High rollers

On a 475-acre corporate campus on Chicago’s North Side, 15,000 people work for drug manufacturer Abbott Laboratories. Each year 1,200 walk off the leafy site for good, either because they are retiring or because they are changing jobs. When they leave they take with them 401(k) balances averaging $165,000.

Down the road the local Ramada Inn hosts regular financial planning seminars for the staff of Abbott and other local employers. Among the sponsors of those seminars are brokers from Merrill Lynch & Co. and Morgan Stanley -- all hoping to persuade the departing employees to turn their retirement accounts into rollover IRAs with their firms. Says David Tyrie, director of retirement services at Putnam Investments, which administers Abbott’s retirement plan, “Of course, we are eager to hang on to those assets rolling out of Abbott accounts.” Yet he estimates that his firm keeps just one out of three dollars.

The remaining two? Some go to rival mutual fund companies and insurers, and some go to brokerages in town. In downtown Chicago, Smith Barney broker William Easom reports, “My revenues are growing by 20 percent each year.” His entire book of business -- $1 billion in assets under management -- comes from rollover accounts.

Call it the Rollover Rumble. Brokerages, mutual fund companies and other 401(k) providers are fighting both to hold on to the 401(k) accounts they manage and to snare accounts from rival firms -- grabbing the substantial savings of retirees and the smaller but still attractive assets of job changers.

No market is more important to the money management industry. Morgan Stanley equity analyst Christopher Meyer estimates that $20 trillion will move out of defined contribution plans between 2001 and 2046, with the pace picking up significantly in 2025. “It’s the single largest pool of money expected to move in the next few years,” he says.

For the moment, at least, brokerages are gaining the upper hand. This year, estimates Stamford, Connecticutbased consulting firm Brightwork Partners, retirees and job changers will pull $380 billion out of defined contribution plans. In 2001 that total was $290 billion.

What happens to all those assets? Of the departing $380 billion, 52 percent, or $198 billion, will move into rollover IRAs. About 30 percent will stay in the employer’s defined contribution plan -- many companies allow retirees to keep their retirement accounts in the company 401(k) until the participant and the surviving spouse die -- and about 20 percent will be cashed out or converted into annuities.

Mutual fund companies have the most to gain or lose when that 401(k) money moves, because they dominate the $2.7 trillion defined contribution market, commanding a 44 percent market share, versus just 7 percent for broker-dealers. (Recordkeepers, insurers and banks share the rest.)

The losses are painful. According to Brightwork, the average provider retention rate -- the proportion of assets in defined contribution plans that a provider continues to manage after those assets leave the employer’s plan -- fell from 29 percent in 2001 to 21 percent at year-end 2004. (In calculating the rate, Brightwork does not count assets that remain in the plan when the employer offers a departing employee that option.)

Changes in the IRA market strongly suggest that brokerages are gaining an edge over mutual fund providers in the rollover race. Between 1999 and the end of 2004, mutual fund firms’ share of total IRA assets fell from 48 percent to 43 percent, while brokerages’ share increased from 36 percent to 40 percent.

“With baby boomers in the early stages of transitioning from work life to their next phase, we’ve been focusing on the work site,” says Abu Arif, vice president of marketing strategy and retail retirement at Ameriprise Financial, the financial adviser unit spun off from American Express in October.

“Brokers and financial advisers have woken up to the fact that the rollover market is one of the best places to find reasonably wealthy people concentrated in one place,” notes Louis Harvey, founder and president of Dalbar, a Boston-based consulting firm that tracks the brokerage industry.

Acknowledging the importance of financial advisers, in part in retaining and snaring rollover assets, fund behemoth Fidelity Investments -- the country’s largest 401(k) provider, with $424.6 billion in defined contribution assets under management-- increased its network of financial advisers from 1,400 at year-end 2004 to 1,600 in late October 2005.

The rollover market will only get bigger as contributions increase and market appreciation boosts the asset base.

