Has Schwab Cracked 401k Code For ETFs?

June 24, 2013

Schwab's ETF-only 401(k) plan could open the floodgates for ETFs to enter retirement portfolios.


[This article appears in the August version of ETF Report.]


For years, the 401(k) industry has been seen as the final frontier for exchange-traded funds. After initial acceptance from traders and tremendous growth from registered investment advisors over the last 20 years, ETF sponsors like BlackRock's iShares and Vanguard have looked to retirement providers for acceptance and a next leg of growth.

However, the path to that acceptance has been a rocky one. The space is largely owned by mutual fund providers who, after the revolution of the 1980s, established deep roots in the 401(k) industry. Rather than uproot these money-making machines, most issuers have steered clear—watching and waiting. Until now.

Charles Schwab, one of the biggest, as well as one of the youngest, of the ETF sponsors, plans to launch an ETF-only 401(k) plan for providers. Built off of the success of its index mutual fund plan, the San Francisco firm thinks now is the time to shake the retirement industry to its core. And here's the thing: It just might succeed.

History Lesson

The pitch for a big company to launch a 401(k) plan is simple: They offer medium-sized businesses—where a huge chunk of the wealth in this country resides—a way to make their employees pay for their own retirement. And the secret sauce is mutual funds.

Most mutual funds, even the cheap, no-load variety, include a 12(b)1 fee. In theory, this fee lets mutual funds recoup expenses used for distribution or servicing. In practice, the 12(b)1 fees are actually rebated to the company that's administering the 401(k) plan, to pay for everything involved in making that plan work.

Historically this has largely been a win-win situation for everyone involved: The company can offer a 401(k) plan without having to pay for it. The mutual fund company gets assets. The administrator gets a client. Investors get a 401(k) plan, frequently featuring company matching. Given that U.S. investors are chronically under-saved for retirement, even putting the issue of cost aside, saving something is better than saving nothing.

And save they have. The 401(k) market has roughly $5 trillion in assets as of year-end 2012, according to the 2013 Investment Company Fact Book. Easily half of those assets are in mutual funds. The money that's not in mutual funds is in separately managed accounts, company stock or self-directed brokerage accounts. Do the math and that's perhaps $6 billion in collected 12(b)1 fees, on top of the management fees for the mutual funds themselves—call it another $10 billion. That's a $16 billion apple cart the mutual fund industry would like to leave the wheels on.

Indexing Advantage

As you can imagine, the ETF industry would love a slice of that pie. But breaking into the space has been an unsolvable puzzle for most issuers. Charles Schwab thinks it can crack that code.

The tenth-largest ETF issuer created its Schwab Index Advantage 401(k) program in January 2012, taking on big players like Boston-based Fidelity Investments. Its goal was to tap into the growing popularity of index-based investments. Not only are investors looking for lower fees, the firm said, but so are the employers offering the plans and, increasingly, federal regulators. So naturally, cost is the big focus of Schwab's platform.

The plan offers passively managed mutual funds sponsored by Schwab as well as big players like Vanguard and BlackRock. A typical portfolio on the platform has an operating expense ratio of less than 15 basis points, with the added cost of advisory services that include annual rebalancing and individual consultations. That upgrade costs upward of 45 basis points.

David Gray, vice president of Schwab's 401(k) client experience, attributes the growth of the program not only to the lower fees, but the focus on service.



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