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AARP Readies New State Street Funds: New Sub-Advisor Deal Imperils Scudder Partnership

The 50-and-over crowd will soon have new mutual funds to consider investing their hard-earned money in.

AARP of Washington, the not-for-profit organization that caters to mature individuals, has registered with the Securities and Exchange Commission to offer three new asset-allocation mutual funds that will invest in various combinations of three passive index portfolios. The funds will be sub-advised by State Street Global Advisors (SSgA) of Boston.

According to the funds' registration statement, each of the new AARP Retirement Readiness Funds will invest in varying proportions of a U.S. equity index portfolio, a bond market index portfolio and an international equity index portfolio, all managed by SSgA, which is the second-largest index manager in the world. As of Sept. 30, SSgA managed $294 billion in passive U.S. equity assets and another $50 billion in passive fixed-income money.

The new AARP Retirement Readiness Funds are called the AARP Conservative Fund, the AARP Moderate Fund and the AARP Aggressive Fund. They also offer low fees; after fee waivers, each fund's total expense ratio will be 50 basis points.

It is possible that the new index-centric investment mandate could end up displacing the 20-year-old active management arrangement that AARP has with more than three dozen funds from Scudder Investments.

Not only is AARP in the process of offering the new index funds, it is also in the process of spinning off a financial services unit called AARP Financial, which will be headquartered in the Boston suburb of Tewksbury, Mass.

The new division, which AARP is currently in the process of staffing, will absorb all of the other financial services products AARP offers through third parties, including traditional insurance products and a co-branded Visa credit card. With pricing power as an arsenal, AARP contracts with a number of well-regarded providers to make services available to its 35 million members, most of whom reside in the U.S.

Over the past few years, AARP has been more keenly focusing on economic security for its members, explained Val Dingle, director of the new AARP Financial unit. "To truly bring that commitment to light, it warranted the establishment of a new entity," she said.

Up until now, all third-party-provided services had been handled through AARP Services, a subsidiary of the broader AARP organization. That unit offered financial services, as well as other consumer services, retail partnership programs and special member discounts.

This is a big win for SSgA and its parent, State Street Corp., which worldwide, manages $1.4 trillion in assets. After two years of seriously trimming expenses, including selling off its private asset management unit to U.S. Trust in Oct. 2003 for $365 million, State Street is now bolstering its investment management business. Publicly filed documents show that in 2004, 84% of State Street's investment group revenues came from investment servicing, which includes providing custody, transfer agency, fund accounting and other services to mutual funds and others. Only 16% of its revenues were derived from investment management fees.

SSgA officials declined to comment on the new partnership with the AARP.

There won't be a full membership roll-out, Dingle said. There will be a pilot program. "No matter what products we offer, we want to be sure that it works first," she said.

AARP's new resounding support for mutual funds that provide low fees, simple choices and indexing versus active management raises the question of what will happen to the partnership AARP has had for years with Scudder Investments, the investment management unit of Deutsche Bank.

The two have had a multi-year arrangement under which Scudder currently makes a no-load class of shares, dubbed the AARP Class, of 38 of its proprietarily managed mutual funds available to AARP members.

Today, those combined AARP share classes have an estimated $9.7 billion of assets under management, according to Lipper of New York, which tracks 35 of the 38 funds. That accounts for about 15.5% of the total $62.2 billion that Scudder collectively manages in that diversified lineup of funds.

Disclosures in the new AARP funds' registration document fly in the face of Scudder's active management style and appear predictive that AARP might throw more of its support behind State Street's low-cost index funds. One portion reads: "Years of investment research show that active managers rarely, if ever, beat most market indexes over time. Yet those same managers almost always charge higher fees than index funds. When you factor in the lower fees charged by index funds, indexing is clearly one of the most cost-effective ways to invest."

When asked whether AARP is reconsidering its arrangement with Scudder, Dingle said: "We currently have a relationship with Scudder that is ongoing through the end of the year." While she declined further comment, she conceded that the relationship is up for review. As of press time, Scudder officials had not returned calls seeking comment.