Paradigm shifts in IT can have huge effects on information-based industries. The instant accessibility to previously inaccessible information has transformed travel, personal stock trading and personal lines insurance. And now, the same wave is posed to wash over the 401k marketplace.
Could anyone have predicted the impact Chicago-based Morningstar Inc. would have on the mutual fund industry when its star-based rating system debuted in 1985? Now 4- and 5-star funds gather upwards of 80% of all new assets, while lower-rated funds wither or die.
Just as all pre-Morningstar funds claimed to be "above average," most sponsors and manufacturers of 401ks believe they are offering a competitive plan. Previously, there were limited methodologies to learn if any one plan was good compared to others, usually requiring expensive consultants. This inability to identify the quality of a specific plan was like being lost in the fog-you had no idea where you were, but neither did anyone else.
Now, San Diego-based BrightScope Inc., has consolidated all of the previously available information on 401ks from regulatory and government sources and made it easily accessible. By adding information on funds and menu choices, and by application of some proprietary algorithms, BrightScope is able to rank plans and expose detail information on plan costs. In other words, the fog is being dispersed, and one can see just how ugly it is out there.
This new development creates problems for plan sponsors who have a fiduciary duty to provide a quality plan to their employees. Whether sponsors are meeting that obligation is questionable if the fees on either the plan or the fund choices are substantially higher than a similar plan, and these fees are now easy to compare and understand.
Many plan manufacturers' business models are now at risk. How can a sponsor select Provider A over Provider B when B has lower costs on the plan? Some plan providers milked the 401k industry through excessive fees on plans and investment menu options, all of which eventually got charged to the plan participants, and a portion of which they then paid out to advisers, agents and salespeople.
IMPACT ON MANUFACTURERS
Now that plan sponsors, participants and advisers have visibility into their own plans as well as others, we can expect significant changes in 401ks from plan manufacturers.
Insurers may lose their current small-plan market dominance. Providers of plans with less than $5 million in assets are currently dominated by several insurers. However, small plan prices will come under the most severe pressure as enhanced technology-enabled platforms come to the market. Furthermore, direct sellers with great efficiency may automate their offerings and bypass advisers for lower total cost offerings. Plan prices for the low-end segment could fall dramatically. As a result, fee transparency will make it difficult for prudent, fiduciary-minded plan sponsors to stay with higher-cost providers.
Innovative features will be used to distract sponsors from focusing solely on pricing. Plan manufacturers will try to create features designed to make their plans less dependent on pricing comparisons. Potential examples could include automatic plan re-pricings once certain asset levels are reached. For example a provider might automatically re-price the plan when it reaches $1 million, $2 million and $5 million in assets. That way, plan sponsors can be confident that fees won't drift up over time as the plan grows in size.
However, the change in information accessibility does have some upsides for manufacturers. For the first time, they will be able to easily identify weaknesses with their own plan offerings before bringing them to market. Because plan sellers will have to compete in a more transparent environment, with all cost components visible for the first time, manufacturers may well develop more targeted plans for different industry segments.
Expensive, simple plans will rapidly disappear from the market as advisers will be unable to sell, and sponsors are unwilling to buy, uncompetitive plans.
Plan providers that can't compete in this new transparent world will exit the business, especially as the legal problems that arise with developing and providing underperforming or overly expensive plans will make the business more risky and less desirable.
With this relentless focus on cost efficiency, plan sponsors must be able to ensure that their operating environments are able to adapt to this new world that is dawning. Inefficient systems and processes have lots of room to hide in a high-fee environment, but with margins poised to tighten, operating efficiency becomes even more important. Insurers that are unable to reduce their cost bases through effective use of technology will be at a serious disadvantage.
Robert Ellis is a principal at Novarica and head of Wealth Management research. He can be reached at rellis@novarica.com.
