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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Protecting Pension Plan Participants Through Investor Education

Keynote Address by

Paul Roye

Director, Division of Investment Management
U.S. Securities & Exchange Commission

Before the International Foundation of Employee Benefit Plans
The Washington Court Hotel
Washington, D.C.

May 9, 2000

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Roye and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

I. Introduction

Thank you and good afternoon. As you are probably aware, the primary mission of the SEC is to protect investors and maintain the integrity of the securities markets. As more and more first-time investors turn to the markets to help secure their futures, these goals are more compelling than ever. Our Chairman, Arthur Levitt, firmly believes that the best defense against fraud and abusive securities practices is an educated investor. Not surprisingly, educating investors has been a central goal of the SEC during the past six years.

My remarks will focus on investor education initiatives that the SEC has undertaken, and the need for such initiatives in light of recent innovations and trends in the marketplace, such as the widespread use of the Internet by novice investors and the growth of defined contribution plans. I also will touch upon a few other of our regulatory initiatives that I believe will be of interest to you.

II. Why We Should Focus on Investor Education

The need for investor education is very apparent.

There are more Americans investing in the stock market than ever before Ė nearly half of all American households. One of every three people in America invests in a mutual fund. In 1980, that number was one out of 18. However, many of these investors lack basic knowledge about the meaning of financial terms and about the way different investments work. For example, a 1996 study by the Investor Protection Trust concluded that only 18% of investors surveyed were literate about financial matters specifically related to investing. Unfortunately, this study shows that investors are not as informed as they should be on how the securities markets work, and the risks and rewards of investing.

The massive movement of middle America into the securities markets shows no signs of slowing down. Under these circumstances, the need to educate investors about investment risks becomes more pressing.

a. The Influence of the Internet

The Internet has made investing easy, quick and convenient. By the end of this year, there will be nearly 5.5. million domestic online brokerage accounts, with 20 million expected by 2003. A November 1999 report by SEC Commissioner Laura S. Unger notes that more than one in three trades by investors are effected online. According to a recently published report, there are $1 trillion dollars in online brokerage accounts. These numbers will only increase as a greater percentage of investors avail themselves of the economies of online trading.

While the Internet has brought significant benefits to investors, it also has created significant dangers for the unwary. The Internet, coupled with the greatest bull market in history, has brought millions of relative novices to the markets, while also providing simple, effective, and anonymous ways for unscrupulous people to defraud them. Accordingly, the SEC has created the Office of Internet Enforcement within the Division of Enforcement to combat Internet fraud. Through March of this year our Enforcement Division has filed approximately 120 Internet-related enforcement actions.

Nonetheless, the best way for investors to protect themselves against fraud is to do their homework. With the explosion of finance-related sites on the Internet, investors have access to information that up until a few years ago was available only to securities professionals. Some argue that this glut of information contributes to the confusion that many investors have about investing. We need to educate investors about the basics of investing so they will have the tools necessary to make sense of information they find on

b. The Growth of Pension Plans and the Shift from Defined Benefit Plans to Defined Contribution Plans

Clearly, the growth of pension plans is another reason we see more Americans participating in the stock market. Private pension plans are major holders of corporate stock and bonds, holding an estimated 20% of all outstanding stocks and 17% of all outstanding bonds. According to the Department of Labor (DOL), the total number of private pension plans nearly tripled between 1974 and 1999, from 270,000 to 700,000. Pension plan assets also increased during this time period, from $225 billion in 1974 to $4.3 trillion in 1999.

Americans also are more directly involved in the stock market because of the growth of defined contribution plans. According to DOL, the percentage of pension plan participants who were enrolled exclusively in a defined contribution plan grew from 13% in 1975 to 50% in 1996. As you know, unlike a defined benefit plan, where the employer makes the investment decisions and bears the risk of loss, a defined contribution plan generally places the responsibility and the risk of investment choice on the employee. While in most multi-employer defined contribution plans the boards of trustees have remained responsible for directing plan investments, a significant number of multi-employer defined contribution plans have switched from trustee directed to participant directed plans. This is being driven by union members who want greater control over their savings, particularly after having accumulated considerable account balances in their plans. They have seen the performance of one of the most extraordinary bull markets in history and want to participate in the opportunities that the securities markets offer. Many multi-employer plan trustees are concluding that a one-size-fits all investment program can limit an individual participantís financial opportunity.

