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Non-Proprietary Funds in DC Plans to Grab Assets

Assets in investment products, including mutual funds, commingled funds, institutional separate accounts, as well as annuity sub-accounts in defined contribution plans, are expected to exceed the $1 trillion level by 2010, according to new estimates by Financial Research Corp. of Boston. At year-end 2003, these assets, which FRC refers to as the "investment-only defined contribution market," totaled $400 billion.

And what will drive this 150% increase in assets will be non-proprietary investment products, which, by the end of the decade, will surpass the assets held within the proprietary mutual funds typically offered by some DC plan recordkeepers, according to FRC.

The trend was revealed in a new survey of industry executives called Gathering Assets in the Investment-Only Defined Contribution Market. What's driving the assets flowing into DC plan recordkeepers' platforms toward outside, non-proprietary managers? Competition.

"Competitively, DC plan recordkeepers are being forced to open their plans to outside investment managers," said Chris Brown, vice president and director of retirement plan market research at FRC. The days of having a lock on a 401(k) menu are gone, as the industry has moved to an open-architecture, multi-manager standard, he added. "We are seeing demand for a diversification of investment managers, especially in light of the [mutual fund] scandal," Brown noted. A 401(k) plan sponsor offering only the funds from a scandal-tainted fund group could face liability and lawsuits from employees charging that the sponsor offered unsuitable investments, Brown added.

Opening the Gate

"To be able to compete today, you have to be able to offer open-architecture 401(k) plans," said Cathy McBreen, managing director of Spectrem Group in Chicago, a wealth management and retirement plan research and consulting firm.

In the past, DC plans recordkeepers that also sponsored investment vehicles could offer only proprietary products. That eventually transitioned over, say, to a 60/40 split, whereby they would offer 60% proprietary products and 40% outside investment manager's funds, she explained. Now, plan sponsors expect open architecture, for it has become the standard, McBreen added.

However, that secular change creates a glaring profitability issue for the plan provider, McBreen said. Instead of earning management fees on assets held in proprietary funds, plan providers only garner a smaller distribution fee through a revenue-sharing arrangement with the outside funds. Moreover, there's always a plan sponsor that wants a low-cost Vanguard fund in the lineup, she said. But since Vanguard is well known for not engaging in revenue-sharing arrangements, some DC platform sponsors often end up eating the cost themselves, or charge employers an extra fee to include that particular fund.

In early April, J.&W. Seligman of New York jumped to an open-architecture platform for plan sponsors that are part of the Seligman Growth 401(k) plan. Employers can now choose up to six outside funds from a predetermined list of potential funds to include on the 401(k) plan menu alongside proprietary Seligman funds.

Seligman, which offers its 401(k) plan services to the small-plan market, applies its proprietary time horizon asset-allocation program, which offers 31 investment models, each of which includes an allocation of Seligman mutual funds depending upon each employee's time until retirement. The program, begun in 1997, essentially goes on autopilot, and removes the burden from participants of determining proper asset allocation. As employees get closer to retirement, each participant is automatically migrated from the current model fund mix into one that provides a more appropriate allocation.

Seligman's transition grew out of a multi-manager, co-branded 401(k) plan venture last June with Merrill Lynch that allows for one-half of the plan sponsors' fund choices to be Seligman funds, and one-half to be funds managed by Merrill Lynch Investment Management, said Michelle Rappa, senior vice president of Seligman Advisors.

While there was concern that profit margins would be squeezed, "the big challenge was how to take a proprietary asset-allocation program and figure out how to get other funds incorporated, from a recordkeeping standpoint," Rappa said. Seligman is only offering the new open-architecture program to about 20% of plan sponsors, those with a larger 200 participants and at least $2 million, she added.

Even those that decide to bail out of the 401(k) recordkeeping business still want a slice of the investment-only defined contribution pie. Last month, Delaware Investments of Philadelphia announced it would hand over the administration and recordkeeping services for 1,700 mutual funds-based retirement plans with 130,000 participants to BISYS' retirement services division. "We really see our core competency as asset management, and we wanted to return to our strength," said Tom McConnell, senior vice president of Delaware's tax-advantaged product management.

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