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        Investor's Insight - October 10, 2006           
          "A Digest of Investment Opinion From the 
             World's Leading Financial Advisers"


by Scott Burns

Take a memo: Let's not kill all the lawyers just yet. 

They are the only defense that workers have against 
corporate executives who would rather count their 
stock options than pay attention to workers' 401(k) 

Since those plans are what most workers use for re-
tirement saving, having low plan expenses is important. 
A difference of 1 percent in annual expenses can be 
the difference between a secure retirement and cat 

A new wave of class-action lawsuits started last month. 
That's when Schlichter, Bogard & Denton, a St. Louis 
law firm, filed a suit against defense contractor Northrop 
Grumman. A copy of the complaint, which runs 45 pages, 
names the corporation, its savings plan administrative 
committee, its investment committee and 16 individuals 
for "breach of fiduciary duty." The same firm has filed 
suit against seven other companies: Bechtel, Caterpillar, 
Exelon, General Dynamics, International Paper, Lockheed 
Martin and United Technologies.

More suits may follow.


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The common thread: The plan sponsor is accused of failing 
to fulfill its fiduciary duty to make certain the 401(k) 
plan operates with appropriate expenses.

"The most certain means of increasing the return on em-
ployees' 401(k) savings is to reduce the fees and ex-
penses employees pay from their 401(k) accounts. Unlike 
generalized market fluctuations, employers can control 
these fees and expenses. Federal law requires them to 
do so," the suit against Northrop says.

The suit also asserts that Northrop Grumman failed to 
act appropriately to know about, and reduce, fees for 
its plan investment options and for the expenses asso-
ciated with the way Northrop Grumman shares were treat-
ed as a plan option. Both worked to unreasonably reduce 
the net return to employees, the suit alleges.

This is not about small change. According to its most 
recent SEC filing, the Northrop Grumman plan has more 
than $11 billion in assets spread over 10 investment 
options plus company stock. Northrop matches the first 
2 percent of employee contributions 100 percent, the 
next 2 percent is matched at 50 percent, and the next 
2 percent is matched at 25 percent. Altogether, the 
employer match may total 4 percent of payroll. 

Employees can choose between a U.S. equity fund, a U.S. 
fixed-income fund, a stable value fund, a balanced fund, 
an international equity fund, a small-cap fund, an equity 
index fund, a high-yield bond fund, an international bond 
fund, an emerging markets fund and a "Northrop Grumman 
fund" for company stock. Employees can also choose a 
Schwab brokerage window account.


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While the form 11-K discloses all this, it says not a 
word about the expenses of the plan options.

The most interesting part of the suit is the accusation 
that the Northrop Grumman plan is filled with "shadow 
index funds" that are collecting the much higher fees 
of managed funds. Northrop workers, in other words, 
are paying for something -- active management -- but 
they are not getting it.

And that, the suit asserts, is where the company and its 
executives have breached their fiduciary duty.

Shadow index funds -- sometimes called "closet index funds" 
-- are funds that talk about active portfolio management
but actually practice near-indexing, so their returns won't 
fall far from their benchmark. Whether a fund is a shadow 
index fund is measured by a statistic called the R-squared, 
which measures how much of a fund's performance can be ex-
plained by an index. When the R-squared is 95 or higher, 
signifying that 95 percent of its performance can be 
attributed to an index, a fund is considered a shadow 
index fund.

Among well-known retail mutual funds, for instance, 
Fidelity Trend fund and Dreyfus fund both have R-squares 
of 98 percent. But while it is possible to manage an 
index fund for expenses as low as 10 basis points, 
Fidelity Trend has expenses of 83 basis points, and 
Dreyfus has expenses of 74 basis points, according to 

And here's the rub: According to the lawsuit, every single 
one of the nine fund offerings that claim active management 
have scored as shadow index funds over the last six years. 
As a consequence, corporate management may have been paying 
two or three times as much as their fiduciary duty would 

You can discuss this issue or any other topic in the new 
Investor's Insight forum. Check it out here...

Investor's Insight Forum

(Investor's Insight reflects the opinions of experts. It does 
not recommend any specific investments, and no endorsement is 
implied or should be inferred. For more information, contact 
the individual firms cited).



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