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Teachers' bet

Ex-Merrill Lynch president Herb Allison is rattling the teacups at TIAA-CREF as he confronts fierce competition in its once-secure college pension market.

First, TIAA-CREF aced the test. Then it dropped the class.

As the leading provider of retirement plans to colleges and universities, Teachers -- as TIAA-CREF is known around campus -- reasoned that it was perfectly positioned to manage 529 college savings programs established by the federal government in 1997. These state-administered plans allow families to set aside tax-deferred funds to pay for college expenses. When New York became the first state to put its 529 account up for bid, in 1998, TIAA-CREF's combination of low fees and established reputation won it the five-year mandate hands down. That was the first of 13 plans that Teachers snared on its way to building a commanding lead, amassing more than $4.6 billion in assets as of mid-2003 in the burgeoning 529 market.

But when Albany put its contract out for renewal last summer, TIAA-CREF did an odd thing: It announced that it would sharply raise its fee for managing the money from 60 basis points 75 basis points -- effectively taking itself out of the running. Sure enough, in July, New York awarded management of its plan to a consortium that includes Upromise Investments, Vanguard Group and Fleet Bank's Columbia Management Group. In the process TIAA-CREF ceded leadership of the college-savings-plan market to California-based American Funds, which manages $4 billion in 529 assets; after losing New York's $1.8 billion Teachers manages $2.8 billion.

But rather than go stand in the corner, TIAA-CREF can barely conceal its relief at having forfeited the New York account. "We lost money on the New York plan for five years, and we have an obligation to our participants not to produce losses indefinitely," declares Herbert Allison Jr., the former Merrill Lynch & Co. president who has been New York City­based Teachers' CEO since November 2002 (see box opposite). As other 529 contracts come up for renewal, TIAA-CREF may let them fall by the wayside, too.

The 60-year-old Allison's curriculum for TIAA-CREF is strictly business. He has already fired almost 600 of Teachers' 6,500 employees. In hard-nosed Wall Street fashion, he gave them an hour to pack up their belongings before they were escorted out of the building by security guards.

That kind of behavior has appalled many in the sherry-sipping crowd who traditionally worked at or invested with Teachers. "I think that was an error of judgment," says one TIAA-CREF board member. "It speaks of such a level of distrust that it is inappropriate because of the potential harm to the entire workforce. It's been hurtful to morale."

Critics lament Allison's "Merrillizing" of TIAA-CREF. After all, Teachers has long had the character of a genteel nonprofit. Founded by the Carnegie Foundation 85 years ago to provide affordable pensions to anyone involved in higher education, from deans to professors to janitors, Teachers viewed its enterprise as essentially a form of public service.

"I always felt that just being a wealth management company would be a major blunder," says Allison's predecessor at TIAA-CREF, John Biggs, 67, a former vice chancellor of St. Louis's Washington University. "Our basic mission is to serve all institutions in higher education."

Allison wouldn't quarrel with that, but he is fulfilling TIAA-CREF's modern mission in a blunt, businesslike way that has bruised egos, provoked controversy and -- very likely -- will save Teachers from a seemly but steady decline. He is waging his campaign, moreover, at a time when one mutual fund family after another is being dragged into the industry's widening scandals and Teachers' reputation for fair dealing has become an invaluable asset. Says Allison, "We are a company that has an impeccable record of integrity."

For decades TIAA-CREF enjoyed a virtual monopoly in offering its low-cost, no-frills retirement products to college and university employees. Teachers' assets of $300 billion (it ranks 22nd on Institutional Investor 's list of the top U.S. money managers) and 2.9 million individual participants attest to its dominance in the nonprofit retirement marketplace.

In recent years, however, competitors like Fidelity Investments and Vanguard have mounted a threat to Teachers' lock on the higher-education pensions that account for more than half of the approximately $500 billion 403(b) nonprofit retirement market. Like participants in corporate 401(k)s, employees of nonprofits typically allocate a percentage of their pretax salaries to the plans, while employers chip in contributions. Over the past five years, TIAA-CREF's share of the growing 403(b) market has stagnated at a still-dominant 55 percent. Meanwhile, Fidelity's has more than doubled, to 14 percent.

