The way 401(k) plans have been handled has gone through an evolutionary process during their relatively short life span. Now, they are about to enter a new stage that will fundamentally change the way in which these retirement savings vehicles operate -- changes so dramatic they will affect every company, administrator and investment manager tied to them.
Fees: The driver of change
In order to understand the nature of what lies ahead, it is necessary to understand the primary force behind the changes: fees. Fees are the real driver of what's to come because they are high on the agenda of three influential forces: the government, plan sponsors and the press.
The government wants to ensure service providers are not enriching themselves at the expense of plan participants. Today, the Department of Labor is focusing on two things: (1) the relatively high cost of using retail mutual funds to service institutional clients, and (2) the "hidden fees" that often exist in bundled service programs. While there is no hint the government will attempt to regulate fees, it is almost certain full disclosure of fees received from all sources soon will be required.
Because of the government's actions, plan sponsors will be forced to re-examine fees, recognizing their fiduciary responsibility. Fees must be fair and reasonable to plan participants. This means decisions involving the use of outside service providers -- whether related to investments or administration -- must be based on more thorough information regarding all plan fees, not simply which service provider has the best marketing materials or makes the corporation's job easier, regardless of cost.
The press, while it has no direct role in the process, is the third influential force because it reaches all segments of the market, including government, corporations and plan participants. Through its articles on retirement plans, the press acts as a catalyst for the actions of others. Today, much attention is being paid to the high costs of operating 401(k) plans. This encourages individuals to question their employers about fees, which in turn puts more pressure on the companies to make sure participants' rights are protected.
Two consequences will result from this emerging focus on fees -- the way plans are administered and the way plan assets are managed.
Administratively, plan sponsors will have more complete fee information available to them because of the government's disclosure requirements. With this data, some of which is unavailable today, they will re-evaluate their arrangements to ensure they are competitive vis-a-vis value for the fees being paid. This, in turn, will result in the following:
Consultants and publications that cover the industry reporting comparative cost information will play an increased role in the vendor selection process.
Conflicts of interests that are common today, such as combining profitable investment services with subsidized administrative services, will largely disappear as individual services will be forced to stand on their own.
Large, well-capitalized, independent firms will be formed and will emerge as the dominant providers of administrative services to middle market and large 401(k) plans. This will happen through the consolidation of smaller players.
Many services offered by bundled service providers (i.e., record keeping, investments and education services) will shift to specialty firms that will be better able to ensure maximum quality at minimum cost.
The biggest winners in this will be independent service firms because their activities and fees are not tied to providing multiple services.
But mutual funds will face the greatest challenge in the new environment. As evidence of this, today no mutual fund company will provide administrative services without at least some of its funds being offered as investment options in the plan. These companies will have to determine whether their non-investment services can operate on a stand-alone basis in a cost-effective manner. If not, they may abandon their efforts to provide bundled services.
The impact of government-required fee disclosure will be even greater on the investment side of the business. Mutual funds, the dominant investment vehicle for most 401(k) plans, will be scrutinized. Because of their retail orientation, they have a high cost structure, making them less attractive than other forms of investments. They are further disadvantaged because assets in these funds are managed with an eye toward the tax consequences on their primary customer -- the individual investor. To the extent these factors do not operate in the best interests of plan participants, plan sponsors might have a fiduciary liability.
To address these two problems, companies will look to other investment alternatives. Thus, the dominant 401(k) investment options five years from now are likely to include: institutional-only mutual funds, bank collective funds, separately managed accounts, and self-directed brokerage accounts.
Banks and independent investment firms are positioned to be the biggest winners in this environment. The former will prosper because they can offer investment services either through a collective fund (unique to banks) or through an individually managed account. Independent investment firms will be well-positioned take advantage of these changes by building on their existing expertise in managing defined benefit assets. In addition, they will be able to leverage the relationships with the consulting community they have built up over the years.
As with administration, mutual fund companies stand to lose the most from these changes because they control the vast majority of assets today. Many of them will adapt to the new environment by establishing institutional funds. However, this will not be easy because the investment objectives are so different from those of a retail fund as to require the establishment of entirely new investment funds. This, of course, means no performance history and a high initial expense ratio resulting from spreading fixed costs over a relatively small asset base (assuming the company does not elect to absorb excess expenses). All of this means that, in the short run, it will be difficult for plan sponsors to justify their use.
The coming changes in the 401(k) business will be substantial. It is essential service providers understand them and develop a strategy for dealing with them. Those that are successful will survive in the new environment and prosper. Those that fail to recognize the changes taking place will find it increasing difficult to compete.