This is the second part of a two-part series. This month’s article features insurance companies and banks. Last month, we featured investment firms and alliance partners.

Despite the hassles employers that switch 401(k) plans inevitably face, an estimated 15 to 20 percent take the plunge every year.

It is not masochism that drives the decision. Often technology plays a role, including the threat of the ubiquitous Y2K bug. “Employers want to know if their service provider can handle Y2K in their records,” says David Wray, president of the Profit Sharing/401(k) Council of America, in Chicago.

But the trauma of confronting the new millennium is not the only reason companies decide to switch. Mergers and acquisitions among plan sponsors, consolidation in the 401(k) vendor market, and a desire for daily account valuation are key catalysts for switching providers, notes Pat Pou, a principal at benefits consulting firm William M. Mercer Inc. in Los Angeles.

The good news for companies that sponsor 401(k) plans is that competition among vendors is growing fiercer. About 98 percent of employers in the larger end of the market (5,000-plus participants) already have 401(k)s, therefore “it’s a takeover business,” says Peter Starr, a consultant with Cerulli & Associates, a management consulting/research firm in Boston.

The competition means many sponsors can improve the terms of their plans by making a change. They often buy improved participant services for the same or even lower cost. They can expand fund options, add brokerage windows, and offer daily valuation. Thanks to the roaring stock market, some employers even qualify for cut-rate administration fees because the provider earns a bundle on asset management.

The bad news is there are fewer plan providers to choose from. If you haven’t ventured out into the marketplace lately, you may be surprised by what you see. Some recordkeepers left the business rather than invest heavily in Y2K compliance. Other recordkeepers, such as Watson Wyatt Worldwide, decided to stick to consulting rather than compete against the largest providers, like Fidelity Investments, Vanguard Group, and State Street Global Advisors. Together, this threesome managed 37.6 percent of 401(k) assets in 1997, up from 31 percent in 1996, according to Cerulli.

Obviously, mammoth providers can spread their costs over a wider user and asset base. “Often, the investment management fees subsidize the record-keeping function,” Starr says. For plans with 1,000 or more lives, average recordkeeping costs have dropped from 0.17 percent of assets in 1995 to 0.12 percent of assets in 1997, according to the Cerulli study. Investment fees have also declined, from 1.09 percent of assets in 1995 to 1.02 percent of assets through 1997.

Providers continue to try to distinguish themselves by offering more bells and whistles, such as Internet access and education. “As investment platforms get more open, there is less differentiation by investments,” Starr explains. “So, if you can’t differentiate yourself by investments, you try to differentiate by functionality.”

As more plans adopt these administrative accoutrements, the pressure increases for sponsors to offer them, too. To attract employees used to convenience, employers need to upgrade plan service, says Jerry Rigg, senior vice president and director of human resources for the investment bank Donaldson, Lufkin & Jenrette, in New York.

DLJ is moving its 401(k) plan to Fidelity this spring. Instead of 4 investment choices and monthly valuation, DLJ’s new plan will feature 19 options and daily online valuation. “Our investments have outperformed the S&P for the past 15 years, so most people were pleased [with the old plan],” says Rigg. “But we decided to be more responsive to the new people who are accustomed to a larger number of investment options.”

DLJ’s decision reflects the buyer’s market for 401(k) plans, but even in a buyer’s market, some buyers get much better deals than others. The marketplace’s interest in your business may be constrained by the size of your company or its particular 401(k) needs. Finding a vendor is never easy, and assumptions about services and price may not be realized. There is also the inevitable pain of transition, during which many employees may be frustrated by the blackout period that freezes most common transactions.

Betty Crocker’s New Recipe

For General Mills Inc., the surprise was that many of the larger players in the 401(k) business sat out its bid, making for a difficult search to upgrade its 401(k) plan. The primary reason: General Mills’s finance department manages the money and will continue to do so, believing that the higher expense ratios of retail funds harm investment performance. General Mills is not alone in this. Roughly 18 percent of 401(k) assets held by employers with 5,000 or more employees are managed in-house, Cerulli reports.

