FOR INVESTMENT MANAGERS THE FAST-GROWING POTS of money in defined contribution plans have been like honey -- a steady flow of sticky funds with sweet margins. Total assets stand today at more than $4 trillion, up from next to nothing in 1981, when section 401(k) of the Internal Revenue Code launched the now-popular savings plans.
Managers of this huge pool of money are split into two camps. One offers only investment management services to plan sponsors. The other also does the lower-margin administration work -- tasks such as recordkeeping and mailing statements to beneficiaries -- as a way to build relationships with employers and improve its chances of gathering more of that honey.
In recent years the investment-only crowd has been gaining ground. These mostly institutional asset managers -- including such giants as AllianceBernstein, Barclays Global Investors and Pacific Investment Management Co. -- claim 40 percent of defined contribution assets, up from 34 percent in 2000, according to Waltham, Massachusettsbased consulting firm Chatham Partners. Meanwhile, firms that bundle plan administration with investment management -- mutual fund houses like Fidelity Investments, Vanguard Group and T. Rowe Price Group -- have seen their market share decline to 43 percent, from 48 percent in 2000. (The remaining defined contribution money is in company stock.)
But this trend appears to be petering out, as bundled providers take advantage of several favorable provisions in landmark pension legislation that took effect last year. The Pension Protection Act of 2006, which became law in August of that year, allows employers to automatically enroll employees in 401(k) plans and escalate employees' contributions. Most important, the new law (elements of which were not clarified until late October, when the Department of Labor issued interpretive rules) gives plan sponsors the authority to direct their employees' savings into new kinds of default investment options, including so-called target-date funds, that are riskier and more profitable for investment managers than were earlier default options, which consisted primarily of money market, stable-value and balanced funds.
These changes play squarely into the hands of the bundled 401(k) managers. The majority of target-date funds -- long-term portfolios that alter their asset allocations as employees near retirement, starting with an aggressive mix and progressing to safer, income-oriented investments -- are already offered by the bundlers. These firms also administer some 80 percent of all defined contribution assets, putting them in position to influence plan sponsors to choose their in-house target-date funds as default investment options for automatically enrolled employees.
By the end of 2006, 53 percent of plans with default investment options relied on some sort of targeted retirement fund, also known as life-cycle funds. That's a big change from traditional practice. As recently as 2003, 86 percent of plan sponsors with automatic deferrals chose among money market, stable-value and balanced funds, according to a survey by the Profit-Sharing/401(k) Council of America. And of the $129 billion in defined contribution assets now invested in target-date funds, 57 percent are with bundled providers, according to data from the Investment Company Institute and Chatham Partners.
"About 80 percent, even 90 percent, of defaults are now going into target-date retirement funds, and most of those funds are proprietary," says Susan Walton, a senior investment consultant at pension advisory firm Watson Wyatt Worldwide.
Many in the industry see the U.S. going the way of Australia, whose retirement system relies almost exclusively on defined contribution plans. In Australia most of the money contributed to retirement plans heads straight for asset allocation funds, similar to U.S. target-date vehicles. "This is what we will see in the U.S. five years from now," predicts Yariv Itah, a partner at Casey, Quirk & Associates, the Darien, Connecticutbased consulting firm.
Any advantage in the defined contribution market that bundled managers can gain by peddling proprietary target-date funds to clients is likely to be long lasting. The structure of target-date funds holds out the promise of retaining participants' assets longer. Fund choices are designed for the duration of an employee's career, with the mix of equities and bonds shifting gradually toward less risk as retirement approaches. These built-in adjustments may lead employees to hold on to the funds into retirement.
"Those assets are going to be incredibly sticky," sums up Vanguard institutional chief Jeffrey Molitor. About $10 billion of Vanguard's $240 billion in defined contribution assets are in proprietary target-date funds. Adds Ann Combs, a former assistant secretary of Labor who heads Vanguard's institutional strategic consulting group: "The 401(k) has evolved from being a supplementary savings vehicle to Americans' primary retirement plan, and defaults are going to be the dominant investments for retirement plans."
Vanguard and other retail fund houses came early to the game. T. Rowe Price, for one, brought its first target-date fund to market in 2002, and has since attracted $15 billion in defined contribution assets to such portfolios. Historically, bundled providers have dominated the management of defined contribution assets because they have been willing to bear the costs of administering the plans. Until the Pension Protection Act, the recent market share gains of investment-only players seemed to be rendering that strategy obsolete. Now administration relationships are once again proving more valuable.
Bundled providers' target-date funds typically include a straightforward mix of in-house equity and fixed-income funds, which shifts as the investor nears retirement. Beneficiaries investing in these portfolios generally aren't able to choose which underlying funds make up the target-date product. More recently, some bundled providers, like Fidelity, have begun giving clients the ability to choose which of its funds will be part of the target-date grouping. Charles Schwab & Co., another bundler, is offering truly open architecture, allowing sponsors to choose any funds, regardless of which firm manages them. Outside investment consultants often help employers make such selections.
