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Schwab to make long-awaited move in 401(k) market with an all-indexed mutual fund and ETF strategy

Market leader Fidelity not likely to mirror the move because of its legacy structure

Thursday, February 10, 2011 – 2:50 PM by Lisa Shidler
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Lou Harvey: This gives them a huge edge on Fidelty.

Brooke’s Note: Schwab’s ambitious new 401(k) effort was one of the two pillars of long-term growth that its president and CEO, Walt Bettinger, announced at the company’s analyst meeting. The other was a plan to dramatically increase the size of the company’s branch network. See: Schwab will expand its branch network with independent operators. The two initiatives derive from a burgeoning optimism at the San Francisco brokerage, said Bettinger. “This is the time that successful companies accelerate out of the curve. We are ready to stomp on the accelerator,” he said in his introductory remarks.

Charles Schwab aims to undercut its competitors in the retirement arena by offering indexed mutual funds and exchange traded funds at dirt cheap prices in 401(k) plans next year.

At its recent winter business update meeting, Walter W. Bettinger II, Charles Schwab president and chief executive officer, told advisors his firm has been working behind the scenes for the past year so that it can introduce an index-only mutual fund 401(k) plan later this year and an ETF-only 401(k) program early next year.

“I think it’s safe to say we’ll really break glass when we introduce the first fully scaled and fully functional ETF-only 401(k) program in the industry,” he said at the Feb. 3 event. “I don’t mean once a day trading… I mean the true access to intra-day ETF-funds exclusively within your 401(k).”

To read Bettinger’s full take on this 401(k) plan, See: Schwab’s CEO engages in a Q&A about how his company’s deep-discount, more-advice 401(k) plan will work

The company is hoping to grab more of the estimated $3 trillion in 401(k) assets and Bettinger said he feels the ETF 401(k) funds are appealing because of the cost. The 401(k) plan would save participants about 35% to 85% costing just 15 to 25 basis points compared to a typical fee of about 55 to 95 basis points for a mid-sized plan, he says.

Biggest player so far to adopt index-only strategy

Bettinger’s new 401(k) mission plays to his heritage. In 1983, at the age of 22, he founded The Hampton Company, a provider of retirement plan services to corporations and their employees. The Charles Schwab Corporation acquired Hampton in 1995.

While Schwab isn’t the first company to introduce ETFs into the 401(k) arena, industry experts said the company will be the biggest player by far to offer ETFs in 401(k) plans. In part, Schwab has the freedom to do this because it has not traditionally been a big 401(k) player. The company said it has spent significant amount of time bulking its resources to handle ETFs in 401(k) plans.

“This gives them a huge edge on Fidelty,” said Louis Harvey, president of Boston-based Dalbar Inc. “If Fidelity tried to do a low-cost EFT they’d be cannibalizing their own customers. The major players are prohibited from doing this,” because of existing mutual fund customers.

Fidelity spokesman Mike Shamrell did not comment but sent a position paper published in July by his company on ETFs and 401(k) plans.

Here’s the conclusion of the paper:

“Fidelity believes index mutual funds are more suitable than index ETFs for workplace savings plan participants seeking passive exposure to the capital markets. Index mutual funds offer the same key advantages as ETFs without the potential to incur excessive trading costs, and any other ETF advantages are generally irrelevant to retirement plan investors. For these reasons, Fidelity does not support ETFs as a designated option within a 401(k) plan. Should a plan sponsor wish to make ETFs available in its plan, it may do so via Self-directed Brokerage.”

Fidelity administered corporate plans totaling $759 billion at the end of March, up from $626 billion at the end of June 2009. Schwab had $233 billion of “institutional” assets encompassing retirement assets as of the end of 2010.

See: What the confidential documents uncovered by Reuters say about Fidelity’s future in the 401(k) business.

