What changed? More competition. Until recently, about the only choice for small-company pension plans was an insurance company. They often used third-party administrators who added their own fees to already expensive money-management charges. The giant mutual funds and brokerages that have revolutionized the 401(k) market were too busy chasing big employers, where they could sign up 10,000 participants at a time.

But with that market saturated, big names like Fidelity Investments, Merrill Lynch, and American Express have been turning their attention to the nation's 7 million smaller companies -- and learning to scale down their products to serve fewer than 50 people at a time. They're giving employees at small companies the same bells and whistles -- daily valuation, 24-hour call centers, and Internet access -- that people working for much larger companies have had for years. In the process, they're forcing banks and insurance companies that still dominate the market to improve their services and setting off a price war. In May, 1998, one of the biggest sellers of small plans, Aetna Inc., lowered fees on some products by as much as 33% and added eight new investment offerings. The reason: Mutual funds are suddenly knocking on the same doors as insurers, much to their chagrin. "That's not normal," says George Payette, product manager at Aetna Retirement Services Inc. Next month, things get even stranger. Fidelity is promising that its new e401k plan, which makes its debut on July 1, will be sold and serviced entirely over the Internet and priced 20% below what's on the market today.

At the center of the tussle is the defined-contribution pension plan, better known as the 401(k). After health benefits, it's probably the most desirable benefit an entrepreneur can offer. Employees make contributions from their before-tax salary to a retirement account, where the money grows untaxed until it's withdrawn. Usually it's invested in mutual funds. In that respect, the plan is similar to the personal retirement accounts, such as IRAs, that entrepreneurs already own. But because 401(k)s are pension plans, they come with lots of regulation, paperwork -- and headaches. In some cases, tHe costs and complexity have been so huge that small companies just skipped the whole idea -- only 13% have a 401(k) plan. What entrepreneurs want, says Peter J. Smail, president of Fidelity Institutional Retirement Services Co., is "a one-step, turnkey product that does everything for them."

They haven't always been getting it from insurance companies, which have dominated the small-plan market with 24% of the 1 million participants in small plans, according to Jeff Close, a pension consultant at the Spectrem Group in Connecticut. Banks and pension consultants also still play a big role in the market, with each of these segments serving 23% of small-plan participants. Generally, banks and insurers form alliances with third-party administrators, often called pension consultants, who handle actual administration of the plan. Often, customers wind up having to communicate with two or three vendors for money management, record-keeping, and administration.

Mutual-fund companies represent the new kids on the block, serving 18% of small-plan participants, up from almost nothing at the beginning of the decade. They have made inroads using the same formula that helped them muscle into the retail market for mutual funds: lower fees and well-known brand names tied to strong investment returns. More important, perhaps, they bundle the money management, record-keeping, and administrative functions into one package, providing clients with one-stop shopping.

That was the attraction for Sherri Neasham, president and CEO of FinanCenter Inc., a developer of financial software and operator of its own Web site in Tucson. She put a priority on having a plan in place for her four-year-old company, which is expected to generate $4 million in revenue this year, because it intends to boost its staff from fewer than 20 people to almost 30 by yearend. When Neasham explored the alliance route, she ran out of time and patience trying to figure out how to structure the plan. In the end, she took the easy way and hired T. Rowe Price Associates, the Baltimore-based mutual-fund company. "You call them up, they ship out the paperwork, you ship it back, and that's it," she says.

It's also easier to figure out how much you're being charged for a bundled plan. The traditional alliance structure typically resulted in layers of fees charged by each member of the team. While brokers and insurance agents can provide useful advice on setting up a plan, their commissions are often assessed as an annual percentage of plan assets, and that can eat into your returns. By contrast, fund companies that sell direct typically charge simple flat fees, with no commissions to insurance agents or brokers. The fees generally fall into four categories:

Startup fees. This represents the one-time cost of doing the paperwork and setting up the right structure. Typical cost: $1,000 to $2,000. Most providers will also charge a similar "conversion fee" if you're moving your account from another company.

