The advice givers

Anxious employers are hiring third-party firms to tell employees how to save enough for retirement in their 401(k)s. Now Congress may open the advice game to plan providers.

“I haven’t looked at it,” confesses Neil Diamant, an associate professor of Asian studies at Dickinson College, “but I know what it’s going to tell me.” What he’s steadfastly ignoring is a personalized assessment of the state of his retirement plan that is newly available to him through his Pennsylvania liberal arts college’s defined contribution provider, TIAA-CREF.

“I’m not saving enough to retire,” Diamant, 39, says with a guilty shrug. “My wife is working too, but I’ve got two young children, and I just can’t afford to save any more.”

Along with most other defined contribution providers, the teachers’ pension manager has begun to offer plan participants like Diamant a custom-tailored appraisal of their progress, or lack thereof, toward adequate retirement savings. TIAA-CREF launched its program, in partnership with Ibbotson Associates, in December 2005. Most 401(k) participants, like the professor, pay such progress reports no mind.

Despite this lack of enthusiasm, worried employers and opportunistic money managers see providing sound saving and investment counsel -- mostly through a crop of third-party vendors -- as critical if employees are ever to properly feather their nest eggs.

Now, with companies such as Alcoa, IBM Corp. and Verizon Communications rushing to freeze defined benefit plans, employees are even more dependent on their 401(k)s. Says Lori Lucas, director of participant research at benefits consulting firm Hewitt Associates: “Sponsors are cutting back on defined benefit and retiree medical plans, making the 401(k) the primary retirement vehicle. Employees need to take ownership of their retirement responsibility.”

The need would seem to be glaring. When companies study their 401(k) plans, they find that a significant number of their employees are either not enrolled, enrolled but not contributing enough for the company to match them or insufficiently diversified in their investment choices.

To help plan sponsors counsel their wayward employees, defined contribution providers have been turning to a handful of firms known simply as “advice providers.” These specialized companies create personalized long-term investment strategies for participants -- but draw only on the investment products that are offered by the plan provider that hired them. Critically, the advice provider becomes a fiduciary to each plan that it serves.

Depending on the employer’s choice, participants access advice online or have it implemented for them via individual accounts managed by the advice provider.

The leading players: Chicago-based investment adviser Morningstar Associates, a division of Morningstar with roughly 9,500 participants and 800 plan sponsors under managed-account arrangements and more than 9 million participants online; Chicago-based Ibbotson, which Morningstar acquired in early March, with 185,000 participants and 6,700 sponsors in managed accounts; and Palo Alto, Californiabased Financial Engines, with 494,000 participants and $3.5 billion in managed accounts. Another advice provider is GuidedChoice of La Jolla, California, serving 58,500 participants through 2,500 sponsors both online and in managed accounts whose assets total $2.5 billion.

How often do employees take advantage of the proffered advice? Estimates range from 10 to 30 percent.

“It’s one thing to design an online service, and it’s another to get a lot of people to use it,” says Jeff Maggioncalda, president and CEO of Financial Engines. “Among our Fortune 500 clients, typically after a year, about 25 percent of participants are using the service.”

A 2001 survey by Hewitt found that 18 percent of large employers offered such advice; by last year that figure had jumped to 37 percent, with an additional 12 percent saying they intended to add it shortly.

Even as the advice market takes off, Congress may be poised to throw it wide-open by inviting plan providers -- now barred from directly offering 401(k) counsel because of conflict-of-interest concerns -- to proffer investment guidance.

The current third-party advice givers, working alongside plan providers, typically offer participants Web-based recommendations on saving and investing that they may adopt or disregard. The employer pays for the advice in about half of the deals; the rest are paid for by the plan or the participants, according to Hewitt’s industry surveys.

According to David Wray of the 401(k) Council of America, a trade group, it costs firms about $15 per participant to provide advice. The major expenses: software development and liability insurance to cover the advice provider in its role as plan fiduciary.

In some cases, participants can authorize advice providers to act as their financial advisers in setting up managed accounts for them within their 401(k)s. Here the advice firm chooses from the plan sponsor’s roster of investment products, putting together a lineup that is tailored to the participant; the advice provider receives a fee ranging from 40 to 100 basis points of account assets, paid for by the participant.

In their quantitative methods and their overall guidance -- lesson one is invariably “save more” -- the advisers’ models are fairly similar. They begin with the participant’s investment allocation, assets and salary-deferral rate. From that foundation they simulate many investment futures, demonstrating to the employee the likely range of income and assets that would be available for retirement. The models recommend how much to contribute toward their retirement goals and what level of investment risk to take along the way.

There is one notable distinction between the models of Financial Engines and GuidedChoice, on the one hand, and those of their rivals, on the other. Both GuidedChoice, whose advisers include Nobel laureate Harry Markowitz, and Financial Engines, founded in 1996 by Nobel laureate and Stanford University emeritus finance professor William Sharpe, create custom portfolios for each plan participant. Morningstar and Ibbotson, founded by Yale finance professor and indexing pioneer Roger Ibbotson, construct between five and ten model portfolios and recommend one to each participant.

