Last January 1, Lear Corp., a $6 billion (in revenues) manufacturer of automotive interiors, in Southfield, Michigan, radically overhauled the structure of its 401(k) plans. Lear had three different plans as a result of acquisitions, and each was overseen by a different 401(k) service provider. But each provider handled all aspects of the plan it oversaw, including investment management, record-keeping, and trustee services.
Today, the three plans have been merged into one. But different providers handle different services. Record keeping for the plan is done by The Kwasha Lipton Group, the consulting arm of Coopers & Lybrand LLP. Wachovia Bank NA of Winston-Salem, North Carolina, is the trustee. And the plan's seven mutual funds are managed by five different fund families.
Why the big change at Lear? "We felt we had outgrown our original bundled arrangement, and we were getting an outcry from our employees to provide more diversity among investment options," says Michael P. Miller, Lear's vice president of global compensation and benefits.
Lear is far from alone, say consultants. "There's definitely more unbundling of 401(k) [services] going on today," insists Timothy Murphy, a 401(k) consultant at Hewitt Associates LLC, a human- relations consulting firm in Lincolnshire, Illinois.
Most sponsors aren't going as far as Lear. They are merely adding funds from other families. One example is Price Waterhouse LLP, the accounting and consulting firm, which for years has used Delaware Investment & Retirement Services Inc., an investment management firm in Philadelphia, to run its bundled plan. "They did our record keeping, and with the exception of a couple of GICs [guaranteed investment contracts], we used only their investment options," says Riggs Griffith, managing director of benefits administration and planning.
So what convinced Griffith to tweak that arrangement? "We wanted to give our employees a spectrum of investment options, and we didn't think any single fund family had a corner on the best stuff," he says. In fact, the Keogh plan the firm runs for its partners was offering its participants funds from eight different providers, with a single record keeper keeping tabs on everything. Since that arrangement seemed to be working well, Griffith warned Delaware it would be moving its 401(k) in the same direction.
In response, Delaware offered to quarterback a so-called strategic alliance for Price Waterhouse. "They convinced us they could do it," says Griffith. "It started last January 1, and it has worked great."
Now Delaware runs a strategic alliance of 26 mutual funds from nine different fund companies for Price Waterhouse's plan. Delaware continues to act as record keeper-- receiving all employee contributions and funneling them back and forth among the funds in the alliance. "The crucial thing in considering an alliance is that it must be able to do same-day, NAV [net asset value] trades among fund families," says Griffith. "Delaware said they could do that. It has worked as we hoped it would, and employee feedback has been very positive."
True, other plan sponsors are going in the opposite direction from Lear and Price Waterhouse. They're moving from several service providers to one that does it all. "Bundling is still increasing in popularity," says Charles Vieth, president of T. Rowe Price Retirement Plan Services, a subsidiary of the mutual fund giant.
At this point, the one-stop setup remains the dominant arrangement. According to Access Research Inc., a retirement-plan research firm based in Windsor, Connecticut, 61 percent of the 248,000 401(k) plans in place at the end of 1996 were fully bundled, with all services bought from a single provider --up from 50 percent at the end of 1991 (see "Bundled Plans Still Reign, page 66).
BEST OF BOTH WORLDS
Yet anecdotal evidence suggests that a growing number of leading-edge plan sponsors, usually of very large 401(k)s, have moved beyond pure bundling into what seems to be yet another stage in the evolution of their plans. The result is the dawning of what might be called third-generation 401(k) plans, in which sponsors seek the best of the bundled and unbundled worlds. Even T. Rowe Price's Vieth concedes that "bundling is being redefined."
In this third generation, no single provider is seen as having the skills, the smarts, or the investment options to do it all. So these leading-edge companies are shopping around-- often under the guidance of a consulting firm-- to find the best combination of providers. To understand why, a review of the first and second generations is in order.