An article in last Fridayís Wall Street Journal reported on the debate in Florida and other states of allowing state employees to opt out of the statesí traditional pension plans for defined contribution plans with workers making their own investment decisions. The April 3rd edition of Pensions and Investments reports that Washington, Utah and Ohio are the latest states to pass defined contribution legislation for public employees, and at least 11 others are poised to introduce or consider similar bills. It looks as if Florida, which has the fourth largest public pension system in the country, will allow 650,000 state and local employees to switch from the stateís pension system into a new 401(k) type savings plan. Proponents of the plan argue that the plan offers quicker vesting of benefits and allows workers the ability to take investments with them if they change jobs. However, the new arrangement concerns some who fear that state workers do not have the financial sophistication to manage their own money. The Wall Street Journal article notes that 25% of public employees donít pay into Social Security, so they have no safety net if their investments perform poorly.

Thus, an employee who must decide how to invest his or her assets in a defined contribution plan must understand the basics of investing. However, it is not enough that employees participating in defined contribution plans understand the basics of investing, they must also receive adequate information about their investment options from the sponsorsí of the plans in order to make intelligent choices. I am especially interested in this matter because employee benefit plans are themselves one of the fastest growing sources of investments in mutual funds. My division, the Division of Investment Management, has primary oversight responsibility for the more than 7,400 mutual funds that hold almost $7 trillion in assets.

Under the Securities Act of 1933, mutual funds must deliver a statutory prospectus to purchasers of fund shares prior to or with confirmation of a sale. The disclosure rules under the Employee Retirement Income Security Act of 1974 (ERISA), in the past, only required disclosure about the plan itself. Thus, plan participants were not necessarily receiving the information they needed to make an informed choice about their retirement assets.

In 1992, the Division of Investment Managementís "Protecting Investors" Study recommended legislation amending the federal securities laws to require the delivery of prospectuses to plan participants who direct their investments. As a partial solution to the lack of investment information for some plan participants, the DOL adopted regulations under Section 404(c) of ERISA.

The 404 (c) regulations reduce the exposure of a planís sponsor and trustees to liability for losses in participant accounts and, at the same time provide employees more information about, and more control over, their investment choices. While the new rules are voluntary, a plan that does not conform to the rules cannot claim immunity from lawsuits by employees who are disappointed with their investment return. Among other things, the 404(c) regulations require that a plan offer a range of diversified investment vehicles. The regulations also require the sponsor to assure that plan participants are given, or can obtain, the information necessary to make an informed investment decision. At a minimum, sponsors must give employees information about each investment option, as well as information about transfer procedures, the expenses and performance of each investment option, and last, but not least, a prospectus for any vehicle, including a mutual fund, which is registered under the Securities Act.

Although these rules are voluntary, they represent a significant step in closing the information gap that had existed in the defined contribution area. I would like to take this opportunity to encourage plan sponsors and trustees to keep moving in this direction, and adopt an aggressive approach to investor education. I recognize that furnishing investment information to plan participants can be a challenging task for a board of trustees of multi-employer plans, however you need to design an effective educational program for your participants so they can make sound investment decisions. If you are considering moving to a participant directed plan, there is a lot of assistance available to you. Many of the mutual fund firms that are used as investment options provide plan participants with the tools to facilitate retirement plan investing. Comprehensive investment information and counseling are typically made available to participants initially and on an ongoing basis.

c. Social Security Reform

The need to educate investors would become even more important if we invested Social Security contributions in the stock market. Social Security benefits are projected to exceed revenue from payroll taxes in several years. By 2032, the Social Security Trust Fund is expected to be depleted. Three basic options exists to close the gap between benefits and revenue, and thus extend the life of the Trust Fund: reduce benefits, increase social security contributions or raise the expected rate of return for contributions through investment in the stock market and other private sector securities.

Many proposals that attempt to close the gap between benefits and revenue involve some type of market investment. For the most part, these proposals draw upon two basic ideas: (1) having the government invest the Social Security Trust Fund in the stock market; or (2) allowing individuals to invest a certain percentage of payroll contributions in an individual private account. If individual accounts are adopted as part of Social Security Reform, more than 140 million American workers would be investing their retirement funds in securities. Those workers must be prepared to invest their accounts wisely. No matter how perfect the plans to reform Social Security, it wonít be as nearly as effective as it could be if investors donít understand the relationship between risk and return and the benefits of a diversified portfolio.

III. SEC Initiatives on Investor Education

To help educate investors about the securities markets generally, the SEC has established the Office of Investor Education and Assistance whose mission includes developing educational programs that will enable investors to better protect themselves and make wiser investment decisions. We've produced a series of pamphlets, handbooks, and brochures designed to teach people about different types of investments, and how to invest their money wisely. These materials - such as one offering investors general tips on how to invest wisely, and another warning investors of potential investment frauds on the Internet - are available through a toll-free telephone number at the SEC or through the SEC's Website (www.sec.gov).

