Paper profits

In the 401(k) business, investment management has always been the real gold-spinner, with providers earning operating margins of 30 percent or more. By contrast, recordkeepers, who handle the cumbersome paperwork for much lower fees, barely break even.

Traditionally, recordkeepers have had an especially tough time making money serving small companies, because the fees for providing services to, say, a couple dozen employees haven't been high enough to cover the fixed administrative costs. On the other hand, the large-company market is saturated; an estimated 97 percent already have 401(k)s in place. So 401(k) providers look for ways to make money in the small-plan market.

Several providers started in the payroll business and found that administering 401(k) plans, even to small employers, can prove rewarding.

Among them are two leading payroll processors -- Automatic Data Processing and Paychex -- as well as fund giant Fidelity Investments. Operating margins for these dual-purpose companies are about 35 percent, estimates David Farina, an analyst at William Blair & Co., a Chicago-based investment firm, while Fidelity touts payroll as one of its fastest-growing lines of business.

How do they do it? To begin with, the payroll processing specialists charge per-participant fees in lieu of, or in addition to, asset-based fees. They also enjoy economies of scale from their core businesses that easily translate to the tasks of handling 401(k)s for their mostly small-company clients. "Because we are leveraging our payroll business, it brings a new dynamic of savings to the 401(k) plan," explains Anthony Tortorella, who heads the marketing of retirement plan services for Rochester, New York­ based Paychex.

Payroll providers already have the data processing systems in place to handle the contributions to 401(k) plans. Fulfilling both functions is mostly a matter of tweaking those systems. In addition to issuing paychecks at regular intervals, the payroll company deducts the 401(k) contribution from each paycheck and adds the employer's share. The processor can use existing payroll data to check compliance with the IRS's nondiscrimination requirements. It's not much more work to create systems to keep track of investment returns, asset allocations, loans and withdrawals.

By using a single vendor for both payroll processing and 401(k) administration, a small company can more easily afford to set up a 401(k) program. For instance, a company with 50 employees might pay $4,500 a year for its payroll processing with Paychex, says Tortorella. Adding 401(k) recordkeeping would increase the cost by about $3,780 a year. Hiring a 401(k) recordkeeper who didn't handle payroll would cost anywhere from $1,750 to $3,750 a year (plus per-participant charges), depending on the complexity of the plan's design.

Fidelity, for its part, commands such a powerful technological infrastructure -- last year the Boston-based mutual fund company spent $2 billion, about 20 percent of revenues, on technology -- that it, too, can wring substantial economies of scale from its recordkeeping division. That business got a big boost last year when the firm acquired IBM Corp.'s European payroll operation, which handles about 540 companies with a total of roughly 12 million employees.

Until that purchase Fidelity had managed payroll operations for some 200 U.S.-based companies, the majority of which have fewer than 1,000 employees. Fidelity expects that total to increase about 45 percent this year. "Payroll is the fastest-growing part of our business," reports Peter Smail, president of the firm's employer services unit.

Paychex currently administers the largest number of plans with fewer than 100 employees -- about 29,500 -- and ADP is a close second with 29,160. Overall, ADP claims more than 30,700 defined-contribution-plan clients with a total of about 1.3 million participants, while Paychex, which serves only the small-plan market, has a total of 413,000 participants.

"We still have a huge marketplace to penetrate," contends Paychex's Tortorella, pointing not only to the company's 460,500 payroll clients who don't have 401(k) plans with Paychex but also to the 7 million U.S. companies with fewer than 100 employees that are Paychex's target market. Paychex deploys about 1,100 salespeople for payroll services and another 200 for retirement plan services. "We've sold more 401(k) plans each year through the market downturns," reports Tortorella. "There is huge pent-up demand in this niche."

Fidelity also has found tremendous growth in both small-plan recordkeeping and payroll services. The firm gradually broadened its menu of services through the 1990s, adding defined-benefit-plan administration, health and welfare administration and, finally, payroll. "These human resources functions are just not a core business for most companies," says Smail.

Does it make sense for other defined-contribution-plan providers to offer payroll services, not only as a profit center but as a way to bring in more assets for investment management? Several of Fidelity's chief competitors have considered and rejected the notion.

"We are focusing on investment management," reports Gerard Mullane, director of institutional sales for Vanguard Group. "We would rather remain among the best and let our clients find the best among the very good payroll providers out there."

New York Life Investment Management echoes that sentiment. Says Donald Salama, who heads up product development for the insurer's retirement services unit, "We'll stick to our knitting and stay out of the payroll business."

That's just fine with Fidelity and the payroll processors.