Rough times are ahead for the US 401(k) industry. The assets of the individual pension plans are shrinking, competition is growing, fees are declining and new business models are struggling. These are the current trends according to a new report by Cerulli Associates, a Boston-based research and consulting firm.
Because of the stock market decline and participants’ demographic changes, for the first time in their history, 401(k) plan assets shrank in 2000, losing $72bn to close the year at $1.766trn; and the average participant balance declined to $41,919 in 2000 from $46,740 in 1999.
“We estimate,” says Lisa Baird, the report’s compiler, “that net new flows into 401(k) plans will remain flat at around $40bn between now and 2006”. On one hand, the workforce is aging and distributions are growing at a faster pace than contributions: in 2000 for every dollar contributed to a 401(k) plan, 74 cents were distributed to retirees and job changers; this will increase to 83 cents by 2006. On the other hand, the stock market is not helping as much as in the last decade, when much of the growth in 401(k) plans (nearly 80% of it in the last five years) was due to market appreciation.
All this is bad news for 401(k) service providers, already confronted with difficult strategic options. Only very few are successful full-service providers: the top five ones – Fidelity Investments, Hewitt Associates, CitiStreet, Vanguard Group and Merrill Lynch – control 43% of 401(k) assets. Fidelity alone recordkeeps $418bn in 401(k) assets, more than twice that of Hewitt, the next largest competitor.
Many competitors are realising that what was thought to be the right strategy 10 years ago – that the key to capturing 401(k) assets was to build in-house administrative capabilities – has proven to be untrue and, in many cases, unprofitable. So much that a number of high-profile full-service providers (such as Merrill Lynch and Prudential) have announced plans to outsource all or part of their recordkeeping business or to exit the business altogether in the past 18 months.
“Full-service providers are feeling a lot of pressures from different sources,” explains Baird. “As a result, the 401(k) market is quickly approaching a state in which it will be dominated by a few large recordkeepers with the remaining providers acting as asset hunters that distribute their investment products to 401(k) plans through fund alliance platforms or exiting the market entirely.”
Among the pressures, there are the increasing costs of recordkeeping since the mid- 1990s, even for the most efficient players, because of all substantial technology investments required by the market. This is more and more demanding: sponsors want web-based plan administration services, participants want internet access (including online account statements and complete transactional capabilities), personalised rates of return on account statements, online advice and guidance, self-directed accounts.
These swelling costs cannot be balanced with raising recordkeeping fees (price competition has become the name of the game), let alone by raising management fees. In fact less and less managed 401(k) assets administered on full-service platforms are in proprietary funds: they declined from 95% in 1992 to 77% in 2000, which means a substantial bite out of asset-based revenues. This cut of revenues is worsened by the movement of assets toward lower-fee products, such as institutional mutual funds, separate accounts and passively managed funds. The latter, for example, in 2000 held nearly 18.8% of asset, up from 5% in 1994.
Who is going to profit from the new shape of the 401(k) market? “Internet-based service providers,” answers Baird, “promised to rewrite the economic equation of serving 401(k) plans and to open up the market to the smallest of employers. But these promises have proven to be difficult to deliver. We believe that internet-based service providers by and large will not be able to remain independent entities; rather Internet-based plan administration services will be incorporated into traditional service platforms.”
In the meantime full-service providers are turning attention to the investment-only (IO) marketplace. In 2000, $597bn in 401(k) assets were in IO options and the IO market is going to grow to $1,423bn by 2006, thanks to plan sponsors’ and participants’ demand for outside managers combined with the development of institutional open-architecture platforms. “But IO distribution is not a panacea,” points out Baird. Also the costs of IO product distribution are increasing. Today, IO marketers must address multiple constituencies: (1) full-service providers, to gain access to alliance platforms; (2) large plan sponsors, to create product demand and to improve leverage with full-service providers; (3) investment consultants, to cultivate demand from plan sponsors; and (4) providers seeking sub-advisers for investment products, to secure institutional investment management opportunities”. Keep it in mind if you think of penetrating the US pension market!