Are SMAs Appetizing For 401(k) plans?

June 1, 2007 Sydney LeBlanc

401(k) plan sponsors now can serve them up on their investment menu.

It’s no secret that, for most individuals, 401(k)s are their primary savings vehicle for retirement. Essentially do it yourself plans, more participants than ever before are asking for professional investment advice and a larger number of these individuals are educating themselves about their investment choices, including separately managed accounts (SMAs). Increasingly, participants are not happy with their options or their plan performance, and many preretirees are feeling anxious about their looming retirement future.

Harry Clark, president and CEO of Clark Capital Management in Philadelphia, believes that 401(k)s historically have been the worst investment in the world. People take advantage of the deferral opportunities of these accounts, but don’t understand how to manage money, Clark says. They often leave the majority of their assets in money market funds which will not provide sufficient growth to meet their future needs.

Clark adds that the Pension Protection Act of 2006 allows for more professional investment advice that will increase the use and implementation of SMAs in 401(k)s, an idea he says has been well received by his clients. A provision of the PPA that allowed plan sponsors to automatically enroll new employees into their firm’s defined contribution plans was clarified by the DOL last fall with new rules. Now, sponsors can choose from three types of investments for the employees, including separately managed accounts.

Clark’s firm saw and captured this opportunity, recently introducing Navigator Simplified 401(k), which claims to be the first managed account defined contribution plan to offer institutional protection strategies in conjunction with ‘best in breed’ money managers. Clark Capital Management currently manages more than $1.2 billion in assets, and as it prepares to roll out its newly offered 401(k) platform nationwide expects to raise $100 million in 2007.

Dissenters In The Midst

Jeffrey Vivacqua, the director of advisory services for Mutual Service Corp. (MSC) in West Palm Beach, Fla. doesn’t believe this concept makes much sense in today’s environment. MSC is one of the largest independent broker-dealers in the nation, with more than 1,500 advisors in all 50 states. The cost structure and technology haven’t come down enough to make separately managed accounts viable products within 401(k)s, he says. Since most of these are relatively small accounts, few individuals would qualify for the initial minimums and many managers who brand themselves as high-end would not be willing to participate. In many cases, the employees would be left to invest with second- or third-tier managers. Vivacqua also points out that separately managed accounts often offer tax efficiencies, a benefit that is not really needed in tax-deferred accounts like 401(k)s.

We are not getting many questions about managed accounts from our advisors, says Vivacqua. They don’t seem to be longing for this option. It is the rare exception that they have this demand.

Jeff Carlin, vice president of managed accounts for Charles Schwab, agrees. He thinks investors appreciate the cache of managed accounts, but does not see many benefits for 401(k) plan participants. Many high-net-worth investors who are running small to mid-sized companies use separately managed accounts for their personal investments and would like to incorporate them into their company assets as well, Carlin says. However, they need to ask themselves if they would recognize cost savings for their plan participants. While managed accounts may allow them to drive down their investment management costs as compared to mutual fund fees, they may be immediately swamped by the increased expenses in administration services.

He adds that these retirement plans must be properly unitized with daily valuations. There is a cost for doing this and it may not be economical, particularly for smaller plans.

While Carlin claims that more advisors are adopting separately managed accounts on a broader basis for their individual investors, he has not seen any great trend of plan sponsors moving into SMAs for 401(k) assets. It is really more of an accommodation than a proactive strategy to gather assets, he adds.

Pooled Assets In A Trust Structure

While Clark understands the skepticism, he feels the overall structure of his 401(k) platform helps eliminate many of these issues. His company oversees the management of several collective trusts that represent various asset classes. The plan participants can invest in up to three trusts at one time. They essentially own a pro-rata share of a large portfolio of pooled assets, much like a mutual fund, and enjoy diversification, professional management and flexibility. Unlike mutual funds, collective trusts are not required to be registered with the SEC.

The trust structure is really the beauty behind our whole 401(k) platform, Clark points out. The collective trusts overcome the concerns of liquidity, minimum balances and high fees and are very easy to manage. In fact, we have engaged some of the ‘best in breed’ separate account managers like Louis Navellier, Anchor Capital, Victory Capital and Groesbeck Investment Management to participate in our platform. They recognize the tremendous growth opportunities in the retirement plan market.

