Market timing and other short-term trading patterns impose costs on mutual funds by disrupting management, forcing funds to maintain excessive liquidity, and driving up tax expenditures. The SEC issued final rules on mutual fund redemption fees last year to curb these abuses. (See “SEC Redemption Fee Rules Affect Retirement Plans,” in our May 2005 issue of Benefits in Brief.)
Plan sponsors and administrators will want to determine how they and their service providers can best deal with the requirements of this new SEC “Rule 22c-2.” Although the rules are not difficult to understand, they may impose a substantial burden in certain cases. In particular, certain choices imposed on ERISA fiduciaries may make them think that “Rule 22c-2” was modeled on Catch-22.
Mutual funds have until October 16, 2006, to comply with the new rules, but many funds are already imposing redemption fees on short-term trading. This article suggests some key questions to consider in this area, as well as some of the potential ERISA “Catch-22s.”
Have you received any Rule 22c-2 information from your trustee or custodian? Most mutual funds will probably send information and agreements related to Rule 22c-2 to the financial institution holding your plans assets. If you have not yet received this information, you should contact your trustee or custodian.
Have participants been informed of any changes? If new redemption fees or trading restrictions have been adopted by any of your plans mutual funds, be sure these changes are communicated to participants in an easy-to-understand fashion. In particular, ensure that plan participants understand that the redemption fees are in addition to other mutual fund fees.
Have your plan’s mutual funds complied with Rule 22c-2? Rule 22c-2 has two main requirements. First, mutual funds must either adopt a redemption fee for short-term trades or affirmatively decide that one is unnecessary. Second, the funds must enter into written agreements with “financial intermediaries,” obligating those intermediaries to provide information needed to identify short-term traders and to follow the funds instructions to restrict their trades.
Catch-22: Since Rule 22c-2 compliance can impose costly recordkeeping and monitoring burdens on mutual funds as well as redemption fees on plan participants. It may be in the best interests of your participants that a mutual fund not comply with the regulations. However, any fund that does not comply cannot legally permit a redemption of shares within seven calendar days of their purchase. This could be particularly disadvantageous to participants in the event of sharp decline in share prices or a personal financial emergency. Moreover, retaining a non-compliant mutual fund as one of the plans investment options may expose plan fiduciaries to allegations that they acted imprudently.
Is the redemption fee (if any) reasonable? Rule 22c-2 permits mutual funds to determine both the amount of any redemption fee and the length of the holding period that will constitute short-term trading. The fee may not exceed two percent of the value of the shares redeemed. The holding period, however, may be any time period of seven days or longer. Some funds have defined “short-term trading” to include any redemption made within one year of purchasing the redeemed shares. Plan fiduciaries should certainly compare any redemption fee amount and holding period to those of similar funds to see if they are commercially reasonable.
Catch-22: A high redemption fee combined with a long minimum holding period may benefit plan participants if a fund would otherwise suffer from excessive liquidity requirements. But such a fee may also function as a disguised back-end load. Fiduciaries should therefore consider whether a redemption fee may harm plan participants. They should also make certain that any redemption fee accrues to the fund and not to the fund manager.
Have you received an agreement on shareholder information and trading freezes? To comply with Rule 22c-2, a mutual fund must enter into a written agreement with each “financial intermediary” of the fund. Although amendments to the definition of this term are possible, “financial intermediaries” currently include ERISA plan administrators and any entity that maintains plan participant records. This agreement must obligate each financial intermediary to provide information needed for the fund to identify short-term trading and to follow any instructions from the fund to restrict such trading. If you have not yet received any such agreements, you should probably contact your plans institutional trustee or custodian.
Catch-22: The requirement to follow instructions from the mutual fund to restrict short-term trading creates another potential minefield for ERISA fiduciaries. Obeying an unreasonable instruction to freeze a participants trades in mutual fund shares could leave the fiduciary liable for any participant losses attributable to those shares. Be sure that any agreement includes objective criteria for identifying short-term trades and specifies appropriate restrictions on such trades. Communicate these criteria and possible restrictions to participants in advance. Then, if trading restrictions are actually imposed on a participant, inform him or her immediately.