Thursday, December 11, 2008

401(k) Trading Restrictions Old Fix..New Fault

Following the mutual fund market timing scandals in 2003/2004, mutual fund companies and plan sponsors took action to prevent short-term in and out trading, other wise known as “market timing”. The goal of a market timer of that era was to capitalize on changing markets and in particular to take advantage of arbitrage opportunities in international markets due to stale pricing. While market timing was not per se illegal, it was argued that market timing disadvantaged fund shareholders and therefore required fiduciaries to employ methods to prevent it. Consequently, many mutual funds established a regimen of redemption fees and trading restrictions designed to reduce trading activities in their funds. Some plan sponsors also amended their plan documents to allow for trading restrictions. By definition, these trading restrictions limit the amount of control a plan participant has on their investments.

Section 404(c) of the Employee Retirement Income Security Act of 1974 (ERISA) provides, among other things, that if a plan permits its participants to exercise control over their assets and that they exercise such control, then Plan fiduciaries would not be liable for any loss, or breach which results from that exercise of control. Section 404(c) further provides statutory criteria for determining whether participants would be deemed to have independent control. According to the statute a Plan would not fail to provide the opportunity for control because, among other things it:

"Imposes reasonable restrictions on frequency of investment instructions. A plan may impose reasonable restrictions on the frequency with which participants and beneficiaries may give investment instructions. In no event, however, is such a restriction reasonable unless, with respect to each investment alternative made available by the plan, it permits participants and beneficiaries to give investment instructions with a frequency which is appropriate in light of the market volatility to which the investment alternative may reasonably be expected to be subject".
Could excessive trading rules, which often limit a participant’s ability to execute roundtrip trades within a 90 day period even in the context of a normal, well disciplined rebalancing protocol, be unreasonable in today’s volatile investment environment? One might certainly argue so! Investment fiduciaries should be careful not to shoot themselves in the foot under 404(c) while fighting yesterday’s battle on market timing.

Links to this post:

Create a Link

<< Home