With 10,000 401(k) participants, the Minneapolis-based food manufacturer and purveyor of Betty Crocker products had begun evaluating the need to change its plan design–which had been an in-house operation–two years ago. A task force, drawn from finance and benefits staff, along with three representative employees, recommended adding a brokerage window and increasing the hours of the customer call center, according to Michael Davis, vice president of compensation, benefits, and staffing. The $6 billion company also decided to use an outside vendor as recordkeeper rather than continue to administer its plan records in-house.

Not only was General Mills offering no asset management, it also decided to limit valuation to monthly statements. “We believe monthly valuation has an advantage,” says Davis, explaining that it keeps participants focused on the long term. That eliminated other vendors committed to offering daily valuation only. “Our search was narrowed quite a bit,” Davis says.

The winning bid came from New York-based Metropolitan Life Insurance Co., which has aggressively pursued the 401(k) market since acquiring Benefit Services Corp. in 1996 and Bankers Trust’s 401(k) recordkeeping business in 1997. Met Life not only will keep the books and produce quarterly statements and monthly valuations, it also will offer a brokerage window through Charles Schwab. Adding a direct-investment option to the mix of options was essential, Davis says, because General Mills believed it should offset the limitations of monthly valuation for participants who want to manage assets more actively.

The transition was “a ton of work,” Davis says, but the system was blacked out a mere 24 days. “If I underestimated anything at the beginning, it was the effort you need to communicate the change,” he says.

That’s where the employee representatives on the task force proved especially valuable to the process. They reported that employees didn’t fully understand the ramifications of the switch. “We realized quickly the need to bolster what we did and how we did it,” Davis says.

Parting Ways

At Gleason Corp., a change of investment-management philosophy led to a change of investment managers. Gleason’s managers wanted to offer predominately index funds in its 401(k) plan, explains William Stein, director of human resources at the $409 million gear maker in Rochester, New York. However, incumbent provider Fidelity balked at the idea, according to Stein. “Fidelity views itself as a manager of funds, and didn’t want to get involved with a passive approach,” he says. So after 10 years with Fidelity, Gleason decided to shop for another 401(k) vendor, eventually choosing Vanguard.

In accordance with its belief in the value of index funds for the company’s roughly 1,300 U.S. participants, Gleason’s executive committee expanded the plan to include 26 funds, up from 9. Of these, approximately three-quarters are index-driven. “There is a fine balance between offering the entire marketplace and our ability to educate participants, so we tried to strike a balance with enough funds to cover the entire risk spectrum,” Stein says. The plan continues to offer Fidelity’s Magellan and Equity Income funds.

Although Vanguard is well known for offering a broad range of index funds at low fees, Stein says his company also made sure to scrutinize the provider’s Internet capabilities, voice response system, and its ability to issue statements on time.

The difference between Fidelity and Vanguard’s recordkeeping fees was not a critical issue for the company. “It was not our objective, and it wasn’t a big difference. However, we did get the benefit of offering lower operating-fee ratios to our employees, who as a result will be able to have more of their contributions working for them to earn a greater return,” says Stein.

Unlike General Mills’s brief transition from one vendor to another, at Gleason the switch from Fidelity to Vanguard entailed a blackout period that lasted from late November 1997 through the second week of February 1998. Although it was protracted, Stein claims that the length of the transition was not a problem for the company. “It was a nonevent,” he says.

Change via Acquisition

Sometimes mergers and acquisitions leave the new, combined company with a tough decision to make. When 3Com Corp., a supplier of networking equipment, acquired U.S. Robotics Corp. in June 1997, 3Com’s 401(k) provider was State Street and U.S. Robotics used American Express Financial Services. “There were good points and bad points in each plan,” says Bill Dietz, director of compensation and benefits for Santa Clara, California-based 3Com. “We decided to take a real hard look at the marketplace and get other major players to respond to an RFP.”

A search committee drawn from the legal, tax, and benefits departments of both 3Com and U.S. Robotics identified the six most important attributes of a 401(k) provider: investment quality, flexibility, recordkeeping capability, services to participants, communications, and fees.

Based on investment quality alone, five providers–Fidelity, Merrill Lynch, Charles Schwab, T. Rowe Price, and Vanguard–made the first cut, along with the two incumbents. “All these players are top drawer, and there weren’t giant differences among them,” Dietz says. So the committee developed a grading system to quantify the differences, and State Street came out on top.

