PALO ALTO, Calif. -- Nobel laureate William F. Sharpe and several financial backers are launching an Internet-based investment advisory service that could have significant reverberations in the mutual fund industry.
The service -- Financial Engines, Palo Alto, Calif. -- will begin this summer. It is designed for the 30 million participants in U.S. defined contribution plans.
Participants using the service could make significant asset allocation changes, Mr. Sharpe said.
Financial Engines will bring some of the same thinking to individuals in defined contribution plans that has been accepted for decades in defined benefit plans -- called modern portfolio theory. It also makes affordable to everyone the latest scientific investment models.
The service will recommend optimized portfolios to participants -- that is the highest expected return for a given level of expected risk. And the optimization will be based on a participant's total portfolio -- or savings -- not just the 401(k) assets.
Unlike most software available to 401(k) participants, Financial Engines will recommend in which investment options participants should invest.
Financial Engines will analyze the investment styles of mutual funds inside a 401(k) and take into account the styles of mutual funds the participant invests in outside of the 401(k). Financial Engines will use what is called returns-based analysis, perfected by Mr. Sharpe and widely used in the defined benefit community.
As a result, participants using Financial Engines probably would stop picking investment options on the basis of what the mutual funds call themselves.
A mutual fund that calls itself a growth equity fund might really be investing on a value basis, for example. Thus the risk level might be different from what the mutual fund's name would indicate.
In MPT, an investor can't optimize his portfolio without taking his total assets into account. Yet, the typical 401(k) investor has no way, short of going to a financial planner, to scientifically optimize portfolios now.
But Financial Engines will give participants scientific optimization through the Internet for $25 to $50 a participant per year.
Simple to use
Financial Engines executives claim their software is simple enough to use, although scientifically robust, that no financial planner is needed to interpret the recommendations. That might be an unwelcome shock to financial planners.
With few exceptions, the help most participants get now is hugely different.
Mr. Sharpe describes the typical financial planning/investment education program as "poor" to "misleading."
An MPT cornerstone is measuring risk. The danger of not using that approach is taking much greater risks than necessary to achieve a level of investment return, or sharply falling below what is needed to retire.
Jeff Maggioncalda, president and chief executive officer at Financial Engines, said education programs can be so bad that retirees will wind up with not enough money. Then, they might sue employers, citing the poor education they received.
"The idea that you can make an investment decision without even thinking about risk seems surreal to me at the least," said Mr. Sharpe.
Financial Engines will offer forecasting that takes into account millions of realistic scenarios of inflation, interest rates, dividends and investment returns, Mr. Sharpe said. It will offer ongoing advice on investments, and will model every possible combination of available investment and select the investment mix offering the highest expected return for the level of risk acceptable to the investor.
How big an impact?
A question remains about whether Financial Engines has the financial staying power and attractiveness to make a big impact.
Mr. Sharpe is a major attraction for pension executives. Among his current defined benefit clients are the California Public Employees' Retirement System; AT&T Co.; Hewlett-Packard Co.; and United Technologies Corp.
Major financial backers have faith in his service. Co-founders of Financial Engines and major financial backers include Paul Koontz, a general partner of Foundation Capital, Menlo Park, Calif., an early stage investor, specializing in software startups, and C. Richard Kramlich, a general partner of New Enterprise Associates, Menlo Park, Calif., a large venture capital firm.
Foundation Capital and NEA invested in Financial Engines. The amount wasn't disclosed.
Other financial backers include George Roberts and Henry Kravis, partners in the leveraged buyout firm Kohlberg, Kravis and Roberts, San Francisco.
On Financial Engines' board of directors, and a co-founder and director, is Joseph Grundfest, a former commissioner on the SEC.
Financial Engines consulting programs are being tested at Alza Corp., Palo Alto, Calif.; Netscape Communications Corp., Mountain View, Calif.; and Gap Inc., San Bruno, Calif.
Describing his pilot testing of Financial Engines, Harold Fethe, vice president, human resources at Alza, said, Financial Engines "is stunning. If people understand what it is, I don't see how it can fail to catch on."
Alza, which has a defined contribution plan of more than $100 million, intends to subscribe to Financial Engines when the testing period ends.
Financial Engines sales executives first will target corporate plans; next will come government 403(b) and 457 defined contribution plans. From there, they probably will go worldwide to individuals.
Financial Engines won't be the only sophisticated, Internet-based advisory service.
Fidelity Investments Strategic Advisors, Boston, plans to offer something similar on the Internet by the middle of the year, said spokeswoman Camille Lepre.
While Fidelity's Internet program will make recommendations on specific mutual funds in a 401(k) it won't optimize for a participant's total assets.
Several financial services companies have won Department of Labor approval to advise 401(k) investors. They include TCW Group Inc., Smith Barney Inc., PaineWebber Inc., Wells Fargo Inc. and Prudential Securities Inc.
What competitors do
Most fund companies making recommendations are limiting themselves to options and assets within a defined contribution plan.
TCW is expected to offer an investment advisory service, Guided Choice, this summer after beta testing it this spring. It is an Internet and a telephonic service.
Guided Choice also will take into consideration a participant's total assets; it would be imprudent not to, said Brian Tarbox, a senior vice president at TCW. But it only will make investment recommendations on TCW mutual funds.
Financial Engines makes recommendations on 6,500 mutual funds and separate accounts.
Mr. Tarbox said the TCW advisory service uses MPT to optimize portfolios.
An Internet-based defined contribution participant advisory service already in existence is 401(k) Forum, San Francisco.
About 8 months old, it has gained three clients, Fujitsu America Inc., San Jose, Calif.; Findlay Industries, Findlay, Ohio; and a pilot program with Oracle Corp., Redwood Shores, Calif., said David Peckman, vice president of marketing.
The service optimizes participant defined contribution portfolios, but not participants' total assets. It makes recommendations on investment options, and offers profiles of mutual funds and education about investing issues at its Web site.
Cost per participant per year ranges from $20 to $60. It also offers a monitoring program for defined contribution plan sponsors.
Other programs available
Other providers of defined contribution software say their programs are sophisticated, too.
Ed Cook, project manager for investor education services at Frank Russell Co., Tacoma, Wash., said his company's LifePoints Retirement Planner software takes participants "by the hand" through an interview process. It helps participants determine a minimum they can live on in retirement and determines when participants are saving enough money. He said participants can model multiple investments, not just their 401(k)s.
LifePoints, however, doesn't offer personalized optimized portfolios.
"It's not designed to do a lot of modeling based on 72% in this, 15% in that and the remainder in this. It's a little more general," Mr. Cook said.
The company is considering putting some retirement planning software on the Internet, he said.
Hewitt Associates LLC, Lincolnshire, Ill., offers retirement planning software called Futre$aver, tailored to fit individual 401(k) plans, said spokeswoman Monica Gallagher.
She said the software helps plan participants figure out how much money they will need and what tax rates they will face, and creates different financial scenarios. But she didn't know whether it included MPT principles or calculated probabilities.
Fidelity has an existing Web site that includes a financial planner but not MPT. On the subject of risk, the planner asks: "Are you a daredevil, wallflower or someone in between?" This is the type of phrasing Mr. Sharpe said he scorns because it is too vague.
When faced with complicated theories, some non-investment people "freeze or do nothing," Russell's Mr. Cook said.
However, Mr. Sharpe said, MPT principles can be incorporated into software so it is not just for "pointy-headed intellectuals." Ordinary people understand probabilities, he said, and are familiar with ideas like "an 80% chance of rain or 90% success rate."