The "Cultural" Fix for Funds

Doug Klein of 401(k) Education says compliance officers will fail unless they feel free to report abuses directly to top execs

One of the biggest problems within fund companies is compliance, says Doug Klein, a founder and director of communications at 401(k) Education, a Verona (N.J.) fee-only consulting firm that provides advice to retirement-plan sponsors. Klein, who has studied the industry's inner workings, stresses the need for directors to hire a team of surveillance experts and create an open avenue of communication.

"Mutual-fund companies aren't like some sort of police organization or the IRS where you're going to get recognition if you find bad guys or you bring in cheaters," he says. "There's no culture of that existing in the mutual-fund company."

Klein's clients are typically smaller companies with retirement plans that have less than 1,000 participants, which also tend to have few resources devoted to analyzing those plans. Klein's firm has no conflict of interest when it recommends a certain investment or fund family. "We truly believe that we're recommending the organization because they have proven themselves," he says. "The other way around, if we discourage a client from investing with a company and recommend that they stop using them, we don't get any money, or there's no repercussions to us financially or contractually with steering people away from a certain entity."

On Dec. 3, the Securities & Exchange Commission proposed new rules for mutual funds, including a 4 p.m. (ET) cutoff to receive buy and sell orders, and requiring funds to name independent officers to ensure compliance rules. The SEC will review additional rules in the next few months. Karyn McCormack of BusinessWeek Online recently spoke with Klein about how some of the proposed reforms will affect mutual-fund companies and shareholders. Edited excerpts from their conversation follow:

Q: What is the SEC proposing, and when will the changes take effect?


The only rule that's going to be hard is the 4 o'clock deadline for all participants. [For] all of the other proposals, there's going to be a 45-day public commentary, which I will be submitting. And the SEC staff and officers have already acknowledged that they really don't know the best way to implement having a chief compliance officer and the actual rigid guidelines of how the reporting structure would work. That is going to be a fluid situation.

Even when they do have the final proposal, the industry will still probably have about nine months to find the right people and implement it. So my guess is that you're not going to see any actual hard change on internal compliance infrastructure for 10 to 12 months from today.

Q: Why the 4 p.m. cutoff? Isn't that already the rule?


The 4 p.m. trading deadline actually affects 401(k)s more than any other entity. A regular retail customer of mutual funds that buys through Fidelity, Schwab, a broker, or calls up a company themselves, already knows that they have to have an order to buy or sell by 4 o'clock. It's already ingrained.

The 4 o'clock rule came about because of a loophole that some clever brokers discovered. If they hid a client's true identity as a 401(k) account -- even if the client was really a hedge fund -- the trades would actually go through as legitimate trades. The experts in the industry, who aren't bad guys, never imagined that this loophole could possibly exist for profit.

Q: Will this hurt individual investors?


If you take a hard view on these matters like I do, if a person in a 401(k) account is ever worried about a daily transaction, they are totally losing the focus of what that 401(k) account really represents. It's a long-term investment account. On the day they turn 65, the transaction that they did in December of '03 is going to be absolutely insignificant.

So the 4 p.m. rule is going to affect the companies. They're not going to be able to abuse the order-entry system, which is what Bank of America (BAC ) did.

Q: Is it a first step?


The 4 p.m. situation is really shutting the barn door after the cow left. And now the government is realizing that they should have always had a better lock on the door in the first place. Now, the compliance officers' situation is something that has to be addressed. What we're talking about is how they become part of a corporate culture.

Q: What do you mean by make compliance a part of the culture?


Everyone knows on Wall Street that there's no culture where the compliance and the surveillance people are part of the inner circle of management of the top decision makers who eat lunch at the same place, get together at the same place for happy hour, maybe go to the same football games together when there's only four tickets. The compliance people are never in that inner group of elite. They simply do not have the personal comfort level to go to senior management and say, listen, I've discovered that our star employee who makes $1.1 million a year is engaged in illegal activity.

I know personally -- in working at three or four places in 20 years -- of at least two people in surveillance who were terminated because they uncovered the wrongdoing of their employees. And the rationale was, you weren't doing your job because you should have detected that they were doing bad things immediately, like on the first day. As opposed to letting us know about it after this illegal activity was going on for a period of time -- either months or years.

