Over 44 million Americans actively participate in defined contribution plans, about 31 million of which are in 401(k) plans.⁵ Indeed, today, the 401(k) plan is frequently the primary or only retirement plan for many workers. 401(k) plans provide a visible, easy-to-understand benefit in the form of an account balance. By engaging employees in the saving and investment process, 401(k) plans provide a disciplined way to save and encourage long-term saving and retirement planning early in an individual’s work life. Moreover, because the account balance is portable, it is well-suited to today’s mobile workforce. Finally, 401(k) plans offer participants flexibility in managing their retirement savings by providing multiple investment options, loans and hardship distributions, and various distribution options, each of which enables the plan to satisfy the needs of differently-situated individuals.⁶

Because of the increasing importance of the 401(k) plan, the Institute, in conjunction with the Employee Benefit Research Institute ("EBRI"), has undertaken an on-going, multi-year project to study the investment behavior of 401(k) plan participants.⁷ What follows is a summary of some of the key findings.⁸

First, plan participants are accumulating substantial account balances. Participants age 60 and older with 30 or more years of tenure with their current employer, on average, have balances in excess of $185,000. Average account balances overall, of course, are lower. At year-end 1998, the average account balance for all participants was about $47,000; the median balance was about $13,000. These amounts, however, understate individual 401(k) savings, because they reflect only an individual’s account balance with his or her current employer, and do not include assets remaining in the plan of a previous employer or rolled over to an IRA.⁹

Second, average account balances are growing. From year-end 1996, the first year in the EBRI/ICI database, to 1998 the average account balance grew 26 percent.

Third, in the aggregate, plan participants generally are investing assets appropriately. Younger participants invest more heavily in equities and older participants invest more heavily in fixed-income securities.

Fourth, 401(k) plans appear to be effective across all income categories. Measured as a percentage of salary, low and moderate income individuals participating in 401(k) plans have similarly-sized account balances as higher income individuals.

III. Disclosure, Education, and Investment Advice

While the growth of 401(k) plans has been a very positive development for the reasons noted above, it also has posed new challenges. Most fundamentally, because participants in 401(k) plans both are responsible for deciding how to invest their retirement accounts and bear the risk of any such investment, it is imperative that they have access to the tools they need to help them make informed decisions. In many respects, existing law and regulations are adequate to satisfy this objective. For example, at least in the case of mutual funds, participants generally receive full disclosure regarding the funds in which they may invest. The Department of Labor ("DOL" or the "Department") also has issued guidance that facilitates the provision of educational information to plan participants.

An important gap remains, however. Many participants need or want investment advice to help them decide how to allocate their 401(k) accounts. Unfortunately, existing rules largely prohibit participants from obtaining this advice. Thus, perhaps the most important way in which Congress could act to modernize ERISA would be to enact legislation that would make it easier for participants to obtain the advice they seek.

A. Current Disclosure Requirements

Under the securities laws, mutual funds are required to deliver prospectuses to all direct investors. The prospectus contains SEC-mandated disclosures covering the fund’s investment objectives, investment policies, risks, past returns, and management, as well as how to purchase and redeem shares. Importantly, the prospectus also sets forth all relevant fees and expenses in a standardized, easy-to-read fee table. The securities laws do not require that 401(k) plan participants receive prospectuses for mutual funds in which they invest because the plan itself, rather than the individual participants, is considered to be the investor. Nevertheless, current ERISA regulations in effect provide for the delivery of mutual fund prospectuses to participants. In order to qualify for safe harbor protections under section 404(c) of ERISA, employers must, among other things, provide mutual fund prospectuses to participants.¹⁰ As a result, plan participants automatically obtain full disclosure of all relevant information regarding their mutual fund, including fees and expenses.

Unfortunately, there are gaps in the disclosure regime established under ERISA. Most importantly, neither ERISA itself nor DOL regulations require that plan participants automatically receive comparable information concerning plan investment options to which the securities laws do not apply. The only disclosure about such products a plan fiduciary is required to deliver to participants under section 404(c)’s regulations is a "general description" of the investment option. Fee disclosure is limited to transaction-related fees; information about operating expenses, such as investment management fees, must be provided only upon participant request. Similarly, neither the statute nor any regulation requires the delivery of information about other types of fees and expenses charged against participant accounts.

To address this gap, the Institute has consistently urged the Department to revise its rules so that all participants are fully and automatically informed of all relevant information about all of their investment options—not just mutual funds—including complete disclosure regarding fees and expenses. At a minimum, this requirement should apply in the case of all plans that fall within the section 404(c) safe harbor, regardless of the nature of the investments being offered.

B. Effectiveness of Participant Education

Participants need disclosure of all fundamental information about their retirement plans and the products in which they are able to invest in order to make informed investment decisions. Many participants, however, desire or need additional assistance. The Department of Labor, recognizing this, has done much in recent years to facilitate the delivery of educational materials and investment tools to participants. Most notably, in 1996 it released guidance that clarified the types of assistance that would be considered "education" rather than "investment advice."¹¹ These educational services and programs, designed by financial institutions, including mutual funds, take many forms. These include newsletters, retirement planning "kits" and other written communications, group meetings with employees at their workplace and interactive software available on computer disc or company websites. Programs often include retirement "calculators," to help investors estimate the savings necessary for retirement and to develop an appropriate investment strategy. These programs and services have been very well-received by plan participants.

