Many banks and other financial institutions have recently developed strategies to enter, or grow in, the pension market by building their defined contribution business. This product line is, in fact, generating impressive growth rates, but multiple challenges exist both for new entrants and established players.
In 1983, defined benefit plans accounted for more than 46% of the pension market, while defined contribution plans totaled 23% and government plans accounted for the remainder. In 1992, defined contribution plans and defined benefit plans each had 34%, with the remainder government-related.
Defined contribution plans have registered a 6% real growth rate over that period, while defined benefits have suffered about a 2% real rate of decline. Total defined contribution assets now exceed $1 trillion with a nominal growth rate expected to be in the 9%-12% range.
The reasons for the shift to defined contribution plans are well known. Many companies have actively moved to defined contribution plans in direct response to tougher pension legislation.
The responsibility for investment performance is increasingly being placed with the employee, rather than the company, which could risk backlash for poor investment performance results.
In addition, defined contribution plans may enable firms to reduce their overall pension costs by requiring employee contributions, which are then matched by the employer.
Many employees have responded favorably to these plans, welcoming the investment choices they offer. Going forward, the shift away from defined benefit and toward defined contribution plans should continue.
The economics of this business can be attractive to a bank that builds sufficient scale. The profitability of the existing book can continue to grow as the bank's cost to acquire a plan "runs off."
"Overall, yearly account attrition is relatively low, at about 5%-10%. This varies by plan type.
Successful players providing defined contribution plans can generate returns on equity well in excess of 15% from a business that has a much lower risk element than many other banking businesses.
Further, given the access to plan participants, cross-selling opportunities exist for products such as brokerage services, retirement planning, and Individual Retirement Account rollovers.
In light of the growth of the defined contribution business and its fee-based profit potential, the competitive environment is, not surprisingly, getting tougher. Less sophisticated players risk finding that they are unable to generate the returns that they have projected.
Acquiring attractive accounts has become more expensive in two ways. First, customers are negotiating interest rate subsidies on guaranteed investment Products and fee waivers for mutual funds.
The long-term trend away from guaranteed products, commonly known as GICs and BICs, and toward mutual funds may further reduce the profit margin for the defined contribution provider.
At the same time, distribution costs are rising as commissions increase. The net result is reduced revenue for the defined contribution provider.
Moreover, investment spreads on guaranteed products are shrinking as competitive pressures increase and interest levels remain low. Traditionally, companies in this business accepted low spreads (i.e., high participant credit rates) in the first few years of a plan and recouped this investment by gradually widening the spread.
Recently, large mutual fund companies such as Fidelity, Vanguard, and T. Rowe Price have leveraged their vast retail asset base to offer low-load or no-load products to institutional investors.
While these companies have historically targeted 1,000-plus life plans, both Fidelity and T. Rowe have recently established separate units to pursue the 100-1,000 life segment.
Viewed in perspective, the defined contribution business offers an excellent example of how competition within the financial services industry now approaches a free-for-all.
Focus on Smaller Plans
An analysis of key segments of the defined contribution business emphasizes the need for a bank to choose where it wishes to compete. For example, companies with 1,000 or more participants buy unbundled plans in which the investment and record-keeping decisions are separate.
This market, in particular, is already highly penetrated. The only chance to build business in this segment is by taking it away from some other institution. That other institution will typically be a strong, "name brand" national player with deep pockets.
For regional and community banks, however, opportunities still exist with natural market segments -- defined contribution plans sold to small (less that 100) or mid-size (100-500) participant groups. This is the one area in which local banks could have some competitive advantage.
Typically, smaller plans require a bundled product and easy-to-understand product features, as well as low cost. One factor that can weigh strongly in a local bank's favor in this market is the value that some smaller plans place on a local presence, both in follow-up service and marketing.
Importantly, a decision maker buying the plan is the local business person. Having access to him or her and being able to provide them the necessary "education" required is a key to selling to this market.
Today, only Norwest Bank appears in the list of the top firms servicing the 25-100 participant market. Insurance companies and investment firms are the biggest players.
With the exception of Norwest and Bankers Trust, State Street and Mellon on the high end, banks have been largely ineffective in building market share in this business.
Our analysis indicates that product penetration in the "small plan" end of the market is actually quite low, at about 10%. The fastest growing segments, both in assets and plan growth, will, therefore, be the small and lower-middle markets.
Setting Up for Growth
How should banks position themselves to grow in the small plan market?
First, banks must offer the right product, that is, a bundled product that is easy to understand.
Second, they need to provide a full range of products. Small companies often require profit sharing, ESOPs and SEPs as well as 401(k) plans.
Third, varied investment options are necessary for an increasingly demanding individual investor.
Fourth, to assure profitability, banks need to develop a cost-effective distribution system for selling smaller plans to existing and target customers.
In pursuing this market segment, strategic alliances among banks, record keepers, benefit consultants, and mutual fund companies may be the essential infrastructure required to ensure both the right product offerings. and low distribution costs.
Clearly, banks approaching this market will need to develop nontraditional tactics. A willingness to develop joint ventures and other "partnerships" will be required if they are to succeed at taking on some tough competition. The potential payoff to banks for doing so can be substantial.