"The first 401(k) plans were unbundled by default, because there was no one around to do the bundling," says Mary Rudie Barneby, president of both Delaware Investment and the National Defined Contribution Council, a trade association of organizations that serve the defined contribution world.
In the early 1980s, a hastily cobbled first- generation plan might have offered participants a choice among the sponsor's stock, a GIC from the insurance company that provided the sponsor's group life, and maybe one no-name mutual fund. The sponsor's benefits consultant did the record keeping by default. But there weren't many records to keep, since sponsors reported to participants yearly, and changes in investment options were allowed only infrequently.
The second generation--the bundled generation-- began arriving in the mid-1980s, brought on by a combination of mutual-fund marketing muscle, a growing investment sophistication among plan participants, and a desire by corporations to make their defined contribution retirement plans as alluring to their employees as possible while minimizing the cost to themselves.
The fund company's pitch: We have administrative and record-keeping skills and the ability to crank out educational material, so pay us a management fee of maybe 100 basis points for handling all the money, and we will throw in record keeping, trust services, and the rest at no extra charge.
The idea of being able to contract with a single provider that did it all for one fee had obvious appeal. "The sponsors looked at it and said, 'This looks great. It's very inexpensive compared with what we were getting before, and we can get it all in one place,'" observes Margaret-Ann Cole, a principal with Kwasha Lipton.
And the fund companies' enormous range of investment options-- plus reams of educational material for investors--was exactly what sponsors of 401(k) plans wanted to put them on the right side of the Employee Retirement Income Security Act's rule 404c. This rule, which the Department of Labor adopted in 1992, limits fiduciary liability for sponsors that provide a minimum level of plan diversification and education.
Finally, the mutual funds found fertile ground among participants who wanted such brand-name mutual funds as Fidelity Magellan, standard fund services such as daily performance reports and the capacity to switch among funds as often as desired, and technological bells and whistles like toll-free telephone numbers and voice response systems.
No wonder that mutual funds' share of the 401 (k) market is up to 37 percent and growing, while that of both banks and insurance companies has eroded dramatically (see chart, page 70). But if the bundled plan handled by a mutual fund company is the industry's current standard, it is starting to be challenged.
In a sense, the fund companies are victims of their own success. Participants in 401(k) plans, who a decade ago made do with a GIC and a no-name investment fund, today hanker for a whole universe of investment options-- including the full range of stock and bond funds, plus an international fund. As Access Research notes in its 1997 Marketplace Update, almost 70 percent of new contributions to 401 (k) plans are going to equity options. Further, since more and more employees see 401 (k) plans as the very heart and soul of their retirement plans, they have become highly vocal in making those hankerings known to management. "Plan sponsors [are] reacting to plan participants expressing their desire for a wider variety of funds and fund families available to them," says Hewitt Associates's Murphy.
Having fueled the demand for more and more options, such fund families as Fidelity, Vanguard Group, Price, and Putnam Investments now find themselves on the defensive. "Obviously, a plan is going to be able to get a wide variety of asset classes from any of the big fund managers," says Murphy. "The real issue is whether any one fund company can be the best in each asset class, and be deep in that asset class. And the answer to that is, probably not."
Consider, again, Lear's unbundling. Kwasha Lipton, which quarterbacked the process, presented Lear with 200 different funds, in 12 investment categories, to consider. Paine Webber, the Wall Street brokerage firm, helped narrow the field by advising Lear on which it considered to be the best funds in each category. Lear's own benefits and treasury department made the final choice of the 7 funds the 401(k) now offers.
Even those sponsors that count themselves in the bundled camp are no longer content with standard fare. Dennis Furey, director of investment management at Armco Inc., a $1.7 billion (in revenues) specialty steel maker in Pittsburgh, says 95 percent of the 4,500 employees in its plan are satisfied with the eight investment options currently offered: five equity funds from T. Rowe Price, a sixth from Vanguard, company stock, and a stable value fund that Furey's group manages internally.
