March 12, 2004
This e-mail concerns the negative interrelationship between Automatic Rebalancing and Redemption Fees. This is a crisis which impacts every forward-thinking 401k plan. The crisis begins with the fact that I dont think the SEC staff understands either a what is automatic rebalancing or b the breadth to which it is used and growing. What is Automatic Rebalancing? Its used with more and more 401k plans in connection with customized Model Portfolios - which are themselves completely advantageous to 401k participants. The starting point of all of this is DOL Interpretative Bulletin 96-1. 96-1 gave special safe-harbor status to certain forms of investment advice - specifically 1 retirement calcluators, 2 risk tolerance questionnaires, and 3 asset allocation portfolios as long as the decision as to whether or not to use them was retained by the participant. E.g. 96-1 was to be read in concert with ERISA Title I Section 404cso as to prserve the independent but informed decision making power of the participant. 96-1s safeharbors also needed to be accompanied with Statements of Assumption so that the participant could understand and evavluate the safeharbors basis. Anyway, immediately after the release of 96-1 the mutual fund industry introduced LifeStyle funds. Great idea automatically rebalanced asset allocation portfolios extremely poorly marketed wrapped with excessive fees and received participants saw them as homogenous and when they did use them the often mixed them with other investments thereby destroying their investment analytical efficiencies. The boutique cottage industry of Registered Investment Advisors saw both the opportunities and shortcomings and began prevailing upon non-mutual fund companies e.g. Third Party Administrators to build systems to recordkeep and automatically rebalance customized Life Style funds - renamed as Model Portfolios. Their success has been phenomenol. So much so that just about every mutual fund recordkeeper has now come kicking and screaming to the party and now offers these - as well as their own Life Style Funds. Who does? Well to name a few: Milliman USA, Mass Mutual, Met Life, Principal, T.RowePrice, Putnam, Hewitt, CIGNA, US Bank, BISYS, FASCorp., Wells Fargo, American Funds, MFS, Strong, Charles Schwab - and just about every regional TPA. So, whats the rub? The rub is that in their rush to anticipate your restrictions, mutual fund companies are putting into place Redemption Fees to be triggered by any short term trade. A case in point is Artisan International - which is proposing to do just that. Heres the result: a payroll hits on June 15 and funds are invested on June 16 and a regularly scheduled semi-annual Automatic Reblancing takes place on July 1 - which triggers a Redemption Fee for the trade that took place on June 16. Not only is this untenable - but it flies in the face of 404c and all prudent investment practice. E.g. Automatic Rebalancing is being punished. With Artisan International, the present cure is to not have it in the lineup. But how does that benefit participants? In fact, this whole trend will lead back to bundled solutions because they can waive those fees against themselves - which were the cause of the trouble in the first place. So, the reason Im writing is so that your legal staff get-up-to-speed on what is fundamentally not a legal issue - but an investment one. E.g. Automatic Rebalancing is - by every single account - a huge step forward for 401k participants. As such, it should absolutely trump the issue of Redemption Fees. How? A couple of obvious solutions come to my mind and Im sure that there are others. The first most obvious is to distinguish between a participant directed trade and a sponsor directed trade. Even thats not a perfect cure because the ultimate systems - of which there are now quite a few - allow either or both the participant and/or sponsor to initiate an Automatic Rebalancing. So, that would be even better - exempt Automatic Rebalancing regardless of who triggers from Redemption Fees. In fact, the very notion of Automatic Rebalancing prevents short-term trading abuses such as arbitrage because its never about liquidating a holding but merely realligning it. Alternatively, bring some reasonableness to the notion of excessive trading. E.g. in the case of Artisan - theyre announcing that any short term trade will trigger the redemption fee. Rather, give some leeway like 3 or 4 or 6 sells - thereby exempting payroll buys within a 90 day time period. The bottom line is that in everyones rush to fix the institutional fraud that just occurred theyre about to irreparably harm millions of 401k participants. Please do not stand idly by and let that happen. P.S. My firm knows perhaps more about Model Portfolios / Automatic Rebalancing than any other firm in the U.S. Here and at our previous employer, we were the beta site firm for that functionality as it was built by T.RowePrice, Putnam, MassMutual, Strong, and Principal. Thus, you are encouraged/welcome to contact me for more comments/insight. Sincerely, I hope you will heed my comments. Thank you.