State Street’s low cost and its development of an investment Web site were critical factors, explains Dietz. “As a committee, we wanted to minimize fees but get excellent funds. Cost is State Street’s strength,” he says. Because State Street offers institutional accounts not sold to retail consumers, its expense fees traditionally are lower than most retail funds. However, several such funds from Franklin, Dreyfus, and Invesco do populate the plan, which is designed with 13 funds and includes a brokerage window.

Less Switching Ahead

Some believe vendor switching will crest this year. Y2K concerns shouldn’t linger much past January 1, 2000, and already 50 percent of plans with 1,000 or more participants include daily valuation, another driver of change, says Gregory Metzger, director of defined- contribution consulting for Watson Wyatt.

But other trends inevitably will emerge to continue to encourage switching–among them, the increased role of the finance department in managing the plan. When plans were small and had meager assets, the human-resources arm dominated the selection of vendors. With today’s larger plan assets, finance is assuming more decision-making responsibility.

People like Starr at Cerulli believe it is likely financial managers will demand the same qualitative and quantitative process in the creation of 401(k) investment options as they do with their defined benefit plans. There is likely to be a push for more individual accounts rather than mutual funds. Mutual funds, which now account for 40 percent of 401(k) assets, will peak at 44 percent in 2001, according to Cerulli’s study.

Although few sponsors now switch to provide improved communications and education to participants, that may change, too. More sponsors may seek out lifestyle funds or funds-of-funds that blend assets to strike a risk/reward balance for participants based on age and future retirement needs. If online education and retirement planning takes root in the industry, sponsors will have to extend these services to participants to attract new recruits.

Most dramatically, the trend toward bundling services to reduce glitches among the trio of 401(k) functionaries–the recordkeeper, the asset manager, and the trustees– may soon come to an end. The National Securities Clearing Corp. (NSCC) has announced a centralized system for processing 401(k) transactions called the Defined Contribution Clearance and Settlement System (DCC&S). The system should eliminate the need for the functionaries to communicate with one another, reporting to the NSCC instead.

By acting as a central repository for 401(k) trade activity, the DCC&S platform removes technological barriers that prevent administrators, fund companies, and trustees from communicating among themselves. Just as the Internet established a communications protocol for PC users, DCC&S will promote interconnectivity among 401(k) providers.

That will greatly increase the options for sponsors to pick and choose what Starr calls “the true best-of-breed” products. There will be new opportunities to choose not only the best products, but the most cost-effective ones as well.

Jeannie Mandelker is a freelance writer based in Montrose, New York.

———————————————————————— IT PAYS TO SHOP THE MARKET
You monitor the investments in your 401(k) plan annually. You should be monitoring the plan as well,” advises Pat Pou, of William M. Mercer Inc. in Los Angeles. Too often, she says, clients think of how well they are serviced by their provider only when it comes time for a search. The regular benchmarking of administration services, such as the time it takes to answer a telephone inquiry or for the delivery of participant statements, is another way to see if the provider is working up to par.

“Every couple of years, you need to do a marketplace check and look at prices, services, and performance,” says Gregory Metzger, of Watson Wyatt Worldwide in Los Angeles. He recommends presenting providers with a “Triple-5” challenge. Over the course of a three-year contract (that’s the triple), ask for a 5 percent fee reduction, a 5 percent increase in administrative bells and whistles (such as enhanced statements), and a 5 percent increase in services (such as increased access to live operators). “The reason you can get this today is that the market is competitive and providers are making a great deal of money from the assets,” he says. For instance, a plan with $10 million in assets could grow to $12 million in a year. If the provider’s fee is 100 basis points, that fee will grow from $100,000 to $120,000. “But the amount of work hasn’t increased, and the plan probably runs smoother,” Metzger says. That’s plenty of reason to justify the demand.

Sean Hanna, editor-in-chief of The 401kWire.com reminds sponsors it is their fiduciary responsibility to ensure that plans are run correctly. “Some view that as a responsibility to see they are paying appropriate fees,” he says. A full-fledged search usually encourages current vendors to reduce their fees. Maybe the threat of a search would work just as well. — J.M.