Fees have been falling throughout most of the money management industry (glaring exception: hedge funds), but nowhere has the decline been more dramatic than in managed accounts for defined contribution plans.
In roughly the past three years, average fees have dropped as much as 50 percent, to 30 to 60 basis points; fees on retail managed accounts outside defined contribution plans, by contrast, have fallen 5 to 10 percent, to 100 to 200 basis points. Plan participants and retail customers pay the managed-account tariffs on top of fund management fees.
“Everybody’s cutting deals,” says Dano Bartolai, a principal at Dallas-based Affiliated Computer Service, a 401(k) service provider and parent company of Buck Consultants. “People are trying to grab market share.”
What explains the steep decline in 401(k) fees, but not retail fees? Although retail managed accounts have been around for more than a decade, they appeared in 401(k)-type plans just four years ago, and since then most major plan providers have begun offering them and often competing on price.
Better technology has made the administration of the accounts more efficient. For example, Christopher Jones, executive vice president of investment management at Financial Engines, an online financial advice provider that runs about $2.5 billion in managed accounts for 401(k) plans, reports that the cost of disc storage space “is coming down by a factor of two every 18 months,” even as the ability to create and manipulate databases improves.
Important, too, in the wake of the mutual fund scandals and the advent of fresh disclosure requirements, plan sponsors are increasingly demanding that plan providers give their employees a better deal on price. “Plan sponsors are extremely fee-sensitive,” Jones says.
The competition will only intensify if, as some industry watchers predict, employers use managed accounts as the automatic default option for their employees. That is, managed accounts would be the recipients of employee 401(k) contributions unless the employee made other choices. Proponents say these accounts are ideal for automatic enrollment, because third parties choose investments tailored to the employee’s financial situation and risk profile.
“Managed accounts are getting a lot of attention,” notes Stephen Deschenes, an executive vice president of Fidelity Institutional Retirement Services Co., which runs about $464 million in managed accounts out of $424.7 billion in total defined contribution assets under management.
In a sense, the popularity of these accounts threatens to become too much of a good thing for plan providers, because profit margins will come under pressure. According to consulting firm Sterling Resources, operating margins for full-service plan providers are running about 16 percent. That’s up significantly from 5 percent in 2003, but well below the asset management industry’s overall margins of 31 percent.
Still, as more employers demand managed accounts, plan providers will have no choice but to offer them. If they don’t, their rivals will. “It’s a matter of competition to retain customers,” says consultant Bartolai.
Managed accounts come in various forms, but all offer some personalized advice, which is what many investors -- retail fundholders and 401(k) participants alike -- demand. An adviser helps clients determine investment goals, establish asset allocations and choose investment vehicles. The adviser then monitors and rebalances their portfolios.
Managed accounts aimed at the average retail investor tend to include all the services in a single platform for one wrap fee, with mutual funds the preferred investment. Products aimed at an up-market demographic group -- an account minimum of $100,000 -- may cherry-pick among money managers and provide extra services, including sophisticated tax advice and personalized benchmarks.
Managed account fees have been pretty stable in the retail world for the past several years. Consider the data compiled by Boston-based consulting firm Cerulli Associates, which divides retail accounts into five different types. One of the most popular categories is labeled “mutual fund advisory” accounts, which Cerulli defines as “programs designed to systematically allocate investors’ assets across a wide range of mutual funds.” In 2001 the average annual fee for those accounts was 118 basis points; in the first quarter of this year, it was 116 basis points.
Retail vendors simply aren’t under the same kind of price pressure as their 401(k) counterparts. “Retail clients are looking for service and convenience,” says Robert Lee, a senior vice president at Keefe, Bruyette & Woods who follows this market. “Price considerations are not at the top of their list.”
Moreover, in both retail and institutional markets, fees often fall as a new industry consolidates, vendors figure out economies of scale and the field becomes established enough to draw in more competition. For the retail world, that has already happened. John Daly, a Greenwich, Connecticutbased independent consultant, says prices were more than 100 basis points higher about 20 years ago.
Until four years ago employers were leery of offering managed accounts to 401(k) holders because such accounts involved investment advice. Under ERISA, the 1974 statute that governs the retirement industry, employers have a fiduciary obligation to run retirement plans in the best interests of participants; companies understandably worried that if employees lost money after following the proffered advice, they as plan sponsors could be held liable.
But those concerns ended in December 2001 when the Department of Labor gave its blessing to managed accounts for defined contribution plans as long as the advice emanated from third parties independent of the investment managers.
Typically, the plan provider teams up with an independent advisory firm, such as Financial Engines, which then chooses the investments for participants from among the choices in the plan lineup. The independent advisory firm may or may not recommend some of the provider’s own funds. Usually, the advisory firm’s suggestions include some of the provider’s products, but they don’t typically dominate its recommended list.
The Profit Sharing/401(k) Council of America reports that 20 percent of the more than 1,000 companies it surveys offered managed accounts in 2004, up from 13.6 percent in 2002. And as plan sponsors have became more comfortable with managed accounts, increasing numbers of providers have moved in to service this niche. David Wray, president of the council, estimates that 401(k) managed-account vendors have doubled since 2001, to about a dozen.
The increase in vendors has put further pressure on fees. When the accounts first came out, Wray says, pricing evolved as it does with any new product: “People charge what they think the market will bear. Then as other people come in and competition spreads, the costs come down.” Financial Engines’ Jones notes: “When managed accounts were introduced to the 401(k) arena, some smaller plan providers offered programs with retail pricing. That is not holding, at least in the larger plan market.”
Consultant Bartolai suggests that one result of the fee pressure could be a consolidation among the ten or so small third-party advice firms. But no one expects the big plan providers to leave this expanding territory.
As managed accounts become more popular with employers, Bartolai predicts that one fifth to one third of all defined contribution plans will ultimately make managed accounts their default option. If managed accounts do become the default option in more plans, they will gain millions in assets. That’s the good news. The bad news: This could lead to even more pressure on fees.
“We could see fees drop -- again -- by a meaningful percentage,” predicts Jones.
What will cause that decline? Jones cites growing competition and providers’ ability to cut costs through economies of scale. In addition, consultants and employers will demand lower fees, arguing that it’s wrong to automatically put employee money into an investment option that tends to be relatively expensive because of the double layer of fees.
Defenders of the accounts counter that the advice is worth that extra helping of fees. “That additional fee might be the most appropriate way to get people to a better outcome,” contends Fidelity’s Deschenes.
In any case, backers of managed accounts say they are a more sensible default option than money market funds.
