Convincing plan sponsors and pension consultants to join a ETF paradigm shift to ETFs is a big ask, its executives tell Wall Street

February 18, 2014 — 4:11 PM UTC by Lisa Shidler

4 Comments

Brooke’s Note: Schwab seems to have invented a better 401(k) mousetrap but now it needs to invent some appetizing cheese. Its new ETF platform promises low costs, high liquidity and decent transparency. Yet, PBS specials and DOL laws aside, the 401(k) business has never been about those things. It’s more about making business owners comfortable about choking down the cost of an employee benefit. See: Why the industry needs to accept some blame for 'flaws’ in PBS Frontline’s 'Retirement Gamble’. The new system may not be an advance on that because ETFs aren’t ripe for revenue-sharing kickbacks. Schwab seems to have one obvious play here: to appeal directly to the end user and generate pressure for its products from the bottom up. It seems like a noble undertaking but one of sobering difficulty. Its high hurdles may explain why Schwab execs spent a good hour of time on their business update covering this issue.

The Charles Schwab Corp. posted some impressive results for 2013. Yet, it was the San Francisco-based giant’s zero-revenue 401(k) program that monopolized its update Feb.12 as executives explained why three years of developing technology, filing for patents and working with regulators may have been the easy part. See: Bernie Clark discloses that Schwab Advisor Services hit $1 trillion of assets — and why the order for commemorative T-shirts is still on hold.

Schwab has just launched its ETF 401(k) plan and now the company is disclosing its next challenge: getting the 401(k) establishment to play along. See: Why the whiff of another delay of Schwab’s ETF-only 401(k) plan is drawing so much attention.

The problem for Schwab and the participants, i.e. the end investors, is that, in a sense, they don’t do business with each other. Employers buy the plans and they rely on the recommendations of pension consultants. These consultants may be tough nuts to crack. They are accustomed to the old way of doing business using mutual funds — and creating a no-fee atmosphere for these business owners by funding the plan expenses with 12(b)1 fees with revenue-sharing agreements. ETFs don’t have such fees. See: Schwab makes play for ETF-distribution domination but not without risks.

“There’s really a conflict out there,” says Steve Anderson, executive vice president of Schwab Retirement Plan Services on the call to analysts. “The conflict is driven either from actively managed side … and also some consultants. None of the consultants are utilizing our business model. We have to answer questions and put in a supplemental proposal in.” It’s a measure of the Anderson’s ambition that he was rated among the industry’s most influential.

In addition, many employers are sold on traditional mutual funds. “We’ve got some plan sponsors who are wedded to certain actively managed funds. They love it and won’t get rid of it. There are people at companies that struggle with an all-index lineup.”

No takers

Schwab’s plan is available now but no plan sponsor has signed up yet. The reason is it typically takes six to 12 months for an employer to decide on a new 401(k) plan, Anderson says. The firm hopes an employer will sign up sometime this year, according to Anderson.

Walt Bettinger: Since we announced the ETF Schwab index advantage there have been a number of different articles asking if we do need ETFs.
Walt Bettinger: Since we announced the
ETF Schwab index advantage there have
been a number of different articles
asking if we do need ETFs.

With such an entrenched bureaucracy pushing mutual funds, Schwab is betting that the relative merits of ETFs are so great that market forces — with help from Schwab’s mighty brand and marketing machine — will usher in a new era similar to what is happening in the non-retirement side of the business. See: One-Man Think Tank: A method for analyzing and comparing the costs and fees for mutual funds and ETFs.

But Walt Bettinger, chief executive of Schwab, referenced during the call how the industry is publicly taking the position that exchange traded funds are a misfit with 401(k) plans and that actively managed mutual funds are still the answer.

“Since we announced the ETF Schwab index advantage there have been a number of different articles asking if we do need ETFs. As the press goes out on interviews with active managers and they say we don’t need ETFs.”

He adds with a note of sarcasm: “I’ve been stunned by the response.”

Still, Bettinger adds that there may be a constituency that will bring a fiduciary ear to the market — the 7,000 RIAs that keep nearly $1 trillion of assets in custody with his company.

