Shake, rattle and rollover

Providers of 401(k)s are losing tens of billions of dollars annually - just when these accounts become most profitable.

By Jenny Anderson
March 2001
Institutional Investor Magazine

It's a swift, painful goodbye.

Financial services companies that administer and manage 401(k) plans spend years patiently helping workers build up their retirement savings, devoting no small amount of time and money to the cause. Then, just when the nest egg is about to hatch, the workers fly the coop, moving their funds to rival asset managers.

There's a lot of money in motion. Industry experts estimate that perhaps $250 billion will be pulled from these accounts in 2001 as employees switch jobs or reach retirement age. Cerulli Associates estimates that 18 percent of the money is simply taken as cash, while a small percentage follows workers to their new company's plan. But the bulk of the money - nearly two thirds - shifts into rollover IRAs.

That's sensible planning, of course: Retirees need to manage their money as carefully as ever. But for investment houses, it's an enormous challenge to keep the money from rolling over and right on out the door to a competitor, taking with it a bonanza in future profits. Most firms are not doing a particularly good job, and some are doing an utterly wretched job of retaining retirement assets. Cerulli estimates that 401(k) providers hold on to just 19 percent of all rollover assets.

"By and large," says Robert Gordon, co-chairman of Banc of America Capital Management, "the industry has not been successful at retaining these assets."

Call it the rollover crisis. And it's only going to get worse. Because the bulk of the money switching managers comes from retirees, it's the biggest, most lucrative accounts that are leaving firms. And that pool of money is rapidly growing, as the baby boom's creakiest representatives turn 55 this year. In the wake of an unprecedented bull market that transformed many middle managers into 40l(k) millionaires, more accounts than ever, and vastly more assets, will soon be up for grabs.

Not surprisingly, 401(k) providers are pulling out the stops to hold on to their assets, but they face ever-fiercer competition from rival money managers, brokerage firms, banks and insurers, all of whom want to snap up these plum accounts. The irony is that just as workers near retirement and start to receive cold calls from aggressive brokers, the 40l(k) providers are hobbled by regulations that restrict their ability to market directly to plan participants.

"Many 401(k) providers have invested a ton of money in creating a recordkeeping platform with the expectation and hope that they would control the 401(k) assets for a long time. They expected that those assets would be converted to retail accounts. But in fact that is not happening," says Lisa Baird, a consultant at Cerulli and co-author of the firm's 2000 study on the rollover market.

Retention rates vary widely, but some of the best-known retail firms, including Charles Schwab & Co. and Vanguard Group, have rates of 40 percent and above. The biggest losers tend to be those that are not primarily thought of as investment managers. Banks and insurance companies, for example, retain only about 5 percent of their assets. But the fact remains that even the most successful companies are losing 60 percent of their most lucrative accounts - and that's nobody's idea of a good time.

"This is a serious problem," says Paul Heller, head of the full-service defined contribution division at Vanguard, which keeps 40 percent of its 401(k) assets in new rollover IRAs. "When we lose a person retiring, he is replaced by a new employee. The average balance for the lost employee is probably about $150,000. The average balance for the new worker may be $2,000."

Rollover IRAs are simply more profitable to manage than 40l(k)s. According to Sanford C. Bernstein & Co., money managers in 1999 earned net income of $3.8 billion managing $2.4 trillion in total IRA assets, half of which was rollover money. By contrast, they earned just $300 million managing $1.7 trillion of 40l(k) money. That gap reflects the enormous costs of running 40l(k) plans. "Servicing the IRA market is easier," says Jag Alexeyev, a senior analyst at New York-based consulting firm Strategic Insight. "There are no costs associated with administration and recordkeeping, no tax reporting or nondiscrimination testing. Dollar for dollar, an IRA is much more profitable than a 401(k)."

The winners in the battle to control these honeypots are broker-dealers, which claim about 40 percent of rollover assets, according to San Francisco-based Spectrum Group. Mutual funds take 17 percent, while banks get 10 percent and insurers receive 15 percent. The rollovers are a boon for brokerage houses, which currently control just 11 percent of the 401(k) market versus the 50 percent share held by mutual funds and 11 percent controlled by banks.

Some firms that abandoned the 401(k) business in recent years because profits all but disappeared have jumped back into the market, hoping to roll up some rollover assets. Banc of America Capital Management last year linked up with Diversified Investment Advisors. After stepping out of the mid- and large-plan 401(k) market five years ago (BofA was then known as NationsBank), the bank rejoined the industry as a full-service provider, with Diversified providing recordkeeping and administration services as of the end of last year.

