NEEDHAM, Mass.- Electronic 401(k) or e-401(k) has the potential of disrupting the defined contribution industry and attaining $2 trillion in assets by 2005, according to a new study by TowerGroup.
E-401(k)s are created and serviced online, and, with some services providers, investment options are more plentiful than those offered by a traditional provider. Under Tower's definition, e-401(k) services include electronic business-to-business clearinghouses designed to link plan sponsors seeking 401(k) services with service providers.
Thanks to the growth of the e-401(k) in the small plan market, combined with the growth in the overall 401(k) market over the next five years, 401(k) plan assets will swell to almost $5 trillion by 2005, the study noted.
And the window for new providers of electronic 401(k)s will be closing in five years, the study predicts. Some 65% of businesses with 500 employees or fewer will have 401(k) plans in 2005, up from 35% at year-end 2000.
"We think this is a big market, a growing market, and it's changing rapidly," said Dennis J. Ceru, director of TowerGroup's online brokerage and investing group. "The 401(k) industry is ripe for change. It is largely serviced by a conventional method that has not had any dramatic changes in awhile."
Should catch on
The electronic 401(k) is expected to catch on because emerging technology will enable providers to serve a bunch of smaller 401(k) plans at lower costs. Moreover, some new electronic 401(k) providers are moving away from the traditional business model in which most of the service providers' fees come from plan assets, according to the study. Under the new models, fees could come from per-head charges, user fees, distribution charges or separate administrative fees, for example.
"Changing the pricing structure behind the 401(k) product, particularly the asset-based fee structure, may be the single most disruptive activity in which the brave new e-401(k) engages," the study indicated.
If participants can choose any investment option across the investment universe, then money managers no longer will have a lock on assets simply because their funds are in the plan, explained Mr. Ceru, who wrote the study.
"This would be true even if plans were to offer a wider choice, if not a complete choice, of all possible investments across all plans," he said. "Money managers would then be forced to compete on management fees, distribution fees and performance within asset class, not rely primarily on brand trust."
Were this to happen, the investment community might be pushed to rethink pricing structures, Mr. Ceru said.
Cost is a big issue in the current state of the electronic 401(k) business, said Tom Rossi, consultant with Watson Wyatt Worldwide, Bethesda, Md.
"The last thing we want to see is the anarchy of the 403(b) business, where it is very retail and high expense funds," Mr. Rossi said.
Some web-based models charge a flat fee for service of as much as $131 per month per participant, Mr. Rossi said. "The fees are enormous, particularly since the investments are not the lowest expense ratio funds."
Most of the online providers offer only retail funds for small plans, he said.
Internet providers, meanwhile, will run into the same issue third-party administrators now face, he said. They are sure to encounter competitors who will charge a third of what they are charging.
A 401(k) plan is still a price-sensitive purchase and providers are not protected from this just because they are on the web, Mr. Rossi said. People still want someone on the phone or who will visit them, he said.
"The winning e-provider will be the one who will match the high-tech with the high touch," he said. "Employees want to dial up a person or have a way to get some piece of paper in their hands."
Consumers also are more sophisticated, demanding more investments and more information, Mr. Ceru said. The essential difference between traditional and electronic 401(k) providers is how the investment choices are presented. In the conventional plan, participants have one set of investment choices. Electronic 401(k) plans are emerging with more investment options, Mr. Ceru said. Some offer an open set of choices and some have unlimited choices, he said.
Among the e-401(k) offerings:
* Conventional providers brought web-enabled versions of their existing services or created new Internet-based plans to market. Fidelity Investments, Boston, was first to the marketplace (in 1999), with an Internet-based electronic 401(k) plan initially targeted to businesses with fewer than 100 employees. Fidelity's e-401(k) plan provides services at a reduced fee and offers no-load, retail-priced Fidelity mutual funds.
* A second model is the business-to-business version of an electronic clearinghouse or matchmaking services geared to linking plan sponsors with independent financial service professionals. Some of the companies that do this work include 401kExchange, Expertplan, Pensiononline and Search 401(k).