“Being a leader in the RIA space, the fastest growing space in the financial services positions us very well.”

Ho hum

But though Schwab is alluding to exogenous forces to help explain why a multiyear project still has no takers, other observers in the industry say that by fumbling its launch and delaying its marketing for so long after the fanfare of initial reports of its existence, Schwab’s actions have taken a toll.

“There’s a lack of excitement,” says Rick Meigs, founder of the 401khelpcenter.com. “It’s almost like they spent three years figuring out how to do this and now they can’t back off now. But the market’s moved on. Three years ago, everyone thought this would be the next big thing and three years later and no one even cares anymore. Advisors have talked to clients and prospects and nobody’s saying anything about it and no one is demanding it. If clients don’t care, then advisors don’t care.”

Rick Meigs: Three years ago, everyone thought this would be the next big thing and three years later and no one even cares anymore.
Rick Meigs: Three years ago, everyone
thought this would be the next
big thing and three years later
and no one even cares anymore.

Another wrinkle that seems to be unclear is the regulatory issues. One of Schwab’s delays was blamed on regulatory problems. When asked if the firm received regulatory approval for the initiative, spokesman Greg Gable responded only saying: “The issue that we needed to work through in putting together the ETF version of Schwab Index Advantage are addressed.” See: New company will allow RIAs to manufacture ETFs.

Even more pessimistic about Schwab’s efforts is Phil Chiricotti, president of The Center for Due Diligence based in Western Springs, Ill.

“The 401(k) ETF plan won’t go anywhere in the industry,” he says. “I think it is a non-event. Custom asset allocation solutions are going to drive the industry, including advisor-driven solutions in the mid-plan market. Liquid alternatives are going to start showing up in these solutions.”

Marketing muscle

But if Schwab does start pushing its ETF 401(k) plan, then it’s possible it could take center stage again, Meigs says. “That’s the thing with Schwab. You just don’t know. With the marketing muscle they’ve got, it could still gain traction. We just have no idea. It is just too early to know if Schwab’s the ETF-only 401k plan will is a game changer.

“With the marketing muscle behind Schwab, we do know plan sponsors are going to become more aware that the option exists and what the perceived advantages are. That is the first key step if the ETF-only 401k plan is to gain any market mind-share,” Meigs says.

Three years ago, according to Meigs, Charles Schwab’s announcement of an ETF-only 401(k) plan was a spunky move by a company already behind the eight-ball in the retirement business, but now after many problems and delays, the company is back on the defense. See: Technical challenges may push Schwab’s ETF-only 401(k) plan schedule into 2014 — deferring an intriguing financial clinical trial.

Catching up

There’s no apologizing for the delays, Anderson says. It was necessary to push back the efforts to get it right. The mission last Wednesday at the winter update was to remind investors Schwab has big plans in this space. For instance, the company came into the 401(k) industry 20 years behind everyone and has still managed to make it in the top 10 assets.

Phil Chiricotti: The 401k ETF plan won't go anywhere in the industry.
Phil Chiricotti: The 401k ETF plan
won’t go anywhere in the industry.

“The vast majority of early adopters started in the late 1970s and early 1980s. It wasn’t until 1995 that Schwab really entered the market in a big way and that point in time much of the market share had been grabbed by bigger players,” Anderson says. “In 17 years, we’ve grown to be in the top 10 terms of assets. It’s going to be tough to change the industry. No question about it. We’re looking at this as a long-term play. We’ll be here in five years.”

Even though Schwab has just 3.1% of assets in the 401(k) arena, given how tiny ETFs are in the 401(k) arena, the firm is convinced it can grow that market share very fast with the new ETF effort. ETFs make up less than 1% of 401(k) assets. See: TD Ameritrade beats Schwab to the punch with ETF option for retirement plans.

Schwab is targeting employers whose plan asset sizes are $20 million to $1 billion. The average plan size is around $50 to $70 million. The firm manages about $98 billion, which is just a drop in the bucket compared to the $1 trillion in assets that market leader Fidelity carries in this space. See: Fidelity launches major division in Denver with an 'ETF quarterback’ calling the shots. Total 401(k) assets were estimated at about $4 trillion by Boston-based Cerulli Associates at the end of 2012.