Baby boomers, born between 1946 and 1964, comprise 60 percent of the participants in defined contribution plans, but they own more than 80 percent of the assets. About 700,000 baby boomers will retire each year between 2005 and 2010. That number will rise to a projected 1.35 million annually from 2010 to 2015, according to Julia Lynn Coronado, who leads the retirement research program at consulting firm Watson Wyatt Worldwide.

Morgan Stanley’s Meyer forecasts that rollover IRAs will account for 7.3 percent of wire house and regional brokerage revenues by 2010. Currently, they contribute 1.9 percent.

Mutual fund companies have become more and more dependent on 401(k) assets. In 1994 defined-contribution-plan accounts comprised 14.8 percent of total fund assets. By 2004 that had grown to 19.5 percent. As more of those assets roll over in coming years, the hit to mutual fund companies could be severe.

“The rollover threat is looming,” notes Peter Demmer, CEO of Sterling Resources, a Paramus, New Jersey, consulting firm. “A few older plans -- those with gray demographics and large account balances concentrated among those now retiring -- have already started to turn in negative cash flow” -- that is, their assets have started to shrink. “The big question is when 50 percent or more of plans will reach that stage -- will it be in 2010 or 2013?”

But those assets are not disappearing into thin air.

LPL Financial Services, with 6,000 financial advisers, reeled in $7 billion in rollover assets during the 12 months ended August 2005, up from $5 billion in the preceding 12 months. “We expect that growth rate to continue, if not pick up steam,” says Jonathan Eaton, LPL’s senior vice president for product marketing.

At Putnam Investments, says Tyrie, “we had retention rates of 40 percent in 2001. Now it’s slipped back to about 30 percent.” During the bear market, Tyrie believes, people were looking for more-personal advice about their investments -- a need that brokers have met especially well.

Dennis Joppe, president of First Mutual Investment Management in Grand Rapids, Michigan, says his firm has $160 million in assets under management, almost all of it from rollovers. The business has been growing 18 to 22 percent annually for the past five years, Joppe explains. Most of the assets come from people who are three to five years from retirement.

“The strongest link in our business is our dedication to meeting with our clients at least every six months, preferably once a quarter,” says Joppe. He has noticed a slight step-up in mutual fund companies’ efforts to keep the rollovers -- more service, more contact and increased automation -- in the past two years. “But my clients are choosing us over a mutual fund company thousands of miles away -- and a clerk to whom they might talk to once on the phone but wouldn’t be able to find again,” he says.

Dino Capitani heads a team of four Merrill Lynch brokers in the Chicago suburb of Oakbrook, Illinois. Capitani credits his relationships with four large local employers -- Abbott Laboratories, Borg Warner, Illinois Tool Works and William Wrigley Jr. Co. -- with generating most of his rollover business, which these days represents about 75 percent of his new inflows. “Among rollover accounts, about 90 percent are retirees and 10 percent are from layoffs or job switchers,” he says.

Of course, in the rollover race not all brokerages are flourishing and not all mutual fund firms are struggling. Fidelity, T. Rowe Price Group and Vanguard Group are all powerful players; they claim retention rates higher than the industry average, though they decline to be more specific. Among brokerages, whose executives are equally reluctant to provide details, Merrill Lynch, Morgan Stanley and Citigroup’s Smith Barney, as well as strong regional firms like Edward Jones, McDonald & Co. and Raymond James Financial, are leading competitors.

“During the late 1990s, when the mutual fund firms were boosting their retention rates, they were capturing the low-hanging fruit,” notes Ron Bush, managing director and co-founder of Brightwork. “Then the retail asset gatherers began to step up their efforts.”

Among insurers, Des Moines, Iowabased Principal Financial Group, with $40.9 billion in defined contribution assets under management, reports that it retains 54 percent of the assets moving out of its clients’ defined contribution plans. But unlike Brightwork, Principal counts assets that have been left in the plan as part of its retention rate.

