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Doing the dirty work

Because of low margins, many firms fled recordkeeping. Now the few survivors find they can grab a bigger slice of the investment management fee.

Because of low margins, many firms fled recordkeeping. Now the few survivors find they can grab a bigger slice of the investment management fee.

By Jinny St. Goar
September 2001
Institutional Investor Magazine

In the 401(k) business, recordkeeping is capital intensive and low margin - a largely thankless task. As a result, many financial firms that initially thought this administrative chore was a necessary part of their 401(k) services have abandoned it. The most recent defections: In early March John Hancock Funds sold its 401(k) recordkeeping business to Universal Pensions, which in turn sold out to Bisys Group in early June. In May FleetBoston Financial Corp. sold its recordkeeping business to Invesco Retirement. The top five firms - CitiStreet (a joint venture of Citigroup and State Street Corp.), Fidelity Investments, Hewitt Associates, Merrill Lynch & Co. and Vanguard Group - claim a combined 43 percent market share, according to Cerulli Associates.

But lo and behold, the laws of supply and demand do prevail: The diminished ranks of recordkeepers - also known as administrators - have suddenly found they can push for a larger slice of the investment management fee they share with money managers. Though recordkeepers traditionally pocketed 25 basis points for administering equity funds, in the past year or so, some have been claiming 35 basis points.

"The power of their delivery channels combined with the mergers and acquisitions [among the administrators] mean that recordkeepers will be able to demand higher fees," says Geoffrey Bobroff, a Rhode Island-based consultant to the mutual fund industry.

They have a lot of catching up to do. Although the profitability of recordkeeping is closely guarded, Bobroff reports that ten years ago net margins ranged between 17 and 23 percent. "Now they're shrinking to the low teens or less," he says, mainly because of the substantial capital investment needed for computer hardware and software.

To boost compensation for recordkeepers without eating into their own margins, several mutual fund companies in recent months have launched new classes of shares, whose fees are used to pay the more assertive plan administrators. In March OppenheimerFunds launched its N class, targeting the retirement market with an extra 25 basis point fee; at the same time, American Funds brought out its F shares, with extra freight ranging from 3 to 11 basis points.

Although mutual fund families are not asking their current plan sponsor clients to shift to the more expensive shares, they are trying to market them to new prospects. "Mutual fund companies are trying to stanch the bleeding with these new classes," says Dano Bartolai, who heads defined contribution administration for PricewaterhouseCoopers.

So who's buying these more expensive shares? Mostly small companies that don't have the economic clout to negotiate better deals with plan providers.

The revised fee arrangements reflect the mutual fund industry's increasing dependence on the retirement market. In 2000 about one fifth of all mutual fund assets were held in retirement accounts, mainly in 401(k)s - up from only 6 percent in 1990, according to the Investment Company Institute.

In the 401(k) game revenue-sharing between money manager and recordkeeper has long been a work in progress. The first alliance was struck in 1991 between Hazlehurst & Associates, an Atlanta-based recordkeeper, since purchased by Northern Trust Corp., and Twentieth Century Investments, now known as American Century Investors. Mutual fund companies agreed to pay Hazlehurst between 10 and 15 basis points for fixed-income funds and 15 to 25 basis points for equity funds.

"Now 35 basis points is becoming more common, along with graded schedules," says Brian Ternoey, a consultant with Curcio Webb, a New Jersey-based consulting firm that works with plan sponsors on manager searches. Money managers are now looking to give recordkeepers more incentive to distribute their funds, offering, for example, 25 basis points on the first $5 million in assets, with an increase to 35 basis points on assets in excess of $5 million.

Not surprisingly, large-plan sponsors often balk at the new fees, while small companies can do little but grumble to themselves. "Different classes of shares simply have not been so successful in the large-plan markets," reports Andrew Adams, the chief operating officer of Northern Trust Retirement Consulting and the designer of the first revenue-sharing agreement between Hazlehurst and American Century.

