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by Holly Yeager, AARP Bulletin, April 5, 2010
Like so many small investors, Arline Winerman put most of her money in mutual funds because it seemed like a smart, simple thing to do.
“I didn’t want to have to do the research and figure out which stocks are good,” says the 74-year-old retired fifth-grade teacher and school administrator. “I let the mutual fund take care of my money,” giving her more time to devote to her true passion: line dancing.
But in 2003, when charges of illegal trading practices rocked the mutual fund industry, she started paying more attention to her investments—and to the fees she was being charged.
“I’m very conservative with money,” Winerman says from her condo looking out over Tampa Bay in Florida. “I don’t have a lot and I’m very careful of how I spend it.”
The more she studied the fees, the more exorbitant she found them. That concern led Winerman and two other retirees to file a lawsuit against Harris Associates, an investment advisory firm that runs the Oakmark group of mutual funds, in which all three plaintiffs put money. The investors alleged that Harris’s fees were set so high that they amounted to a violation of the vaguely defined “fiduciary duty” the company has under law to look out for the financial interests of its investors—an accusation the firm rejected.
A federal district court and the Seventh Circuit Court of Appeals each sided with the defendant in the case, Jones v. Harris. And in its opinion, the Seventh Circuit appeared to make it more difficult for disgruntled investors to successfully contest mutual fund fees.
The case ultimately reached the U.S. Supreme Court, and the stakes were high. Until now, investors have had little luck challenging these fees. If the high court upheld the Seventh Circuit’s ruling, it would become even harder. The mutual fund industry has nearly $11 trillion in assets, including 401k retirement plans and college savings plans. Any court ruling that made it easier or harder for investors to successfully challenge how fund managers are compensated could impact the $90 billion in fees the industry collects each year.
But a murky opinion issued on March 30 allowed both sides to claim a sliver of victory. The Supreme Court rejected the tougher standard endorsed by the appeals court, and largely kept in place the existing standard, which has proven friendly to the mutual fund industry.
Preparing for retirement
Mutual funds—pooled investments in stocks, bonds and other assets—are an important investment vehicle, especially for retirees and those planning for retirement. According to a recent report on mutual fund investors from the Investment Company Institute, a trade association for the sector, saving for retirement was one of the financial goals cited by 94 percent of households that own mutual funds. More than three-quarters of those households said saving for retirement was their primary financial goal.
Many investors are like Winerman, preferring the ease of mutual funds to the close attention required for managing a portfolio of individual stocks. Winerman says she would check her mutual fund statements once in a while, but she didn’t read every chart she received, “and if I did, I probably wouldn’t understand it.”
But the fine print is important. Just consider this example, from the Labor Department’s Employee Benefits Security Administration:
“Assume that you are an employee with 35 years until retirement and a current 401(k) account balance of $25,000. If returns on investments in your account over the next 35 years average 7 percent and fees and expenses reduce your average returns by 0.5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5 percent, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28 percent.”
With such real-life consequences in mind, AARP Foundation Litigation and the Consumer Federation of America filed a friend-of-the-court brief in Jones v. Harris on behalf of Winerman and her fellow investors. Noting that the amount investment advisers are paid for their services is deducted from mutual fund assets, the brief said that “resolution of the issues in this case will have a significant impact on the ability of current and future retirees to realize financial security in retirement.”
Winerman puts it more plainly. “This is my retirement,” she says. “This is what I’m going to live on for the rest of my life.”
Challenging the fees
While mutual funds offer convenience to investors, their structures are often far from simple. The Oakmark group of mutual funds was created by Harris Associates, which also decided who would sit on the fund’s board—the same board that approves the fees to be paid to Harris for its advisory work. It’s a common structure in the industry, and one that inherently poses a conflict of interest, critics say.
Congress attempted to address that sort of conflict in 1970, when it amended the Investment Company Act, a 1940 law that set standards for investment companies. The new rules said investment advisers have a “fiduciary duty” not to charge too much—a duty that Winerman and the other plaintiffs said Harris breached by charging excessive fees.