Allison's remedial program for TIAA-CREF calls not only for scaling back or shedding money-losers like the New York college plan but also for shifting Teachers' emphasis from products to customers and returning it to its roots as a money manager for employees of nonprofits.

"We're narrowing our focus back to what we've been doing for 85 years," Allison says. "We aim to set a new standard for financial services that is very customer-focused."

He contends that TIAA-CREF weakened its competitive position partly because it got off track after 1997, when it lost its tax exemption but gained the right to sell new products, such as the 529 plans and mutual funds, to the general public. This giddy new-product parade he says distracted management from its core customers and contributed to rising costs, he believes. Between 1998 and 2002 Teachers' pension expense ratio edged up from 38.7 basis points to 47.7.

Now Allison is investing in sales and marketing to raise Teachers' profile -- especially among its own customers. He plans to "significantly" boost the company's $25 million advertising budget. In November Teachers parted company with Ogilvy & Mather, which had handled its ad account for 17 years, and hired a Boston-based start-up named Modernista!, best known for its Hummer auto ads. Over the next 18 months, TIAA-CREF expects to open 22 offices in college markets around the country, doubling the current total. And Allison will spend $100 million this year, on top of Teachers' $250 million information technology budget, to upgrade client recordkeeping.

The goal: to more aggressively market Teachers' investment offerings to its nearly 3 million participants, particularly the most affluent among them. Some 10 percent of TIAA-CREF's clients are reckoned to have $1 million or more to invest. Allison envisions dispensing sophisticated financial advice to well-to-do participants to give them added incentive to keep their money with Teachers -- most critically, when they retire and roll their savings over into IRAs. TIAA-CREF also plans to ramp up its trust, estate-planning and philanthropic services.

Critics complain that catering to the better-off with special services conflicts with Teachers' traditionally egalitarian character. Biggs, for one, pointedly observes that on his watch "we wouldn't do special things for business schools or medical schools, where participants had higher incomes."

A history professor might note that in refocusing on college clients, Allison is merely reverting to the Teachers archetype that existed before Congress forced it to give up the tax-exempt status it had enjoyed since 1918. The 1997 law didn't change TIAA-CREF's identity as a nonprofit: Teachers is effectively owned by its plan participants, who are supposed to receive their "profits" in the form of lower fees and, therefore, higher investment returns. But elimination of the tax-exempt status opened up TIAA-CREF's higher-education market to real competition, because without the tax break, Teachers could no longer undercut the fees charged by commercial rivals like Fidelity. Of course one welcome side effect of the law was that it let Teachers peddle products to the public -- Fidelity clients, for instance -- for the first time.

Biggs, who was Teachers' CEO from 1993 to 2002, moved to take advantage of this heady new freedom (and, perhaps, allay the impact of fresh competition on Teachers' regular college business). In 1997, TIAA-CREF rolled out no fewer than six no-load mutual funds intended for the general public, including a growth fund, an international equity fund and a bond fund. But the retail venture failed to take off; the funds have pulled in only about $3.4 billion. Blame the bear market for some of that showing, but poor performance by TIAA-CREF's funds was also a factor. The $500 million growth fund, for example, returned an average annual ­3.18 percent for the five years through mid-December, compared with ­1.91 percent for the Standard & Poor's 500 index.

Biggs also avidly pursued the new 529 college savings plans, seeing this burgeoning market as a natural extension of TIAA-CREF's higher-education franchise. The only hitch was that for Teachers, as for nearly all 529 providers, managing college savings plans was and is a money-losing proposition because of the heavy marketing requirements imposed by the states as well as the relatively small size of individual accounts.

Still, Allison is not abandoning the 529 market willy-nilly. He plans to evaluate Teachers' 12 remaining state contracts on a case-by-case basis and dump them if they are perennial money-losers like the New York plan.

Allison is also taking a hard look at TIAA-CREF's overall product lineup. Teachers' assets continue to be concentrated in just two long-standing offerings: the TIAA Traditional Annuity, which currently holds $137 billion in U.S. bonds, and the CREF Stock Account, a variable annuity, which has $88 billion invested in global equities (80 percent U.S., 20 percent international). Together they represent three quarters of TIAA-CREF's assets. Both have decent returns for annuities.

