Financial Engines Management Discusses Q3 2013 Results - Earnings Call Transcript

| About: Financial Engines, (FNGN)

Financial Engines (NASDAQ:FNGN)

Q3 2013 Earnings Call

November 05, 2013 5:00 pm ET


Raymond Jay Sims - Chief Financial Officer and Executive Vice President

Jeffrey Nacey Maggioncalda - Chief Executive Officer and Director


Mayank Tandon - Needham & Company, LLC, Research Division

Michael J. Grondahl - Piper Jaffray Companies, Research Division

Hugh M. Miller - Sidoti & Company, LLC

Brian Dean Hogan


Good day, and welcome to the Financial Engines Third Quarter 2013 Earnings Conference Call. Please note this event is being recorded.

I would now like to turn the conference over to Mr. Ray Sims, Chief Financial Officer.

Raymond Jay Sims

Good afternoon, and thank you, all, for being on today's call. Before we get started, I need to remind everyone that part of today's discussion will include forward-looking statements, such as statements regarding our operating metrics; anticipated cost and expenses; growth and growth opportunities; strategy; trends impacting our business; our competitive position; impact of new laws and regulations; enrollment rates; implementation and potential impact of enrollment enhancements and strategies; anticipated benefits, success and impact of our services, including Income+; anticipated adoption of our product and services; anticipated benefits and impact of customer experience enhancements; long-term objectives; and financial outlook for 2013 and 2014.

These statements are based on what we expect as of this conference call, as well as current market and industry conditions, financial and otherwise, and we undertake no obligation to update these statements to reflect events, circumstances or changes that might arise after this call, including our esteemed elected officials shutting down the government and embarrassing us all. These forward-looking statements are not guarantees of future performance or plans, and therefore, investors should not place undue reliance on them. We refer all of you to our SEC filings for more detailed discussions of the risks that could impact our future operating results and financial conditions, which could cause actual results to differ materially from those discussed in these forward-looking statements.

I also want to inform our listeners that we will make some reference to non-GAAP financial measures during today's call. You will find supplemental data in our press release, which reconciles our non-GAAP measures to our GAAP results.

Now I would like to turn the call over to Jeff Maggioncalda, our Chief Executive Officer.

Jeffrey Nacey Maggioncalda

Thanks, Ray. Good afternoon, everyone. Thank you for joining us today. I'm pleased to report that Financial Engines had a good third quarter. Let's take a look at our numbers for the quarter. Revenue increased 28% to $62.1 million in Q3, compared to $48.4 million a year ago. Non-GAAP adjusted EBITDA increased 50% to $21.4 million in Q3, compared to $14.3 million a year ago. And non-GAAP adjusted earnings per share increased 54% to $0.20 in Q3 compared to $0.13 a year ago.

In addition to our financial performance, we report quarterly on some important operating metrics, including assets under management, assets under contract, total members and enrollment rates. Please refer to our SEC filings for definitions of these operating metrics.

We had a solid quarter against each of these metrics. As of September 30, assets under management reached $82 billion, a 33% increase from $61.5 billion a year ago. Assets under contract increased by 34% to $752 billion from $560 billion a year ago. Total members enrolled in Professional Management grew to more than 742,000 members, and enrollment rates among employer plans, where services have been available 26 months or more, averaged 13%, and an estimated 12.9% had AUC been marked-to-market at the end of the third quarter of 2013.

There are a number of fundamental forces driving our growth opportunities. As we've discussed previously, demographic trends continue to drive our business.

Financial Engines recognizes the generational opportunity represented by the retirement planning needs of the 78 million Baby Boomers in America. Boomers entering into retirement are facing a more complex and daunting situations than did their parents.

Participants approaching retirement, who we refer to as near retirees, have seen an unprecedented proliferation of financial products and services offered over their careers such as 401(k)s, IRAs, Roth, ETFs and health savings accounts. The rules are changing at a dizzying rate. And with more choices comes more complexity.

On average, workers will hold 11 jobs over their careers and likely have multiple self-directed retirement accounts in and outside of the workplace. Boomers are facing the fact that they may need to delay retirement or consider working part time in retirement. According to the U.S. Bureau of Labor Statistics, the number of Americans, aged 65 or older, who are still in the workforce, rose by 64% between January 2003 and January 2013. Boomers also need to consider a longer financial planning horizon. In 1940, the life expectancy of a 65-year-old was almost 14 more years. Today, it is more than 20 years from age 65.

In addition to demographics, we believe another factor driving our growth is the increasing reliance on defined contribution plans. Retirees are depending heavily on their defined contribution plans, as more defined benefit plans close or freeze.

Fewer workers have access to a pension plan. Between 1979 and 2011, the percent of private sector workers, who participated in a defined benefit plan only, dropped from 28% to 3%. During the same period, private sector workers participating in DC plans only rose from 7% to 31%. This trend represents a major transfer in retirement plan financial risk from the employer to the employee. In a recent Charles Schwab plan participant survey, 6 out of 10 respondents reported that their 401(k) is their only or largest source of retirement savings.

In a survey conducted by Prudential and CFO Research, finance executives reported that defined benefit plan de-risking is top of mind, and that companies continue to deemphasize to find benefit plans in favor of defined contribution plans.

65% of the executives surveyed say that lump sum distributions can be effective in reducing the size, exposure and volatility of pension obligation. We believe that Financial Engines will benefit from employers shifting from defined benefit to defined contribution plans and especially from the trend of employers offering lump sum distributions.

