Schwab’s All-ETF 401(k) Is A Big Deal

Has the ETFs-in-401(k)s code finally been cracked?

Here’s the thing about the 401(k) market—it’s big. The Investment Company Institute estimates that assets in 401(k) plans in the U.S. are about $2.8 trillion. That’s almost double the size of the entire ETF market.

The vast majority of 401(k) investors park their retirement in mutual funds, and while some of them pick perfectly good index mutual funds, almost all of them are still paying way too much for what they’re getting.

At first blush, putting ETFs into a 401(k) might seem like an odd fit. After all, some of ETFs’ biggest advantages really don’t apply to 401(k) investors.

The much-vaunted tax efficiency of the structure is kind of irrelevant in a non-taxable account, and the intraday market trading creates problems—you don’t want to dollar-cost-average your payroll contributions into a bunch of ETFs if you’re paying per-trade commissions, and it’s pretty hard to wedge an exact dollar amount into a limit order.

Still, there are a few good reasons for ETFs in 401(k)s.

The first is access. The ETF structure has opened up corners of the investing market that traditional mutual funds can’t touch, such as precious metals or broad-based commodities. The second is long-term cost.

ETFs are simply cheaper to run than traditional mutual funds, and by design, index-based ETFs should track better too, as they can avoid most internal transactions.

There have been a few attempts to wedge ETFs into 401(k)s so far.

They generally fall into two categories. The first is to simply make ETFs available through a brokerage window. That’s fine, but only about one-third of plans nationwide have a brokerage window, and usage is generally very low. Worse, relegating ETFs to the brokerage window means only those “in the know” even get access to ETFs.

The second way has been to wrap ETFs up in some other structure, often a trust.

The trust goes out and buys shares of a given ETF, and strikes an end-of-day net asset value (NAV) for each sleeve of the trust. This essentially turns an ETF back into a mutual fund, often with another cost layer bolted on. It solves the “I want to buy $1,000 of SPY” [the SPDR S&P 500 ETF (SPY | A-97)] problem by letting you own fractional shares of the trust, and a similar omnibus trading system has been used by the ETF 401(k) innovator “Invest N Retire” for several years.

And then Schwab came along. Schwab’s no newbie to the 401(k) business. It’s been out there selling in the mid-tier market (call it $20 million to about $1 billion in plan assets) for decades. A few years ago, however, it launched its “Schwab Index Advantage” program.

Index Advantage is notable for solving a few problems, even before the ETF version came along. First off, the plan comes bundled with advice. This is important, because the biggest issue with 401(k) plans for a long, long time has been getting participants to participate, and to make reasonable asset allocation decisions.

For most of the folks reading this blog, this may seem like no big deal.

But for most Americans, it is, in fact, rocket science. So the Index Advantage plan uses the cheapest investment vehicles it can find, and takes the savings and uses it to fund a managed-account program.

The program then recommends portfolios based not just on age, but on all the demographic information that comes with the payroll feed (marital status, savings rate, income level and so on).

That managed account is the plan default, so if you’re a young 401(k) plan participant, by default you’re going to end up in a diversified, age-appropriate, auto-rebalancing, annually reviewed portfolio of cheap index funds. And you’ll pay a total of about 60 basis points, or $60 for each $10,000 invested, all in. Sixty basis points isn’t nothing, but honestly, that’s not bad.

In fact, both the cost and the resulting investment portfolio is far better than the average plan participant across the U.S.

And hey, if you’re a smarty pants, all you do is opt out of the “advice” part, save yourself 35 to 45 basis points, and you’re left with a pile of cheap index funds to choose from.

The ETF Twist

So where do the ETFs come in?

Part and parcel of the Schwab ethos here is “drive the investment costs as low as possible to fund advice.”

As Steve Anderson, the head of Schwab’s Retirement Plan Services group, put it: “Advice has a price tag. You need to find a way to pay it. We thought a low-cost program with unbiased third-party advice would really provide better outcomes for plan participants.”

So the ETF part is really just about costs. The mutual fund version of the program clocks in around 15 basis points on average expenses. The ETF version? 10 basis points.

The best part is that they didn’t have to invent some layered structure or some new trust vehicle to do it. Because Schwab is vertically integrated, it simply wrote its record-keeping system to deal with fractional shares, so people can in fact just put in an order to “by $1000 of SCHE” [the Schwab Emerging Markets Equity ETF (SCHE | C-86)].

How it works is simple. SCHE is trading at $23.29. You put your order in now, at 1:49 p.m. on a Friday, to buy $1,000 worth. You can enter that as either a market order or a limit order. Let’s say you get the fill right away.

Your 401(k) account shows you a confirmation for 42.93688 shares of SCHE. That’s what Schwab’s record-keeping system shows. The actual custodian who holds the assets (Schwab Bank) keeps track of the whole plan’s assets, and if you’re the only one who owns SCHE, well, their records just show the plan owning 42.93688 shares as well.

So what actually happened on the trade? Well, Charles Schwab & Co., the broker dealer, got your order and rounded it up to 43 shares. And it just kept the remainder on its brokerage books. Every once in a while, when they have enough “residual” shares, they go out into the market and trade them.

It’s surprisingly simple, and very elegant, and really only possible because Schwab owns all the pieces along the way. No extra fees get charged.

Also, nobody has to manage a big risk book. With only 70 or so ETFs in the program, Schwab’s actual unwanted exposure is probably under $100,000 on any given day, and easily hedged.

Schwab’s Lead

Competitively, this puts Schwab in a very good position. They’re offering dirt-cheap investments in essentially every asset class you’d want in a 401(k)—including precious metals and commodities. They’re completely unbundling fees, so everything is transparent and above board.

Self-directed investors get, essentially, a completely free trading environment that allows them to do 401(k)-style payroll deduction dollar cost averaging. And participants who need advice get managed portfolios at reasonable prices using the best vehicles in the market.

I don’t expect Schwab to keep the lead forever. What they’ve done here isn’t rocket science, and I’d expect other 401(k) providers to follow suit eventually.

But for the moment, they can carry the “good guy” flag and get the ETF halo at the same time. Long term, I’m betting this is the program we look back on as the one that “cracked” the ETFs-in-401(k) problem.