Administration fees. This annual fee for record-keeping and other administrative work ranges from $1,000 to $2,500 a year for a plan. On top of that, expect to pay $15 to $50 per participant or employee. That should cover the cost of accounting, statements, and making sure the plan complies with government regulations.

Money-management fees. All mutual funds deduct a percentage of your assets each year to pay for fund operations, everything from research to rent payments. This "expense ratio" can range from as little as 0.18 to more than 2 percentage points. Generally, the fees are higher at insurance companies and brokerage-run funds, lower at mutual-fund companies. Don't ignore the difference. A 2% reduction each year for 40 years can cut the amount of money in an employee's equity mutual fund nearly in half. And if you're inclined to dismiss that as tough luck for your workers, consider that the majority of assets in a typical plan are held by the owner and senior managers, notes Stephen Butler, president of Pension Dynamics Corp. in Lafayette, Calif.

Supplemental fees. Given what you're already paying, you'd be amazed at what's not included. Merrill Lynch, for example, charges a fee of $3 per participant per year to cover the cost of sending them account statements. Vanguard Group charges $2,500 to run compliance tests that federal law requires of all plans. And almost all plan providers charge supplemental fees for handling employee loans.

The solution, of course, is to compute the total cost for your plan, because many plan providers cross-subsidize their expenses. If a plan provider's administrative costs are low, they tend to have higher money-management fees, notes David W. Huntley, principal at HR Investment Consultants in Baltimore. For instance, Principal Financial Group, which sells more small-company plans than anyone else, charges just $600 to establish or convert a small plan. However, annual expense ratios on their investment offerings average 1.5 percentage points a year. By contrast, Fidelity charges anywhere from $1,500 to $4,000 to set up a plan, but expense ratios on its funds average just 0.81 points. Over five years, on a plan with $1 million in assets and growing a modest 8% a year, the Fidelity option would save more than $80,000.

The best deal really depends on what kind of plan and company you have. A small startup plan at a company that does not expect employee assets to grow beyond $500,000 in five years probably would be best off with someone like Principal Financial. Startup and ongoing expenses are relatively low, and because assets under management are modest, the amount of money going to investment expenses isn't that much. Small companies that expect assets in their plan to reach $1 million or so within five years are better off going to a fund company. Want the best of both? Start up a plan with an insurance company when assets under management are low. As the plan grows and assets increase, switch to a vendor that has low money-management expenses.

Of course, low fees are no bargain if you're stuck with lousy investment choices. Funds run by banks, brokerages, and insurance companies are notorious laggards compared with those offered by mutual-fund houses. And nearly all of them pale in comparison to an ordinary index fund, which generally has a rock-bottom expense ratio and a track record that beats almost any other mutual fund you'll be offered. Try to insist on one in your plan. Among the major vendors, Fidelity, Vanguard and Price offer index funds to small plans.

But mutual-fund companies are not always the right choice. Some companies, such as Vanguard, won't take a plan unless it has $1 million in assets. And modest fees don't prevent fund companies -- T. Rowe Price, for example -- from falling into long slumps that affect many of their star funds. One alternative is to choose a plan that offers dozens or even hundreds of funds. If you think you can wade through so many choices, the alliance route is the way to go. About 400 third-party administrators from around the country have alliances with Charles Schwab through which they offer 2,200 funds from 300 fund companies. American Express and MetLife recently teamed up to offer 21 funds cherry-picked from eight fund families.

The fact is, some small-business owners prefer dealing with a local pension consultant, broker, or insurance agent. Their quality varies greatly, but pension management is a notoriously detail-oriented business. Kosola & Associates, for instance, settled on Principal Financial Group because of the personal touch. "I feel a lot more comfortable with someone who's willing to talk to me one-on-one," says Carmella Owens, who adds the new plan has worked out well from her point of view. "I didn't ever think this was an option for me. Now, I'm actually going to have a retirement, and my kids will have money if something happens to me." Sounds like an employee who plans to stick around.

By Virginia Munger Kahn

This article was originally published in the June 28, 1999 print edition of Business Week's Frontier. To subscribe, please see our subscription policy.

To: STAFF & BENEFITS