Clark adds that his firm serves as overlay manager and maintains the responsibility of performing ongoing due diligence and replacing any of the individual managers when deemed necessary. The employees understand that we oversee the entire process and they are participating in a completely managed, professionally run 401(k) program.

Dr. William R. Nelson, chief financial strategist of Eqis Capital in Oakbrook Terrace, Ill. has some concerns about the collective trust structure and its appropriateness for 401(k) plans. For one, he believes this structure eliminates some of the primary benefits of separately managed accounts over mutual funds. Each investor in a collective trust does not have a separate account, but rather a piece of the trust, Nelson says. By using the format of a 401(k) in which clients’ assets are commingled in a trust, there is essentially no tax or control distinction between these separately managed accounts and mutual funds.

Leonard Reinhart, president of Lockwood Advisors, an affiliate of Pershing LLC, believes that separately managed accounts within 401(k)s make sense for a group of highly compensated professionals like those within medical practices or law firms, where the individual account balances exceed $1 million. He also believes that large companies with significant assets in their 401(k) plans might enjoy some cost efficiencies by using managed accounts within their own pooled investments.

Plan sponsors must deal with issues like valuation and administration when using managed accounts, Reinhart says. By creating investment pools for the various asset classes and hiring separate account managers to run them, very large plans sponsors may be able to manage them more efficiently and less expensively than by using mutual funds.

Reinhart adds that the trust structure for 401(k) accounts is not an entirely new idea. In fact, he claimed that EF Hutton created pooled equity funds for just that purpose more than 20 years ago. In those days, firms did not have the technology to compute daily valuations, Reinhart says. Mutual funds had a big advantage over managed accounts at the time in terms of administration fees. Today, because of scalability issues, collective trusts may offer some advantages over mutual funds, for very large plans, in terms of cost efficiencies and flexibility.

Nelson raises some questions about the overall cost structure. He states, The cost question is difficult to answer without knowing each firms’ cost structures, but I would bet the collective trust format provides little if any savings.

Reinhart believes the true appeal of such a platform will be recognized by the company or plan sponsor as opposed to the employee participants, who may not even realize they are investing with separate account managers. This is a company sale, not an employee sale, Reinhart points out. Enlightened companies should be asking themselves, ‘What is this plan costing us to administer using mutual funds?’ ‘Can we do it cheaper ourselves?’ After all, companies are fiduciaries and have responsibilities to do what’s right for their employees.

Demand Still Lacking

Mark Coffrini, senior vice president of plan administrator services for Schwab Corporate and Retirement Services, believes managed accounts make the most sense for nondaily valuation plans like defined benefit and profit-sharing plans. These plans maintain lower cost structures than 401(k)s because they do not incur the expenses of unitizing or valuing the portfolios on a daily basis. Still, he has been seeing some managed accounts inquiries from larger 401(k) plan sponsors as of late.

Each plan is different; each company’s philosophy is different, Coffrini says. While there is no hard and fast rule, we are starting to see a little more interest from 401(k) plans with assets of $500 million and above. Bear in mind, the fiduciary must make sure the valuations are done on daily basis and whoever is calculating the NAVs each night is doing so correctly. This requires the rigors of a good fund accounting system, just like the mutual funds use.

Coffrini also thinks that some people have grown weary of mutual fund companies because of the scandals of the past few years, and often seek out alternative investment structures. Still, while inquiries have increased somewhat, he is not seeing a significant rise in demand. While sponsors and even advisors have been asking about managed accounts for daily plan portfolios like 401(k)s, most are not willing to incur the associated costs involved. The process is time-consuming and must be done right.

Schwab’s Carlin adds that even the more sophisticated plan participants do not seem to be seeking a managed account solution. Some of these investors like to track the daily performance of their funds in the newspapers each day, he claims. They will not have this opportunity in the separate accounts world like they do with mutual funds.

But Clark has an easy solution to this concern. Employee participants can access the Clark Capital Web site, where they can see their portfolios on a daily basis, he explains.

The jury is still out on the ultimate appeal of SMAs within 401(k)s. While Clark Capital has gathered a few million dollars in the program to date, Clark insists that the potential is quite significant. He stated, I believe that we can raise a billion dollars over the next three or four years which, as you know, is a pittance in the 401(k) marketplace.

Only time will tell if SMAs will be able to slice out a hefty portion of the retirement plan pie.