C. Participants’ Need for "Investment Advice"

Although current educational programs appear to be effective for many 401(k) participants, some participants may need or desire additional assistance. While educational programs such as those discussed above can, for example, suggest general guidelines for how to allocate retirement savings among broad asset categories (e.g., equity versus fixed-income), they do not provide participants with specific investment recommendations upon which they can rely. A recent survey by Merrill Lynch indicated that 69 percent of plan participants reported that they desired "individual recommendations" on their 401(k) investments.¹² Moreover, some participants would like to have their 401(k) portfolios reviewed by someone on an ongoing basis. The demand for these services increases as the number of available investment options expands,¹³ as participants become more experienced, and as accumulated account balances become larger. In addition, many individuals with assets in addition to those in their qualified retirement plans frequently seek investment advice on their entire savings portfolio.

D. Limitations on the Availability of Investment Advice to Participants

Despite the growing number of participants seeking investment advice, such advice can be difficult to obtain. This is because ERISA’s prohibited transaction rules act to prohibit most participants from obtaining investment advice from the financial institution managing their plan’s investment options and, often, already providing educational services to them. Under ERISA, persons who provide investment advice cannot do so with respect to investment options for which they, or an affiliate, provide investment management services or from which they otherwise receive a fee—unless they are able to obtain an exemption from the Department. This prohibition applies even if an employer selects the investment adviser and monitors the advisory services in accordance with its fiduciary obligations under ERISA section 404 or if an individual participant seeks out the adviser on his or her own volition outside of the workplace. It also applies no matter how prudent and appropriate the advice, how objective the investment methodology used, or how much disclosure is provided to participants.¹⁴

By disqualifying financial institutions that manage some or all of the investment options in a 401(k) plan from providing advice, ERISA disqualifies those institutions that are frequently the ones best situated to provide advice to participants, because of their proximity to the plan participants, their investment expertise, and their knowledge of the particular investment options offered. Many participants are more comfortable turning to these firms for advice, because they are familiar with the quality of services and investments provided to them under their retirement plan.

Similarly, many employers that might want to make investment advice available to their employees would prefer to use the 401(k) plan service provider with whom they already have an established relationship. Employers frequently prefer obtaining all of their plan support services from a single provider—"bundled services." These "bundled" arrangements are very popular with employers because there is no need to maintain multiple relationships with multiple contracts. The Merrill Lynch survey cited above reported that 97 percent of employers surveyed would prefer to contact the plan provider, administrator or investment manager to provide advice for employees.¹⁵ In contrast, forcing an employer to turn to a separate entity if they wish to provide their employees with investment advice can necessitate a costly, cumbersome and time-consuming search, and thus acts as a significant disincentive to making such advice available. In addition, many of these vendors have significantly less experience in offering investment advice than those financial institutions managing the plan’s investment options.

For these reasons, if Congress wishes to enable 401(k) plan participants to obtain the investment advice that they need and want, it must amend ERISA to remove the prohibition on those financial institutions that are best situated to provide advice from doing so. We believe that Congress can do so in a manner that would fully protect plan participants from any possible conflicts of interest on the part of those institutions.

E. Recommendation

In order to ensure that participants have access to the long-term financial planning and investment assistance they need, financial institutions that provide investment management services to retirement plans should be permitted to provide investment advisory services to plan participants. At the same time, the Institute strongly believes that such advice should be provided in a manner that protects against any possible conflicts of interest.

The best way to protect against these conflicts of interest is to ensure that (1) the financial institution providing the investment advice is required to disclose fully and clearly to the participant the nature of its advisory service and any and all relevant fees it and its affiliates earn, and (2) the financial institution is subject to the strict fiduciary standards of ERISA with respect to the advice provided. Under these rules, participants would be fully aware of any potential conflicts of interest the adviser might have, and the institution providing the advice could be held liable for breach of fiduciary duty if providing imprudent advice.

In order to implement this proposal, Congress should provide a statutory exemption from the prohibited transaction rules set forth at ERISA section 406(b) for the provision of investment advice, if the advice provider meets the following conditions:

In addition, to the extent that an employer engages a specific advice provider for a plan, as under current law, it would be required to make a knowledgeable, informed, prudent decision concerning the plan’s participation in the program and to monitor the advice provider to assure the continued appropriateness of the advisory service for plan participants in accordance with the employer’s existing fiduciary obligations under ERISA section 404.¹⁶

It is important to keep in mind that the enactment of a statutory exemption along these lines would ensure that any advice provider would continue to have a fiduciary responsibility under ERISA (and, frequently, an overlapping fiduciary duty under the Investment Advisers Act of 1940) with respect to the investment advice provided to a plan participant.

We believe that the benefits of such an exemption to plan participants would be significant and would be more than sufficient to address any concerns regarding potential conflicts of interest.

