Overview Years from now, industry professionals will look back on 2006 and see that it was a
transitional year that started a restructuring the likes of which we have not seen since the early ‘90s when 401(k) plans began to emerge as the primary retirement benefit offered by most companies. Some of the changes causing this upheaval include:
- Passage of the Pension Protection Act (PPA)
- Numerous law suits challenging fees paid by plans
- Directional clarity on fee disclosure regulation by the DOL
- Increased reliance on Registered Investment Advisors
- Changing nature of investment options
And, because these changes are coming from so many different directions – legislative, legal, regulatory and operational – no service provider will be immune to them.
Not only will they have an impact on how the industry operates, they will almost certainly accelerate consolidation as companies continue to reevaluate their position in the marketplace. This will be especially true among bundled providers as they begin to question whether there is any real benefit in offering administrative services in order to gather assets under management as more companies look to separate the two functions. Other service providers are also likely to reevaluate their position in the industry as their potential liability exposure increases and corporations begin to shift their focus from basic administrative needs to investment assistance.
The bottom line is that 2007 marks the beginning of an industry restructuring that will see an increasing number of service providers exiting parts of the business, strengthening others (through acquisition or otherwise) and adding new services to accommodate structural industry changes.
Now for the specifics.
Pension Protection Act (PPA) The passage of the PPA is significant in two respects: (1) it further dampens interest in defined benefit plans (at least for large companies), and (2) it makes 401(k) plans more viable as a primary retirement vehicle for employees.
Since defined benefit plans are not a major factor for most employee benefit service providers, these comments are limited to the affect the PPA will have on 401(k) plans.
The PPA affects service providers on three levels:
- Administrative. The PPA now sanctions the use of automatic enrollment and automatic contribution increases. This means that all providers will have to make some changes in how they operate if a plan sponsor opts to take advantage of these provisions. The impact is twofold: (1) accommodating the automatic enrollment, and (2) being able to unwind it if the employee decides to opt out. A provider may also be impacted by the provision that permits automatic increases in the contribution rate that is made at the time of the automatic enrollment.
- Investment. In order to accommodate automatic enrollment, plans must have a qualified investment alternative. In many cases this will already exist. Where it does not, it will need to be created. While this is a plan sponsor decision, providers may be consulted and will be responsible for implementing the decision.
- Legal. All plans will have to be restated, which presents potentially positive and negative factors. It is positive in that it offers an opportunity for increased one-time fees for integrating the changes. The downside is that it takes people, time and effort to accomplish what needs to be done.
Consequences. All of this, in one way or another, has an impact on the operations of service providers. While the effect on individual firms will vary, one thing is certain: the effects of the PPA cannot be ignored.
Litigation Within the past several months, a number of law suits have been filed against some of the largest plan providers. The complaints basically allege that the companies violated their fiduciary responsibilities by: (1) entering into agreements with parties that required the payment of unreasonable and excessive fees, (2) failing to understand revenue sharing arrangements engaged in by the fund companies providing their investments, and (3) not monitoring the overall fees and expenses of the plan.
In addition, recent law suits with similar allegations have been filed against some investment and administrative service providers. In these cases the challenge is somewhat greater in that there is no consensus on whether the parties involved are even fiduciaries. Nevertheless, the issue remains on the table.
Consequences. Potentially, both of these types of cases have serious ramifications for all service providers. In the first instance,
all plan sponsors are certain to pay more attention to the fees they pay for administrative services. Even when all fees are fully disclosed by a service provider, given the emphasis on “kickbacks” from fund companies, plan sponsors are more apt to have fees charged in the form of “hard” dollars. This puts fees in the spotlight and is almost certain to put pressure on how fees are charged.
In the second instance, service providers have to face the possibility that they will be determined to be fiduciaries. Regardless of what affect this might have on past actions, firms must evaluate the consequences of doing business as a fiduciary. Some will feel comfortable with the title; others will be more concerned with the responsibilities.