The bond fund delivered a solid average annual return of 6.84 percent over the ten years ended September 30, versus 6.92 percent for the Lehman Brothers aggregate bond index; it boasts a five-star rating from Morningstar. The Stock Account has returned an average annual 8.34 percent a year over the same period, versus a 10 percent return for the S&P 500; it has a four-star rating.

Teachers' greatest marketing asset, however, may not be its sound long-term performance but its reputation for probity. Scott Evans, executive vice president in charge of CREF investments, notes, "The mutual fund scandals are having a negative effect on the public's confidence in capital markets, and we've had the benefit of not having conflicts of interest."

Allison announced last month that TIAA-CREF would strengthen its internal corporate governance by subjecting the CREF board to annual elections and convening meetings of independent trustees without management present. He has published revised corporate governance guidelines for the companies that TIAA-CREF invests in, calling for the annual election of board members and auditor independence.

Nevertheless, critics contend that Allison himself has compromised Teachers' authority as a corporate governance watchdog by drawing too generous a pay package: a $1 million base salary and a $3 million bonus for 2003 plus guaranteed long-term compensation of $4 million. In addition, the TIAA-CREF boss will receive a $1 million-a-year lifetime pension and a $24 million severance payment if he is dismissed without cause before November 2004. Teachers disclosed Allison's remuneration in November, just days after he had been named to an independent New York Stock Exchange board charged with avoiding the type of outlandish compensation that forced out NYSE chief Richard Grasso. He and former secretary of state Madeline Albright were the only previous members nominated to the new board.

Biggs, who received $5.1 million in total compensation in 2001, notes dryly that he had been offered an even richer pay package by Teachers' 21-person board, which consists of a mix of businesspeople and professors. "I said it wasn't right," he recalls. "My job was not comparable to Sandy Weill's."

Allison doesn't compare his responsibilities to those of the former Citigroup CEO, either. But the fact is that the Merrill veteran's pay packet, though handsome, is in line with those of chief executives of life insurance companies, although Teachers admittedly is a nonprofit.

A human resources director at a midsize university who has long been a TIAA-CREF participant puts the pay issue in perspective: "Allison's compensation seems to me a bit excessive -- he had better earn it."

The former Wall Streeter seems determined to do just that with his intense focus on the bottom line. That is a far cry from the company's early days. Indeed, TIAA-CREF began basically as a charity. In 1905 steel magnate Andrew Carnegie invested $15 million to establish the endowment of the Carnegie Foundation, which provided free pensions for college professors. Thirteen years later that foundation was reorganized into the Teachers Insurance and Annuity Association, a nonprofit stock life insurance company. Professors were asked to contribute to their own pensions. TIAA was in effect a pioneer of defined contribution plans.

Until 1952 Teachers provided nothing more than a single fixed annuity that invested solely in bonds. That year it added stocks to the mix, forming the College Retirement Equities Fund, which would provide participants with variable annuities. Now academics could invest their pension money in the stock market. Yet not until 1988, when it introduced a money market fund, did TIAA-CREF offer any alternative to the two annuities. Even so, that was enough for Teachers to dominate the 403(b) market -- such was the clout of its venerable name in the groves of academe.

In 1990, however, TIAA-CREF faced the first real challenge to its market supremacy: Under mounting pressure from plan participants, Teachers rewrote its rules so that they could pull out their assets and shift them to other providers; participants had been required to hold all their assets in TIAA-CREF funds until they retired, at which point the balances converted automatically into annuities. Fidelity, Vanguard and other rivals began to slowly but steadily sign up Teachers' customers.

That trend accelerated in 1997 when TIAA-CREF lost the competitive advantage that its tax-exempt status had provided. Biggs's diversification drive into mutual funds and other nonpension businesses failed to offset the damage.

So when Biggs announced his retirement in 2002, TIAA-CREF's trustees initiated a search for a successor who could deal decisively with the new competitive environment. "We had started to move but not gone very far," says trustee Bevis Longstreth, a retired partner of New York law firm Debevoise & Plimpton and a former commissioner of the Securities and Exchange Commission. "Strong leadership that moved us further and faster was called for." Says another trustee, "We wanted to bring the discipline of a for-profit to bear."