Financial Engines also continues to benefit from the legal and regulatory tailwinds. In 2010, the Department of Labor's Employee Benefits Security Administration proposed amendments to the definition of fiduciary, which would more broadly define the categories of persons who would be deemed to be "fiduciaries" subject to the Employee Retirement Income Security Act of 1974.

In part, the issuing of the proposed rule was in response to the changing landscape of the retirement industry since the rule was first adopted nearly 40 years ago, such as the growth of self-directed defined contribution plans and the changing practices of financial professionals, especially with respect to individual retirement accounts.

The purpose of the proposal was to help level the playing field for participants and to provide them the expectation that the investment advice they're receiving is in their best interest, free of conflict and not in the best interest of the advice provider. The Department of Labor has been refining this proposal based on comments to date, and a reproposal is now expected in 2014.

We believe that the fiduciary standard benefits Financial Engines by reinforcing the importance of independence and the need for help for plan participants.

We are encouraged to see policymakers raising public awareness with respect to the retirement crisis facing the Baby Boom generation. In September, at a hearing titled, The Changing Retirement Landscape for Baby Boomers, the U.S. Senate's Special Committee on Aging heard from economic and retirement policymakers who presented a troubling picture of what retirement looks like for many Americans who are approaching retirement. From changes in pension plan to the rising cost of health care to the impact of the recessions on their retirement savings, speakers examined a host of factors that are contributing to what they called "a seismic decline in retirement prospects." Of note to Financial Engines, Senator Susan Collins of Maine raised the issue of whether the Social Security Administration is doing enough to educate near retirees on the importance of a Social Security claiming strategy.

We believe that the broad adoption and the flexibility of Income+ will allow us to take advantage of this increased focus on retirement income inadequacy by incorporating help on Social Security and linking Social Security claiming strategies to overall investment and drawdown strategies.

We also see a trend of plan sponsors providing more help to participants in 401(k) plans. Many employers have a growing sense of responsibility for their employees' financial wellness. The J.P. Morgan 2013 Defined Contribution Plan Sponsor Survey found that 71% of large plan sponsors say they feel a, "somewhat high to very high level of responsibility for their employees' financial wellness." The survey also found that more than 75% of employers consider increasing the financial security of employees and helping to ensure that the employees have a financially secure retirement to be highly important goals for the employer.

With many plan sponsors reviewing the retirement readiness and financial wellness of their employees, we believe that we are uniquely positioned to provide the personalized, holistic help that participants may be seeking from their employer.

So our growth opportunities continue to benefit from demographic trends and increasing reliance on 401(k) plans, legal and regulatory tailwinds, and demand for investment advice in the workplace.

Now I'd like to discuss our strategy to take advantage of these growth opportunities and the progress that we've been making.

Let's start with asset under contract, which is the value of assets in retirement plans where Professional Management has been made available. Assets under contract rose to $752 billion by the end of Q3, up from $667 billion at the beginning of the quarter, and up 34% over the last year.

The year-over-year growth in the third quarter was driven primarily by new employers making our services available, the positive performance of financial markets over the last year and the steady contributions that participants and employers have been making into their 401(k) accounts.

Our Q3 assets under contract include a few very large sponsors that went live at the end of Q3, but have not conducted enrollment campaigns in the quarter.

Competitors, including new investment advisory firms and established players alike, continue to focus on providing managed accounts to the 401(k) market. We recognize that we will need to continue to broaden the scope of the services we offer and to improve the customer experience in order to further differentiate from target date funds and managed account competitors as we grow our AUC.

According to the Q3 Cerulli Edge report, Financial Engines is again the leader in the growing managed account provider space, with more than double the assets under management of the closest listed competitor.

As of the end of Q2, Financial Engines' year-over-year AUM growth rate was 37%, compared to 27% for all of our listed competitors. Additionally over the past 2 years, Financial Engines has grown its assets under management by more than twice as much as all of the other competitors combined.

As we broaden the scope of our services, we believe that improving the customer experience will also drive engagement, enrollment and retention, especially among the near retiree demographics.

We continue to focus our efforts on converting assets under contract into assets under management by improving enrollment. In Q3, we added $4.8 billion of AUM from new enrollment, yielding $2 billion net of voluntary and involuntary cancellations. This growth in AUM was due to high campaign volume and increasing ongoing enrollment.

In addition to enrollment campaigns, we're pleased with the ongoing progress from our integrated enrollment efforts and continue to focus on noncampaign enrollment methods.

We continue to rapidly test and iterate messaging to participants, and we're encouraged by the progress and the effectiveness of this enrollment method. We continue to make progress understanding what drives enrollment, designing more effective communication programs and deploying these programs more broadly across our install base.

Enrollment for employers rolled out 26 months or more averaged 13% at the end of Q3 or 12.9% had AUC been marked-to-market. This is up from 12.7% a year ago and 11.4% at the time of our initial public offering in March of 2010.

An attractive characteristic of our business model is the built-in growth that comes from ongoing contributions from 401(k) participants. Every 2 weeks, a part of most participants' paychecks is deducted and deposited into their 401(k) account, which is usually partially matched by their employer. We estimate that in addition to the $2 billion of AUM from net new enrollees, our AUM increased by approximately $1.4 billion more in Q3 due to member and employer matching contributions, which is an increase of 27% over the last year.

For the trailing 12 months, contributions have increased our AUM by more than $5 billion. There are signs that participants are improving their savings behavior. A recent Charles Schwab participant survey found that more than half of the respondents increased their 401(k) contributions in the past 2 years. We believe a primary factor in the growth of contributions is plan sponsors' broader adoption of automatic features, such as automatic enrollment and automatic savings escalations of deferral rates, in order to influence participants' positive savings behavior. The Bank of America Merrill Lynch 401(k) Wellness Scorecard found that the number of plans offering automatic savings increase rose by 17% in just 1 year.

