[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.
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.
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.
"When you lower cost, you can keep more," he said. "But we know that maybe 85-95% of participants in a retirement plan really don't have the time, the interest or knowledge to manage their own retirement account." Schwab's solution is to give clients the choice of an optional service that makes investment allocations on behalf of the client and adjusts them over time, based on personal factors such as the client's age, compensation, savings rate and target retirement date.
So far, Schwab says the plan has been successful. Approximately 50 employers had signed on to the plan as of February 2013, adding up to more than $4 billion in assets and more than 36,000 individual participants. With that foundation, Gray says the next step is an ETF-only plan.
Set for launch by the end of 2013, Schwab's ETF 401(k) plan will mirror the index-fund offering's philosophy of low costs and available advisory services. It will also build on the choices available to the end investor: While the firm hasn't yet detailed what ETFs it will provide, Gray says that the platform will feature Schwab ETFs as well as "all other major names in the ETF space."
Large-, mid- and small-cap equity will be represented, including funds that tilt toward value and growth stocks. Emerging and developed international equity will be included, alongside U.S. intermediate government and corporate debt, inflation-protected bonds, real estate and capital preservation options.
Gray says that Schwab's evaluation criteria centers on the same factors that most ETF investors are already looking for. "We're looking for larger assets under management," he said. "We want highly liquid, highly traded ETFs. And we're going to do it in a way in which there are no commissions." The current plan is to include ETFs in a broader scope than those offered on Schwab's OneSource brokerage platform.
Are ETFs The Answer?
In the course of our conversation, Gray calls out what he sees as the many benefits of ETFs for 401(k) providers and investors. Low expense ratios mean that investors can keep more of the return for themselves, and that's obviously central to Schwab's plan. But Gray sees even more benefits to using exchange-traded products, such as transparency.
"For one, most ETFs publish holdings daily. That's a level of transparency that's not going to be found with mutual funds. Secondly, the intraday trading means that the trades go to market when the participant or the sponsor wants the trades to go to market, and they receive a confirmation of what that execution was seconds after the execution is done. Contrast that with the current environment, where you place a trade and you wait for the end of the day. Then you might check back with your record keeper that night or the next morning to find out what happened."
Jon Chambers disagrees. A principal at Schultz Collins Lawson Chambers, Chambers is no stranger to the complexities of the 401(k) system. While he agrees that ETFs are fantastic investment vehicles, he's unconvinced of their benefits for retirement investors.
"We're working with larger plans in our practice," said Chambers, "and we're usually selecting either institutional or Admiral Shares of Vanguard funds. The open-end funds have a cost advantage relative to ETFs. But even in plans that wouldn't qualify for institutionally priced index funds, if there is a cost advantage to ETFs, it's very small."
Joel Dickson, principal and senior investment strategist at Vanguard, points out the loss of cost advantage, as well. He says that the largest providers in the 401(k) space "already have pricing power, and can get indexing exposure at a lower cost than even the cheapest ETFs." Dickson also notes that Vanguard currently has smaller 401(k) platforms that offer a choice between traditional mutual fund share classes and its ETFs. "But there are still record-keeping costs that need to be paid," he noted. Those pricing differences often come out of the participants' pockets.
Chambers also sees the tax efficiency and tradability of ETFs as a false benefit for 401(k) programs, largely because of the way these programs have historically worked. "Daily trading is just plain unsupported on virtually all 401(k) platforms," he said. "A 401(k) reporting system assumes a single NAV per fund per day, because everything trades at the same price. That's not true with ETFs." Worse still, most 401(k) investors make regular payroll contributions that are put to work immediately. That means buying $400 of an investment each month, perhaps, which won't always equal a certain number of ETF shares. Mutual funds are built with fractional shares already in mind, and avoid this problem. And of course, one of the main advantages of ETFs—their vastly superior tax efficiency—is largely irrelevant to the tax-deferred 401(k) investor.
To get ETFs to work on these platforms, Chambers says many providers put the funds into collective trust funds. It works like this: The employee's payroll department adds her 401(k) contribution to the collective trust in the morning, and the trust manager buys the SPDR S&P 500 ETF (SPY) during the day. The employee loses the benefit of intraday trading but can still get the fractional shares of the collective trust.
There's also one more downside: an additional layer of cost for the collective trust fund. "It's going to vary," said Chambers, "but I would say it's anywhere between 2 and 10 basis points."
When asked about how Schwab plans to tackle fractional shares, Mike Peterson, director of the firm's corporate public relations, said the company could not confirm specifics on its system, but reiterated that the program "can accommodate fractional shares."
The Benefits For Schwab And The Investor
If the benefits of exchange-traded funds are largely washed away in the 401(k) space, why would Charles Schwab push so aggressively into the field?
Chambers sees a broad business reason: It makes the firm stand out. "Schwab is doing [this] because it's a relatively late entrant to the 401(k) space," he said. "I'm not being down on Schwab—it does a good job. But it needs to be able to do something that Fidelity and Vanguard and T. Rowe Price and the big 401(k) providers that have a 20-year lead in the business aren't doing today."
Those big providers have yet to meaningfully address the investor appetite for ETFs, arguably because they do not want to upset the apple cart. But if Schwab could tip the scales, says Chambers, it might be an advantage.
The other argument is the more positive one for end investors: ETFs really do offer something better for 401(k) participants. I asked Matthew Forester, chief investment officer of CFG Asset Management, about the lost benefits of ETFs in the 401(k) space. His answer was simple: "I'm not sure there are any disadvantages."
CFG manages ETF strategies for separately managed accounts, and uses the same strategies for the 401(k) market. He says the ETF advantages are broader and more simple than the three bullet points consistently cited for new ETF investors: low costs, tax efficiency and intraday trading. "The advantages are the innovations of indexing in the ETF space," he said. "More than that, architecturally, there's so much money tied up in 401(k) platforms, and there's one-time shifts occurring in the marketplace to new index designs where the costs are generally lower."
These new indexing innovations are not necessarily new for ETF-focused advisors, but they're a revelation for the 401(k) market. "A couple of years ago," Forester pointed out, "you didn't have the opportunity to buy seniors loans. Now, you have several options. The innovation in the indexing space is occurring for ETFs."
Those innovations mean better exposure at lower costs. Forester says the innovations are universal, but happen first in ETFs. "Arguably, that could go to passive-based mutual funds, but to me, the ETFs are a better mousetrap for the 401(k) arena. The end clients are demanding ETFs in their plans."
Examining the basic structure that allows lots of investors to pool their money together and invest.
Women in ETFs made its San Francisco debut this week. It’s about time.
A new ETF canvassing online life in the emerging markets really is a distinct idea.
ETFs are cheap, but not always in the way you think.