The SEC has also organized investor and small business town meetings at locations throughout the U.S., where investors or small business owners can address questions in person to Commissioners and high-ranking staff members. These meetings allow us to hear directly from investors and small business owners; answer their questions in-person; and find out what ideas they have. We also have been able to get state securities regulators, self-regulatory organizations, and representatives from industry groups to give seminars at these town meetings.

More recently, the SEC in partnership with nearly 50 government agencies (including the Department of Labor), consumer organizations and business groups launched the Facts on Saving and Investing Campaign. The campaign seeks to encourage Americans of every age and income to "get the facts" they need to save and invest wisely and avoid financial fraud. Key campaign events included: (1) a national roundtable on saving and investing that brought together many of the leading voices from government, industry, consumer groups, and the media to focus the nationís attention on financial education; (2) widespread distribution of the Ballpark Estimate Ė a single-page worksheet that helps individuals calculate how much theyíll need to save each year for retirement; and (3) a national town meeting on saving and investing that was transmitted by satellite from Washington, D.C. to 34 downlink sites throughout the United States. This year the campaign will reach out to students and young workers.

The Facts on Saving and Investing Campaign was launched to help Americans learn how to obtain financial security. Research by the Investor Protection Trust showed that over 65 million American households will fail to reach one or more of their financial goals because they failed to plan for their financial future. A 1998 survey by the Employee Benefit Research Institute found that only forty-five percent of workers have even attempted to figure out how much theyíll need to save for their retirement.

The SEC has also worked with the sponsors of employee benefit plans to help them educate investors. The SECís staff issued an interpretive letter that enables an employer, without registering with the SEC as an investment adviser, to provide investment-related information to employees who participate in the employerís defined contribution employee benefit plan. The SEC staff issued this letter in conjunction with an interpretive bulletin published by the DOL. The bulletin clarified the circumstances in which a plan sponsor or service provider may assist plan participants in making informed investment decisions without being deemed to be providing investment advice regarding plan assets.

As I stated earlier, the SEC was established to protect investors. A key component of protecting investors is educating them. Educating investors is a responsibility not just for the SEC, but for the employee benefit plan industry as well. There is an unacceptably wide gap between financial knowledge and financial responsibilities. We must help prepare investors today for a secure tomorrow. Clearly the knowledge gap is among the most important problems we face today Ė and itís a gap we must bridge. That's a goal we can achieve and we will achieve with your help.

IV. Regulatory Initiatives

Now I would like to turn your attention to certain regulatory initiatives that I think will be of interest to you. Many of you may be in the position of selecting investment advisers to manage the assets of your plans. My Division regulates those investment advisers under the Investment Advisers Act of 1940 (Investment Advisers Act). At the SEC, we are currently engaged in revisiting our regulatory approach on many issues under the Act, in a comprehensive effort to modernize our regulations to respond to the changes that are sweeping across all financial service industries.

a. Proposed Investment Adviser Registration Depository

Recently, the SEC proposed the Investment Adviser Registration Depository, or IARD, system. The IARD will be an Internet-based system of electronic filing for investment advisers created by the SEC and the state securities authorities. The system is being built and will be operated for us by NASD Regulation (NASDR). NASDR already operates the Central Registration Depository system for broker-dealers, which in many respects is similar to the system we believe is needed for investment adviser registrations. The IARD system is the product of several years of intense work by our staff, and is designed to offer numerous benefits to the clients of investment advisers.

In particular, the proposal includes rule amendments regarding advisersí disclosure obligations that are designed to vastly improve the quality and format of the information advisers provide their clients. The proposal requires that all advisers provide clients with a narrative brochure containing disclosure about the advisory firm written in plain English. This approach is designed to build on the success the SEC has had with requiring mutual funds and other issuers to draft prospectuses in plain English.

The SEC also is proposing to require that the firm brochure be accompanied by a supplement containing important information about the advisory personnel with whom the client will be dealing. We believe that advisory clients want and need information about the individuals on whom they will rely for investment advice. This new approach replaces the current check-the-box/multiple choice format in current Form ADV (the registration form for investment advisers), which does not lend itself to meaningful disclosure about the advisory firm or its personnel.