In court papers, the investors noted that the 0.88 percent management fees Harris charged individual investors in three Oakmark funds were nearly double the 0.45 percent that pension funds and other institutional investors were billed for similar funds. “In dollar terms, the funds would have saved between $37 million and $58 million in one year alone under the fee schedules” used for Oakmark’s institutional clients, they argued.
But Harris disagreed, insisting that the fees were permissible because the three funds had performed well, and the fees were similar to those charged by other industry funds.
Since 1982, such disputes have been governed by a federal appeals court ruling that said fund advisers were only in violation of the 1970 law if their fee was “so disproportionately large that it bears no reasonable relationship to the services rendered,” and could not have resulted from a fair bargaining process—a standard that has proven nearly impossible for disgruntled investors to meet.
The Seventh Circuit seemed to add to that burden by ruling that the investors needed to show that the advisers—in this case, Harris—misled the fund’s board directors who approved the fees. The Supreme Court, in its unanimous decision last week, rejected the Seventh Circuit ruling. But the opinion, written by Justice Samuel Alito, kept in place the industry-friendly 1982 standard.
A partial win for both sides
The mutual fund industry called the ruling a victory. Paul Schott Stevens, president and CEO of the Investment Company Institute, says that by maintaining the existing standard, the Supreme Court’s decision “brings stability and certainty for mutual funds, their directors, and almost 90 million investors.”
But advocates for investors also saw good news in the decision. James C. Bradley, an attorney for Winerman, notes that the opinion specifically clarified that courts may consider the discrepancy between fees charged to individual investors and those charged to institutional clients when evaluating whether fees are excessive—a comparison that the mutual fund industry had hoped to avoid. That gives investors a new tool that could make it easier to challenge mutual fund fees.
A lower court will now rehear Jones v. Harris, and Winerman’s team plans to use that clarification from the Supreme Court ruling to bolster its case.
Though seemingly minor, that change is significant, says William A. Birdthistle, an associate professor at Chicago-Kent College of Law and an expert on the mutual fund industry who also filed a brief on behalf of investors in the case. “It’s still not a great place to be as a plaintiff,” he says. “But it imposes slightly more pressure on the industry to justify these fees.”
The high court’s ruling may not be the last word in the matter, Birdthistle says. He points to the last line of the opinion, which called a philosophical debate between two appeals court judges over the role of the market in setting compensation rates “a matter for Congress, not the courts.” While mutual funds have not received much attention during the current debate in Congress over changes to the financial regulatory system, Birdthistle says that opening from the Supreme Court could prompt lawmakers to take up the issue.
An unlikely ally for investors
The high court’s ruling in the case didn’t satisfy John Bogle, the feisty 80-year-old founder of the Vanguard Group, Inc., the mutual fund giant, who these days seems almost regretful about the industry he helped create. “I feel very strongly that the normal checks and balances we might think about in setting management fees have been badly violated by the mutual fund industry,” Bogle says.
Bogle complains that investors usually see their fees expressed as a tiny percentage, and he worries that they don’t realize how that number can chip away at the income their fund is generating. “If a fund is yielding two percent growth, and it’s a one percent fee, you’re consuming half in fees,” he says.
Bogle also filed a brief in the case on behalf of investors. He says he was disappointed that the justices didn’t pay more attention to the many millions of dollars in fees collected each year by top fund managers, or to the messy corporate governance issues raised by tangled relationships like those between Harris and Oakmark.
Vanguard boasts that it operates at cost, keeping its funds much less expensive than others, and its funds are independent of Vanguard’s investment advisers—setting an example that Bogle would clearly like to see the rest of the industry follow.
“I think this is an industry that provides an essential service to investors,” says Bogle. “But it could be so much better than it is.”
But investors have a role to play, too. He points to a conclusion he drew in his senior thesis, written at Princeton in 1951, which he believes remains true today: Mutual fund managers cannot beat the market. “They are the market, and they charge money!”
With that in mind, it’s up to individual investors to pay close attention to those fees. “You want to minimize your costs, you want to minimize the croupier’s take,” says Bogle. “You want to go into Las Vegas, make your bets, and get out.”
Holly Yeager lives in Washington, D.C.
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