"I wish we were further along in 401(k) business," says BofA's Gordon. "But in the rollover market, there's a poor record of retention, and I don't think we're late there."

Ten or 15 years ago, when plan providers effortlessly signed up new corporate clients and plan assets were just beginning to take off, providers could afford to let some of the rollovers roll away. But today, when 97 percent of all large companies have 401(k)s in place and growth in contributions has slowed, from a 19 percent rate from 1995-'96 to only 8 percent between 1999 and last year, the game has decidedly changed. Retaining assets when they roll over and snatching accounts from rival providers are now urgent tasks.

"The 401(k) market is mature," says John Doyle, vice president of marketing and communication for retirement plan services at T. Rowe Price. "The real cash flow growth is in rollovers."

As the 401(k) market has matured, it's grown increasingly competitive and concentrated. These days the top three full-service providers - they perform low-margin recordkeeping and administrative services as well as asset management - control more than 40 percent of what the industry calls "addressable" assets. (These are assets other than company stock.) Profit margins have narrowed as providers cut their management fees and offer back-office services at little more than cost.

The recent move to so-called open architecture, in which providers offer competitors' products as well as their own, further squeezes margins. In 1992 full-service providers controlled 95 percent of a sponsor's offerings; today that share stands at 77 percent.

As a result, firms are doing what they can to hold on to this money. Their main tools are intensive education of workers, which involves convincing job changers and others not to pull their money out early; increased advertising and brand burnishing; and better efforts to coordinate actions internally. At many firms, for example, the rollover IRAs have been handled as retail accounts while the 40l(k)s have been treated as institutional business.

In their campaign to win rollover assets, providers usually begin with a tutorial in retirement savings, explaining to uninformed employees that if a 401(k) account is cashed out before the participant turns 591/2 years old, the entire balance is taxed as ordinary income. There is also an early withdrawal penalty of 10 percent. If an account is rolled over into another 401(k) or IRA within 60 days, there is no tax liability.

Remarkably, though, an estimated 54 percent of all participants take a lump-sum payment when they close out their 401(k)s, despite tax penalties, although collectively these people own less than 20 percent of the assets that leave 401(k)s.

According to a survey conducted by Hewitt Associates last year, two thirds of participants who left a 401(k) cashed out their accounts. Another recent survey, conducted by consultants Basset, Fleming and Rodrigues, reported that only 28 percent of participants in a group of 401(k)s invested their distributions in a rollover account, although the 28 percent represented 56 percent of the plans' total assets.

For many in the retirement business, the newfound attention to rollovers represents a fundamental change in focus. "Ten years ago the [idea] was to get people to accumulate wealth," says James Phalen, CEO of CitiStreet, a joint venture between State Street Corp. and Citigroup. "Now you have people who have contributed to their 401(k) for 20 years, and you've had great equity markets. You've had the wealth accumulation, and, all of a sudden, the distribution phase has become very important." CitiStreet now offers a best-of-breed IRA, which it cobrands with CSFBDirect. In addition, when a plan participant requests to speak to a financial adviser, CitiStreet refers him to a Salomon Smith Barney representative who will get back to him within two days. CitiStreet dubs the process the "warm transfer."

As providers attempt to hang on to these rollovers, they must walk a fine line. The statutes that govern defined contribution plans stipulate that sponsors or their providers may educate participants about retirement strategies. But the investment education cannot be seen as "self-dealing." So, for example, a provider might suggest that a 28-year-old employee who is changing jobs move 30 percent of his rollover IRA into growth funds, but it may not market its own particular aggressive growth fund to him.

Most significantly, providers may not solicit 401(k) participants - though they naturally know quite a bit about them - without permission from the plan sponsor. When they do approach employees, they must be careful to respect the regulations outlined by ERISA. Ultimately, it is the employer, in its role as plan fiduciary, that could be held accountable for the choice of investment manager.

Many providers find they must educate and lobby plan sponsors to prevent employees from making hasty or ill-advised decisions to cash out. "We say to the sponsors, 'You have to stop the insanity,'" says Ray Martin, president of CitiStreet Advisors, which administers $200 billion in defined contribution plans held by 5 million participants. "How do we stop unnecessary taxation? It's bleeding 40 to 50 percent of the assets."

Of course, although providers must be restrained in their marketing presentations, outside brokers and financial advisers face no such strictures. Their typical sales pitch to a customer thinking about opening a rollover IRA is quite direct: Let us manage your complete retirement plan. Research shows that the pitch is more effective when it comes from an adviser already working with a participant. (According to a 2000 Merrill Lynch & Co. study of its 401(k) participants, 35 to 40 percent used a financial adviser).

