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The School of Hard Knocks

TIAA-CREF the teachers' retirement and insurance giant, has learned some painful lessons as it seeks new growth in 529s and mutual funds

In mid-March, TIAA-CREF will get an important grade on its efforts to graduate from a niche provider of pension and insurance products to a broad-based money-management giant. It's a pass/fail test. If the company passes, it will keep the California 529 savings plan business; if it fails — adding California to a growing list of states, including New York, that have taken their business elsewhere — it will be a setback not only to TIAA-CREF's 529 efforts, but also to its wider ambitions.

“It wouldn't be catastrophic if they lost it,” says Morningstar analyst Christopher Davis. Nor, for that matter, would a complete retreat from the college savings business be a financial blow (529s represent around $5 billion in assets). Still, developing 529s, retail mutual funds and other new lines of business are critical to TIAA-CREF's transformation from a nonprofit provider of annuities and insurance for teachers, researchers and others associated with academic professions.

Nearly a decade into that transition, the 88-year-old company is caught somewhere in between. It has pushed into the broader mutual fund business, launched costly consumer-marketing efforts and has bet heavily on 529s — all as a way to bring in more assets and expand its customer base. Along the way, it has shed some of its historical baggage (a bloated bureaucracy, a penchant for social activism and tiny fees). But new businesses remain small — and not particularly profitable.

The transformation began in 1997, when the company lost its tax-exempt status, sending then-CEO John Biggs scrambling for a new strategy. He decided to enter the retail money-management business by rolling out six growth-oriented mutual funds, tuition savings plans, a trust company and life insurance products. The funds, mostly index-tracking products, were supposed to stanch the flow of assets to Vanguard and T. Rowe Price, which specialized in offering low-cost funds for retirement accounts. Since the 1980s, when changes in the tax laws allowed those fund companies into the 403(b) market, TIAA-CREF had lost nearly a third of its retirement assets.

In late 2002, former Merrill Lynch COO Herb Allison inherited Biggs' job and his strategy. The company had just launched six additional funds, including four specialized equity funds, an inflation-linked bond fund and a real estate investment trust fund (REIT). It had driven aggressively into the 529 college savings business, winning contracts to manage the plans in 12 states. In 2003, the company added a prepaid college tuition plan, supported by 250 universities.

But the growth in assets had not materialized — not least because of the middling performance of the mutual funds. Between 1999 and 2002, assets dropped from $290 billion to $260 billion, thanks largely to the bear market. Going into 2003, Allison ordered cuts, laying off 8 percent of the workforce and reshuffling his executive and portfolio management teams.

Allison has not been shy about expanding upon Biggs' strategy and has been remaking the company in the image of other retail investing giants. He broadened the product line with more actively managed funds and no-fee IRAs. Last November, directors approved seven lifecycle and 14 institutional funds. He has added an online brokerage operation, an advice platform and more than doubled the number of TIAA-CREF “client centers” to 55, up from 23 in 2002.

Allison, who declined requests for interviews, has said publicly that he wants to add many more advisors and call center employees and move toward open architecture. He is also working on cash-management and insurance products. In other words, it seems he is building a full-service financial platform (the company denies this). Total assets under management have risen from $290 billion in 2000 to $370 billion. But little of that is new money — 60 percent to 70 percent of the gain is market appreciation, estimates the Spectrem Group. Assets in TIAA-CREF 529 plans have grown to $5.4 billion from $3.1 billion in 2002, but the company has fallen from the top spot in the industry to fifth place, according to Financial Research Corp.

From 1997 through 2005, TIAA-CREF's mutual fund family brought in a total of $11.8 billion, $3.6 billion of which was raised since Allison signed on, according to FRC. During that same time, low-cost rival Vanguard has gathered $700 billion in assets, FRC says.

The plan was to sell the new funds to the 3.2 million individuals who already have TIAA-CREF accounts through their employers. “It didn't seem to work,” says Geoff Bobroff, a mutual fund consultant. Even though the company had a field force of 11,000 advisors, they did not have direct connections to the retail clients, says Bobroff.

The company now has 23 funds in three different share classes: retirement, institutional and retail. It has four major distribution agreements with independent advisor channels, including Schwab and Fidelity. In addition, TIAA-CREF offers clients the ability to buy and sell shares of nonproprietary funds through its brokerage window.

Performance continues to be an issue. TIAA-CREF funds have done better lately, but its average equity fund yielded a -0.19 percent return over the five years ended Jan. 31, 2006, says Morningstar. One of its flagship funds, TIAA-CREF Growth Equity produced a negative return of -4.33 percent, more than five percentage points below the S&P 500 and lagging its category average for five out of the last six years. Over three years, the numbers are better: averaging 22.7 percent total return, versus the large-cap growth average of 15.9 percent.

Meantime, marketing expenses have soared. TIAA had done little advertising — in the education business, sales were mostly at the institutional level — and is now trying to crack the mass market. In 2004, it launched its first television campaign, during the Olympics. And it has stepped up efforts in the independent advisor channel, through RIA platforms. (Only very recently has it made moves into the broker channel; it has hired a handful of wholesalers, but has no plans to introduce commissioned products, as Vanguard has).

