Outsourcing a 401(k) plan.

EXECUTIVE SUMMARY

* WITH 401(k) BALANCES GROWING, SMALL AND MEDIUM-sized companies are finding themselves burdened with myriad responsibilities of operating a retirement plan for employees. Many companies are choosing to outsource the plan to an outside provider to handle some or all of the tasks involved--performance monitoring, investment selection, educating plan participants and administering plan recordkeeping and reporting.

* THE INDIVIDUAL IN CHARGE OF OUTSOURCING SOME or all of the plan's operations should consider carefully what the company wants and needs in taking this step. Some companies retain recordkeeping and reporting in house and hire an investment manager to select mutual funds and monitor their performance.

* SOME COMPANIES HIRE AN INVESTMENT MANAGEMENT consultant to help them evaluate available retirement plan resources. A consultant can help a company hire a new plan vendor to handle some (unbundled) or all (bundled) of the plan's functions.

* COMPANIES FACE A VARIETY OF LIABILITY CONCERNS. Outsourcing a 401(k) plan allows the employer to pass a lot of the responsibility of investing back to employees. Employers should be ready to document that they demonstrated due diligence in selecting a new plan provider.

* ONCE A COMPANY HAS SELECTED A NEW PROVIDER, there are a variety of steps to follow in making the transition. This includes transferring existing investment holdings to the provider, executing trust and service agreements, informing employees of the change taking place and educating them about the new plan and its offerings.

How to make the right choices.

Some 30 million workers participate in a defined contribution retirement plan, most of them 401(k) plans. Contributions to 401(k) plans reached a whopping $1.7 trillion in 1999, up from $550 billion in 1992, a growth rate of 17% per year, according to a recent study by the Employee Benefit Research Institute and the Investment Company Institute. Released in February 2001, the study found that participant account balances had averaged $55,502 by yearend 1999, up 18% from the previous year.

Clearly, employees are investing heavily in their retirement, which signals an expanding burden on companies acting as plan sponsors. Small and midsize companies may be particularly overwhelmed,by myriad tasks: monitoring the performance and suitability of the investment opportunities offered to employees, keeping abreast of statutory and regulatory changes, running educational programs for participants, attending training sessions, lectures and seminars and administering plan recordkeeping and reporting.

Pension policies at most companies allow outsourcing when the plan reaches certain asset or participant levels. Typically a company's board of directors will then ask the individual administering the plan, perhaps the CFO, controller, treasurer or vice-president of finance, to off-load some or all of the responsibilities listed above. Before celebrating however, the financial manager has to consider some minefields, since his or her fiduciary role is far from over.

WHAT TO DO FIRST

Since the current plan document is the basis for most discussions with outside advisers, the first step the financial manager in charge of outsourcing some or all of the plan's operations should take is to review the plan internally and ask participants about their satisfaction with the current investment choices. If the plan offers a family of mutual funds, have the funds met employees' needs? Are there services participants would like to have, such as online access to account information?

The next step is to consider what the board wants. For instance, does it prefer to continue selecting investment options for participants and outsource only the recordkeeping and reporting functions? Or, does it want to retain those operations in-house and hire an investment manager to select funds and monitor their suitability? Perhaps the board seeks an investment adviser that will set only some benchmarks and guide the company personnel in management of the plan and investment selection.

For many companies, investments are where they need the most help. "Some plan sponsors are extremely investment focused," says Steve Schneider, director of retirement services for Strong Capital Management, in Menomonee Falls, Wisconsin. "They request benchmarks for long- and short-term performance and ask how the investment provider performed against those benchmarks." Increasingly, company plan sponsors want to know what portion of the plan's performance can be attributed to management skill. In fact, Schneider says, many sponsors are asking for daily reporting to help them evaluate manager performance.

The various outside choices available to a company are not as simple as they may seem, each coming with a host of fiduciary pitfalls, advantages and disadvantages. For this reason, many companies hire an investment management consultant to help them sift through the options. (Exhibit 1, lists some of the available consultant resources.) With a list of employee and company needs, the company is better equipped to find the right help.