* One model that came to market in 2000 was the full service e-401(k) sold to the small and even microplan market as a low-cost, no-frills, self-service approach, Mr. Ceru said.
"In fact, however, the product remains complicated and is heavily laden with IRS requirements for testing, compliance and reporting, as well as the functional requirements of employee education, access and ongoing plan maintenance," TowerGroup's study noted. "Therefore, some third party usually remains involved, if for no other reason than to provide due diligence and ongoing review."
While plan sponsors and their financial advisers have used these e-401(k), matchmaking-type services to see what's on the market, few have bought plans online, acknowledged Donald K. Lanman, vice president of marketing at 401kExchange.com, Lake Worth, Fla.
Under these companies' business models, matchmakers get paid when the match is made, Mr. Lanman explained.
First site last year
401kExchange launched its first site last March. By the end of the year, plans totaling $3 billion in assets had used the service to shop for service providers. However, only a fraction of those actually hired a service provider through the site.
Most of the closes, when plan sponsors were matched with service providers through the online system, occurred in the last half of the year, and most were startups or spinoffs, Mr. Lanman said.
Moreover, 90% of those using the service to find a 401(k) service provider are financial advisers acting on behalf of a plan sponsor client, Mr. Lanman said.
"This mirrors the industry - 85% to 90% of the business is sold by financial planners in the under 1,000-employee market," Mr. Lanman said. "In fact, when we are approached directly by a plan sponsor, we do recommend and encourage the plan sponsor to consider a qualified retirement adviser or benefits consultant to help them through the process because it is so complex."
Other industry insiders think online matchmaking sites will be a good place to shop, but not necessarily to buy.
"Businesses are all going to find that using the Internet for the search process is going to be useful, but I don't think the impact on the plan environment is going to be huge," said David Wray, president of the Chicago-based Profit Sharing/ 401(k) Council of America.
"Most plans will still want to interview service providers personally," Mr. Wray said. "It will enhance the current processing, but will not be revolutionary."
Small business owners are too busy chasing their accounts receivable to bother with their 401(k) plans, Mr. Wray said. Most small plans are sold by a finance professional with which the owner has an established relationship, he explained. The real savings will be from putting all of the plan administration on the Internet, removing paper from the process, Mr. Wray said.
This is the tack being taken by Emplanet Inc., Westborough, Mass. Its online, all-in-one 401(k) plan is being marketed to intermediaries to be sold to their plan sponsor clients, said Gary Gould, Emplanet senior vice president. On Jan. 26, Emplanet enhanced its website to make it more user-friendly for financial advisers. And all of the backroom processes are located on the web, making the administration paperless.
"Small 401(k) plans are sold, not bought," Mr. Gould said. "We created a process for advisers to sell 401(k)s that requires significantly less expertise. Financial advisers do not have to be 401(k) experts to sell (Emplanet's) product."
The details of setting up and running Emplanet's 401(k) plan are online, with telephone support, he said. Soon, Emplanet executives expect to unveil an Internet chat mode in which plan sponsors, advisers and participants can get their questions answered instantaneously online, Mr. Gould said.
Emplanet's service is not for every small company. Firms in which few employees have Internet access would not benefit, he said.
A little glitch
But many of these models have a glitch that might prevent them from being financially successful, said Ward Harris, managing director of the Berkeley, Calif.-based consulting firm McHenry Consulting Group. The glitch is that most of the new online services neither provide investment options nor own the sales network, and so have to try to make money as the middleman, Mr. Harris said. Moreover, few of the new ventures have the brand recognition of established players like Fidelity.
"I don't think most plan sponsors care that a plan can be set up in 15 minutes over the Internet," Mr. Harris said.
The Internet may be service providers' best hope of selling plans to the small market and still make a profit, said Ann Mahrdt, director of the Spectrem Group, New York.
"The issue from the plan sponsors' (perspective) is whether they will accept that kind of model or will they feel too much is being pushed back at them," Ms. Mahrdt said.
So far, no model has come out as the market leader, Mr. Ceru said.
"I think all models will have their place," he said. "It seems to be most natural that there will be a contraction. One or two folks will be good at it. Large players with established asset bases will stay viable well into the future."