To offset the costs of marketing new funds and adding analysts, the company has jacked up management and 12b-1 fees. Total cost rose from, on average, 24 basis points for its stock funds to 45 to 50 basis points, versus 22 basis points for Vanguard. That leaves TIAA-CREF in the awkward position of charging more for poorer performance. In the example of the TIAA-CREF Institutional Small-Cap Equity Fund, retail clients pay a new 12b-1 fee, with total fees, including waivers, running 85 basis points, up from 30 basis points, Morningstar says.

If the fee increase had been in place in 2004, TIAA-CREF says it would have collected $13.2 million in management fees from shareholders, instead of the $3.8 million it actually realized, and it would have earned a profit of $1 million. The fee-hike was unavoidable, says TIAA-CREF spokesperson Katherine Miller: “Since their inception, the funds have operated at a loss. This was not a sustainable business model.” The fees remain among the lowest in the industry.

Still, in a crowded fund industry where clients are focusing more attention on fees, the move seems ill-timed. “By increasing fees, they're moving in the wrong direction,” says Davis of Morningstar. The company, he says, is “less shareholder-friendly” since Allison took over. It has voted against two shareholder proposals splitting the CEO and chairman roles and proxy disclosure.

In its current position (neither a strong rival to Vanguard in the low-cost, direct-to-consumer space nor a popular choice for advisors), “They may have difficulty making it as a retail asset manager,” Bobroff concludes.

And, just when the company didn't need it, in late 2005 it hit another pothole: Glitches in its back-office system caused major delays in payments and transfers. According to internal documents, between early October and the end of November, 5,529 school and university participants experienced payment delays. On Jan. 12, Allison addressed the issues in a letter to shareholders and asked the millions of pensioners, fund shareholders and 529 participants to be patient as the company fixed the problems.

That did not assuage some account holders. A number have lodged complaints with the SEC and state insurance departments. One of its irate customers, Lehigh University physics teacher A. Peet Hickman, even launched a blog called “TIAA-CREF is Falling Down,” where he provides details about his struggle to transfer assets from a tax-deferred account at TIAA-CREF to a traditional IRA.

Perhaps the most surprising setback has been the 529 business, which seemed like a natural extension for a company that has been working with the higher education community since its founding in 1918 by Andrew Carnegie. TIAA-CREF's early drive into the 529 business made it a leader. However, it soon became clear that winning 529 contracts and delivering performance (and profits) were two different things.

The business began to unravel quickly. The first big blow came from New York. Even though its funds had fared poorly for Empire State residents, when the contract came up for renewal in 2003, TIAA-CREF proposed increasing its fees to 0.8 percent from 0.6 percent. Vanguard and Upromise bid 0.6 percent and won. There went $1.8 billion in assets.

Next came Missouri, which was lost to Vanguard and Upromise in January 2006. That was another $800 million. If the California renewal bid goes south this month, TIAA-CREF faces the loss of $1.8 billion more. “Retaining the California contract is going to be critical,” says Brian Boswell, an analyst at FRC. “They're going to fight tooth and nail for it.” The rivals: Upromise/Vanguard and Fidelity.

Losing California could also make it more difficult to hang on to Idaho, whose contract expires in 2006, Tennessee and Michigan, whose contracts expire in 2007. If it is forced to exit the 529 business, the company stands to lose more than $6 billion. That's a small percentage of its total assets but it would also leave a gaping hole in its distribution strategy.

The 529 business has turned out to be underwhelming for many participants (See, “Will Reform Drive Brokers From 529 Sales?,” Registered Rep., November 2005), but TIAA-CREF is feeling more pain, because it had the biggest ambitions. “Win every state you can win. That was the noose around their neck,” says one 529 consultant who asked not to be identified. The company wound up with a complex, low-margin business that involved oversight by state administrations across the nation, all with different demands. Money managers who entered the business more recently have taken a different tack: sticking with fewer states, but marketing them more aggressively to out-of-state parents. (Things could swing back in TIAA-CREFs direction, however, if regulators mandate that advisors steer clients to in-state programs to capture the tax benefits.)

But TIAA-CREF's 529 problem may not be about regulations or anything very complicated, suggests Joe Hurley, founder of “If TIAA-CREF were showing outstanding investment performance, they'd be having no problem with their 529 business,” he says. “A year from now we could see things swing in their favor,” he adds.

Getting Schooled

Assets and market-share rank of the top providers of 529 college savings programs.
Alliance Capital $2,664 $4,215 $5,419 $6,370 2 2 4 4
American Funds $2,048 $5,329 $9,272 $13,452 4 1 1 1
Citigroup - $2,161 $2,813 - - 8 8 -
CAM North Am/Legg Mason - - - $3,483 - - - 8
Salomon Smith Barney $1,125 - - - 7 - - -
Fidelity (combined) $2,332 $4,017 $5,827 $7,438 3 3 3 3
Merrill Lynch $1,402 $2,292 $3,099 $3,587 6 7 7 7
Putnam $1,919 $2,848 $3,370 $3,801 5 5 6 6
Strong Capital Management $721 $1,355 - - 9 10 - -
T. Rowe Price $762 $1,435 $2,180 $2,888 8 9 9 9
TIAA-CREF $3,120 $2,901 $4,234 $5,537 1 4 5 5
Vanguard $375 - - - 10 - - -
Upromise - $2,640 $5,927 $8,532 - 6 2 2
Wells Fargo - - $1,350 $1,580 - - 10 10
Source: Financial Research Corp. ($ in millions)
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