When it settled fraud charges with the Securities and Exchange Commission last December, Alliance Capital Management agreed to cut its management fees by 20 percent over the next five years. Optimists in the business held out hope that this would be an isolated incident, but most executives braced for a rash of fee reductions.
Sure enough, the rollbacks soon began. In late January, Putnam Investments, which had earlier settled SEC charges of market timing, pledged to reduce its fees by $35 million a year. Shortly thereafter MFS Investment Management settled federal and state civil fraud charges, agreeing to pay $225 million in penalties and cut its management fees by $125 million over five years, or about 6 percent a year. Industry officials say that management fees will keep falling.
"It's going to be a game of follow-the-leader as more managers decide to lower fees," says Benjamin Brigeman, the senior vice president in charge of Charles Schwab & Co.'s employer services unit, which has $15 billion in assets under administration.
This bad news for mutual fund companies will be even worse for 401(k) providers, continuing a recent decline in profit margins and accelerating industry consolidation. As scandal-tarred funds slash their fees, other 401(k) providers -- insurers, brokers and funds not implicated in the scandals -- will feel compelled to match their cuts, slicing into their own revenues. Meanwhile, expenses are rising inexorably. Compliance with new, postscandal regulations on late trading and market timing increases the cost of managing and administering a 401(k). The inevitable result: Profit margins for 401(k) providers, which shrank from 15 percent in 2000 to 5 percent last year, will further decline. "We've already seen so much consolidation, but in the wake of the scandals, we're going to see even more," sums up Rhode Islandbased consultant Geoff Bobroff. He estimates that within five years the top ten providers will control 80 percent of industry assets; today 20 firms control about 85 percent of total assets.
The interdependence of mutual funds and the 401(k) business is striking. Most industry leaders are mutual fund families, which now account for 46 percent of all assets in defined contribution plans, according to Boston-based consulting firm Cerulli Associates. That's up from 36 percent in 1996 and just 9 percent in 1990. At the same time, defined contribution assets represent 16 percent of all mutual fund assets, up from 6 percent in 1990.
In the 401(k) business, it is investment management that delivers real profits, with margins of some 30 percent, while recordkeeping barely breaks even. For bundled providers, the recordkeeping and money management are handled by one company; in other instances, a stand-alone recordkeeper handles the paperwork while money managers take care of the portfolio.
Beyond the attractive margins, asset managers find an added appeal in defined contribution plans -- a reliable, steady cash flow. Since employers and employees make regular contributions year after year, 401(k) accounts are, in the industry jargon, very sticky assets.
"The defined contribution business remains very productive for us," says Richard Buoncore, CEO of $49 billion-in-assets Victory Capital Management, a subsidiary of KeyCorp. That's why Victory continues to handle the investment management of about $1 billion in defined-contribution-plan assets even though it sold its 401(k) recordkeeping business to Principal Financial Group in June 2002.
The fee structure of defined contribution plans illustrates why asset management is the more attractive line of business. Investment management fees average 120 basis points, with 100 basis points going to the money manager and 20 to the recordkeeper. The 12b-1 distribution fee averages 50 basis points, split evenly between the recordkeeper and a brokerage, if one is involved. The transfer agency fee, generally $5 or $10 per participant, goes to the recordkeeper.
Revenues are already under pressure because 401(k) assets significantly declined during the three-year bear market and have only partially recovered in the past year. According to Cerulli Associates, average 401(k) account balances fell from a peak of $38,450 in 1999 to about $27,000 by year-end 2002, then nudged up to $29,700 at the end of 2003. Cutting fees postscandal will only exacerbate the situation.
"Will it hurt the industry for fees to be lowered?" asks Ward Harris, founder and managing director of Emeryville, Californiabased McHenry Consulting Group. "Does it hurt to do sit-ups?"
Just who will feel the pain is still unclear, as recordkeepers and money managers have yet to determine how they'll divvy up a reduced fee. Industry observers expect that recordkeepers will fight hard -- and are likely to succeed in keeping their current share of management fees. "The fee cut will have to come out of the investment manager's share, except in the case of the largest investment managers, who may be able to negotiate some reduction in the recordkeeper's take," says Luis Fleites, a Cerulli consultant.
As reduced revenues squeeze margins, higher costs in meeting new administrative and regulatory burdens could really tighten the vise. Case in point: The SEC has proposed a "hard" 4:00 p.m. close for all mutual fund transactions. If that reform, designed to eliminate the possibility of late trading, is enacted, providers will have to revise their systems to meet the new deadline. That will certainly be an expensive undertaking.
"It's not just a matter of changing a table or two," says F. William McNabb, head of the 401(k) business at Vanguard Group. He estimates that money managers will spend "hundreds of millions of dollars" on a 4:00 p.m. close. Peter Smail, president of Fidelity Employer Services Co., agrees with that estimate. "But this is simply a matter of business development," he says. "While it may mean that we don't invest in a few other things, we are spreading these costs over the base of 10 million participants."
The paperwork hassles could increase administrative costs by as much as 20 percent, estimates consultant Bobroff. Schwab's Brigeman suggests that the 4:00 p.m. trading cutoff would mean that when a participant wants to rebalance a portfolio, the trades would settle over at least two days and maybe three. With a hard 4:00 p.m. close, 401(k) investors on the East Coast would have until 1:00 p.m. to place an order. Over the several days that trades settle, Brigeman says, 401(k) administrators will have to collect sweep fees -- both interest and transaction costs on short-term money market accounts.
Postscandal, 401(k) providers will face higher costs as they redouble their efforts to prevent investors from rapidly trading in and out of the funds in their plans. Industry observers anticipate growing business for firms that can help providers meet their new obligation to police market timers.
The 401(k) recordkeeping and administration business has long rewarded size, with providers serving more than 1 million participants enjoying meaningful economies of scale. These new cost burdens will only increase pressure on smaller players. The 20 defined contribution providers who control 85 percent of today's assets claimed only 68 percent as recently as 1999. The No 1. and No. 2 players in 401(k) administration have remained the same for some five years: Fidelity Investments is the market leader, with $403 billion in assets under administration (47 percent of that in its own funds) and 8.9 million participants; Hewitt Associates ranks second, with $187 billion in assets and about 5 million participants.
Last year three 401(k) providers, each with about 1 million participants, exited the business: Cigna Corp., purchased by Prudential Financial; Northern Trust Retirement Consulting, now owned by Hewitt; and PFPC Retirement Services, a PNC Financial unit that was bought by Wachovia Retirement Services. They all determined that retirement services was not one of their central businesses.
In early January, Wachovia picked up the defined contribution business of Bank of New York Co. Wachovia acquired BoNY's recordkeeping and trustee business, leaving marketing and servicing to BoNY. "It's true that our business will only get squeezed more," says Joseph Ready, director of Wachovia Retirement Services. "But scale for the sake of scale doesn't work. Acquisitions have to fit strategically."
As the pace of consolidation quickens, industry survivors will have to watch their step.