We continue to focus on retention of Professional Management members. A current area of focus for improving retention is with members in the first 90 days, where we see a larger proportion of our voluntary cancellations occur. We believe that we can reduce cancellations over the coming years by increasing personalization, flexibility and the breadth of services that we offer.

For the third quarter of 2013, our average quarterly overall cancellation rate was 3.7%, which is in line with our historical cancellation rate.

Because we typically see higher participant cancellation rates in the 90 days following a completed campaign and we had a high volume of campaigns in Q2 of 2013, we saw a corresponding increase in voluntary cancellations in Q3. Additionally, in Q3, we saw unusually high involuntary cancellations from one relatively large and a few smaller plan sponsors who moved to record keepers with whom we do not have plan provider connections.

Our other primary growth initiative is Income+, a retirement income feature that provides retirees with a steady monthly paycheck from their 401(k) to a checking account that can last for life. We continue to make progress deploying Income+ with our provider partners and plan sponsors. Providers who have committed to offering Income+, including those whose connections are not yet live, represent more than 95% of our AUC.

As of September 30, 2013, 45 plan sponsors have made Income+ available to more than 828,000 participants, representing $81 billion in assets under contract, which is an increase of 200% from the third quarter of 2012.

We are seeing accelerated rates of adoptions, as provider connections come online, as the installed base of sponsors with Income+ grows and as the industry becomes more familiar with our Income+ offering.

As of September 30, all signed contracts for Income+ represent 104 plan sponsors, over $182 billion in retirement assets and 1.9 million participants.

We believe that the broad adoption of Income+ by plan providers and plan sponsors positions Financial Engines to become the standard for retirement income in 401(k) plans.

We expect that the larger benefit of a broader retirement plan offering, including Income+ and IRA management, will be realized over the longer term as the demographic wave of Baby Boomers retiring continues over the next 2 decades.

2/3 of our AUC is with near retiree participants who are 50 years of age and older. Before we introduced Income+ and IRA management, Financial Engines lost every dollar of AUM that rolled from a 401(k) to an IRA in the form of involuntary cancellations at a life stage when the member's balance is usually at its highest point. We believe that we can reduce cancellations by better meeting the needs of the near retiree as they approach the transition into retirement. In our effort to reduce cancellations, we are committed to evolving and enhancing our customer experience to meet the needs of the near retiree as they transition into retirement by offering broad and holistic retirement income planning that takes into account not only their 401(k) accounts, but also their IRA accounts, pensions, Social Security, Medicare and spousal accounts.

Since 1998, we've been executing on a long-term strategy that we believe will help us take advantage of the opportunity driven by the needs of the near retiree demographic. In 1998, we launched Online Advice in the workplace for plan sponsors and the participants. In 2004, we launched Professional Management, our managed accounts program to help employees who want an independent professional to manage their 401(k) for them. In early 2011, we increased our focus on near retirees with the announcement of Income+, a retirement income feature that is designed just to provide steady monthly payouts from a 401(k) that can last for life. In 2012, we launched Total Retirement Advice to provide help on tax-deferred accounts outside the 401(k). And earlier this year, we introduced IRA management, which includes the Income+ capability, allowing us to manage additional accounts outside of the 401(k) for existing customers and also to retain customers as they retire and leave the workplace.

Although investment accounts, such as IRAs and 401(k)s, are very important, Social Security will represent the largest source of income for most near retiree households. And it is becoming clear that Social Security is far more complex and important than most Americans realize. There are over 8,000 Social Security claiming combinations that a couple could make. The vast majority of people claim Social Security almost immediately upon reaching age 62 or retiring, which can reduce expected Social Security lifetime benefits by as much as $250,000 or more. These are the findings of Financial Engines Board member and Stanford professor John Shoven in his paper, Efficient Retirement Design. We've been working with providers, sponsors and participants to test ways to help people with Social Security, and we've been pleased with their response.

We are finding that it's important to integrate the Social Security claiming strategy into the broader retirement household picture, including the Social Security claimant's decision of their spouse, the management of their retirement investments, such as their 401(k) and IRAs, their pension income and lump sum distribution options, their part-time work and medical costs and benefits eligibility. We believe that our distribution channels and broad customer base, our technology and methodology, and the availability of our investment advisor representatives all make us well positioned to address this opportunity to help Baby Boomers with Social Security.

We will continue to invest in extending our offering to better address more of the needs of the near retiree, which we believe will help drive engagement and enrollment. And broadening our services will also differentiate us from competitors and products like target date funds. We believe also that extending our service offering to help mitigate the pricing pressure prevalent in the industry, and we expect a broader offering, including Income+ and IRA capabilities, can improve sponsor and member satisfaction, revenue per member and voluntary and involuntary retention rates over time.

We continue to expand the number of retirement plan sponsors that we serve. At the end of the third quarter, we had 550 plan sponsors where Professional Management was available, representing $752 billion in assets and about 7.7 million plan participants. At the end of the third quarter, we were managing portfolios worth $82 billion, more than 742,000 members, and half of those members had less than $50,000 in their accounts.

As of September 30, 2013, 143 of the Fortune 500 have hired Financial Engines to help their employees, and their advice is available to 9 million participants. When I look at the fundamental trends driving our growth, the breadth and strength of our relationships and the quality, scalability and uniqueness of our services, I feel that Financial Engines is increasingly well positioned to take advantage of a significant market opportunity to deliver on our promise of providing everybody with the independent, personalized retirement help that they deserve. And now I'd like to turn it over to our CFO, Ray Sims, to discuss our financial results in more detail. Ray?

