September, 1997 Vol II, No.1

Pensions & Investments:The International Newspaper of Money Management

TCW may advise participants

by Fred Williams

LOS ANGELES - TCW Group might become the first money manager to provide investment advice to 401(k) plan participants.

Capping a two-year quest to establish a presence in the defined contribution market, TCW has proposed a precedent-setting program - using outside financial and behavioral finance experts to provide defined contribution plan investments and participant investment advice.

The proposal is being reviewed by the Department of Labor.

Under the proposal, participants would direct their investments into four commingled trusts. The trusts, in turn, would invest in TCW's Galileo family of 13 no-load mutual funds.

Each trust's fund lineup would be determined by an outside financial expert and be designed to accommodate different investment strategies and risk tolerances, based on asset allocation models developed by the independent financial expert.

TCW proposes that Jeffrey E. Jaffe, professor of finance at Wharton Business School at the University of Pennsylvania, Philadelphia, serve as the independent financial expert. He would make the initial asset allocation recommendation and decide in which trusts to invest.

In addition, a behavioral finance expert - TCW proposes Shlomo Benartzi, professor at the Anderson School of Management at UCLA - would review participant data to formulate individual risk profiles and possibly, recommend more conservative investment approaches.

The independent financial expert would develop the methodology for assessing participant retirement needs; the behavioral finance expert would develop the risk tolerance.

Sources say Nobel laureate William Sharpe is designing the computer program that incorporates the methodologies designed by the two financial experts.

Information from participant responses would go into the computer program to produce the investment recommendations.

The participant would be free to accept or reject the recommendation.

The proposal also states TCW's investment advice will help maintain or increase participation, or the plan sponsor would be encouraged to end its relationship with TCW, according to sources.

ERISA exemption needed

Word of TCW's plans surfaced when it requested, from the Labor Department, an exemption from the prohibited transaction provisions of the Employee Retirement Income Security Act.

In its proposal, TCW acknowledges its fiduciary responsibility to the participant for rendering investment advice.

But, because of the way the product is structured - independent financial experts provide the investment advice and develop the asset allocation - TCW is insulating itself from potential breaches of fiduciary obligations relating to self-dealing.

Self-dealing could occur if a money manager were providing the advice and recommending the use of its own mutual funds. Then, fees could become an issue.

Under the terms of the proposal, TCW would collect management fees for using the funds in the trusts, the same fees as if it were in an arm's-length transaction, but would not be the party recommending the use of those funds.

That is the job of the independent financial experts, who will have complete responsibility for the mix of funds in each trust and for rendering the advice to participants.

Plus, only 5% or less of the experts' annual income can come from TCW.

A Labor Department spokeswoman wouldn't comment on TCW's proposal, except to say the comment period was to end Sept.

1. after which the proposal may be adopted as is or modified.

Sources expect the TCW proposal to gain approval by the end of September, barring major objections from the industry.

A TCW spokesman wouldn't comment pending Labor Department approval.

Others will follow

If TCW's proposal is approved, others surely will follow. But TCW will gain a major advantage as the first to offer professional investment advice combined with investment management.

"The proposal is ground breaking in that it opens a completely different channel. . . . The fund manager can now provide advice and creates a whole new supply of advisers who have an incentive that third parties don't usually have, the underlying investment fees," said Michael Berry, managing director at Bankers trust Co., New York.

"It is going to help fill the needs of plan participants who are saying they want someone to tell them how to invest, and the employer who is going to be getting more value for his expenditures in helping people prepare for retirement," said Mr. Berry.

An industry expert familiar with the TCW proposal said the "only source of profit for TCW will be through the management of the assets in its institutionally priced mutual funds. The participant will be paving nothing more than he would be paying for the mutual funds alone."

The DOL's proposed exemption emphasizes TCW will receive no fees other than those charged by the funds.

The expense ratios for the Galileo funds range from 4 basis points for a money market fund to 144 basis points for a Latin America fund. The core fixed-income fund expense ratio is 76 basis points; the core equity fund, 82 basis points.

Expense ratios 'shape up well'

John J. Mulligan, president of Retirement Plan Strategies Inc., Braintree, Mass., who consulted with TCW in developing the product, said the TCW Galileo funds' expense ratios "shape up well" with other no-load funds.

For example, the average institutional expense ratio for international equity funds is 127 basis points, according to Morningstar Inc., Chicago, a mutual fund rating service. The average institutional diversified equity, fund is about 95 basis points; domestic equity fund, 96 basis points; high-quality bond funds, 63 basis points.

Andrew L. Oringer, an ERISA attorney with the New York law firm of Rogers & Wells, said the TCW design minimizes the risk of fee-based conflicts. He also said the opportunity for abuse by TCW appears "extremely low."

Should the DOL approve the request, Mr. Oringer said: "A lot of firms may begin to adopt a similar approach. My own hope is that this may serve as a springboard for others to develop their own innovative solutions to this problem. "

Mr. Berry of Bankers Trust said the Labor Department "deserves credit" for its apparent receptiveness to the TCW proposal.

"The DOL has recognized that the 401(k) is becoming an important retirement vehicle and that asset allocation is important. They are committed to finding a way through ERISA" to help participants align their investments with their long-term objectives, said Mr. Berry.

"We at Bankers Trust consider advice to be the next important issue in this field, the next step we all have to take. This ruling will open the door for all providers to consider and also will permit the development of new products you couldn't use if you weren't rendering advice," said Mr. Berry.

Under the proposal, TCW would provide each participant from a plan sponsor client with a work-sheet of questions designed to assess retirement needs and risk tolerance, and including information about other financial assets, tax bracket and other funding sources.

The questionnaire would be analyzed and evaluated by the independent financial experts; each participant would receive a written recommendation from TCW of an appropriate investment trust.

In addition to the four commingled trusts, participants would have access to a money market fund and a guaranteed investment contract fund.

Why the DOL is interested.

Clearly, the Labor Department is looking at the TCW approach as a model, industry experts said. The reasons: adequate retirement savings, the demand for personalized retirement advice and the stagnant participation rates in 401(k) plans.

Retirement Plan Strategies' Mr. Mulligan expects the DOL to approve the application. He called the approach "a major step forward."

He said the "hundreds of millions of dollars" being spent on investment education to encourage participation and realistic asset allocation have met with limited success.

Participant rates, he said, are stuck" between 70% and 80% contribution rates, he added, also are stuck, around 6% and asset allocation still is too conservative.

"Current behavior is not going to get us to where we need to be, and the tactics we have used so far haven't done the whole job," said Mr. Mulligan.

"If TCW is right and the program gets results, and utilization improves, it will catch on and spread like wildfire just like daily valuation did."

Another source said the Labor Department had been searching for methodologies to assist 401(k) plan participants, in light of the uncertainties surrounding Social Security, the decline of defined benefit plans and what many professionals consider too conservative asset allocations.

"This whole idea is due to DOL's efforts to get people out of GICs and into equities . . ."

Participants "have been asking for specific advice, and now the government sees a way to lower the potential conflict-of-interest questions connected with financial services companies" providing advice," he said.

Investment advice 'necessary'

Mr. Benartzi, the behavioral finance professor, said most 401(k) plan participants need investment advice.

"I believe advice is necessary; people are making too many mistakes. Many young individuals invest too conservatively because they are worried about short-term losses. We have found that people have the wrong concept of diversification," said Mr. Benartzi.

He said he will work with the software developers to construct investment models "to help the individual make the right decisions."