While there are hundreds of independent DC recordkeepers across the country, the lion’s share of DC plans are record kept by large financial firms. Pick up any guide to the top 20 recordkeepers and it’s obvious that firms that manage money dominate the list.
It’s difficult to predict what this list will look like 10 or 20 years from now. However, given certain industry trends, don’t expect the asset manager to step away from the recordkeeping business any time soon. In fact, due to advancements in technology, one can expect to see independent recordkeepers become asset managers, thus increasing the frequency in which the recordkeeper and the asset manager are one and the same.
The Rise of the Asset Manager/Recordkeeper
When DC plans began to supplant the traditional DB plan in the early ’80s, it was mostly the investment manufacturers (i.e., mutual fund firms, insurance companies and banks) that began to dominate the recordkeeping business, especially in the small and mid-markets. Over time, even in the large/jumbo markets, most of the large consulting firms exited the DC recordkeeping business, essentially yielding it (mainly) to the large mutual fund complexes.
Some would argue that the ascension of the asset manager/recordkeeper was because many of these large (mostly retail) firms have strong capabilities related to serving individual investors (including DC participants). Though there certainly are facts supporting this thesis, the biggest driver of the rise of the asset manager/recordkeeper was the economics of the DC business.
A CEO of a large mutual fund company was once asked about why his firm was in the recordkeeping business, and he answered that it was “for the same reason that Walmart has parking lots.” In other words, the main driver for asset managers to enter the recordkeeping business has been to gain access to individual DC investors — either directly as consumers of funds through investment lineups or IRA rollovers. This created an economic situation where it was possible for asset managers to take losses on the recordkeeping side of the house as long as the shortfalls in recordkeeping revenue were made up for in asset management fees.
On the face of it, for an asset manager and DC recordkeeper to be one and the same would seem to represent a conflict of interest. However, if the investment provider is a “big box store” type of investment manufacturer and competes favorable with other major retail fund providers, the mutual fund company’s CEO’s parking lot analogy is not an unreasonable position to take. The courts have mostly focused on whether investments are reasonable, prudent and the best share class available, as opposed to whether the asset manager and recordkeeping firm are one and the same.
Mainly due to the economics of the DC business, the asset-manager-as-recordkeeper model grew quite rapidly and was the dominant model throughout the ’80s and much of the ’90s. Those were the heydays for asset managers/record keepers. This began to change, however, with the advent of revenue sharing in the mid-’90s, which accelerated the trend toward open architecture.
Due to this trend, asset managers/recordkeepers often saw their fund revenue cut in half when outside funds were utilized instead of their proprietary funds. Thanks to revenue sharing, most asset managers could still make money from a plan’s fund lineup, just not as much. On the other hand, there were many asset management/recordkeepers that could no longer compete in an open architecture environment — and many of those firms chose to exit the recordkeeping business.
The Financial Challenges of the Independent Recordkeeper
The history of the independent recordkeeper has been almost the inverse of the asset manager/recordkeeper. For the last 30 years or more, these non-investment firms have struggled with razor thin margins, mostly due to their lack of access to fund fees. With the advent of revenue sharing, many of these firms got somewhat of a financial boost; however, for many firms it was too little, too late. Moreover, these independent recordkeepers were still at somewhat of an economic disadvantage given that it is more profitable to be the fund manufacturer than simply receiving revenue share from fund manufacturers. And, of course, with the advent of target-date funds, the asset managers with a suite of proprietary TDFs received an economic boost, adding back much of the revenue lost due to the advent of open architecture.
In addition to the rise of open architecture, there are two more recent developments in DC investing that have a greater potential to balance the economic scales between asset manager/recordkeepers and independent recordkeepers: the rise of passive investing and the emergence of DC robo platforms.