Raymond Jay Sims

Thanks, Jeff. As Jeff said, total revenue increased 28% to $62.1 million in the third quarter of 2013, compared to $48.4 million in the prior-year period. The increase in revenue was driven primarily by growth in Professional Management revenue, which increased 33% to $52.5 million in the third quarter of 2013.

Professional Management revenue growth was driven by higher AUM, which reached $82 billion at the end of the third quarter, compared with $61.5 billion ending the prior-year period.

This increase in AUM was the result of increased enrollment from marketing campaigns and other ongoing member acquisitions, as well as market performance and contributions.

Platform and other revenue was up 8% to $9.6 million for the third quarter of 2013, compared with $8.9 million for the third quarter of 2012.

Cost of revenue, exclusive of amortization of internal use software, increased 31% to $24.6 million for the quarter, compared to $18.8 million for the prior-year period due primarily to an increase in data connectivity fees as revenue increased.

As a percentage of revenue, cost of revenue increased from 39% in the third quarter of 2012 to 40% in the third quarter of 2013 as data connectivity expenses grew at a slightly faster rate than revenue.

As most of you already know, employee-related costs are our largest expense and include items such as wages, cash incentive compensation, noncash stock-based compensation and benefits. The expense variances that I will be talking about within each of the functional areas were driven primarily by increases in employee-related wages, benefits and employer payroll taxes from growth and headcount and annual cash compensation increases.

Noncash stock-based compensation expense increased as a result of equity awards granted in November 2012, as well as the commencement of a performance-based, long-term incentive program in May 2013.

Research and development expense increased to $7.3 million for the quarter, up 12% from $6.5 million in the prior-year period due primarily to a decrease in the amount of internal use software capitalization, as more developer hours were dedicated to updating and maintaining existing core services in the current period, as well as an increase in noncash stock-based compensation expense.

As a percentage of revenue, R&D decreased from 13% in the prior-year period to 12% this quarter, as employee-related and facilities-related expenses grew at a slower rate than revenue. Sales and marketing expense remained constant at $10.4 million for both the recent and the prior-year quarter. There was an increase in noncash stock-based compensation and wage expense, offset by a decrease in consulting and cash incentive compensation expense.

As a percentage of revenue, sales and marketing expenses decreased from 22% in the prior-year period to 17% this quarter, as employee-related and consulting expenses grew at a slower rate than revenue.

General and administrative expense increased to $5.4 million for the quarter, up 48% from $3.7 million in the prior-year quarter due primarily to increases in employee-related expenses, such as noncash stock-based compensation expense, wages, benefits and cash incentive compensation expenses.

As a percentage of revenue, general and administrative expense increased from 8% in the third quarter of 2012 to 9% in the current quarter, primarily due to noncash stock-based compensation expense increasing at a faster rate than revenue during the same period.

Income from operations, as a percentage of revenue, increased to 20% in the third quarter of 2013 from 15% in the prior-year period. Net income increased to $8.1 million in the third quarter of 2013, compared with net income of $4.8 million in the third quarter of 2012.

As many of you know, we look at non-GAAP adjusted EBITDA as a key measure of our financial performance. Our earnings release has a table that reconciles our GAAP net income to adjusted EBITDA. Adjusted EBITDA in the quarter increased to $21.4 million, up 50% from $14.3 million in the third quarter of last year.

Adjusted EBITDA is one of the metrics we use to determine employee cash incentive compensation. We provide further information about the calculation of our non-GAAP adjusted EPS in today's earnings release.

Non-GAAP adjusted EPS was $0.20 in the third quarter of 2013, compared with $0.13 in the third quarter of 2012.

In terms of cash resources, as of September 30, 2013, we had total cash, cash equivalents and short-term investments of $232 million, compared with $166 million as of September 30, 2012.

On October 31, 2013, Financial Engines' Board of Directors declared a cash dividend of $0.05 per share of the company's stock. The cash dividend will be paid on January 7, 2014, to stockholders of record as of the close of business on December 13, 2013.

Now on to our outlook for 2013. Based on financial markets remaining at October 31, 2013 levels, when the S&P 500 Index closed at 17.57%, we estimate 2013 revenue to be in the range of $238 million to $240 million and 2013 non-GAAP adjusted EBITDA to be $80 million plus or minus $1 million.

We estimate that from October 31, 2013 market levels a sustained 1% change in the S&P 500 index on October 31 through the end of 2013 would impact our 2013 revenue by approximately 0.17% and our 2013 non-GAAP adjusted EBITDA by approximately 0.31%, all else being equal.

While we have historically provided sensitivity based on the S&P 500 for simplicity, we encourage investors to use the breakdown of our aggregate portfolios provided in our earnings release to more accurately run sensitivity.

As international equity and bond market performance may deviate substantially from the S&P 500's performance, the recommended indices are the S&P 500 for domestic equities, the MSCI EAFE Index for international equities and the Barclays Capital U.S. Bond Index for bonds.

Now let me provide our first look for 2014.

Based on financial markets remaining at October 31, 2013 levels, we estimate 2014 revenue to be in the range of $274 million to $279 million and 2014 non-GAAP adjusted EBITDA to be in the range of $92 million to $94 million. We estimate that from October 31, 2013 market levels, a sustained 1% change in the S&P 500 index on October 31 through the end of 2014 would impact our 2014 revenue by approximately 0.61% and our 2014 non-GAAP adjusted EBITDA by approximately 1.08%, all else being equal.