Beat you

But competitors such as TD Ameritrade are happy to remind the industry that they were first to the ETF stage launching their own ETFs in 401(k) plans three years ago while Schwab was working on its project. In March 2011, TD Ameritrade launched its own program that offers ETFs. See: Relentless TD Ameritrade antes up a killer ETF platform.

There are some differences between the two programs, says Skip Schweiss, managing director at TD Ameritrade. For instance, his firm’s 401(k) plan is not exclusive to ETFs, but also offers mutual funds.

“It’s really a combination of ETFs and mutual funds. We don’t pretend to say a plan should use all ETFs or all mutual funds. We let them use whatever is best for them. We don’t do ETF-only and we don’t do mutual fund only. What we typically see is advisors’ are advising a plan and they want to use both ETFs and mutual funds.”

Also, TD sells its plan only through RIAs and Schwab partners with Guided Choice and Morningstar, Inc. for investment advice.

TD does not complete intra-trading on ETFs. Instead, the firm only offers end-of-day ETF trading.

“Each of us has our reasons for our own strategy,” Schweiss says. “It’s interesting. I love capitalism. You’ve got different providers and different clients. That’s why we offer the ability to put anything in a plan. We don’t want people to have to pick and choose just one thing.”

About 11% of 401(k) plans choose to have ETFs and of those plans who do, about 50% of total assets are in ETFs, which Schweiss says is much higher than the national average. Still, about 85% of assets are in mutual funds and the rest are in company stock and collective trusts.

The real deal

Skip Schweiss: That's why we offer the ability to put anything in a plan. We don't want people to have to pick and choose just one thing.
Skip Schweiss: That’s why we offer
the ability to put anything in
a plan. We don’t want people
to have to pick and choose
just one thing.

But speaking to analysts last week, Anderson acknowledged that competitors feel that they are ahead of Schwab since they’ve had ETFs on the marketplace for only several years. But Anderson agrees with Schweiss that the efforts are very different. He thinks the biggest difference is that others (namely TD) don’t allow intra-day trading of ETFs such as his firm does.

“This creates a differentiation for us in the marketplace. No one else is doing this,” Anderson says.

Rather than to complete the ETF trades at the end of the day, Schwab wants participants to get the benefit of the intra-day trading prices. “Why not realize the trade right then and there,” Anderson says.

“We recognize others say they’re doing this, but there are differences from our competition. If we’re going to build a platform for the industry with a vision, why not use ETFs are they’re intended to be used and trade during the market day whether it be a participant trade or contribution or even a match that comes in based on a year-match. We’re unique in the marketplace and a bit innovative in how we’ve done this,” Anderson says. See: Would the intern buy an ETF?.

Mutual funds all the way

Meanwhile, the nation’s biggest retirement leader Fidelity Investments with $1 trillion in assets, hasn’t budged from its all mutual fund mantra and the firm sees no reason to even suggest putting ETFs in a 401(k) plan, says spokesman Mike Shamrell.

“Fidelity believes that mutual funds are a better option in this scenario given the tax-deferred structure of defined contribution plans and costs that mutual funds do not have, including bid-ask spreads that need to be considered. However, plan sponsors may still make these and other ETFs available to participants via a Fidelity self-directed brokerage option.”

High hopes

Still, Schwab has a number of pro-ETF supporters. For instance, it’s no surprise that longtime ETF fan Tom Lydon, of Global Trends Investments, has high hopes for Schwab’s big plan.

“I’m bias because I’m a huge fan of ETFs. And, I’m a huge fan of Schwab too. I think their hearts are in the right place. For Schwab not being a huge 401(k) provider, this is a worth the fight. Some of the big 401(k) providers aren’t making it a priority. Even TD has something, but it’s not Schwab. Schwab has the brand and muscle they can put behind it.”

Lydon hopes that employers do consider the ETF-only option because it could make a massive difference for investors.