Still, a small group of more sophisticated investors does want more choices. So Furey is studying a ninth option: a self-directed account in T. Rowe Price's discount brokerage. "An individual could invest in any of literally hundreds of mutual funds, plus any listed securities--stocks or bonds," he says.
Participants would pay extra fees to participate in that option, and they would pick up all commissions. But the desires of the demanding few would be met, without having to clutter the Armco plan with more investment options. Otherwise, Furey proclaims himself very satisfied staying mostly bundled with T. Rowe Price. "We think all the things that are visible to our participants are being done very well," says Furey. "We haven't found any need to go out and find someone else."
FEAR OF FRYING
If participants are demanding more investment flexibility, plan sponsors have a vested interest in providing it to them. For one thing, it's an easy way to keep key workers motivated. For another, what plan sponsors fear most, in their heart of hearts, is a crash in the investment markets that leaves plan participants bereft, and that triggers a rash of employee lawsuits. The more that sponsors can show they did all they could to provide employees with the very best in investment options, the more secure from lawsuits they can feel. This fear of lawsuits isn't something corporate executives are eager to talk about, but consultants point to it as an obvious consideration.
"More sponsors are looking at their plans and saying, 'Are we living up to our fiduciary responsibilities by offering enough diversity among investment managers?'" says Barneby of Delaware Investment. "Companies realize that by offering all the investments from one fund company, we may be overlooking a manager who may be better in this particular asset class."
Says Cole of Kwasha: "More and more, we're finding that no company wants to be associated with just one fund family."
The fund companies' answer to the flexibility issue has only encouraged unbundling. Their solution is the strategic alliance, in which a plan gains access to investment options beyond those offered by any one mutual fund company.
As usual, it was Fidelity that pushed the alliance concept into the 401(k) world. Since Fidelity already sells funds from a whole universe of fund families through its no- transaction-fee program, it was a piece of cake to offer that same array of funds to the 401(k) plans it runs. Fidelity today offers 74 funds from 14 families to 401(k) plans.
Vieth of T. Rowe Price thinks it was desperation more than inspiration that got Fidelity into the alliance game. "Here you have the largest provider of 401(k) services, which has tremendous performance and turnover problems," he says. "As a defensive move, to hold onto its book of business, it offers an alliance. All of a sudden, Fidelity is into outside funds, and outside funds are the way to go."
Fidelity declined comment.
Vieth notes that there were alliances before Fidelity--that, in fact, T. Rowe Price has been providing plan participants with outside funds ever since it got into the 401(k) business. "It has always been a competitive need to provide funds from other families," he says. Still, even if other providers have offered strategic alliances before, Fidelity remains the 800-pound gorilla of the mutual fund business. Once Fidelity climbed on board, strategic alliances became all the rage. Access Research reports that the percentage of plan sponsors making use of such alliances more than doubled in the past five years, from only 6 percent at the end of 1991 to 14 percent at the end of 1996.
MORE THAN CHOICE
Two forces besides the demand for more investment options are driving the change. One is sponsors' desire for tighter internal controls. Lear's original bundled arrangement, for example, had been created for a much smaller entity. By the time Miller came on board early in 1996, an acquisitions binge had made Lear a much bigger, and more complicated, company. "We have 31 different payroll points, and the first thing we needed to decide was who was capable of administering all this. We didn't just pick Kwasha out of a hat."
NO FREE LUNCH
Then there is the issue of pricing. On closer examination, mutual fund fees of 1 percent of assets under management look pricey, now that others are offering to manage money for a whole lot less. "The very large plans," says Barneby of Delaware Investment, "are beginning to look at the mutual funds and say, 'They're great. They offer many benefits. But we have a lot of assets in our plan. Is this the most effectively priced vehicle we can offer to our employees?'"
And the answer quite often is no. "What the sponsors is saying is, 'We understand the cost game now,'" says Murphy of Hewitt Associates. "'We understand that free is not really free.'"
