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New economy 401(k)

Investors may shun their stocks, but defined-contribution-plan providers are pursuing technology start-ups as an outpost of growth in a mature market.

Investors may shun their stocks, but defined-contribution-plan providers are pursuing technology start-ups as an outpost of growth in a mature market.

By Jenny Anderson
November 2000
Institutional Investor Magazine

No one said growing up was easy.

In the winter of 1996, when Lycos was taking its first baby steps as an Internet start-up, the Waltham, Massachusetts­based company established a 401(k) plan for its 150 employees. The plan was simple: six core fund options, all managed by Fidelity Investments and administered by Brown Brothers Harriman & Co.

Then Lycos began to grow.

In 1998 it acquired four companies. In 1999 it picked up another four. Through October of this year, it added two more.

The acquisitions brought with them additional 401(k) plans, to be converted to the Lycos 401(k) or, if too large to be folded in, run by Lycos as a separate plan. Assets in the original Lycos 401(k) swelled from $2.2 million in 1998 to $5.4 million a year later, a combination of market appreciation and new investment. From late 1998 to early 2000, when Internet access provider Terra Networks agreed to acquire Lycos for about $12.5 billion in stock, the company added 500 employees and five different 401(k)s.

The plans were a mess. Employees were unable to access their account balances online -- at an Internet portal, of all places -- much less make fund transfers or take out loans over the Web. Only 40 to 45 percent of the company's workers even participated in the plans, versus an average of about 75 percent for all plan sponsors. And many of those who participated failed to receive their quarterly statements because of processing snafus.

Vanguard Group saw an opportunity. The Valley Forge, Pennsylvania­based mutual fund giant swept into Waltham with a Web-based presentation that focused on education, a critical necessity for a young company with a youthful workforce and low plan participation rates. Vanguard offered to streamline the enrollment process and allow participants to manage their 401(k)s in a paperless environment. They even offered online meetings to educate employees who were traveling or based in remote offices, an offer that resonated with a company that has employees everywhere from Miami to Mountain View, California.

Since Lycos was an attractive account, Vanguard was not alone in its pursuit. Fidelity also made a pitch to administer the plan, as did American Express Co., Scudder Kemper Investments and the original provider, Brown Brothers Harriman.

"It came down to who could handle our size as we go on to acquire more companies," says Stephanie Koch, a benefits specialist at Lycos, "and who can give us access to information 24-7. That's key."

Call it a happy marriage of convenience.

To plan providers, tech companies offer the increasingly rare prospect of an open, fast-growing market. Since 97 percent of all large companies (those with 5,000 or more employees) already have 401(k)s in place, providers understandably pursue the market for small (100 to 500 employees) and micro (under 100 employees) plans, where only 20 percent of all companies have set up a 401(k). Many small but fast-growing tech companies view a retirement plan as more than an employee benefit. They see it as a symbol of corporate stability and a much-needed complement to stock options, which now appear quite shaky.

"The technology market is one of the fastest-growing areas of employment in the U.S. We have to crack this nut because there are just not any more General Motors and Fords out there," says Lee Harbert, director of defined contribution business development at Barclays Global Investors, which manages 401(k) assets but is not a full-service provider.

According to Karen Clark, director of corporate human resources at Red Hat, a 550-person Linux software company based in Durham, North Carolina, 401(k) providers are anything but shy about trying to crack that nut. "We probably get one 401(k) call a week or every two weeks," she says. "In the two years I've been here, it hasn't slowed down."

Says Vanguard's William McNabb, managing director of the institutional investor group: "Historically, we have focused on companies with 1,000 employees or more. But in the past three years, we've made a more concerted effort to go below that. We look around for companies that will grow. A company may only have 50 people and $5 million in assets, but in ten years it could be the next Intel."

Or the next bankruptcy case. According to Forrester Group, more than half of today's dot-com start-ups will be gone by 2001. (Morgan Stanley Dean Witter examined 1,501 technology IPOs from 1980 to 2000 in its Technology & Internet Yearbook and found that 8 percent had gone bankrupt or been delisted, recapitalized or liquidated and an additional 23 percent had been acquired.)

These are real risks for 401(k) providers. Says Christopher Blair, national sales manager for the Schwab Plan, Charles Schwab & Co.'s bundled 401(k): "If we're the provider and a company is acquired, we've made a major investment in a relationship. It's a risk, and a reasonable one, but it is higher in the technology arena."