Under typical market conditions, we estimate 2014 revenue to be in the range of $285 million to $290 million and non-GAAP adjusted EBITDA to be in the range of $98 million to $100 million.

Our outlook for 2013 and 2014 is consistent with the longer-term objectives we shared with you earlier, which assume fairly normal market conditions: revenue growth of 20% to 30% per year, operating margins of 15% to 20%, long-term EPS growth of 25% to 40% per year, assets under management growth of 25% to 30% per year, and enrollment rates and plans rolled out for 26 months or more of 12% to 15%.

With that, operator, we would now like to open it up for questions.

Question-and-Answer Session


[Operator Instructions] Your first question comes from Mayank Tandon of Needham.

Mayank Tandon - Needham & Company, LLC, Research Division

First question is on the AUC levels. The big jump -- I think, Jeff, you mentioned that there were some large contracts coming up live this quarter. Should we expect the trends to normalize back to what we've seen over the past several quarters in terms of building out the AUC in our models?

Jeffrey Nacey Maggioncalda

Yes, I think that it's fair to assume that it will normalize. One of the things that we wanted to also point out is that these sponsors -- they're pretty big sponsors and in aggregate represented tens of billions of dollars. They also happen at the very end of the quarter before the campaign is concluded. So overall, enrollment rates might look a little bit lower than you might have expected because we have a pretty big slog of AUC coming on just at the end of the quarter. So that got recorded in AUC, but there wasn't a lot of corresponding AUM because the campaigns really were mostly being conducted this quarter. And I would say that generally speaking, there's nothing different about these sponsors from any other ones that should cause us to think that the longer-term trend is -- shouldn't apply to them as well.

Mayank Tandon - Needham & Company, LLC, Research Division

Okay. Then -- over what time frame do expect to run these marketing campaigns to drive enrollment levels? And could that potentially result in an acceleration in the top line as these plan sponsors ramp up?

Jeffrey Nacey Maggioncalda

Yes, so we do expect that as these campaigns run their course, which is typically over approximately a quarter, sometimes, it will take 2 quarters, it does result in AUM. So the AUM is what you'll typically see first. In many cases, there might be a free trial period in terms of pricing, so revenue might follow a little bit beyond that. However, the outlook that Ray put out for 2013 and 2014 as well includes really a bottoms-up analysis plan sponsor by plan sponsor, so that when we give you the outlook, pretty much all of the very specific characteristics of sponsor-to-sponsor timing and the run rates are incorporated in those outlooks.

Raymond Jay Sims

I think that's consistent with the way we've explained the business that we count all of the AUC in the plan when any participant is enrolled. And then over the course of the campaign, we have pretty good metrics depending on sponsors and demographics as to what the enrollment rate is immediately after the campaign and the years following, and that's what really what drives the growth of our business.

Mayank Tandon - Needham & Company, LLC, Research Division

Okay, that's clear. And moving on to competition, Jeff, you touched on the comparative landscape. Just wanted to get a sense from you, how are you faring versus the target date funds within your plan sponsor customer base? And then also are you seeing any emerging flares looking to attack what is a very lucrative market clearly?

Jeffrey Nacey Maggioncalda

Yes. The -- so with respect to target date funds, as far as we know, among the 500-plus companies who hired us to offer Professional Management, managed account services, we're the only managed account program offered. So there does not appear to be any direct competition for managed accounts within any of the plan sponsors who've hired us. Over 90% of those sponsors, however, do have target date funds in their plans. And so target date funds coexist with Professional Management in almost all the plans, in 9 out of 10 plans. And what we are finding is that the younger participants typically are defaulted into target date funds. Typically, many younger people with very small balances, as the average age gets higher, you see a larger and larger proportion of the assets in participants using Professional Management as opposed to target date funds. So I think in terms of sort of competing within a plan against not a direct competitor, but a near substitute, we are really working on differentiating these services to appeal primarily to those near retirees who have more elements to consider in their total household picture. They're thinking about things, like retiring and Income+. They'll often have multiple accounts from previous jobs, so they have things like IRAs. And increasingly, we see that they want to really see the whole retirement picture, including income sources like Social Security and a pension, not just their savings. And these are all really excellent opportunities to differentiate from target date funds. And we do feel that we're getting some good traction in separating ourselves from target date funds especially to near retiree who is concerned about a much richer and more personalized set of issues that they're facing.

Raymond Jay Sims

Based on aggregate published data, we appear to be gathering assets at a faster rate than the overall composite of target date funds.

Mayank Tandon - Needham & Company, LLC, Research Division

Makes sense. And then finally a question around pricing. Obviously, the overall pricing numbers look very consistent with the last several quarters and years. But just behind the scenes, are you noticing any incremental pressure on pricing that may be compelling you to add more services, like Income+ and like other offerings, to be able to maintain pricing at current rates?

Jeffrey Nacey Maggioncalda

Yes, for sure. If you look again at the target date funds, we see fairly substantial declines. And not just in target date funds, in almost all of the investment products that are available in the Fortune 1000 plans, you're seeing compression in pricing. Now it's not a direct substitute, but as a near substitute, it certainly does make our services look relatively more expensive. And there is absolutely an imperative from the sponsors' point of view to say, "Look, guys, you've got to make sure that the services that you're offering are worth the price." And when the price of a near -- of an alternative or a near substitute is getting so cheap, you really have to provide more value. And so that has been a big thing that's been driving the expansion of our services. And with Income+, with IRA management and as we think about additional services that we might offer, we're looking at ways to really drive higher value by offering more services at no additional cost to the sponsor or participant. And that's -- that is not optional. That's something we absolutely need to be doing, and we feel like we're doing a pretty decent job continuing to differentiate and add more value to these services.