Credit the consultants for much of that understanding. Their argument: What if, instead of letting a Fidelity or a Vanguard or a T. Rowe Price manage your 401(k) plan assets, you used an institutional money manager--maybe the same one now managing the assets of your defined benefit plan--that was willing to do it for much less?
"They might charge as little as 10 basis points for managing the money," says Cole of Kwasha Lipton. Of course, you'd now have to find someone to take on the record keeping. But with the money saved on the management fee, you could easily afford to hire a consulting firm such as Kwasha to take over that function. How much does Kwasha charge for record keeping and the other administrative chores? "Depending on your asset size, that might be only 10 basis points as well," Cole says. (For a look at how Eli Lilly is cutting its 401(k) plan costs, see "Who Needs Mutual Funds Anyway?" on page 69.)
It is not always evident to what extent, if any, these money-saving strategies benefit the employer directly, since participants foot most of the 401(k) bill. But having shifted the administrative cost to participants through their earlier move to bundled plans, sponsors are now attempting to cut that portion of the tab. After all, the 401(k) plan has become a key benefit, with participation among eligible employees up to 78 percent in 1996, according to Access Research.
But some sponsors clearly are cutting their own costs as well. Take still another look at Lear. Sure, Miller insists that performance was the key consideration in unbundling Lear's plan. "Cost wasn't the driving factor," he says. "The driving factor was giving our employees the best universe of funds."
But Miller clearly paid close attention to pricing. And the arrangement he finally worked out brings some dollars back in. They come in the form of a share of the annual fees that the mutual funds in his plan collect. Because Kwasha Lipton and Paine Webber take over administrative chores that the funds normally would perform, the funds agree to waive the 25 or more basis points they charge in 12 b-1 fees, reducing the cost that participants bear. And because Kwasha and Paine Webber charge less than 25 basis points for their services, Lear gets to keep the difference. Miller won't quantify how much money gets spun back to his plan, but he does say it is "a lot."
At this point, unbundling remains an option mostly for bigger plans--those with enough participants and money to tempt the fund companies and the benefits consultants to tailor something special. But with competition for 401(k) dollars showing no sign of letting up, it's probably only a matter of time before unbundling spreads to midsized and smaller plans.
After all, as Access Research notes, the smaller end of the market is where the real growth opportunities are today for the fund companies and the other plan providers. Virtually all companies with 5,000 or more employees have 401(k) plans. But there are nearly 2 million companies with 500 employees or fewer, and barely one-third of them have plans.
WHO NEEDS MUTUAL FUNDS ANYWAY?
Eli Lilly doesn't.
Defined-contribution pension plans have long been a world apart from more traditional defined-benefit plans in terms of who manages the money.
In the defined-benefit world, private managers typically oversee assets, while in the defined- contribution universe, made up chiefly of 401 (k) plans, mutual fund managers hold sway.
But that's starting to change with the unbundling of 401(k) plans. A growing number of plan sponsors who have long-standing relationships with private managers for defined-benefit plans are turning to them to run their 401(k) money as well. "The 401(k) market is more and more becoming DB [defined benefit]-like," says consultant Timothy Murphy of Hewitt Associates. "It's becoming an open architecture, and it's anybody's game."
The chief benefit: plan participants can realize significant cost savings. Says Mary Rudie Barneby, president of Delaware Investment & Retirement Services Inc.: "They already have people managing the assets in their DB plans. If they use the same managers in the defined contribution plan, they can negotiate very low management fees because the pool is bigger. And they are doing due diligence on the managers only once."
Consider Eli Lilly and Co., a $7.3 billion (in revenues) pharmaceuticals company with $2.6 billion in 401(k) assets. Since 1993, most of that has been managed by private investment managers--many of them managers of Eli Lilly's defined benefit plan assets.