For Allison, running TIAA-CREF is the realization of a long-held ambition: to head a leading financial services company. His 28-year career at Merrill ended abruptly in July 1999 when then-CEO David Komansky forced him out. Both president and COO of the brokerage at the time, Allison had been one of a handful of candidates thought likely to succeed Komansky. Unfortunately for Allison, he earned the enmity of Merrill staffers and his own avuncular CEO with his cost-cutting zeal during and after the 1998 bond market meltdown: Allison laid off more than 3,400 of Merrill's employees that year.

Yet Allison had good reason to resent the manner of his own dismissal, after a long and largely distinguished career at the brokerage firm. The son of an FBI agent, he earned a BA in philosophy at Yale University in 1965. He served as an officer in the U.S. Navy for four years, including one year in Vietnam, before proceeding to Stanford University for his MBA. Joining Merrill in New York in 1971, Allison clambered up the corporate ladder in fits and starts. He was in Iran from 1973 to 1978 as deputy managing director of a Merrill joint venture called Iran Financial Services. Allison's wife, Simin, was born in Iran.

Returning to New York in 1978, just before the fall of the shah of Iran the following year, he became close to then-CEO Roger Birk and served as his assistant for two years. In 1980, Allison became a manager in the market planning department. Two years after Birk retired in 1984, Allison became head of human resources, where he remained until 1989. From then on newly named Merrill president Daniel Tully gave Allison a series of high-profile assignments in finance, investment banking and the corporate and institutional client group. As one of Tully's top deputies, Allison won praise for his intelligence, energy and single-minded devotion to Merrill's performance. As CFO in 1990 he created the initially loathed but eventually loved stock incentives that came to be called "Herbies."

"Herb played a huge part in Tully's success in terms of taking Merrill from a big lumbering firm with disastrous earnings to a competitor with Morgan Stanley and Goldman Sachs," says Jeffrey Peek, a former Merrill executive vice president who worked with Allison in the 1990s and is now president of the CIT Group, the commercial and consumer leasing firm.

Yet at the paternalistic (or maybe maternalistic) firm that employees laughingly but affectionately called "Mother Merrill," Allison's strictly by-the-book management style annoyed many staffers, and his detached, almost clinical manner came across as cold.

Even now Allison remains touchy about his Wall Street reputation as a ruthless cost-cutter. "I had a great career at Merrill, and I am not going to go back and try to explain anything that I did there," he says with some heat. "If people looked at my record at Merrill Lynch, they'd see that I actually grew business, and most importantly, I grew a lot of great people who later occupied very senior positions within the company." Chief among them: current Merrill CEO Stanley O'Neill, whose career Allison championed (and whose own cost-cutting skills are formidable).

Allison's restructuring of Teachers didn't spare senior management: Eight of the 16 executive vice presidents were either dismissed outright or took early retirement. Six of the nine members of Allison's top management team come from outside the company, including chief financial officer Elizabeth Monrad, a former CFO at General Re Corp., and executive vice president for risk management Erwin Martens, a former risk manager at Putnam Investments.

"I'm very optimistic that over the next 12 months, people will feel really energized," Allison says.

The next big challenge for Teachers is seizing a sizable share of the looming rollover of baby-boomer retirement assets into IRAs. The 401(k) and 403(b) accounts of those who retired or changed jobs totaled $155 billion last year, says consulting firm Cerulli Associates, and they could reach $468 billion by 2012.

Teachers starts with the advantage of a loyal client base: It manages to hold on to an average of 95 percent of so-called moving assets, compared with only about 40 percent for the average mutual fund. Of course, Teachers has a distinct edge in one respect: Its TIAA annuities can only be cashed out over ten years. Nevertheless, that involuntarily sticky money represents just over half of TIAA-CREF's total assets, so Teachers must be doing something right.

Still, Allison knows he has to do more to bind existing customers and entice new ones. Teachers plans to offer participants more funds from outside money managers. "We want to attract more household assets, and this is one way to do that," says Paul Van Heest, who heads up strategy and implementation for TIAA-CREF.