In addition to the new narrative format, we are proposing that Form ADV be revised to provide additional disclosure that we feel clients need. One of the more important items in Part 2 of Form ADV is the disclosure of conflicts of interests, including personal trading by advisory personnel and interests the adviser may have in securities it recommends to clients. We are proposing that the brochure explain the nature of these conflicts and that the adviser discuss the practices or procedures it uses to prevent these potential conflicts from harming clients. Consistent with the report of our Office of Compliance Inspections and Examinations on soft dollars, the proposed form requires enhanced disclosure of soft dollar practices. Moreover, the proposed form would require advisers to explain whether they vote client proxies and any procedures or practices used in deciding how to vote proxies. Additionally, the new form would require, for the first time, an adviserís brochure to disclose to its clients material disciplinary or legal events involving the adviser or its management.

Importantly, information contained in filings made though the IARD will be stored in a database that members of the public will be able to access free of charge through the Internet Ė giving investors easy access to information about investment advisers. Investors will have access to all current information on file about advisers, including information about advisory fees, conflicts, ownership and control and disciplinary problems. Currently, advisersí filings do not appear on our EDGAR system and are not easily accessible from other sources.

For the SEC, the system will help us better monitor advisers and administer our regulatory program. For example, the system has certain features designed to insure that advisers register with the proper authority, or the system will not accept the filing. Moreover, the new system will enable the SEC to obtain better information to follow trends in the adviser industry, analyze the impact of proposed regulatory changes and anticipate developments that need regulatory attention.

b. Pay-to-Play Rule Proposal

I know that many of you are trustees of public sector benefit plans. As you may be aware, last summer the SEC proposed a new rule under the Investment Advisers Act that would prohibit investment advisers from making political contributions to obtain government contracts to manage public funds, a practice known as pay-to-play.

The proposed rule was the result of an extensive SEC staff examination into alleged pay-to-play practices. The staff found that pay-to-play practices play a similar role in the investment adviser selection process as they played in the selection of municipal bond underwriters before the implementation of the Municipal Securities Rulemaking Boardís Rule G-37. Rule G-37, in effect since 1994, prohibits municipal bond dealers and brokers from engaging in pay-to-play. G-37 has worked well to curb pay-to-play in the municipal finance industry, and I am convinced that its approach and provisions are necessary in that context.

Modeled substantially on Rule G-37, the proposed rule would generally prohibit investment advisers registered with the SEC from providing public pension plan advisory services for two years after the adviser, or any of its partners, executive officers or solicitors, contributes to the campaigns of certain elected officials or candidates. The rule would except certain contributions of $250 or less. The rule would also require registered advisers with government clients to keep records of their political contributions.

The rule proposal has generated a lot of controversy. Certain persons have questioned its approach and scope. Despite that controversy, the SEC is committed to adopting a rule for advisers in this area. The SEC must, and will, act by specific regulation to prevent the practice of buying government business with campaign contributions. It is the right thing to do.

However, the SEC is considering carefully whether the proposed ruleís G-37 type approach or some other approach is best suited for the advisory industry, recognizing that there are differences between the municipal finance industry and the investment advisory industry.

c. Investment Advisers Roundtable

On March 23, 2000, the SEC will conduct a roundtable to discuss a variety of issues relating to investment advisers. The SEC has several initiatives, some of which I have discussed, that promise to dramatically alter the regulatory landscape for advisers. The conference will bring together investment advisers, legal counsel to advisers, investor advocates, representatives from state regulatory bodies, representatives from the National Association of Securities Dealers, Inc., and others to discuss these initiatives and offer their views.

The round table is open to the public, and I invite you to attend.

V. Conclusion

Many of you have responsibilities for making decisions designed to meet the retirement needs of your planís participants. This is a responsibility that I know you take seriously. Many of you are trying to determine whether your members are ready for participant directed plans. It is clear that many of you will move toward participant directed plans because your members want to control their financial destiny. In many respects, an era of institutional reliance is ending, as an era of self-reliance has begun. Today we stand at what may be a defining moment in American economic history, as more and more of us are taking responsibility for our own retirement needs. But, if your participants are not informed and not financially educated, opportunity will lose out to ignorance. We must work together to extend the promise of opportunity and financial security to more Americans.

However, even in participant directed plans, plan trustees continue to have important fiduciary responsibilities. Plan trustees are responsible for evaluating and selecting investment managers and investment options and monitoring services, expenses and performance. There may be instances when you have to terminate an investment manager and substitute another when the manager is not meeting the needs of the participants. At the Commission, we are committed to making your job easier in this regard, be it through better mutual fund prospectuses drafted in plain English, with a focus on essential information including investment risks and fund expenses, or better information regarding advisers through the proposed new Investment Adviser Registration Depository system. Working together we can help more Americans achieve financial security for their retirement years.

Thank you for your attention.