In pitching to rollover customers, providers try to cover all the bases. With permission from plan sponsors, they host retirement seminars at the employer's offices; they produce handsomely designed brochures and information kits. On their Web sites many firms feature retirement calculators that incorporate personal data to project an employee's ideal retirement needs. Vanguard recently developed a collaborative browsing technology, a sort of high-tech hand-holding that enables a customer service representative to work with a customer online.

Providers make every effort to target employees well before they are scheduled to retire. In the past year every plan participant served by Fidelity Investments who is over the age of 55 has received a 16-page retirement brochure, "Retirement Assessment Guide." Fidelity has also begun the practice of "outbound calling." With the employer's permission Fidelity representatives call participants within 60 days of a rollover deadline and encourage employees to direct their assets Fidelity's way.

In choosing rollover IRAs, cost is not a critical concern to most employees. Fidelity, Vanguard and T. Rowe Price will waive their fees, from $10 to $25 per year, for customers whose 401(k)s they had previously managed (or for high account balances). But industry experts report that most employees choose an IRA money manager because they feel that their financial interests will be well served; cost is a less critical concern.

While prices do not vary dramatically, investment options do. American Century Investments, Fidelity, T. Rowe Price, Charles Schwab and Vanguard all offer open architecture in their rollover IRAs, allowing customers to invest in a wide range of mutual funds and investment products. Rollover IRAs from MFS Retirement Services and Franklin Templeton Investments offer only proprietary products. "The average person will find plenty of choice at MFS," says Bruce Harrington, an assistant vice president and IRA product manager at MFS.

Of course, all firms, including most recently Schwab, focus much of their sales effort on rich retirees. That's because 3 percent of lump sum distributions exceed $100,000, and the fight to win those rollover accounts is fierce. In January Schwab launched the Personal Rollover Assistant, an advanced hand-holding and advisory service for Signature Service clients and individuals rolling over more than $100,000.

"The individual 401(k) account balance has grown to a point where it exceeds the value of an individual's home. We want to help people with the rollover process," says Benjamin Brigemen, senior vice president of Schwab Retirement Plan Services.

Principal Financial Group, a Des Moines, Iowa-based insurer, approaches the rollover market with its own, successfully quirky product, a sort of quasi-IRA known as the PRA, or Principal Retirement Account. When an employee retires or changes jobs, he can move his 401(k) account into this tax-deferred retirement vehicle, which provides the same investment choices as his old company plan. Like a 401(k) but unlike a rollover IRA, the PRA allows an employee to take out a loan against it. Daniel Houston, Principal's senior vice president for retirement and investment services, reports that the PRA is a key reason the insurer boasts of an unusually high retention rate of 48 percent.

Even as they fight to keep their own 401(k) assets, providers scheme to lure accounts from their rivals, with some firms offering bounties to brokers who bring in rollover accounts. MFS pays finders' fees of about 1 percent to brokers who deliver new rollover assets.

In the hopes of increasing sales of IRA products from $1.8 billion in 2000 to $2.8 billion this year, MFS last year launched a marketing campaign aimed at distributors that includes Webcast videos about the company's IRA products. It also set up a hotline for its brokers to consult with its IRA specialists.

"We've spent the last six months building out our IRA products," says Harrington. Still, he concedes, MFS faces the same sobering obstacle that confronts many institutional asset managers, banks and insurers: For the average retail customer, the firm has no identity as a money manager. "People don't know that they can stay with us when they open a rollover account," Harrington says.

Some providers find that they must also break down the traditional barriers between institutional and retail sales and marketing. Typically, firms define 401(k)s as institutional products and rollovers as retail products. Until recently, at most firms those divisions were kept separate.

"The key to being successful is having institutional and retail groups that work closely together," says Joe LoRusso, president of Fidelity Institutional Retirement Services Co. "It always surprises me that firms are not further along [in bringing them together]."

Fidelity learned that lesson by trial and error. It set up an independent retail division for its rollover business in 1998 and shut it down less than a year later. Today Fidelity's 401(k) and rollover groups operate together under the Retirement Services banner.

Of course, Fidelity can afford the occasional stumble, since its brand name is so strong. And as the fight for rollover assets intensifies, it seems a safe bet that retail brands will become even more powerful. "At the end of the day," says the CEO of one 401(k) provider, "people are going to say, 'I want to invest my money with an investment company.'"