For a sector-by-sector outlook for 2007 and stock picks from our columnists, please click here.The mutual-fund industry has had the wind at its back for the past four years as strong equity markets propelled assets ever higher. But regulatory developments could be just as important to the industry's growth in 2007, particularly if stocks lose some of their sizzle. The Pension Protection Act, which was signed into law in August, has the biggest potential to increase the flow of money into mutual funds. It enhances several savings programs available to individual investors. Perhaps the most important feature is the so-called "autopilot" 401(k) plan, which allows employers to automatically enroll employees in these defined contribution plans and to put contributions from employees who don't choose a specific investment into options that are better for long-term savings. Vanguard Chairman John J. Brennan says this has big implications for both fund managers and investors. "For more than 20 years, employers have urged workers to enroll in defined-contribution plans," he says in commentary posted on the company's Web site. "But if someone said, 'What should I invest in?' the response was too often a stony silence, as fear of legal liability trumped the impulse to help employees make prudent, long-term investment decisions." The result is that employees who don't select an investment for their 401(k) are typically enrolled in money market funds, according to Edward Giltenan, spokesman for the Investment Company Institute, an industry trade group. He says these funds, which are low-risk but also have low returns, "don't make sense for a long-term savings strategy."
The Department of Labor has yet to clarify rules regarding which types of funds are good default options, but Giltenan says lifecycle funds, target-date funds and other kinds of funds that adjust their asset allocations (from more aggressive to more conservative) as a specified date approaches are more appropriate. Even before the passage of the Pension Protection Act, lifecycle funds were growing in popularity, but the law is expected to fuel further growth. According to the ICI, assets in lifecycle funds were just $1 billion in 1997, but grew to $15 billion in 2003 and $70 billion at the end of 2005. About $48 billion of that $70 billion came form defined contribution plans and $15 billion was from individual retirement accounts. The remaining assets were outside of retirement accounts. The autopilot plan could go a long way toward ensuring that investors save enough for retirement. A 2005 study by the ICI and the Employee Benefit Research Institute found that automatically enrolling employees in 401(k)s greatly increased participation rates, especially among lower-income workers. It also found that the default option selected for the plan can also have a major impact on the amount the employee accumulates before retirement. The Pension Protection Act also fixes a flaw in 529 savings plans, which allow investors to defer taxes on funds earmarked for educational expenses. The tax advantages of this program were set to expire in 2010, meaning parents who opened a 529 account for their newborn when the program was created in 2001 could expect the benefits to vanish when the child was still in grade school. But the Pension Protection Act made the tax benefits of 529 plans permanent, which should encourage investors to keep using them.
The new legislation also made permanent the $4,000 annual contribution limits to Roth or traditional individual retirement accounts, which were set to be rolled back to $2,000 a year in 2010. (Investors over the age of 50 can contribute up to $5,000 a year.) The law also preserves higher contribution limits and catch-up contributions that allow investors over 50 to save as much as $20,000 a year in a 401(k) plan. The new money these savings programs will bring in could be key to growth in mutual fund assets, which has largely been driven by stock market gains over the past few years. The average U.S. stock fund tracked by Morningstar returned an annualized 11.31% over the past three years, while the annualized return of the average international stock fund was twice as high at 24.15% The mutual fund industry reached an important milestone in 2006 when it passed the $10 trillion mark, but $566 billion of the industry's $4 trillion in growth for the year to date (through October) since 2002 has come from new money, according to data from the ICI. Another regulatory development that could benefit existing mutual fund investors and increase the attraction of these investment vehicles to new investors is on the corporate governance front. The Securities and Exchange Commission recently said it was taking another look at the costs and benefits of requiring 75% of fund boards to be independent directors and requiring the chairman to be independent.
Susan Ferris Wyderko, executive director of the Mutual Fund Directors Forum, a nonprofit organization dedicated to improving mutual-fund governance, says a rule requiring that the majority of fund board members be independent was previously adopted but it was later challenged in court and is not currently enforced. Wyderko, who was formerly with the SEC's Division of Investment Management says "it is clear that the issue is still alive at the SEC." Another corporate governance issue that will stay in the spotlight next year is the issue of economic arrangements between advisors and third-party consultants. This was brough into focus a few months ago when the SEC began investigating more than two dozen fund companies believed to have accepted kickbacks from independent contractors in exchange for big jobs. The investigation was prompted when an administrative services unit of Bisys ( BSG) said it had been doing this at the expense of shareholders. Wyderko says the Bisys settlement had an immediate impact on the industry as mutual fund directors now understand that they need to ask additional questions about economic arrangements between advisors and third-party consultants. "The open question is how many and what kind of entities the
SEC will decide to move against in the enforcement context," she says adding that "I assume we will see additional shoes dropping by the SEC in the coming year."