Next we have Mike Grondahl, Piper Jaffray.

Michael J. Grondahl - Piper Jaffray Companies, Research Division

Can you help us kind of size up how much larger is the campaign pipeline going into 4Q than maybe the past couple of quarters?

Jeffrey Nacey Maggioncalda

Let's see. We typically don't go into a lot of detail on that. I guess, it would be fair to say that our -- that we're -- first of all, it's built into our 2013 numbers, so we actually look not only sponsor by sponsor, but -- actually, what we do is we look at the specific campaign. We actually look at the demographics of every person in every plan, their balance, their age and all the predictors to whether or not they'll enroll. That's all actually included in our forecast. So it's a pretty detailed bottom-up, and the outlook that Ray put out there does reflect the expected number of campaigns and the demographics of people receiving those campaigns. And generally speaking, it's not going to look a whole lot different than it has in past years. Ray?

Raymond Jay Sims

Yes. So there's a couple of things to think about. The campaign timing during the year tends to be heavier in the second and third quarter than in the first and fourth quarters. We would -- and that has an effect, by the way, on gross margins because one of the large elements of cost of goods and a smaller element of revenue is where a sponsor, typically a sub-advised partner, reimburses us for print expenses. We have to count the reimbursement as revenue, but the overall print expense is as cost of goods. So it comes with a negative margin, which tends to pull down gross margins, which typically makes them lower in the middle 2 quarters. The number of campaigns grows because as we add sponsors each year, there are more existing sponsors as well as new sponsors to whom we send out campaigns. So you would expect that campaigns in Q4 to be larger in terms of print volume than the campaigns of last year's Q4, but smaller than Q3 and probably smaller than Q2. So there is secular growth with some seasonality in the campaigns, and there's financial repercussions to that.

Jeffrey Nacey Maggioncalda

Yes, just one other thing, Mike, if you look at Q4 historically, net new AUM in 2010, it was $1 billion. In 2011, it was $2.2 billion. In 2012, it was $1.1 billion. So I'd say it's consistent with history, but that's a little bit of variation. And so, I guess, the best thing I can really say is it is incorporated in our 2013 outlook.

Michael J. Grondahl - Piper Jaffray Companies, Research Division

Okay, great. And then it sounded like you added some very nice AUC and some plan sponsors in the quarter and especially near the end. But could you just kind of talk about the pipeline for plan sponsors and how you see that? I mean, you're up to 550 now. What does that pipeline look like?

Raymond Jay Sims

So 550 is a big number, but there are way more large companies handled by our current record keepers. So that represents roughly a 30%-or-so penetration. And when we give our outlook for both revenue and adjusted EBITDA, it takes into account what the pipeline is and how much of that is likely to be converted. We said over time, we expect to add roughly $50 billion to $100 billion of AUC per year. And consistent with that, again, we baked the numbers into the outlook that we provided.

Jeffrey Nacey Maggioncalda

Now we did this quarter do something a little bit atypical, in that for Income+ contracts signed, even before they got rolled out, we decided to put that number out there. A reason why we did that is because we wanted to share with Wall Street, kind of, but mostly with our customers and prospects, the growing adoption of Income+. So we did say that in addition to the $83 billion or so of Income+ AUC that's actually rolled out, there's another about $100 billion of Income+ AUC that we signed and have not yet rolled out. The reason that we actually sort of gave a look into the Income+ pipeline is because we found that when it comes to establishing a standard in the workplace, the earlier adopters, they like to know that there's a lot of other plan sponsors signing up. As I mentioned in previous calls, I've been saying, "Hey, you know what, we're looking at an S curve here, and we're kind of getting to the steeper part of it." Well, we are. And so we wanted to let -- we ought to put the information out there, so we can let other prospective sponsors see that there is pretty widespread and quickening adoption of Income+ among more sponsors.


Hugh Miller, Sidoti.

Hugh M. Miller - Sidoti & Company, LLC

I wanted to start off with, I guess, a question with the 2014 guidance. As you've given that to us, can you just give us a sense to the extent to which you're assuming benefits from the AUC growth from both the IRA and Income+ products?

Raymond Jay Sims

I thought you were going to ask a different question, which is what market assumptions we're using. Certainly, we've talked about in some detail Income+. And with the AUC that has been signed and rolled out and the larger volume of AUC signed, but to be rolled out, we would hope that the impact of Income+ on both cancellations, voluntary/involuntary, and on sponsor adoption of our services would be meaningful and we've baked that into our outlook. In the case of IRA, we're still in the fairly early stages. The anticipated volume of IRA is included in the outlook, but it's much smaller than the anticipated volume of Income+. And we haven't really broken those numbers out yet. We're still in a stage of learning how to effectively get people to sign up for IRA in the companies that have offered it to their plan participants.

Hugh M. Miller - Sidoti & Company, LLC

Okay. And you gave some really interesting color around kind of the adoption rates between younger audience and an older audience. Can you talk to us about kind of what is the strategy for you guys to try and have your products appeal to the younger audience relative to target date funds? Or is it just you feel as though it makes more sense for you to focus on kind of the nearing-retirement individual at this point?

Jeffrey Nacey Maggioncalda

Yes, so we offer a pretty broad array of services. When a plan sponsor hires us, what they're typically looking for is an independent fiduciary, who at low cost and typically no cost to the plan sponsor. Usually, the plan pays and then the individual is to sign up for a plan participants pay out of their accounts. They're looking for a very inexpensive way to have an independent fiduciary help their participants with retirement.