IV. Prohibited Transaction Exemption Process

A. Problems with the Exemption Process

As noted in the introduction, ERISA’s general fiduciary standards have been quite effective. More flexibility is needed, however, under the prohibited transaction restrictions that are set forth at sections 406(a) and (b). The underlying purpose of the rules—to eliminate potential conflicts of interest that might give rise to abuses involving retirement plan assets—is an important one; in seeking to modernize various aspects of ERISA, Congress should not lose sight of this concern. Nonetheless, these provisions are quite broad in their scope.¹⁷ Moreover, while the Department of Labor is authorized to grant exemptions,¹⁸ it has in many instances been reluctant to exercise this authority.¹⁹ The result is that plans have been denied the ability to take advantage of various transactions, products and services that offer significant potential benefits and little, if any, risk of abuse.

An excellent example of these problems is the investment advice issue discussed above. Another is the experiences of plans and investment advisers with respect to cross-trading. A cross-trade can occur when a security is being sold by one client of an investment adviser when another client is purchasing that same security. In many cases, the adviser may wish, rather than sending each order to a broker for execution, to "cross" the trade by transferring the securities between the clients’ accounts. This can eliminate various transaction costs, such as commissions, and thereby save the clients money.

Cross-trades, however, are considered to be prohibited transactions under ERISA section 406(b)(2). And, despite frequent requests from representatives of plan sponsors and investment advisers (including the Institute),²⁰ the Department has been unwilling to grant meaningful exemptive relief in this area.²¹

The reason for this is that, in the Department’s view, cross-trades present an inherent conflict of interest, as an adviser might be tempted to engage in a cross-trade in order to benefit one client at the expense of a pension plan whose account the adviser also manages (e.g., by "dumping" unfavorable positions into the plan’s account). While this is certainly true as a theoretical matter, the Department could readily adopt a class exemption that would allow pension plans to realize the cost savings from cross-trading while containing conditions designed to protect against this potential abuse. Indeed, the Securities and Exchange Commission has adopted an exemptive rule under the Investment Company Act of 1940 that permits mutual funds to engage in cross-trades subject to various conditions (e.g., pricing rules, recordkeeping, approval and review by fund directors) that address exactly the same concerns. As a result, mutual funds have been able to realize considerable cost savings, without harm to the funds and their shareholders. Pension plans under ERISA, however, continue to be denied these benefits.

The example of cross-trades reveals certain problems with the prohibited transaction rules and, particularly, with the standards pursuant to which exemptive relief is issued. First, the statute does not require the DOL to consider other federal laws and regulations that may already provide adequate protections to retirement plan participants. Because prohibited transactions often involve financial transactions and products, frequently securities, banking and other similar laws and regulations already in place effectively address identical policy concerns in the non-plan environment. The Department, however, currently considers these existing legal standards only at its own discretion.

Second, the statute does not require that conditions imposed in an exemption be consistent with those other laws and regulations. Thus, a financial institution sometimes must abide by two conflicting legal standards and, in such cases, cannot in practice use the issued exemption.

Third, the exemption process frequently takes a long time. This is especially problematic in today’s environment, in which there are a growing number of new investment management products, tools and strategies, the use of which by retirement plans may require an exemption from the prohibited transaction rules.

An additional problem with the exemption process is that there is no requirement that an exemption clearly identify the prohibited transaction being permitted or an explanation of why the exemption is necessary. As a result, many parties request unnecessary exemptions out of an abundance of caution, and many others have expressed concern that exemptions appear to have been granted in situations in which it is not clear that an exemption was needed. Unnecessary exemptions have a negative impact on both the applicant, who may agree to conditions that do not apply to others, and upon their competitors, who may face questions from their clients if they do not receive a similar exemption. In addition, the consequent multiplicity of exemption applications exacerbates the already significant workload of the Department’s limited staff.²²

B. Modernize the Prohibited Transaction Exemption Process

We believe that the Department of Labor should continue to review transactions and activities that give rise to apparent conflicts of interest. But the rules need to strike a better balance between risk and benefit and work much more efficiently. Accordingly, we recommend changes to the standards under which exemptions are granted. Specifically, Congress should revise the statute to require the Department, when processing exemption requests, to:

We believe that such changes would provide additional benefits to pension plans and their participants by ensuring that they are not unnecessarily denied access to investment products, tools and strategies available to other entities without undermining the protections they currently enjoy under ERISA.

V. Conclusion

Although ERISA was enacted when pension plans were primarily defined benefit in nature, it continues to be a success story. It protects the rights of participants and beneficiaries and plan assets effectively in the current pension environment where defined contribution plans have a significant presence. Nonetheless, in some respects, ERISA has not kept pace with changes in our retirement system or the financial markets. For this reason, we encourage Congress to modernize ERISA to assure that retirement plan participants are able to obtain the services they need, while continuing to assure that they and their retirement savings are fully protected from abuses. Specifically, we recommend (1) amending ERISA so that plan participants can readily obtain the investment assistance they need in managing their growing 401(k) plan investments; and (2) revising the prohibited transaction exemption process so that it works in a more sensible and efficient manner for the benefit of plans and their participants.

Endnotes