Q: How do you make that happen?


There's a distinction between having a big-shot called chief compliance officer and creating a very clear and open route for the compliance people to go directly to directors. They should be comfortable just picking up the phone and talking to directors and sending them e-mail. There has to be a separate meeting schedule where directors meet only with compliance personnel, and they don't discuss anything else.

And so you have a culture where -- I call them little worker bees -- they're basically going to be solid, clerk-type personnel that make anywhere from $35,000 to $60,000 a year. They're the ones who are going to be poring over these pages and pages of computer printouts. These lower-level people may never have been in the same room as a senator or a CEO or a multimillionaire. A culture has to be created where they feel comfortable communicating what they find. And that's more important than having a compliance big shot.

The flip side of that is the directors have to go out of their way to think that the stuff is out there. They just can't go in every day thinking -- because the portfolio managers and the owners are so wealthy and they're so smooth -- they just can't assume every day that they can't do bad things, that they can't commit fraud.

Q: Do fund companies have to reorganize?


The problem is they're going to have to bring in a lot of people who are very talented and very skilled and cost a lot of money. But they might have a problem because people who have that skill and knowledge may not want to work for a mutual-fund company at the wages that the fund companies are going to pay. If the fund companies raise the wages to the market level -- let's say for what a good auditor makes at a good accounting firm -- then the fees are going to have to go up for all shareholders.

So then the fund company is going to argue to the SEC and to [New York Attorney General Eliot] Spitzer, "Well, you're doing the opposite of what you said. You told us you wanted fees to come down...and yet you're telling us that we have to hire this significant new infrastructure."

That's not just hiring one or two new people. You're talking about hiring enough people that every single trade of every single employee is going to be monitored. You have to figure there's going to be a ratio of new employees needed for every investment person already on the payroll.

Q: Do you think fund expenses are necessarily going to go up?


They're definitely going to go up if there is an inflexible mechanism. The new rules don't take into account the realities of the difference of sizes of organizations and will penalize the small funds. Small companies only have a handful of mutual funds and may actually have a better track record over time than the very large fund families that offer 60 to 100 different mutual funds.

Q: Do you think the SEC is being hasty?


The SEC has to significantly increase its knowledge of the investment-management business. And, unfortunately, they've already demonstrated that they really had a blind spot, and they really didn't know what they were doing when it came to understanding the cultural dynamics of what was really going on in mutual funds.

So now we just need an admission that they really didn't know what they were doing, they weren't good cops, they weren't good detectives, they weren't good at deductive reasoning, of figuring out the kind of stuff that could be going on. They have to bring in a lot of outside talent that really understands this stuff.

Q: Do you think sales practices by fund companies will change?


I really hope so. And that's because the small investor isn't well served by the adventure in investing that mutual-fund companies recommend, by always recommending different portfolios and just letting people change funds willy-nilly. All the numbers that I see from the trade is that the market share of independent advisers is rising every year. And these independent advisers market themselves as being much more prudent and putting the client first and less emphasis on commissions.

Q: How have the fund companies that you consult with reacted to the scandal?


Right now, the internal management of companies are absolutely focusing on it. They're having a lot of conversations with their accountant, lawyer, representative of the 401(k) company, and any sort of personal financial adviser.

This is really going to hurt the 401(k) providers in the short term because they're going to offer so much rebates, so many lower fees, and many guarantees. It's totally destroying the profitability model of these organizations. When they had their flow charts for 2004, their budgets were assuming such a higher level of revenues from the 401(k) plans than what they're actually going to realize for the year.

Q: Which plan providers you do recommend?


In my opinion, the winners are going to be the low-cost providers, and they're going to be Vanguard and Fidelity. A lot of the other ones aren't exactly low-cost. The other big loser in this is going to be the broker -- either the insurance company, the stock broker, or the bank that serves as the third-party intermediary.

And then there's one company -- TIAA-CREFF -- that has done such an incredible job on the retirement side. If they decide to really attack the 401(k) market, I think that they would gain double-digit market share increases every single year. Because they are that good.

Q: What can individual shareholders do to make sure that the funds in their plan aren't being deceptive?


My advice is: Don't speculate, and don't move your money around. Just leave it in index funds. Put half your money in index funds and half your money in bonds. And then don't ever change.

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