And for older folks, they typically have more pieces, they often have more a higher balances, so they have higher stakes and higher fears in making a mistake. They often want to talk to somebody about a broader picture. They often want more personalized service. Target date -- Professional Management really appeals to them. For younger folks, what plan sponsors are really looking for are a few key things. Number one, get in the plan, start saving young. We can help a little bit by saying, "Hey, it's not much of a hassle to invest for retirement if you're getting a plan and someone else is managing your portfolio." But honestly, automatic enrollment does a great job of getting people in the plan. Number two, for younger people, they've got to have a decent allocation in their investment account. Well, when you only have 1 account, you have very small balances, you have 20, 30, 40 years to go, put it in a pretty diversified equity portfolio. It doesn't really need to be personalized. Not a lot of high balance people worried about the money. Target date funds are pretty decent way to go, and they're typically the default.

So I'd say for younger people, what we can do with our services the plan sponsors like is we can actually provide forecasting of that target date fund. Because it's one thing to have a diversified portfolio. It's another thing to say, "How much do I have to save? How long do I have to work? How much money am I going to have?" And then as you get older, that question starts becoming more complicated. You get married and now you have a spouse. You change jobs and now you have an IRA. Then you start getting close to Social Security. You probably won't pick up a pension. But for near retirees today, they have pensions. So I'd say that the Professional Management service in terms of managing your 401(k) is more relevant to the near retiree.

But frankly, our broader retirement help in forecasting and answering the question of, "What do I need to do to retire with enough money?" is something that we can do for younger participants, separate from actually managing their accounts the target date funds just can't do. And so we've been finding quite a bit of uptake actually from sponsors saying, "Well, for my near retirees, you can do something that nothing else can do, we really like that. For my younger folks, you do kind of answer the bigger question about 'What do I need to do to retire over and above just allocating your 401(k)?'" And so we found a pretty nice complement between our services for younger participants, even if they're in a target date fund.

Raymond Jay Sims

I think a practical way to look at that is if you're just starting out and you default into the 2045 or the 2050 fund, your first question is not going to be, "Oh, what happens when I get to 2045 or 2050?" If you are retiring in 2015 or 2020, it's a much more relevant issue of "When I get to those time frames and I'm looking for income in retirement, combined with Social Security and outside assets, how do I make all that work in an optimal fashion?" We can do that with Professional Management, particularly with Income+, which, as Jeff mentioned, is becoming a standard. Target date funds really can't, so we're looking for almost a segmentation that target date funds work reasonably well early on. When your life becomes more complex, when you start thinking about retirement, it's a logical time to transition to our Professional Management service with Income+ as a way to be able to forecast how much money you'll have to spend in retirement for the rest of your life.

Hugh M. Miller - Sidoti & Company, LLC

Okay, very helpful color there. And a question just within the AUM category breakout. It seems like when you look at the line item for market movement and other was up a bit more than what we're looking for. Obviously, you had some nice market appreciation, but can you just say, is that the overwhelming growth in that just being market depreciation? Or were there other things that were kind of being a positive during the quarter?

Raymond Jay Sims

Yes, the overwhelming part of that account is market appreciation. There's a couple of tiny things that we can't really measure, but they're almost all negative. So the market impact was the bulk of it, and the reason it might have been a little higher than what you're expecting is I keep telling people to break out the indices, but during the third quarter, the EAFE Index was up twice what the -- a little more than twice what the S&P 500 index was. And the aggregate bond index, to everyone's surprise, was not negative. It actually grew at about 0.006%. So when you weight the indices that reflect asset appreciation by the portfolio allocations, you get a slightly higher number than if you just use the S&P returns.

Jeffrey Nacey Maggioncalda

But it really is the market's driving pretty much all of that number.

Hugh M. Miller - Sidoti & Company, LLC

Yes, yes, I certainly know that the bond market rally in September kind of helped with the asset valuation sort of fixed income product. Okay, and then just another question in the line of kind of employment matching contributions. I was looking at a study during earlier this year that kind of detailed that the majority of plans that had suspended their matching contributions, the majority have not kind of reinstated them at this point. Is there anything you're kind of hearing from -- you talked to corporations about that, and do you anticipate that, that will start to kind of come back to life and you'll start to see more employers bring back that contribution?

Raymond Jay Sims

Yes, so we have the advantage of being heavily concentrated in the largest 401(k) plans. In the largest 401(k) plans, the overwhelming majority is probably close to 80% have partially or fully restored the matches that existed before the financial crisis. I think partially or fully because some of them have staggered how they're phasing it in. But in the largest companies, way ahead of the overall market for retirement services at corporations, companies have partially or fully restored the match.

Jeffrey Nacey Maggioncalda

Another thing that's sort of latent in that contribution data, that's not obvious when you look at it on the surface is of course, the total AUM coming from contribution is going to grow as the number of members grow. And so you'd expect that number to be going up. But below that, if you look at contributions per member among the people who are currently managing their portfolio, you're actually seeing, as a percentage of salary, those savings rates are growing. Some of that is reflected by higher contributions from sponsors. Some of it also though is reflected by higher individual savings rates. And what we really like is this whole automatic savings escalation phenomenon, where increasingly, plan sponsors are offering the ability to have your savings go up automatically by 1% per year until it hits the cap. There's a lot more promotional availability of these types of programs in 401(k) plans. Sponsors are trying to get individuals to turn them on. And boy, when they turn them on, it's pretty nice because not only you're getting that constant flow, the flow is getting bigger per participant automatically every year.