Nobody in the business can ignore it.
Fee Disclosure The Department of Labor will shortly issue new regulations under 408(b)(2) requiring more fee disclosure -- disclosure that most fund companies and many service providers have been reluctant to provide to date. While the exact nature of the disclosure is not yet known, there is every reason to believe that there will be little room to hide from revealing all fees received and/or paid.
Consequences. Fee disclosure will almost certainly put downward pressure on fees paid – at all levels. This will then put pressure on margins, which in turn will affect business decisions and commitments to continuing enhancements to services provided. None of this, however, is likely to dissuade companies from continuing to demand more and more from their service providers.
Registered Investment Advisors (RIA) Over the past 2-3 years it has become much more common for plan sponsors to look to professionals for help in selecting plan investments. In fact, in 2006, a number of RIAs who had been focusing their attention on high net worth individuals shifted their attention to the 401(k) marketplace. Two things are going to cause this trend to accelerate dramatically in 2007: (1) the wave of litigation (noted above) that will cause more people to seek fiduciary protection, and (2) the PPA’s official sanctioning of providing investment advice by current providers.
Consequences. Asset management consultants, commonly used by large companies, have always been valuable members of a plan sponsors’ team. As such, they are in a position to influence most decisions that relate to a plan’s operation, including administration. RIAs are likely to play a similar role with smaller companies. In this environment, service providers will find it increasingly difficult to rely on long-established relationships or “the good old boy network” to develop and maintain their businesses. Looking forward, service providers would be well-served to consider offering RIA services themselves. Being an RIA will accomplish two things: (1) it differentiates your services from many of your competitors, and (2) it adds a much-needed new revenue stream to a business that is already under price pressure on the administrative side. For service providers not interested in offering RIA services directly, they should make a concerted to develop relationships with RIAs who will feel comfortable working with them.
Investment Options 2006 saw the beginning of one of the biggest shifts in investments being offered since mutual funds became the overwhelming choice of plan sponsors many years ago. More of the larger plan sponsors began to add collective funds to their asset mix. This was driven by two factors: (1) an attempt to reduce the overall expenses of the investments being offered and (2) the rise in the use of index funds and ETFs both as stand-alone investments and in asset allocation models (i.e., either as part of a simple asset allocation or as a life cycle fund). In all likelihood this trend will continue in 2007 and beyond, because it is a low cost alternative to mutual funds and because its approach is specifically sanctioned as a default vehicle under the PPA.
Consequences. Any significant move away from mutual funds will accelerate the use of “hard dollar” fees for services in that there will be no revenue sharing on these assets. While collective funds look like and operate in a manner similar to that of mutual funds, they are actually quite different and are regulated, not by the SEC, but by the Comptroller of the Currency. In the case of ETFs, most recordkeeping systems were not designed to handle individual securities; thus, if a plan were to add ETFs to its investment options, service providers would have to figure out a way to accommodate them.
Summary While 2006 was not filled with headline-grabbing news related to service provider activities, that is apt to change next year. 2006 will likely be noted as the year that set the stage for a true paradigm shift that will play out down the road. Bundled service providers (primarily mutual fund companies) are likely to reexamine their commitment to providing administrative services. TPAs will struggle with the consequences of shifting from a compensation system based on revenue sharing to a fee-for-services model. And the service industry as a whole will search for ways to adapt to the increasing influence of RIAs and their development of asset allocation models that are likely to include ETFs and index funds. Furthermore, as litigation moves through the courts, service providers will be made increasingly aware of their role in the process, including whether or not they are actually fiduciaries themselves.
2007 promises to be anything but dull.
This article has been reprinted by permission of the author.
Paul Kampner is president of TMark Associates Ltd., a Chicago-based consulting firm. Mr. Kampner can be reached at 312-397-9240 or via email at pkampner@tmarkassociates.com.