Charles Schwab & Co., which does not count assets that remain in plans toward its retention rate, says it holds on to between 40 and 45 percent of departing defined contribution assets. Patricia Cox, chief operating officer for the firm’s retirement plan services unit, credits the company’s open architecture and adviser network: “Most rollover business is driven by consultants or financial advisers who are part of the Schwab Advisor Network, with their assets custodied at Schwab.”

Merrill Lynch similarly leverages its relations with its brokers. James McCarthy, Merrill’s first vice president of retirement and education solutions, did a 15-month stint at Fidelity as a senior vice president focusing on retirement products before returning to Merrill in 2001 to oversee a reorganization of the firm’s approach to the retirement market. Merrill now has a common wholesaling force for both its small defined contribution plans and its IRAs (both rollover and regular IRAs); in the past, 401(k)s had been handled by the institutional division and IRAs by the retail division. “In early 2003 the firm decided to make retirement services a centerpiece of our growth strategy, in terms of both staffing and other resources,” notes McCarthy.

Some of the brokerages most successful at snaring retiree assets are affiliated with banks, largely because they benefit from the banks’ trust and estate departments. “Look at Citigroup’s Smith Barney and Wachovia’s recent purchase of Prudential Securities’ brokerage. Both shops are doing well with rollovers,” notes Morgan Stanley’s Meyer. “In the next few years, because of the impetus of the rollover market as well as the intergenerational transfer of wealth that’s on the horizon, we’re going to see traditional retail brokerage firms looking to acquire trust and estate planning capabilities.”

Rollovers are a fast-growing market, but a fragmented one. In contrast, the defined contribution market has a very strong No. 1: Fidelity, which boasts a 29 percent share. The No. 2 firm, Hewitt Associates, a pure recordkeeper, has a 14.6 percent share, and No. 3 Vanguard claims an 8 percent share.

“Rollovers are the dream of any business planner, a huge and unconsolidated market,” says Paul Scibetta, who heads the defined contribution business for J.P. Morgan Asset Management, which reports $20 billion in defined contribution assets under management.

Although baby boomers are the most visible symbol of the rollover market, job changers are an increasingly significant force. This year some 6.1 million people, about 4 percent of the U.S. workforce, are expected to switch jobs, compared with about 1.2 million employees who will retire. Job changers will be pulling $175 billion out of their defined contribution plans, versus $205 billion for retirees.

As job mobility increases in coming years and more of the baby boom generation hits retirement, more assets will exit defined contribution plans. Watson Wyatt’s Coronado predicts that 401(k) providers will see between 20 and 25 percent of their assets exit defined contribution plans by 2010 -- that’s on a gross, not net, basis -- up from about 10 percent today.

To hold on to those valuable accounts, providers have a number of tools in their kits: They can educate plan participants about prudent retirement strategies; they can make sure that the institutional staffers who handle the 401(k) business work closely with the retail divisions that usually manage rollover IRAs; and, as many now do, they can use advertising to strengthen their identities as retirement brands, encouraging employees to choose them as their retirement managers.

But legal constraints make it especially tough for current 401(k) plan providers -- whether they be mutual fund families, insurers or brokerages -- to keep the assets they manage after people retire or change jobs. At the same time, the law gives rival firms an opportunity to snare the rollover IRAs. Because mutual fund families control the majority of defined contribution assets, brokerages especially enjoy that outsider advantage.

The legal constraints date to 1974, when Congress passed ERISA, which, among other things, limits the extent to which plan providers may communicate with participants. They may educate participants about investment strategies for retirement but must be careful not to cross a line into the realm of “self-dealing.” For instance, a provider might suggest that a 62-year-old move 60 percent of his rollover IRA into income funds, but it must not tout its own bond fund.

Most critically, providers may not solicit plan participants without permission from the plan sponsor. That’s because the sponsor, as plan fiduciary, could be held responsible for a poor choice of investment manager. A firm that is not the plan provider -- an outside broker, say -- has no such responsibility.