The cost of investment management for Lilly's 401(k) is about 15 basis points a year. Take out that part of the plan involving Lilly stock, and the cost still is under 30 basis points, less than a third of what the typical mutual fund firm charges. "Mutual funds are more competitive today than they were," says Fred Ruebeck, Lilly's director of investments, "but I think our structure is still lower."
Ruebeck concedes his approach won't work for every company. "We work very closely with human resources, which is important," he says. Too often, HR departments are out of the loop on plan matters after outsourcing 401(k) plans to mutual fund companies. "In some companies, the collaboration between the financial side and the HR side is lacking, and that makes this kind of arrangement more difficult."
Of course, unbundling a 401(k) plan to marry defined benefit managers to defined contribution assets makes sense only if there are enough assets in both plans to produce the necessary economies of scale. "If you are a smaller company, or you don't have a DB plan, then the bundled service probably makes a lot more sense," says Ruebeck.
How to shop for 401(k) services.
The universe of 401(k) plan providers already includes banks, insurance companies, most families of mutual funds, and virtually every bennefits consulting firm. And with the total under management in 401(k) plans now at nearly $1 trillion and climbing, new providers keep appearing.
That makes for a buyer's market. And the bigger your plan, the better able you will be to stitch together a customized package that is more attractive than what you might get from any single provider. If, on the other hand, your plan doesn't have at least $100 million in assets, then bundling still makes the most sense.
Not that bundling is a bad way to go. "We can provide a completely coordinated turnkey solution for our clients," says Charles Vieth, president of T. Rowe Price Retirement Plan Services. "We think we can do a better job of packaging and coordinating all the services the client wants than if the client went out and bought them individually."
But even if you're not big enough to bring a team of brand-name consultants to your door, you can probably negotiate something better with your existing provider--now that competition and open architecture are the order of the day. Here's what to look for in the following key areas:
ADMINISTRATION. This includes record keeping, voice response, call center, loans from the plan, and more. Whoever fills this function will play the key role in making your plan work. Start by filling this function, before filling others. Obviously you want some assurance that the record keeper has had experience keeping the records of plans similar to yours. But you'll also want daily valuation, a call center capable of answering all employee inquiries, and the ability to shift money among all the investment options that you offer. How much work will the record keeper do, and how much will get dumped on you?
TRUSTEE. Most trust services are provided by a bank. But the real question isn't so much how well the trustee does its job, but how well the trustee works with the record keeper. First pick your administrator. Then have the administrator pick a trustee. "Ask the administrator, 'What trustees do you think exhibit excellence in a daily valuation environment?'" says consultant Timothy Murphy of Hewitt Associates. "Some do it really well, and some don't at all."
INVESTMENTS. The best plan sponsors now weigh investment options and performance as carefully for 401(k) plans as they do for their defined-benefit plans. "Instead of accepting that one size fits all, sponsors are picking them individually per asset class," says Murphy. "They are running a search for their small-cap manager. They are running a different search for their large-cap manager."
INVESTMENT EDUCATION. The better you can educate your employees, the smaller the risk of lawsuits over losses, and the more the 401 (k) can become the centerpiece of the whole pension program. Look for material that is timely and easy to understand but detailed enough to be of use. T. Rowe Price, for instance, has very useful investment and retirement planning information--available in both print and CD-ROM form. But look beyond the administrator and the investment manager at the many specialized educational services that exist, to help plan participants make sound investment decisions.
BELLS AND WHISTLES. The role of technology keeps growing. The latest twist: corporate intranets (internal Web sites not accessible by the outside world). Among their most popular functions is providing employees with round-the-clock access to benefits information in general, and 401(k) information in particular. The newsletter Defined Contribution News notes: "Defined contribution service providers are increasingly turning to the Internet as the next must-have feature to stay competitive in the burgeoning 401(k) market." Murphy agrees. "The requests for proposals now usually ask if we have the capability to create an intranet," he says. Unnecessary? If you don't ask about an intranet, your employees most likely will.