“Just slashing only 1% on fees could be dramatic for savers. If you can cut out 1% in fees to 401(k) participants annually for 30 or 40 years, it’s the difference between a so-so retirement and a great retirement.”

!http://www.riabiz.com/i/11345544/b(Tom Lydon: If you can cut out 1% in fees to 401(k) participants annually for 30 or 40 years, it’s the difference between a so-so retirement and a great retirement.)!

Excitement

Another ETF enthusiast is Darwin Abrahamson, CEO and founder of Invest n Retire LLC based in Portland Ore., whose firm has had this ETF offering for years. He’s starting to change his firm’s focus: Rather than working solely with plan sponsors, he’s begun to offer this technology to other vendors. See: After a short engagement, Gus Fleites splits from his CEO spot with an Oregon 401(k) platform provider.

“I take my hat off to Schwab and am thrilled that they recognize the importance of ETFs,” he says. “But they’ve not really built it for advisors. It’s not really that RIA-friendly.”

He points out that both Schwab and TD used third parties to execute trades, and he says his firm directly makes the ETF trade.

“We always have an investment manager involved with the recordkeeping that we do,” he says. “The investment manager has the ability to make designs.”

What happened with Schwab Index?

Although it may seem like Schwab has a long climb ahead to make ETFs a common part of 401(k) plans, Anderson told analysts last week that the firm has already made waves with its index-only 401(k) plan it launched in 2012. See: Schwab garners $4 billion in index-only 401(k) assets fast out of the gate.

Darwin Abrahamson: I take my hat off to Schwab and am thrilled that they recognize the importance of ETFs ... But they've not really built it for advisors. It's not really that RIA-friendly.
Darwin Abrahamson: I take my hat
off to Schwab and am thrilled
that they recognize the importance of
ETFs … But they’ve not really
built it for advisors. It’s not
really that RIA-friendly.

In the past, Anderson said the firm discovered that just 10% of participants or less took advantage of personal advice and the firm felt by subtracting he cost and complexity they could change that number to something much larger.

“We want to strip out the cost and complexity and go all-index.”

The mutual fund all-index was rolled out 24 months ago, and Anderson says it’s been extraordinarily successful. The average base-line expense for the index-only mutual fund 401(k) plan has been $50 for every $10,000 invested for a $500 million plan. Smaller plans pay more.

Before, the average cost was 63 basis points and Anderson says the firm has driven costs down to just 15 basis points for asset management.

“We’ve shifted the economics from the old manager with active management approach,” he says. “We’ve taken active management out of asset level and put it in personal side into a management account. We’re shifting revenue stream from active to advice. It’s a very dramatic shift.”

Not new clients

While the firm has convinced 89 employers to try the index-only approach, most of them were already current clients, Anderson said to analysts.

“The vast majority shifting to Schwab Index Advantage are our current clients who know us and trust us.”


Mentioned in this article:

Morningstar, Inc.
TAMP
Top Executive: Joe Mansueto



Share your thoughts and opinions with the author or other readers.

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Robert J. Martorana, CFA said:

February 18, 2014 — 6:41 PM UTC

Lisa,

Great article.

Schwab has the right product and the distribution clout, but the 401(k) business is slow to change. Are DC-focused advisors like Sageview proponents of Schwab’s efforts in ETFs? Most of the asset growth is in Target Date Funds, and I’m not sure if the ETFs are meant as core or satellite holdings.

Rob Martorana

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Christopher Van Slyke said:

February 18, 2014 — 9:22 PM UTC

Aaaa… tell me again why it’s a good think to have employees trading their ETFs during the day?

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Christopher Van Slyke said:

February 18, 2014 — 9:23 PM UTC

Aaaa… tell me again why it’s a good thing to have employees trading their ETFs during the day?

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Scott Hanson said:

February 19, 2014 — 4:35 AM UTC

It’s high time for total open architecture for 401k plan participants. The majority of folks roll out their 401k upon retirement, typically with the help of a financial advisor. Why can’t participants have access to advisors while they are working? Wouldn’t it be great if a local advisor could work directly with plan participants and assist them with their financial planning and management of their 401k. Schwab’s ETFs would be a great solution.


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