Some providers contract with one adviser, while others offer their sponsors a choice of several advice firms. Employers often bring in advice firms to counsel participants when they first enroll in a 401(k) plan; they provide further advice in regular statements and again when an employee receives a bonus or a raise.

For all this, roughly half of corporate plan sponsors steer clear of offering their employees any advice whatsoever. Why? In most cases, because they’re worried about fiduciary liability.

Until 2001 most plan sponsors did not even consider offering advice to their 401(k) participants. That year the Department of Labor issued a rule interpretation known as “the SunAmerica ruling,” which offers sponsors partial protection against liability suits for investment advice that goes wrong. The decision strongly suggests, however, that although an employer is not responsible for the content of the advice, it is responsible for the selection of the independent adviser.

Although Financial Engines, Ibbotson and Morningstar had been selling their advice services on a modest scale to progressive companies and individual investors since the late 1990s, it wasn’t until the SunAmerica ruling that the advice business got off the ground. Though plan sponsors still fretted about liability, they felt more comfortable using independent advisers.

But not entirely comfortable. “There are still large sponsors whose legal departments won’t allow them to move on adding advice until Congress takes a position,” observes Cynthia Hayes, head of employer plan solutions for Merrill Lynch & Co.'s retirement unit.

Ever since the ruling the financial services industry has lobbied Congress to amend ERISA to explicitly include liability protection in defined contribution regulations. Several bills have been introduced over the years.

Now Congress is again debating legislation, part of the proposed Pension Protection Act, that would revise the advice provisions in ERISA. (Another key provision of the bill calls for accelerated funding for defined benefit plans, which many companies oppose.) A Senate bill would provide plan sponsors with a safe harbor for selecting an advice firm that is independent of the 401(k) plan provider and thus cannot earn fees based on the investments chosen.

The House bill, pushed by the new majority leader, Ohio Republican John Boehner, would give plan sponsors much more leeway in choosing advice providers. It would not require the advice firm to be independent of the provider. This would enable plan providers to offer advice that specifically recommends their own funds, as long as the relationship between the adviser and the 401(k) plan is clearly disclosed.

The House bill would likely weaken the competitive position of the current players, as their chief selling point -- their independence from plan providers -- would no longer carry the weight of a legal requirement.

The asset management industry generally, but not unanimously, favors the Boehner bill -- money managers, after all, would be able to more freely offer their products to plan participants. But T. Rowe Price Group, for one, believes that it can offer top-quality advice from a third party at a lower cost than it can offer the in-house variety.

Consumer advocates like AARP and the AFL-CIO endorse the arm’s-length advice called for in the Senate version. “There’s general agreement that advice to employees is a good thing,” says David Certner, legislative policy director for AARP. “But employers need to be comfortable in providing advice, and having no conflicts of interest is a critical component.”

Even if a new law allows providers to offer advice, employers may still be leery. “Sponsors clearly say that they want advice from an independent third party, not from the investment manager,” says Charles Vieth, president of T. Rowe’s retirement plan services unit. The Baltimore firm offers investment advice programs from both Financial Engines and Morningstar. So far Financial Engines serves 35,000 employees at nine firms; Morningstar advises 11,000 employees at 37 clients.

“You can split hairs over which advice company’s algorithm is better,” says Michael Henkel, president of Ibbotson. “But for people just starting out, illustrating how much you should save is at least as important as the investment advice.”

Of course, not even the best advice is likely to persuade some participants to change their behavior: to save more and invest more shrewdly. But the effort should still be made, says Brian Graff, executive director of the American Society of Pension Professionals & Actuaries, a trade association based in Arlington, Virginia.

“I see advice as a step along the way rather than the end of the evolution,” Graff says. “Large defined benefit plans have sophisticated money managers and consultants to help them with these decisions, yet we expect the average Jack and Jane to make these decisions on their own.”

Ten years from now, Graff expects, 20 percent of 401(k) participants will be willing to pay 50 basis points annually for customized advice. T. Rowe’s Vieth agrees with the 20 percent projection. “The industry is headed for a more automated solution in the form of automatic enrollment in managed accounts or life-cycle funds,” Vieth says.

For the Merrill Lynch 401(k) clients that have chosen to include advice in their plans, participants are offered counsel in three forms: a one-time investment strategy set at enrollment; a fixed strategy, which is rebalanced quarterly; and a discretionary managed account, known as Personal Manager, in which the advice is refreshed every quarter. Merrill wants to avoid any barriers to selecting advice, so it doesn’t charge for the discretionary account. “So far in our implementation, 80 percent of participants have chosen Personal Manager,” says head of employer plan solutions Hayes. “What we draw from this is more evidence that people simply want to be told what to do. They want to be accumulators of savings, but they don’t necessarily want to be investors.”