Exhibit 1: Employee Benefit Services and Consultants

* Buck Consultants, www.buckconsultants.com.

Employee benefits consultants headquartered in New York City.

* DiMeo Schneider & Associates, www.dimeoschneider.com.

Chicago-based institutional investment consulting firm.

* Hewitt Associates, www.hewitt.com.

Global management consulting firm including Hewitt Investment Group.

* Investment Management Consultants Association (IMCA), www.imca.org.

Denver-based professional association for investment consultants.

* Nelson Information, www.nelsons.com.

Information resources on the institutional investment industry, including a directory of pension fund consultants and investment managers.

* Russell/Mellon Analytical Services, www.russellmellon.com.

Provider of investment analysis tools for institutional investors.

* Towers Perrin, www.towers.com.

Management consultant with 70 offices around the world. Provides employee benefit consulting.

* William M. Mercer, www.wmmercer.com.

Worldwide consultant offering a full range of employee benefits services.

USING AN INVESTMENT MANAGEMENT CONSULTANT

An investment management consultant can help a company find the right plan provider and save money. Robert DiMeo, of DiMeo Schneider & Associates, in Chicago says, "We helped one plan sponsor reduce annual plan expenses by over $1 million in a year." But selecting the right consultant is more than just dollars and cents. Credentials are also important. DiMeo, for example, is a certified investment management analyst and member of the Investment Management Consultants Association (IMCA). To gain the Denver-based professional group's CIMA designation, candidates take a prequalifying exam to attend the certification course, which is taught at the Wharton School of Business at the University of Pennsylvania, and sit for a final exam. They also must recertify every two years, according to Evelyn L. Brust, CAE, the program's executive director.

Consultants like DiMeo help plan sponsors hire a new plan vendor, whether just for recordkeeping or handling everything connected with the plan. A consultant will also work with a company on a per project or retainer basis. For example, a company may want to add another family of mutual funds to its plan. The consultant can conduct the search and make recommendations, or design or select benchmarks and monitor all of the plan's investments.

Depending on the complexity of the plan, midsize companies can expect to pay from $5,000 per project or $20,000 a year for a retainer. To play it safe and save time, the company should ask about a consultant's minimum fee before hiring one.

Often a mutual fund family the sponsoring company has already been investing with will recommend a few investment management consultants whose work the fund knows, says Robin Pellish, senior managing director at BARRA RogersCasey, Inc., in Darien, Connecticut. Dreyfus, for example, works with more than 25 different nationally recognized consultants.

A consultant might start out recommending the plan be reviewed for redundancies (funds that mirror each other) which can defeat asset allocation efforts, says Pellish. The consultant will examine the performance risk characteristics of the plan's current investments, suggest alternatives, help plan sponsors weight investment policy choices, conduct educational programs for employees and analyze the fees the company is paying. "That might segue into a retainer situation, in which the consultant and the plan sponsor meet semi-annually or quarterly," says Pellish.

Consultants can also guide sponsors through potentially treacherous liability waters. For example, what if an employee is adamant about investing in emerging market debt, which can boost returns--and risk? The company sponsoring the plan may not be comfortable, from a fiduciary standpoint, including such a fund in its core lineup. In this instance, Pellish suggests using a "window," whereby the sponsor can impose some restrictions, such as limiting the percentage of the employee's account allowed in the risky fund. "An individual may have to pay $100 a year to use the window," as a deterrent, adds Pellish.

Regardless of which consultant they choose, plan sponsors should be ready to document that they demonstrated due diligence in the selection process, including investigating several consultants before picking one. Most important, choosing a consultant doesn't automatically relieve the company of its fiduciary responsibility for selecting the investment manager or other vendors. If the consultant is willing to assume or share fiduciary responsibility, that understanding should be clearly stated in writing.

