Step carefully

Every day the list grows. Sponsors of 401(k)s, like their counterparts in the pension world, are firing money managers implicated in the widening fund industry scandals. Unfortunately, the number of fund companies named in regulatory inquiries is expanding, too, so there's no assurance that a replacement will remain unsullied for long. "You could switch to a new fund family and then discover that it has been charged with illegal trading, too," says Angela Parrish, an investment consultant with Aon Consulting.

Still, many plan sponsors are shaking up their manager rosters. Among other firings since mid-October, the Oregon College Savings Network pulled $134 million out of Strong Financial Corp.; Merck & Co. eliminated two Putnam Investments international funds from its $3 billion defined contribution plan; Microsoft Corp. erased two of Janus Capital Management's funds from its 401(k) roster; and the Colorado Public Employees' Retirement Association notified Janus that the Coloradans would be pulling about $60 million of their 401(k) accounts out of the firm's flagship Janus Fund.

But as quickly as certain funds are disposed of, others make new and equally unflattering headlines. Through mid-December, New York State Attorney General Elliot Spitzer had brought charges against seven firms or individuals working at specific firms, and another four are under investigation or have settled charges. Other states' attorneys general have embarked on inquiries as well. The ongoing probes have focused on everything from market timing and late trading to unfair pricing and illicit personal trading by portfolio managers.

The upheaval has put sponsors and participants of 401(k)s in a tough spot, and consultants and lawyers advise those who haven't dumped managers to move carefully. "Plan sponsors need to demonstrate that they are taking prudent actions, being careful and systematic," says Jeffrey Van Orden, a retirement plan consultant with Milliman USA.

There are practical reasons for thoroughly reviewing a plan's options before making any changes. For instance, "there can be substantial costs associated with moving assets," says Parrish. One of her clients was going to be charged as much as $10 per participant to shift money from a fund that had not been implicated in the scandal but was part of a fund family under scrutiny for its practices in other funds. The client was planning to move into a fund family that had not been implicated in the scandals, but decided to stay put.

As fiduciaries, plan sponsors have legal risks of their own. Under ERISA, companies are liable for any improper or illegal practices on the part of their retirement plan's investment managers or administrators. "Participants cannot sue mutual funds or the funds' investment advisers," notes Linda Shore, an ERISA attorney with Washington law firm Buchanan Ingersoll. "But they can sue plan sponsors."

Simply rolling out a roughly comparable fund alternative for employees could ultimately backfire. "If the fund is performing well, then pulling out assets is probably the riskiest course," says Shore. Replacing a strong performer with a weaker fund could open the sponsor to an employee lawsuit or, more likely, alienate workers.

As a result, many plan sponsors and consultants think the wisest course right now is to work closely with investment advisers, even if they have been named in an inquiry.

Consider the anomalous circumstances of the Ohio Tuition Trust Authority, which has $2.6 billion in its college savings plan that is administered by Putnam. Though OTTA has joined a class-action lawsuit against Putnam, the agency is keeping the embattled fund company as its plan administrator.

"The tuition trust authority, as the plan sponsor, is the entity that has standing to join this suit; our shareholders do not," explains executive director Jacqueline Williams, who describes her current relations with her counterparts at Putnam as "a fine balancing act." Furthermore, OTTA has petitioned to be the lead plaintiff in the suit, filed originally by New York­based law firm Milberg Weiss Bershad Hynes & Lerach on October 21. Williams says that OTTA joined the suit in late December and requested lead plaintiff status on the advice of the Ohio attorney general.

Earlier, the Ohio plan had sought and received assurances from its eight money managers that participants would be compensated for any losses suffered as a result of illicit fund practices.

"Putnam will provide full monetary restitution for all improper trading losses to our fund shareholders," says a company spokeswoman.

Putnam's letter of assurance, signed by Richard Monaghan, head of the firm's retail division, was posted on the Ohio Tuition Trust's Web site.

Reassuring plan participants, of course, is just part of the battle faced by Putnam and other providers. "If Putnam is going to win back investor trust, it will have to do more than get its wrists slapped, but this letter is certainly a step in the right direction," says Milliman's Van Orden. A Putnam spokeswoman declined to comment on whether similar letters were sent to other defined-contribution-plan sponsors.

A few companies are picking up additional assets through the course of the scandal. Pittsburgh-based Mellon Financial Corp., for example, offers plan sponsors a place to park assets for three to six months while they look for a new manager.

Some mutual fund companies, including Putnam, are going on the offensive against employers whose plan participants have engaged in market timing. Putnam ended its relationship with Floral Park, New York­based Boilermakers Local No. 5, whose members' active trading had earlier attracted the attention of state regulators. Putnam executives notified the Boilermakers in late September that their relationship would end within 60 days.

And Principal Financial Group, a Des Moines, Iowa­based insurance company that is a large 401(k) provider in its own right, recently won a lawsuit brought by former Principal employee Brian Borneman and his wife, Melissa, who objected to Principal's prohibiting market-timing trades in their account in the company's 401(k) plan. The U.S. District Court for the Southern District of Iowa ruled that Principal had the authority to enforce such trading restrictions.

But not long after Principal won that courtroom round, it revealed that several employees, including two former portfolio managers, had profited from market-timing funds in their retirement accounts.

The courts will keep busy. Several class actions have already been filed on behalf of mutual fund shareholders.

In one, lead attorney George Zelcs, of the Chicago office of St. Louis­based law firm Korein Tillery, has alleged both negligence and breach of fiduciary duties on the part of several mutual fund companies, including Evergreen Investment Management, the asset management arm of Wachovia Bank; Janus; Putnam; and Scudder. The suit, filed on behalf of shareholders in the funds, charges that the funds failed to use so-called fair-value pricing, in which mutual fund net-asset values are reset during the course of the day to reflect changes in the values of the underlying securities. The suit alleges that the firms' end-of-day valuations left them vulnerable to market-timing abuses by sophisticated traders. "The issue that these suits address is the appropriate threshold to trigger fair-value pricing," explains Zelcs, whose clients, the plaintiffs in the suit, are individuals.

A Putnam spokeswoman declined to discuss ongoing litigation, and a Janus spokeswoman says that the firm takes the allegations seriously.

Ronald Kilgard, an attorney in the Phoenix office of Keller Rohrback who has litigated class actions against plan sponsors, points out that some employers may be in a position to sue their plan providers. The potential grounds: placing plan participants at an unfair disadvantage by granting some shareholders free rein with abusive market-timing practices. "Fiduciaries themselves are possible plaintiffs; they could sue their fund managers," says Kilgard.

In the end, consultants suggest that sponsors who do decide it's best to switch plan providers should move quickly and decisively. Once a new fund has been selected, Aon's Parrish recommends that "plan sponsors alert their participants to the alternative, set a deadline for transferring assets and terminate the fund in which the abusive trading occurred."

And plan sponsors should be prepared for more bad news. In a recent Greenwich Associates survey of 131 large U.S. institutional investors, 60 percent of respondents said they believed that "improper practices were widespread in the mutual fund industry." Only 11 percent thought the practices were limited to a small number of firms.