Sunday, January 21, 2007

Rewarding, Very, Very, Very Rewarding

The 401(k) business has been very rewarding for investment product and service providers. Financial institutions and asset managers around the world have achieved record profits and profitability over the last four years in a row, in part due to the growth in 401k plans, increasing plan contributions levels and steady capital market appreciation. They have a highly leverageable business and economic model. Their consumers generally; accept the value added premise and fees associated with active management as they equate positive short-term performance with skill rather than random chance, prefer the ease of bundled services and fees and rely on brand name as a proxy for quality.

The demise of DB plans and the provisions of the Pension Protection Act, passed in August 2006, promise to generate even greater growth in the 401K market in the years ahead. Morgan Stanley predicts that DC plan inflows will increase to $30 billion in 2008, peaking at $37 billion in 2010. In addition, providers that can establish corporate 401(k) relationships receive an extremely valuable free dividend, hundreds or thousands of plan participant relationships, which they can leverage outside the 401k domain. Recognizing the growth opportunity and the free call option on participant relationships, merger and acquisition and hiring activity in the 401(k) industry is on the rise.

Unfortunately, a portion of the financial success of the 401(k) business has been directly and unknowingly subsidized by Plan sponsors and participants. The recent 401(k) litigation highlights areas where asset managers and service providers have arguably generated excess revenue at the expense of 401k plans. Asset based revenue matched with fixed cost administrative services, the failure to recognize asset management economies of scale by using fixed price retail mutual funds and closet indexing are examples .

The courts will determine the fiduciary prudence of past practices given the “facts and circumstances then prevailing”. The implications however, could be substantial given the prevalence of these practices. Plan fiduciaries have been put on notice and must now be more proactive in dealing with expense and investment value issues or they invite tremendous liability. In light of this, plan fiduciaries should critically re-evaluate their plan structures and provider programs and embrace new options under the Pension Protection Act to reduce their fiduciary liability.

Index- 401K plan fiduciaries retain the responsibility for prudently selecting and monitoring the investments they make available to plan participants. Excluding actively managed investment opportunities represents a substantial opportunity to rationalize plan structure, minimize expenses and hidden costs and reduce sponsor risk and liability. According to William Sharpe “properly measured, the average actively managed dollar must under-perform the average passively managed dollar, net of costs”. This logic is irrefutable and provides a sound fiduciary basis for indexing. Decades of equity mutal fund research also indicate an inability of fund managers to beat market indices. As the separation of “beta” or market returns from “alpha” or active manager relative returns becomes a more commonly accepted way of looking at both investment returns and costs, the potential excessive cost of alpha in many actively managed products could very easily become the next cause of action against plan fiduciaries. 40 sof research indicate equity mutual funds

Unbundle- Unbundling is where plan sponsors select the best provider for each service element of their 401K plan such as; administration, investments or education. Unbundling tends to reduce the embedded conflicts of interest and cross subsidized services that create fiduciary risk and require fiduciary effort to understand. Research indicates that services can be acquired less expensively if separately negotiated. Though larger plans may benefit most from unbundling, the growth in DC plans as well as the number of new competitors in the market means the opportunity and benefits from unbundling apply to a larger population of plans. The introduction of single fund solutions (target retirement funds) and ETF’s make unbundled solutions more competitive in the smaller plan market as the need for investment education, materials and technical support diminishes. Providers who can provide competent recordkeeping and compliance at much lower prices can compete more effectively in a world where 401(k) investors make a single lifetime investment decision.

Plan fiduciaries should consider the economic present value of their 401(k)relationships, including their growing fiduciary liability, when selecting and negotiating product and service agreements with vendors. On the whole, the more rewarding the 401(k) business is for asset managers and service providers, the more exposure plan fiduciaries will have.


Anonymous Anonymous said...

Interesting, but let me comment on a couple of these assertions:

"Excluding actively managed investment opportunities represents a substantial opportunity to rationalize plan structure, minimize expenses and hidden costs and reduce sponsor risk and liability."

Perhaps. Conversely, indexed funds are much easier to evaluate and compare, because their objective is clearly defined, and virtually all the fund's performance variation away from its benchmark is attributable to either fees or lack of skill in indexing--or both. IMHO, a plan sponsor that selects the wrong index funds faces more liability than a plan sponsor that selects the wrong actively managed funds, simply because it is easier to demonstrate that the index fund was too expensive, or too inept. The actively managed fund may simply have been unlucky during the period under evaluation. See our article on evaluating index funds at

Mon Jan 22, 05:53:00 PM 2007  
Blogger Prudence Mann said...

Thank-you for your comment. The distinction you make between index funds and "structured asset class funds" is important and relevant as fundamental indexing and the expanding universe of ETFs are generally promoted as "indexing". The most important decision that Plan fiduciaries make relates to the asset classes they make avaialable. While many structured asset class funds/ETFS clearly do not represent what have been traditionally viewed as asset classes, there are many more whose classification is more ambiguous. Plan sponsors must recognize the former and explicitly evaluate the later or, as you point out, increase their fiduciary risk.

Tue Jan 23, 08:57:00 AM 2007  
Blogger David (fighting Goliath) said...

I completely agree that unbundling is the best solution for both sponsors and advisors (or at least for those advisors who truly want to aid participants)... nevertheless most advisors still push bundled products? It is simply because the sales process is easier or do they simply not understand the marketplace?

Thu Jan 25, 02:27:00 PM 2007  
Blogger Prudence Mann said...

I think it all depends on the advisors priorities and objectives. Unbundling takes more effort and makes costs more obvious for clients. Neither of these outcomes is very appealing to traditional plan gatekeepers. To many sponsors, change to a new service model implies more risk than staying put so inertia abounds.

Thanks for your thoughts

Thu Jan 25, 05:12:00 PM 2007  

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