For the most part, ETFs, often described as industry darlings, have been ignored by advisors in the 401(k) space, because advisors fear they’re too difficult for investors to understand, and companies would need new technology that integrates a brokerage system allowing multiple trades a day while also keeping in line with the 401(k) recordkeeping requirements. Schwab has been working for the past year on upgrading its technology to handle this need, Bettinger said. His other ETF-related move in 2010 was the acquisition of the ETF manager, Windward, that Schwab renamed Windhaven. See: A look inside Schwab’s big deal with a small asset manager.

Schwab has also introduced its own ETFs and an ETF platform. See: 10 reasons why Schwab’s move into ETFs may be an even bigger deal than it appears.

Good for investors?

Some experts also worry that the idea of participants trading their funds throughout the day could lead to more bad decisions by investors who sell funds when the market has a bad day.

“There’s still a lot of resistance to ETFs in the marketplace,” said Rick Meigs, chief executive officer of consulting firm 401khelpcenter.com LLC in Portland, Ore. “Mutual funds are so engrained. It’s been very difficult for vendors pushing ETFs to gain ground, but with someone like Schwab in the picture it’ll add credibility and make it easier.”

Still, Meigs also questions whether employers will want to offer a program to their employees allowing them trading access all day long. He said employers might add specific rules regarding daily trading as part of their plan if they adopt an ETF plan.

“A plan sponsor might wonder if they really want their employees trading the funds during the day when they should be working,” he said.

Some companies have made strides to push ETFs in 401(k) plans. For instance, BlackRock Inc. said that it had more than $2 billion in its iShares unit held in 401(k) plans last year. BlackRock owns iShares, the towering market share leader in ETFs.

Other low-cost providers have also been trying to ease into 401(k) plans. For instance, Tim Kohn, head of defined contribution sales for Dimensional Fund Advisors, which manages about $15 billion in defined contribution assets, has been making a push arguing that passively managed funds are the solution in the retirement arena. See: Buckingham expedites turnkey 401(k) strategy by buying a fellow DFA TAMP.

He maintains that while Schwab has an interesting plan, he feels that there needs to be additional advice offerings. “A lot of folks don’t need the cheapest products,” he said. “They need the best solution.”

Will costs really be so low?

Financial advisors’ reactions to the news were mixed. Advisor Craig Watanabe, of CSCP Penniall & Associates Inc. wrote in an e-mail that he believes the ETFs won’t even be as cheap as Schwab has predicted.

“ETFs are not cheaper than mutual funds,” he wrote in an e-mail. He pointed out that ETF costs soar quickly because of fees associated with a real-time recordkeeping system and trading costs which can add up dramatically with ETFs.

“An ETF model would have to separately bill all of these services and when you add it all up in a fair side-by-side comparison the cost savings for ETFs just aren’t there,” he said.

Terrence Morgan, an adviser and president of Oklahoma City-based OK401k Inc., which is exclusively in the 401(k) arena, says the employers he works with aren’t interested in ETFs at all. He declined to list his assets, but works with companies whose 401(k) plans are on average less than $10 million.

“I just don’t see the marketplace for this at all,” he said. “The proof is in the pudding. If this were important, plan sponsors would be gravitating toward indexes and they aren’t.”

A small company consisting of mostly executives might be attracted to this type of plan, Morgan said. He points out that allowing 401(k) participants’ easy access to daily trading goes against the buy-and-hold strategy of the 401(k) plan.

“This might work for a very small percentage if the participants really understand ETFs,” he said.

But advisor Bart Bonga, a vice president at Rothschild Investment Corp. in Chicago who heads up the firm’s retirement division, said he’s keeping an open mind about the ETF 401(k) option. His firm supervises more than $2 billion in assets. See: Why the DOL’s massive new 401(k) disclosure requirements are a 'very, very big deal’.

“I think anything that drives down the costs is a real positive for the industry,” he said. “I think having lower fees and more transparency are real positives, but I’m not sure it’ll work for everyone.”


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