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Redefined contributions

It was a sweet ride while it lasted. Between 1990 and 2000 American workers piled into their employers' 401(k) retirement programs and then watched as stocks enjoyed their greatest run-up in U.S. history. Assets in 401(k) plans swelled from $300 billion to $1.69 trillion, and the size and profits of money managers expanded with them. Fidelity Investments, for one, saw its defined contribution assets increase from $20 billion to $346 billion during the 1990s.

But a three-year bear market in stocks, punctuated by spectacular 401(k) implosions at AOL Time Warner, Enron Corp., Global Crossing, Lucent Technologies and WorldCom, has shaken the whole 401(k) marketplace. By the end of 2002, assets had retreated nearly 14 percent from their 2000 high, to $1.46 trillion. (New contributions and a strong bond market prevented a much steeper drop.) Wary about the safety of their retirement nest eggs, employees are pulling back: Participation rates fell from 77 percent in 1999 to 73 percent at the end of 2002, says New York­based Buck Consultants, and many of the remaining participants are contributing less or shifting their money to lower-fee asset classes like fixed income. At the same time, some companies are eliminating their matching contributions.

The changed market conditions have hit defined contribution managers hard. Margins on their diminished assets have tumbled, from 13 percent in 2000 to just 5 percent this year, according to Sterling Resources, a Paramus, New Jersey­based consulting firm.

Seeing no signs of a quick reversal in these trends, 401(k) providers are searching for ways to mitigate their impact. "Everyone is looking for new markets and new products," says John (Jamie) Kalamarides, senior vice president of marketing and strategy at Cigna Retirement & Investment Services. Alex Sussman, national director of retirement practice at Segal Co., a New York­based consulting firm, concurs: "Providers are saying, 'We have a decrease in 401(k) assets, we have a decrease in participation -- we have to find a new market.'"

Some firms are tapping their skills to manage or administer other defined contribution­type plans, such as the fast-growing market for college savings accounts, where total assets have leaped to $28 billion from $4 billion in 2000. Then there's the market for executive retirement plans; assets are not reported in company filings but are estimated to total at least $20 billion. A third promising area is the management of stock option programs: Total vested unexercised options in the U.S. carry a putative value of $500 billion.

None of these new markets is a panacea. Their asset values will probably never equal those of 401(k) plans, and some of them will force managers to spend heavily for uncertain returns. Moreover, they are all getting more competitive. Still, they offer attractive opportunities. The average executive pension account is much bigger than a typical worker's 401(k), and right now margins are probably better. And stock option management could grow very quickly once equity markets revive.

Aside from replenishing assets, these new arenas offer defined contribution providers a chance to sell directly to plan participants -- something they can't do as 401(k) providers. This is a critical opportunity, because it gives the firms a better shot at winning rollover accounts, the $100 billion-plus that becomes available each year as 401(k) participants retire or change jobs. Currently, competition for these accounts is a free-for-all, with 401(k) providers holding on to just 20 to 25 percent of the assets, according to an estimate by Boston-based Cerulli Associates. With more baby boomers approaching retirement, rollover assets are expected to grow dramatically.

But providers will need new skills and marketing expertise to reach these sectors. In the marketplace for the college plans -- called 529 plans for the section of the Internal Revenue Code that took effect with the Small Business Jobs Protection Act of 1996 -- an asset manager must first win authorization from a state government; the plans are technically municipal trusts administered by states. And counseling executives on their retirement plans requires expertise in areas like tax law that far exceeds what's needed for the 401(k) market.

In their current straitened circumstances, however, asset managers are more willing than ever to put in the time and deal with the obstacles. "When you have an asset-based market like the 401(k) market and assets have been declining, fees decline," says Richard Koski, a principal at Buck Consultants. "That's why there's going to be even more of a push into areas that would have once been considered marginal."

THE 529 COLLEGE SAVINGS PLANS OFFER investors an effective way to save for tuition, room and board at any accredited college or university in the U.S. Since the Economic Growth and Tax Relief Reconciliation Act of 2001, earnings on these accounts accumulate tax-free; before that they were only tax-deferred. In addition, 24 states and the District of Columbia allow state income tax deductions for contributions to the plans.

Each state identifies at least one firm to manage and distribute its plan or plans, but because investors may join savings vehicles administered outside their home states, providers usually market them nationwide. States, however, often try to discourage residents from hopping to other states' plans by allowing tax breaks only for assets in their own programs or charging tax on money withdrawn and transferred out of state.

The longtime manager of college professors' pensions, TIAA-CREF, dominates the field with more than $3.9 billion in assets. Alliance Capital Management is No. 2 with $2.6 billion in assets, just ahead of Fidelity's $2.5 billion, according to Cerulli, which estimates that Putnam Investments and American Funds, with about $2 billion apiece, are roughly tied for fourth place.