It was actually Biggs who made the first move toward open architecture in 2002, adding Vanguard's Explorer small-cap equity growth fund as well as microcap, emerging-markets and U.S. small-cap value funds from Dimensional Fund Advisors to Teachers' retirement plan roster. Allison intends to go much further. "We're going to offer the best products to our clients, whether we manufacture them or somebody else does," he says. Although he hasn't selected a full lineup yet, he says that it will definitely include a principal-protected fund.

In a turnabout, Teachers may pay brokers and financial advisers to sell TIAA-CREF products. "We're thinking about it," Allison says. "We've had many inquiries from companies that would like to sell our products."

By pulling in fresh assets, this arrangement could generate extra profits and thus benefit all of Teachers' plan participants. At the same time, shelling out money for outside distribution while keeping expense ratios low is a neat trick, as Allison well knows.

Some TIAA-CREF participants are hoping that Allison treads cautiously. "The question is how much room they have to expand services and also maintain their low cost structure," says Alan Crosman, director of human resources at Haverford College. "The jury will be out for a while."

As it also will be on Allison's other initiatives. Still, he deserves honors grades for shaking up TIAA-CREF. "Biggs had a religious belief that if Teachers had cheaper products, customers would come," says mutual fund consultant Burton Greenwald. "But that doesn't work in today's marketplace." And Teachers, unlike many of its participants, doesn't enjoy tenure.

Allison on retraining Teachers

Little more than a year into his tenure as CEO of TIAA-CREF, ex-Wall Streeter Herbert Allison Jr. is well on his way to transforming the once cozy, collegial pension shop into a nimble financial services company focused squarely on the bottom line. In his spacious office at the company's New York headquarters, Allison discussed his ambitions with Institutional Investor Senior Writer Deepak Gopinath.

What is your strategy for remaking TIAA-CREF?

Allison : We are going to be narrowing our focus back to what we've been doing for 85 years. We are facing more competition in our core market, so we need to reexamine our offerings and think about the needs of customers today, both the institutions and the individuals that we serve. We want closer relationships with our clients, and we want to increase our market share. I also want to preserve what's best about this place -- the values, the high integrity, the tradition of offering objective low-cost services.

How will you build closer relationships with your customers?

While our participants accord us an unmatched level of trust, at the same time, they aren't really aware, as much as they could be, of the range of products and services we already offer and how we might help them meet their overall financial needs. So they tend to have an outdated impression of what we are. One of the main objectives we have is to move closer to our clients. Build real relationships with individuals and closer relationships with the institutions.

Absent any changes, would market share have continued to decline?

It might well continue to decline. The only real stability for a corporation is to understand its clients really well, to be responsive to their needs, and that is what we are trying to do.

In the past, TIAA-CREF's philosophy was that if it had the best, cheapest product, the people would come. How is your view different?

We have to do more to acquaint people with the benefits of having a relationship with us. I am not sure they are fully aware of how our prices compare to others or how our returns over time net of fees compare to others. Or whether they know enough about our objectivity. We are a company that has no conflicts of interest, with an impeccable record of integrity, that prides itself on offering objective advice -- and very sophisticated advice as well. So we need to do more to reacquaint our core market with our capabilities.

Does this mean paying advisers?

We are still working on the issue of whether or not we are going to be paying financial advisers. We haven't yet come up with the criteria by which we will do that.

Will you be expanding third-party offerings for TIAA-CREF's participants?

We are going to be moving to an open architecture. We're going to offer the best products to our clients, whatever the source, whether we manufacture them or somebody else does.

Some TIAA-CREF employees and some outside observers fear that as the company focuses on its wealthier participants and bigger institutions, it may end up ignoring its smaller customers. What do you say to them?

Absolutely not. The fact is that more affluent institutions and more affluent individuals have different kinds of needs -- usually they are broader and they are more complex. Often they need more personal-type advice to select between many different products and services or solutions. People who have smaller asset balances tend to have simpler needs. They are looking for low- cost, high-quality service that is hard to find.

Do you see this as your chance to make a comeback after you lost out on becoming CEO of Merrill?

I don't think I have anything to come back from. I've had a great career, and I wouldn't change a bit of it.

Does your generous compensation package raise questions about TIAA-CREF's commitment to corporate governance?

None whatsoever. We are still fully committed to corporate governance.