Investment-only managers are hurriedly launching their own versions of these products in an effort to catch up. The competition between the investment-only and bundled providers will be "the marketing issue of 2008" in the defined contribution market, says Robert Wuelfing, executive director of the Society of Professional Asset-Managers and Record Keepers.
Institutional managers like AllianceBernstein, BGI and Pimco have been hawking life-cycle funds with more bells and whistles and with lower management fees. BGI, for instance, has just introduced what it calls an alpha portfolio, consisting of actively managed institutional funds. The firm also has an index-based global portfolio and a fund with an annuity component that provides guaranteed income for life to retirees. Its latest offerings have an all-in cost of about 85 basis points, whereas the first batch of target-date funds offered by bundled players averaged about 150 basis points.
"We're bringing the best of DB investing to DC plans," says Matthew Scanlan, head of Americas institutional business at BGI, one of the largest investment-only managers, with $188 billion in defined contribution assets.
RiverSource Investments, which claims $10.5 billion in 401(k) assets, launched several target-date funds in May 2006. Today those portfolios house about $220 million. Christopher Keating, who runs RiverSource's institutional business, says that institutional firms are marketing a new generation of life-cycle funds that give participants more choices than did the first generation of plain-vanilla funds that retail firms rolled out several years ago. Plan sponsors, he believes, are demanding "a better mousetrap," including improved pricing.
Investment-only managers are also drumming up more-exotic, riskier offerings. Among these are funds that rely on derivatives strategies, hedge funds and real estate investments. Some investment-only managers are creating target-date funds from collective trusts. Also known as institutional mutual funds, these trusts are much cheaper than retail mutual funds, with costs ranging from 10 to 50 basis points. Though not registered with the Securities and Exchange Commission, they must have a trustee, an investment manager or a plan sponsor who is a named fiduciary. AllianceBernstein, BGI and JPMorgan Asset Management all offer such trusts. Even Merrill Lynch Investment Managers, a big retail fund firm, is weighing collective trusts for its target-date product, says Joan Bozek, CIO of retirement services, who estimates that such funds may garner 20 percent of 401(k) assets by 2010. Merrill plans to roll out its version of target-date funds in the first quarter of 2008; BGI introduced its funds in October.
Many of the largest plan sponsors -- those with at least $1 billion in plan assets -- are hiring investment consultants to create target-date funds out of the investment options already offered by their plans. Investment-only firms stand to gain the most from these sophisticated clients, who will be seeking institutional pricing that bundlers have generally not offered. Sponsors interested in this type of target-date fund had been waiting for the regulators' new rules. But even with the late October announcement, one matter remains ill-defined: What, if any, additional fiduciary liabilities do plan sponsors assume when they structure their own customized target-date funds?
Whether investment-only managers can succeed depends on their ability to differentiate their products. Yet some doubt it will be possible to make meaningful comparisons among funds.
A dearth of reliable benchmarks has hurt the growth of unbundled target-date funds. Research firm Morningstar created three yardsticks for these products in March 2006: one for target dates ranging from 2000 to 2014; another for targets between 2015 and 2029; and a third for 2030 and beyond. But comparing life-cycle funds is difficult, as few have the three-year track record that many plan sponsors insist on. RiverSource's Keating acknowledges the need for a three-year record: "We are still very early in the adoption phase."
However, even with a three-year track record, it remains extremely challenging to compare the results of target-date funds offered by different firms. "Investment managers industrywide have not been able to agree on what should be in a given fund -- say, the one for people intending to retire in 2020," notes Merrill's Bozek. "It's hard to come up with a simplified benchmark."
The future growth in defined contribution assets lies among the nation's smallest employers, who have been slow to adopt 401(k) or other defined contribution plans. Half of the U.S. labor force is not covered by a retirement plan. But some 99 percent of the biggest employers -- those with more than 100 employees -- already offer 401(k) plans, leaving the uncovered workers primarily in small companies. To date, the economics of administering plans for companies with fewer than 100 employees have been unmanageable.
But with the provisions of the Pension Protection Act that are critical to defined contribution plans -- automatic enrollment and automatic escalation of contributions -- those small plans may begin to look more attractive to the recordkeepers. And Jeffrey Schutes, U.S. business leader at Mercer Investment Consulting, the large benefits consulting firm, points out that these smaller plan sponsors are the most likely to adopt their administrative vendors' investment options.
In addition to improving the economics of serving small plans, the two automated provisions of the new pension law will add momentum to the growth of target-date funds. Plan sponsors have been enrolling their employees automatically for several years. But the PPA lifted any lingering doubts about the safety and wisdom of this practice. The employees who are least apt to sign up for retirement plans are also the least likely to choose their own funds -- and therefore will land in the default investment, a target-date fund. And now those investors' contributions will increase like clockwork, up to the pretax ceiling of 6 percent of their salaries unless they say, "Stop."
It's no wonder defined contribution professionals have adopted a pet phrase for the new automated plan designs. With target-date funds as the default option, they say, automatic enrollment and automatic escalation can let beneficiaries "set it and forget it."