Of course, college in most cases lasts a much shorter time than retirement and requires less savings. Currently, the average 529 balance is $6,500, versus more than $36,000 for a 401(k). Partly for that reason, Cerulli estimates that most fund managers still aren't making a profit in the market. Bruce Harrington, director of 529 plans at MFS Investment Management, which took on its first state program -- Oregon's -- only last August, figures that it will take the typical firm three to five years to break even.

Setting up a 529 plan is in part a political exercise, and it doesn't come cheap. When a state designates a financial services firm as its 529 plan provider, it usually extends a five-year contract. As part of the deal, the state will often stipulate that the winning firm make an annual marketing commitment ranging from tens of thousands to several million dollars. And most states levy a revenue-sharing fee that runs between 10 and 20 basis points of total 529 assets under management.

Now that most state plans have signed up with managers, competition centers on contract renewals. That's happening in New York, which with $1.7 billion has the largest plan in the country, overseen by TIAA-CREF. A new, seven-year contract is due to be awarded at the end of June; by late April 81 firms -- including AIM Investments, Citigroup Asset Management and Fidelity -- had signed up to offer a bid.

"New York is an important market. We would not be doing our job if we didn't look at it," says Tracey Esherick, executive vice president of corporate and employee services at Fidelity. But TIAA-CREF is fighting to defend its title, and industry insiders believe that it has a strong edge. Says a spokesman in the New York State Comptroller's office, "We've been very happy with TIAA."

EXECUTIVE RETIREMENT PLANS MADE HEADLINES in mid-April when workers at beleaguered American Airlines forced the resignation of CEO Donald Carty, incensed by the company's generous provisions for top management.

Most of these nonqualified plans -- so called because they don't follow ERISA's nondiscrimination rules and thus don't qualify for tax breaks -- don't prompt the furor that American's did. There's no question, however, that they hold substantial assets, estimated to total tens of billions of dollars. Because they tend to have fewer but bigger accounts, such plans are easier to service than a 401(k). One veteran recordkeeper, CharonECA of Doylestown, Pennsylvania, says its average account has $125,000. That's one reason why money managers like J.P. Morgan/American Century Retirement Plan Services and MassMutual Retirement Services assert that margins for the executive retirement market are equal to or even better than those for the 401(k) market.

Like pension funds, these plan portfolios are run by the company or its designated provider. Traditionally, insurance companies have managed the investments. Possibly the biggest defined contribution player in this market is Vanguard Group, whose assets have increased more than 200 percent in the past five years, to more than $5 billion. But more providers are going after these plans, even though they understand that the accounts demand a different kind of service than a traditional 401(k). Says E. Thomas Johnson Jr., head of marketing at MassMutual, which manages $60 million in nonqualified plans, "You've got to take account of the equity option, the bonus option, tax issues. It takes a while to develop the skill set."

CALL IT A RELIC OF THE LATE BULL MARKET: About 10 million Americans in roughly 4,000 company plans still hold stock options. Back in 1990 just 1 million did so, according to the National Center for Employee Ownership. Vested options are possibly worth as much as $500 billion, based on the estimated value if they were exercised today.

Administrators keep track of when the options vest and under what terms; they prepare the requisite annual and quarterly filings to the Securities and Exchange Commission. For this work, Fidelity, for one, charges a one-time implementation fee of about $15,000, depending on the size and complexity of the plan and how easily it can be integrated into the money manager's information technology infrastructure.

But the big payoff could come when options are exercised. There are the brokerage commissions derived from exercising the options -- typically, standard retail rates -- and, more significantly, the chance to manage this new wealth.

Brokerages have traditionally dominated the business, but fund families have been stepping up their efforts. Although Smith Barney Citigroup and Merrill Lynch are considered the market leaders, Fidelity entered the business two and a half years ago with some success: It now administers 74 plans serving 700,000 option holders.

Fidelity, like other defined contribution vendors, sees opportunity in the fact that only about 40 percent of company stock option plans are outsourced. "We see a real need for enhanced recordkeeping capabilities and enhanced reporting capabilities," says Esherick. "We can apply some of our defined contribution expertise." She won't reveal the value of options under Fidelity's administration, but she notes that profit margins in this field are "probably slightly less" than in 401(k)s.

Even though the option plan administrator may ultimately fail to keep any of the new assets under management, providers consider the effort well spent. "If we service these accounts really well," says Esherick, "the executives and the companies will want to give us more business over time." Like nonqualified retirement plans and college savings accounts, stock option administration represents new territory for defined contribution providers and the promise of some relief from the faltering 401(k) market.