BUNDLED OR UNBUNDLED SERVICES

Many financial services companies offer soup to nuts retirement plan services. Fidelity Investments, for example, the largest provider of 401(k) plans, offers a fully Web-based plan for very small companies, as well as one for small to midsize companies of 100 to 1,000 employees. It promises employers "flexibility in plan design and options and a high level of personalized consultative service." Joe Fein, a manager in Deloitte & Touche's institutional consulting practice, says other major providers include Vanguard, T. Rowe Price, Dreyfus, Cigna Retirement Services and Merrill Lynch. To get flexible options from larger providers, Fein suggests plan assets should be at least $5 million to $10 million. Smaller plans may find fewer vendors and fewer options.

Most of the larger providers appear to be targeting both ends of the business: the bundled, all-inclusive retirement plan management and the unbundled option, offering services such as recordkeeping and investment management separately. "For small corporations, working with one provider (the bundled approach) can be more efficient," says Scott Powers, acting CEO for Defined Contributions Investors, the investment-only 401(k) offering from Dreyfus. But, he adds, bundling services can also mean higher costs due to missed opportunities. "There's more flexibility--the option to choose the lowest cost recordkeeper for example--with unbundled plans."

Due to the nature of technology, shoppers can't always tell what is going to end up being the pricier option, either, says Strong's Schneider. "Internet service is part of most base offerings today," he says. "But third-party administrators who don't offer Internet access or a voice-activated telephone system and who do all their number crunching in-house don't always work out to be the cheaper route." Why? Economies of scale, such as in technology, available to larger providers often take the place of labor, the most expensive component of plan management--salespeople, educators and back office workers. Says Schneider: "Technology and the Internet take a lot out of the cost picture."

Plan sponsors opting for multiple investment managers take on more work in conducting the search, unless they off-load it to a consultant. "It's typical to interview a portfolio manager in person," says Dreyfus' Powers. There is also expanded monitoring work to be sure the new managers are meeting agreed-upon benchmarks and staying within the selected style, such as small cap growth. But the advantage, he says, is being able to hire any series of mutual funds and make decisions on funds based on, say, an expense ratio basis, without being limited to the offerings of one manager.

CHOOSING A 401(k) MANAGER

Kathy Roberts, trained as a CPA and now vice-president of finance for Rollprint Packaging Products, Inc., a flexible packaging manufacturer in Addison, Illinois, maintains a $6.5 million retirement plan for 180 employees. The plan started as a simple once-a-year profit sharing arrangement managed in-house, says Roberts. In 1987, the company added a 401(k) plan and selected an outside provider to manage it.

In 1998, a committee including Roberts, the company president and the corporate controller launched a search for another provider. Rollprint had grown dissatisfied with its current provider's recordkeeping and administrative services, prompting the company to consider moving the plan. Roberts and the controller did the interviewing and reported their findings to the president.

A consultant from Clifton Gunderson, LLP, of Oakbrook, Illinois, Rollprint's auditor, provided input to the committee. Al Herbert, CPA, a Clifton Gunderson partner, referred Roberts to the firm's Chicago-based employee benefits specialist who helped her compare proposals to the services of their current provider.

Roberts also consulted its new insurance agency for help. "They had just hired someone to run their investment services division," says Roberts. He became the fourth member of her selection committee, and explained the difference between the bundled and unbundled options.

Since Rollprint was unhappy only with its current provider's recordkeeping and administration, the committee initially favored replacing the vendor for one function without changing the investment manager. But Roberts found there was a downside to unbundling: "When you have a problem or concern, you have to determine which vendor to call to fix it." Also, she thought it would be hard to fix blame.

Serendipitously, Strong Capital Management, which offers bundled services, happened to make a cold call to Rollprint at that very time. "It was not the lowest priced," says Roberts, "but Strong was the most upfront in letting us know the costs without my having to dig." As it turned out, "unbundling would have been the most expensive approach for us due to commissions and other costs," says Roberts. "It may have ironed out as the plan fund grew, but unbundling was not the best choice for us now."