A large money manager suspicious of the new fees is Kevin Breen, director of sales for Safeco Asset Management Co., which has $5.3 billion under management, about $1 billion of which is defined contribution assets. "We look very specifically at the direct link between services provided and the levels of revenue-sharing."

Defenders of the revised revenue-sharing arrangements point to their new services - like administering Internet access and self-directed brokerage options - as proof that they deserve a bigger share. "It's simply naive to think that these new services have nominal costs," says Robert Dughi, president of CitiStreet.

Some of these fees also represent a general acknowledgement that the marketplace has become more specialized. Fund companies that choose not to become bundled providers, thus avoiding the requisite investment in recordkeeping and administrative technology and personnel, have to pay someone else to do the job. "We recognized early on that we would do better as an investment-only manager rather than handling administrative tasks," says Mark Whiston, president of Janus Capital Corp.

Janus launched its Adviser class of shares - designed for the retirement services market and taxable investors - in the third quarter of 1997. "The real impetus was to be more user-friendly for revenue-sharing," explains Whiston. Although the firm's Aspen series has only a 25 basis point 12b-1 fee, the Adviser series has another 25 basis point fee for recordkeeping.

No mutual fund family has been hit harder by the tech stock meltdown than Janus, which has seen assets dive from more than $330 billion in March 2000 to $200 billion at the end of July 2001. Whereas Janus growth funds were an easy sell when the Nasdaq composite index was trading at about 5,000, these days the fund family needs all the help it can get to reel in retirement assets. Says one anonymous recordkeeper, "Janus is becoming more generous [in its revenue-sharing negotiations] because of the cash outflows."

"The increase in revenue-sharing offerings to 401(k) recordkeepers has nothing to do with our performance or the market's turbulence," counters Whiston. "The revenue-sharing really reflects the incredible growth in retirement plans and our need to earn and maintain shelf space with our distribution partners."

Not all mutual fund companies, however, have been eager to increase their fees to retain their access to the retirement services market. Consider Dodge & Cox, the San Francisco firm with $50 billion in assets under management. Of that, about $15 billion is in mutual funds, while the remainder is in institutional or individual assets. This 71-year-old firm sticks to its practice of rebating only 10 basis points to recordkeepers and administrators.

"We are simply not invited to participate in lots of searches because we don't pay the recordkeepers enough," says Gregory Serrurier, a portfolio manager at Dodge & Cox. The firm is prepared to forgo the asset gathering that has fueled the industry's growth, preferring instead to focus its services on existing clients.

But firms like Dodge & Cox have an advantage: an outstanding track record. This year the firm's flagship large-cap value fund was up 9.62 percent through August 2, 2001, while the Standard & Poor's 500 index was down 7.54 percent. For the 20 years ended July 31, the fund returned an average annual 16.8 percent, versus 15.27 percent for the S&P 500.

"Two recordkeepers have said that they cannot continue to distribute our funds," reports David Edwards, vice president for client services at Dodge & Cox, "but their clients have pressured them to keep offering us." Thus even if the money manager who runs the funds refuses to cough up more money for the recordkeeper, plan sponsors can still muscle their providers to offer their favorite mutual funds,

Aside from jucier fees, new technology is also giving recordkeepers a chance to bolster their profit margins. The National Securities Clearing Corp.'s defined contribution clearance and settlement service, launched in 1998, has cut costs dramatically. Consultant Bobroff reports that it now costs 25 basis points per transaction on the NSCC's new system, whereas for plan providers' proprietary systems the price tag usually ranges from 200 to 300 basis points.

True enough, but many recordkeepers are still wedded to their old technology. Consider the case of Unifi Network, the PricewaterhouseCoopers recordkeeping unit with close to $50 billion in assets under administration, one of the ten biggest recordkeepers in the business. "We still use our own trading desk," reports Bartolai. Although the NSCC's new platform does offer a "significant drop" in expenses, says Bartolai, it affects "less than 5 percent of our cost structure" because so little of his business goes through it.

In short, mutual fund companies will probably need to pay the shrinking pool of recordkeepers more for their services. That's no fun in a bear market.