Since a full-service 401(k) plan does not break even on a participant's account until the balance hits $30,000 or $40,000, providers are often left with a loss when a start-up shuts down.

"Will start-ups turn out to be economical clients?" asks Vanguard CEO Jack Brennan. "The math in our business is easy: You need critical mass and attractive account balance size."

The recent decline in Nasdaq -- down about 20 percent for the year, with many Internet stocks off 80 or 90 percent from their highs -- helps providers make their sales pitch. That's because the swoon in tech stock options means that employers need to offer old-fashioned benefits like a 401(k) plan (along with a good dollop of cash) to attract and retain their top workers.

"The whole marketplace is focusing on profitability now," says Bruce Carlisle, founder and CEO of SF Interactive, a San Francisco­based online advertising firm with about 170 employees. "One of the ways you can get people to think about profits is to share profits with them. 401(k)s provide a mechanism for that." Recruiters find that employees want to be reassured that a company intends to survive an extended shakeout -- and what better sign of endurance than a retirement plan? "A 401(k) symbolizes longevity," says Mike Thompson, founder and CEO of bulldog "Potential employees want to see that we have invested in the infrastructure of the company, and that means human resources infrastructure as well."

Red Hat's Clark concurs, "As a start-up becomes more of a real company, a 401(k) makes you more attractive to professionals in their 30s."

When a provider signs on to set up a 401(k), certain initial costs come with the territory. Typically, for a small plan, a provider absorbs basic start-up costs of $6,500 to $8,000. If a company goes out of business or is acquired before a plan breaks even, the provider's initial investment may be wiped out.

Not surprisingly, the firms making the biggest push for this new business are the large established providers who can afford to take the extra risk. They are the usual suspects: Fidelity, Schwab and Vanguard -- although Vanguard CEO Brennan points out that "this is a tougher business. We're attracted to the market in a disciplined way."

Still, even small-fry 401(k) providers keep rolling the dice, in part because tech company employees earn better-than-average salaries. According to Prudential Securities, in 1997 information technology firms paid annual wages that were 78 percent higher than the average for all private industry. That's good news for providers because higher-paid workers more frequently participate in 401(k) plans. In a Fidelity study, 86 percent of workers who earned between $50,000 and $100,000 a year contributed to a 401(k), versus 70 percent of those who made $20,000 to $50,000.

To lower their costs and bolster their margins as they pursue the small-plan market, providers work the Web. When Fidelity introduced its e401(k) product in October 1999, it first targeted tech companies. "Our original focus was companies that had access to the Internet and were looking for a low-cost solution. It's a market that's very underserved," says Peter Smail, president of Fidelity Employer Services Co.

Providers know that for many of these small companies, implementing and running a plan can be both expensive and labor-intensive. "It's a ton of work," says Douglas Manchester, founder and CEO of Emplanet, a Web-based 401(k) provider. "Coordination, payroll, tracking and processing loans, enrollment materials. The list is huge."

Products like Fidelity's e401(k) attempt to ease that burden by doing all the work -- plan design, enrollment, education, information processing -- online. Instead of lengthy enrollment meetings, participants can attend virtual seminars and sign up over the Web. So far it has been a hit: The company expected to recruit 400 companies in 2000; it will more than double that number.

Schwab likes to do instant polling during enrollment meetings, asking questions like, How many people use a self-directed brokerage account? The provider can then use the results of the poll to do a Web-based campaign.

Plan sponsors benefit as well. Instead of having to muck through mounds of paper, companies can do their tax reporting and nondiscrimination testing online. "We're talking about running a business at half the cost. You pass that on," says Emplanet's Manchester, who spent ten years at Fidelity.

Although Fidelity's e401(k) costs about half as much as a regular corporate Fidelity plan, Manchester argues that the expense of implementing a plan for a 100-person company through Emplanet is zero. Of course, when Emplanet waives its fees, it must make up for the loss elsewhere in the plan, typically through revenue-sharing agreements with mutual funds.

In addition, the plan sponsor working with Emplanet should have an employee base that is totally comfortable online -- all the time. Otherwise, employees start calling Emplanet, and the disappearing costs suddenly start reappearing.

Predictably, each of the major providers chasing this market bases its claim to leadership on its technological prowess. Providers tout their systems integration and their ability to efficiently automate their plans. But in making their sales pitches, providers do not try to sell
cutting-edge technology for its own sake. Rather, they explain how the bells and whistles can both save money and provide employees with greater control over their retirement plans. Schwab's Blair says that when he meets with plan sponsors, "the desire to have more investor flexibility comes through loud and clear."