The Rise of Passive Investing
Without getting into the pros and cons of passive versus active investing, the fact is that many plans are making the shift from focusing on meeting a market benchmark (e.g., S&P 500) and are instead choosing to simply buy the benchmark. According to an article in Pensions & Investments, “The never-ending fight for lower fees and the fear of fee-related lawsuits have pushed passive investments ahead of active management among large defined contribution plans in 2015 — the first time since Pensions & Investments began tracking data from the 100 biggest corporate plans.” (Robert Steyer, “Passive Investment Train Overtakes Active in Corporate DC plans,” Pensions & Investments, March 20, 2017)
Unlike actively managed funds, with most passive funds there is often no (or very little) extra revenue to share. In fact, among many of the large passive fund providers, there seems to be a race to the bottom regarding fees for index funds. Since many of these index funds are sold to DC plans with institutional pricing, there is not much revenue to be had, either by the fund manufacturer or the recordkeeper. The growth of passive investing has leveled the economic playing field between the asset managers and independent recordkeepers, and will likely continue to do so.
The Rise of DC Robo Platforms
While managed accounts (robo-advice) have been around since Financial Engines was founded in 1996, they have never been utilized on a broad basis in DC plans in general, and thus they represent only a small slice of the total DC investment pie. However, as this technology continues to mature and become widely adopted by DC plans as a replacement for TDFs (as opposed to an adjunct to them), asset managers and independents alike will be integrating their recordkeeping systems with DC robo platforms.
Since most of the robo platforms utilize passive vehicles as their underlying investment vehicles, and given the ubiquity of cheap beta via a collective trust or ETF, there really is no bar to entry for the independent recordkeeper to access funds that represent all the major asset classes. On the other hand, the robo platform is just a hollow machine until it has been programed with the algorithms required to properly match risk profiles with the optimal mix of asset classes and manage this mix of investments over the lifetime of the participant. Some independent recordkeepers will go the route of utilizing preprogrammed robo offerings, while others will choose to buy or build their own asset allocation capabilities. The independent recordkeeper which builds or acquires an asset allocation capability delivered via a DC robo platform, will be very close to leveling the economic playing field between their offering and the offering of the asset manager/recordkeeper.
Of course, the asset manager/recordkeeper is not going to sit back and ignore the trend toward robo-DC. In fact, all the major firms are either preparing or deploying their own robo-DC strategies. Many of these firms view the target-date fund as having served as a stepping stone to robo-advice, and are planning to simply imbed their TDF glide paths into a robo-advice delivery model. Many of the large investment firms see robo-DC as a “back to the future” opportunity where, once again, they can garner much of the asset management revenue, often using their own in-house manufactured funds.
The large, well established asset manager/recordkeepers created a strong foothold in the DC recordkeeping market in the early 80s when DC began to emerge as the dominant corporate retirement plan. They have weathered the rise of open architecture, the shift toward target-date constructs and the movement away from active to passive, and now they are responding in various ways to the emergence of robo-DC. The independent record keepers have benefited from some of these market shifts as well. However, the robo-DC model creates an opening for them — either through an alliance or through ownership — to more effectively compete with asset managers by essentially becoming asset managers themselves, albeit as asset allocators as opposed to stock and bond pickers.
For many industry observers, the mantra has been that asset management and recordkeeping ought to be performed by totally separate, unaffiliated firms. Rather than wait for that mountain to move, perhaps a more market-oriented solution would be for many of the independents to level the playing field by effectively becoming asset managers (i.e., asset allocators), utilizing the robo-advice platform as a delivery mechanism.
Competition is a wonderful thing. In the case of DC investing, the real winners will be DC participants who can expect better outcomes as greater precision is brought to their asset allocation programs (through robo-advice technology) as well as lower investment fees. After all, in the aggregate, DC participants are the ones who mostly foot the bill for both recordkeeping and investments. They deserve the best deal that the market can deliver.
Jerry Bramlett is the Managing Partner of Redstar Advisors and Managing Director of Sage Advisory Services. This column originally appeared in the Fall issue of NAPA Net the Magazine.