Ironically, Rollprint's search concluded and it had made its choices shortly before Clifton Gunderson launched its own line of investment services for 401(k) and profit-sharing plans. "This is a very important line of business to the firm," says Herbert. "It's one of three areas we are expanding to service our client base." Herbert says Clifton Gunderson believes clients will look to their CPAs for these types of services because of "the loyalty, trust and high standards they know CPAs maintain."

The liabilities. Despite the turnkey solution she found, Roberts still attends seminars and conferences regularly. At a recent seminar, she learned that retiring employees are starting to file lawsuits against their former employers because their investment choices didn't increase their savings enough to pay for retirement. In one case, employees who participated in a pension plan maintained by Unisys Corp. charged the company had breached its fiduciary duties under ERISA by investing in guaranteed investment contracts (GICs) offered by Executive Life Insurance Co. The employees claimed Unisys knew of Executive Life's financial troubles and should have warned plan participants. A district court ruled in favor of Unisys. The Third Circuit Court of Appeals affirmed the district court opinion and held that Unisys satisfied ERISA's prudence standard.

This ruling notwithstanding, companies still need to be cautious in communicating with employees. Roberts says employee education is the big emphasis now. "But you have to be careful not to go too far with education so that it becomes advice." One option, she says, is to "offer participants enough choices to give room for sufficient growth."

"Most employers give employees a broader range of choices to deal with liability concerns," agrees Richard Matta, an employee benefits lawyer with a specialty in investment management, at Morgan, Lewis & Bockius LLP, in Washington, D.C.

Outsourcing a 401(k) plan allows the employer to pass back to employees a lot of the responsibility of investing, according to section 404c of ERISA. Not all employers who manage their plans in-house are aware of section 404c's requirements, says Matta. For example, if Roberts had hired an investment management consultant willing to take on the fiduciary responsibility of selecting a plan provider, section 404c essentially would protect her as long as she could prove she had followed prudent practice in selecting the consultant. However, if the consultant then gave her three providers to choose from, the fiduciary responsibility could fall back on her shoulders, because Roberts would again be making a choice for the employees.

What about the employees who haven't made very good investment choices? Roberts' concerns about lawsuits are reasonable, says Matta. "If the market really fails, those retiring now might very well file lawsuits. The potential is definitely there. We've been warning employers to take this into account." And some are listening. A survey by www.plansponsor.com found that 45.7% of plan sponsors ranked "basic compliance with section 404c" as one of their objectives in communication and education efforts with plan participants.

Matta advises employers to say, `This plan is meant to conform with section 404c of ERISA.'" It's questionable how many employees are sophisticated enough to translate this into "I'm on my own." Moreover, if a participant in the plan acted on Robert's advice, no matter how well intentioned, she'd be running the risk of a lawsuit against the company. The DOL doesn't require it, and, Matta says, employers should "think carefully before going beyond education to advice." According to www.plansponsor.com, only 16.5% of plan sponsors with assets of $200 million or more offer participants financial advice, compared with 36.2% of plans with assets of less than $50 million.

Sponsors are not held responsible for the provider's investment performance. "If the plan document allows the fiduciary to delegate investment management, the company will generally not be liable for the investment performance of the plan funds if the manager selection and monitoring of performance are done prudently by the fiduciary and according to ERISA standards," says Bertram Schaeffer, national director of investment advisory services for Ernst & Young, in Philadelphia.

10 STEPS TO OUTSOURCING

Once a company has made the final decision to outsource a 401(k) plan previously managed in-house, there are still some important steps the company and the new provider should take. Debra Glegg, vice-president and managing director of product sales for Banc One Investment Management Group, offers these recommendations.

1. The new service provider should review and discuss the existing plan with the employer to determine what changes, if any, need to be made in the plan, including investment options, plan access and reporting procedures.