Says Vanguard's Brennan, "We're essentially a tech company that runs money." Adds Fidelity's Smail: "Tech companies want to know if a provider offers the latest and greatest technology. They are very interested in our Internet capabilities."

In taking on a small-plan sponsor, Fidelity and company are also betting that their new client will grow up -- fast. Says Vanguard's McNabb: "On the surface you are looking at a less profitable business in the small-plan market. But the proposition is: What do you think the company's prospects are? Will it buy other companies? Will it grow? You can make some judgments along those lines."

In the summer of 1998, when Merrill Lynch & Co. won the 401(k) business of a telecommunications start-up called Global Crossing, the plan had just $145,000. Two years later it had $6.5 million in its 401(k). "New companies hire new employees who can transfer balances or roll them over. They can grow very quickly," says Alan Kizor, senior director of institutional sales and marketing at Merrill.

"These companies are growing like crazy," says Manchester & Co. "They are higher risk because many of them won't survive. But the ones that do will turn into very significant clients."

The prospect of an army of Intels-in-training is tempting. But many providers are well advised to look but not touch: Start-ups often demand the same close attention and service as their big-company brethren, while generating a far smaller revenue stream.

"Technology companies are very demanding," says Fidelity's Smail. "They are looking for a lot of flexibility in the delivery of services. They want a provider who moves as fast as they do."

Though there are no statistics available, tech companies usually offer an especially wide range of investment choices that typically includes a self-directed brokerage option. Of the 550 bundled plans that Schwab offers, more than half include a self-directed brokerage option. For companies with mostly professional employees (including technology), that figure is more than 70 percent. More than 25 percent of Schwab's new business in 2000 has come from technology companies.

Often, too, small high-tech companies match their employees' contributions not with scarce cash but with company stock. This means fewer dollars will be invested in a group of funds, and asset management fees will be reduced. Says Michael Littenberg, partner and head of the Internet and new media group at Schulte, Roth & Zable, a New York law firm: "Start-ups are focused on raising capital -- that's their seminal event. They don't pay as much attention to benefits and compensation."

Sometimes providers must give their tech company plan participants a crash course in the power of compound interest and the importance of saving for retirement beginning in one's 20s. For workers weaned on tales of IPO bonanzas, this can be a tough sell, even if many of the dot-com paper fortunes have shriveled beyond recognition.

Says a 32-year-old former employee of an Internet company who now works for a venture capital firm: "401(k)s in the New Economy? Are you kidding? We are all looking to get bought out or go public. We have a magic number. When we hit it, we retire. That money will not be coming from our 401(k)."

Vanguard's McNabb has heard it all before. "The challenge of the whole business is education," he says. "People think they are going to earn their way out by making a fabulous fortune. That's why we always hammer away at the basics. You hit the lottery? Great. Diversify your assets and have a great life. But even at technology companies, how many people are going to become dot-com millionaires?"

While no one tracks the investing patterns of tech-savvy investors, anecdotal evidence suggests that they share a penchant for higher-risk funds. Certainly, in both New Economy and Old Economy industries, younger workers tend to be less risk-averse than their senior colleagues, which is, of course, appropriate. According to a January 2000 report by the Employee Benefits Research Institute, individuals in their 20s invest 62.1 percent of their 401(k) in equity, versus 40 percent for those in their 60s.

At Lycos, says benefits specialist Koch, every employee participating in the company's 401(k) has some money in one of the plan's three most aggressive funds -- Janus Overseas, RS Emerging Growth and T. Rowe Price Midcap Growth. At excite@home almost 60 percent of the company's $37 million in 401(k) assets are invested in growth or high-tech funds. "Our employees are in the technology business, and they want to invest in it," says Barbara Oshima, director of benefits.

At the end of the day, the tech-savviest provider will probably enjoy an edge in winning new tech company 401(k)s. Although SF Interactive opted for Transamerica as its provider, in part because its headquarters is across the street, bulldog re-'s Thompson went with Fidelity because he wanted to make sure he was acting as a responsible fiduciary. "Two things were paramount to my decision: Was I providing the best options for our people? Was I protected? I wanted a blue-chip plan," Thompson explains.

It probably didn't hurt that Fidelity executives had invested in Bulldog (albeit not through Fidelity).

And then there's Lycos. It liked Vanguard's persistence, respected its technological know-how and appreciated the fact that Vanguard scanned the Lycos logo onto every page of its presentation.

In the 401(k) game, it's the little things that count.