[Operator Instructions] Next we have Brian Hogan, William Blair.

Brian Dean Hogan

First question is actually on the operating margin guidance. Your medium-term guidance, as you reiterated, was 15% to 20%. Here in the quarter, it was 20.5%. And I believe your incremental margins are actually quite high, around 70%. So my question is, is it time to revisit that interim guidance? What are your thoughts or are there other projects you should be -- you plan to invest in that will keep the operating margin around that 20% level? What are your thoughts there?

Raymond Jay Sims

So there's a real benefit to consistency. Those are ranges that we first started discussing when we were on the roadshow for the IPO in early 2010. I think a few things are happening. It's nice to be on the high end of the range. I'll remind some of the old timers that when we were on the road with the IPO, we had 11 years of losses and won a -- and we were putting on a target of 15% to 20%, which sounded like a bridge too far. We moved into and now at the high end of the range. To some extent, the pretty rapid movement from 15% to 20% was the fact that we had really good markets this year. And we didn't adjust our spending up as fast as the markets moved up, but by intent. So the margins drifted up. I think in the interim, we have lots of opportunities. We're going to fund the ones that we think will propel sustainable growth. We are more likely to be at the high end of the margins, given the guidance I provided for revenue and adjusted EBITDA, but we probably won't just yet come up with higher ranges. But at some point in time, for that and some of the other metrics we gave very long-term guidance that we've not changed on, including hopefully enrollment rates, as we move into the higher end of the range. If it's sustainable, we'll take another look at the ranges.

Brian Dean Hogan

During in -- the 59 additional sponsors, that you expect to sign up for the Income+ -- over what time period? Is it just waiting for the providers to get the links connected? What's the holdup?

Jeffrey Nacey Maggioncalda

Yes. This is -- it's part of life in the workplace market. So part of them are contracts with sponsors, who are record kept by providers, who do not yet have live connections. All of those contracts though, are with providers who have at least committed to offering Income+, and now we're at a point where there's only a couple of providers that we've announced that are not yet live. And so we're thinking in the next quarter or 2, we should have all the provider connections live. There should -- fairly shortly within the quarter or 2, provider connections will not be the gating factor, which will be nice because I had said in January of 2011, that over a year or so, we'd be getting all these connections live. Beyond that, though, there's not really a big gating factor. That really has been the big one. And once you have the connection in place for Income+, there's really not a lot of additional work or logistics required or any cost really required to get those things rolled out.

So we don't really expect beyond this provider connections, which have unilaterally slowed us down. I mean, that has been the factor that slowed down our Income+ adoption. Beyond the provider connections, we don't see a lot of obstacles in actually converting that from signed contracts into Income+ AUC that actually is rolled out. I guess, what that would say is you should continue to expect fairly, healthy increases in Income+ AUC in the coming quarters as that backlog comes online as these provider connections come online.

Raymond Jay Sims

And the chorus is -- and these are all baked into the outlook that we provided.

Brian Dean Hogan

Sure. And can you -- I guess, this is really hard to do, probably, but quantify the impact it's had on the penetration rate?

Jeffrey Nacey Maggioncalda

Yes. It is a little bit difficult to do, to your point. We think about Income+ as having a number of important sort of objectives. One is certainly attract -- becoming more attractive to near retirees who have the lion's share of assets in the AUC. We mentioned that about 2/3 of the AUC is held by people older than 50. These folks are thinking about retiring and "How do I put the pieces together?" and "How do I spend my savings?" and "How do I claim Social Security?" So Income+ is certainly helpful there. The earlier conversation around differentiating from target date funds is another big positive feature of Income+ though, too. It really helps to explain to plan sponsors why they need a service like ours even when they already have a target date fund in the plan. So I think that the key metrics we're looking at it driving our enrollment retention, contract revenue or sort of AUC growth as more plan sponsors want to offer these services and then to some degree as well, just larger average balance to the extent that our current customers might want to have additional accounts managed via Income+. But it's all kind of mixed together, so it's a strategy that can -- we believe can help us drive many different metrics. And it's a little bit tough to kind of tease them out.

Raymond Jay Sims

Generally speaking, and there are a number of factors at play, enrollment among older workers at firms that offer Income+ is above enrollment of older workers at firms that don't.

Brian Dean Hogan

Nice. TD Ameritrade and Schwab, I believe, those are the only 2 IRA, I guess, providers. Are there -- or that at least that you've announced so far, are there any others in the works? Or is it just those 2 for the moment?

Jeffrey Nacey Maggioncalda

Those 2 for the moment. We do expect, over time, that offering broader choice, given that we don't sell products and we really want to promote, not only the independence of Financial Engines as a registered investment advisor, but also the convenience of not having to move your money, we think that a wider network of IRA custodians will be valuable. But for the moment, we've only announced those 2.

Brian Dean Hogan

Okay. And then Ray, one quick last one. The market assumptions for 2014?

Raymond Jay Sims

Yes, so they're almost certainly wrong whatever they are. And we give the numbers without markets, so each of you can apply your own market assumptions. What I refer to typical market conditions, we're looking at about a 6.2% year-on-year increase in the overall markets in which the assets are allocated. So about 1.5% compounded per quarter across domestic equities, international equities and bonds are the numbers we use to give our nonmarket adjusted outlook for the second set of numbers I talked about. And the first set is so you guys can apply whatever market assumptions your firms believe in.


Well, at this time, we have no further questions. This will conclude our question-and-answer session and today's conference call. We thank you, to management, for your time, and we thank you, all, for attending today's presentation. At this time, you may disconnect your lines.

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