2. The company should "map over" the plan's holdings to the new investment manager's funds. This is a good time to eliminate redundancies and add additional funds for diversification.

3. The company could put all of the plan's existing investment holdings in an Excel spreadsheet to facilitate transfer to the new plan provider.

4. The parties should sign trust and service agreements, including recordkeeping specifications. Compliance and trusteeship is usually part of a bundled service package.

5. The employer should seek legal review of all agreements before executing them.

6. The company should inform employees of the changes that are taking place in the plan and how funds will be transferred and invested.

7. The parties need to set a transition date for transfer of data from the company's system to the provider's. This is done electronically or even by downloading the data onto a disk.

8. The employer sponsoring the plan should communicate regularly with the new service provider--especially during the transition--to make sure nothing gets lost or garbled in the transition.

9. In the future the employer and employees should receive quarterly reports. In many cases information will be available on the Internet for both parties. The company should also hear from a representative of the provider at least quarterly to resolve any concerns the company might have. This is the person the company would call with any problems or questions. Typically a bundled service provider will provide the company with a signature-ready form 5500 after yearend to file with the Department of Labor.

10. The provider should schedule in-person, educational meetings for plan participants to acquaint them with the details and mechanics of the new plan investment offerings.

TOUGH CHOICES

CPAs who help their employers or clients outsource some or all of the administrative and investment functions of the company's 401(k) plan will need to make some difficult decisions as they sift through myriad service providers available today. The resources listed in exhibit 2, below, can help CPAs understand some of what they will need to know to recommend choices that are beneficial to both employer and employee. With the safe and secure retirement of employees at stake, it may fall to CPAs to be vigilant in applying their skills to the decision-making process.

Exhibit 2: Resources for Plan Sponsors

* Association for Investment Management Research (AIMR), www.aimr.org.

Ethical standards for investment professionals.

* BenefitsLink, www.benefitslink.com.

Resource for employee benefits compliance information and tools, including the BenefitsLink Store.

* International Foundation of Employee Benefit Plans, www.ifebp.org.

Educational association serving the employee benefits and compensation industry. Resources include books, conferences, newsletters and periodicals.

* Mid-sized Pension Management Conference, www.ucs-edu.net.

Provided through University Conference Services. Conference will be presented in Chicago in October 2001 and Orlando in January 2002.

* Nelson Information, www.nelsons.com.

Information on the institutional investment industry, including money manager rankings and a directory of pension fund consultants.

* Pension and Welfare Benefits Administration, www.dol.gov/dol/pwba.

Government agency with a variety of available resources, including the "401(k) Plan Fee Disclosure Form," "A Look at 401(k) Fees for Employers" and a glossary of terms.

* Plan Sponsor, www.plansponsor.com.

Monthly magazine and Web site for organizations that sponsor pension plans for their employees.

* Society of Professional Administrators and Recordkeepers, (SPARK) www.rgwuelfing.com.

Defined contribution industry association with 250 member companies. Resources include quarterly newsletter and RFP Guide to help plan sponsors evaluate or select 401(k) plan service providers. Free to SPARK members, $100 for all others.

The Importance of a Diversified Plan

Companies that offer retirement plans to employees are increasingly finding themselves under investigation for failing to operate fully diversified plans, as ERISA requires. The Department of Labor opened 4,311 investigations into companies for failing to act solely for the benefit of plan participants in fiscal year 2000. This represents a 5.6% increase over the 4,081 investigations it opened in fiscal year 1999.

Source: Department of Labor/Invesmart, Inc., Pittsburgh, www.invesmart.com.

LOOKING FOR GREENER PASTURES 

In a 2000 survey of companies that sponsor retirement plans, the companies offered a variety of reasons for leaving their previous plan provider.

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MAUREEN NEVIN DUFFY is an independent journalist based in New Jersey. The founding editor of the Journal of Performance Measurement, her articles have appeared in Institutional Investor, Money and The American Banker.