In addition to their edge as outsiders, brokerages have been especially effective at focusing on high-ticket retirees and job changers. Of the 6.58 million annual rollovers, 9 percent, or 592,200, account for 62 percent of the $380 billion in play, according to Brightwork.

Some brokerages have struck explicit rollover deals with defined contribution providers. Raymond James and McDonald Financial benefit from one such arrangement with insurer Principal. By law, rollover agreements cannot be mandatory or enforceable in any way. Nevertheless, within the limits of ERISA, Principal urges its plan sponsor clients to encourage their employees to consider directing their 401(k) balances into a Raymond James or a McDonald Financial rollover IRA.

Why doesn’t the insurer prefer that the employees open Principal rollover IRAs? It wants to make sure that the two brokerages, which deliver small and midsize 401(k)s to it for a fee, are not put at a disadvantage when plan participants exit an employer’s 401(k). “You wouldn’t want asset-retention efforts to be so aggressive that you are competing with the people who are bringing assets to you initially,” explains Hugh O’Toole, Principal’s vice president for work site solutions. In other words, Principal does not want to bite the hand that feeds it.

There’s another reason brokerages are gaining ground: the gradual growth of third-party administrators, such as Hewitt Associates and CitiStreet, that handle 401(k) recordkeeping but do no investment management. Their market share of 401(k) plan assets has increased over the past decade, from 15 percent in 1995 to 20 percent in 2005. Third-party administrators by definition cannot take on rollover accounts, and many of their departing participants are moving to brokerages.

Notes Ellen Breslow, Smith Barney’s managing director for wealth and retirement planning, “We have contractual agreements with third-party administrators, making clear that our financial consultants are the owners of the relationship with the plan sponsor.” It works like this: When a Smith Barney financial consultant signs up a 401(k) plan and brings it to the third-party administrator, the consultant collects commissions off the plan during its “accumulation” phase, while the participants are still active in the workplace. When participants retire, they are referred to a Smith Barney consultant.

If the original referring broker only works with institutional clients -- plan sponsors -- rather than individuals, the retiring participants are referred to a different Smith Barney broker. At some brokerages, when such a referral is made, the institutional broker retains a claim -- as much as 25 percent annually -- on the revenue stream generated by the retail referral for three years.

One of the mutual fund companies that are giving brokerages a run for their money, Vanguard does especially well with its higher-income participants. Although he won’t provide details, James Norris, head of Vanguard’s institutional group, says that his firm holds on to more than the industry average of 21 percent of 401(k) assets. Among Vanguard’s participants with 401(k) balances that exceed $100,000, some 20 percent have a retail relationship with Vanguard. Vanguard can approach high-balance 401(k) account holders who have a retail relationship with the firm, since ERISA constraints don’t apply in this case. Within that subgroup, notes Norris, “our retention rate is virtually 100 percent.”

Small defined contribution accounts, of course, are often money-losing propositions for plan providers. But because small accounts were the ones most likely to be cashed out when withdrawn from a plan -- employers could either keep the money in the company plan or cash the accounts out when departing participants made no choice -- Congress mandated a change, which took effect in March 2005. As one of the rules promulgated by the Economic Growth and Tax Relief Reconciliation Act of 2001, Congress required that employers must move 401(k) accounts of $1,000 to $5,000 into an IRA if the participant does not choose another option. Employers move the funds into traditional IRAs with the current plan provider, known as the “safe harbor” provider.

Big or small, defined contribution accounts have never been particularly profitable for most plan providers. Sterling Resources estimates that operating margins for full-service providers have recovered to 16 percent (from a penurious 5 percent in 2003). But that’s still meager beside the money management industry’s overall margins of 31 percent. Sterling’s Demmer says that full-service plan providers with less than $10 billion in assets face an especially tough challenge. “You have to be really nimble to make a profit on less than $10 billion in assets. It’s rare,” he says.

The smaller players are thus at high risk from an outflow of rollover assets. “This will only accelerate the industry consolidation that we’ve been watching for years,” contends Demmer.