The high-cost index-fund 401(k)
I like index funds, and I believe that the best way to maximize your retirement savings is, simply, to save more money. So I was intrigued to see a press release from Charles Schwab this week, touting its new 401(k) product, which combines index funds with opt-out advice services. The results, according to Schwab, are impressive: investors save 77% on operating expenses, and also tend to put more money into their plans:
Nearly 90 percent of workers in Schwab Index Advantage plans are receiving low-cost, professional, third-party advice to help manage their 401(k) investments. Prior to the transition, only about four percent of these same workers elected to receive advice…
Schwab data shows that employees who have chosen to use independent, professional, point-in-time 401(k) advice services in the past have tended to save twice as much, were better diversified and stuck to their long-term plan, even in the most volatile market environments.
Sounds good! But it really isn’t. The headline of the press release says that “Schwab’s Index-Based 401(k) Offering Cuts Investment Costs by 77%, Delivering on Low-Cost Goal” — but that’s incredibly misleading, precisely because the overwhelming majority of plan participants wind up paying for that “low-cost, professional, third-party advice”.
Here are the numbers: the weighted average operating expense ratio for the new index-fund product is 14.78bp, down from 65.11bp in Schwab’s old actively-managed plans. That’s a handy savings of just over 50bp. But as part of the deal, all the participants in the new plans automatically get enrolled in a plan which gives them something called “independent point-in-time advice”. How much does that advice cost? Turns out, it’s about 45bp. Which means that far from seeing their expenses fall by 50bp, the new savers are actually only saving about 5bp, all-in. (Under the old system, the advice came free, although it did so on an opt-in basis rather than an opt-out basis.)
Still, it might be worth paying 45bp for advice, if doing so led plan participants to double the amount they are saving. The problem is, there’s no real evidence that it does. The “Schwab data” cited here is based not on the activity of people in Schwab’s new index-fund plan, but rather on the activity of people who took advantage of the old, opt-in plan. And it’s well worth parsing the exact wording of the results of that study:
Approximately 70% of participants that receive and implement 401(k) advice make a change to their deferral rates, and those savings rates nearly double on average as a result, jumping from approximately 5% to 10% of pay.
To recap: when given the opportunity to opt in to advice-giving services, even when they’re free, only a tiny minority of plan participants — about 4% — actually did so. It’s reasonable to assume that most of that 4% of people were thinking about significantly increasing the amount they save, and wanted advice on how best to do that. Now Schwab doesn’t tell us how many people received advice but didn’t ultimately end up implementing it. It does say that of the people who both received and implemented advice, 70% changed their deferral rates. And within that 70%, deferral rates roughly doubled. But at a maximum, we’re still only talking about 70% of 4%, here, which is a by-definition highly unrepresentative 2.8% of participants.
In other words, Schwab has given us no evidence at all that the people enrolled in its new index-based 401(k) plan are saving more money as a result of paying 45bp a year for advice. I’m sure that a small minority of people who want to save more will ask for advice on how to do so — but that doesn’t mean that the advice causes them to save more. Indeed, the causality probably runs exactly in the opposite direction.
It seems to me that Schwab is looking a bit desperate here. It used to be able to make lots of money by charging high amounts for its 401(k) plans, but now that everybody understands the superiority of index funds, Schwab is being forced to offer its own index-based service. Obviously, the only way to sell such a service is to talk about how much participants will save on fees. But Schwab doesn’t want lower fees, it wants higher fees. So while removing management fees with one hand, it simultaneously inserts huge new advice fees with the other — and the advice fees probably have even bigger margins than the management fees did.
What’s more, Schwab’s messaging around this product has always been less than fully honest. Here’s the launch press release:
“Fund operating expenses for index mutual funds and ETFs are typically lower than those associated with most actively managed mutual funds offered in 401(k) plans today. We believe index funds can provide employees with a better opportunity to accumulate more savings for retirement,” said Steve Anderson, head of retirement plan services at Charles Schwab. “Through such low-cost investments, fund operating expenses could be cut significantly. For the average worker in a 401(k) plan, that can mean nearly $115,000 more at retirement.”
The irony here is deeply hidden: in order to end up with $115,000 more at retirement, you would have to opt out of the advice plan that the Schwab index-fund offering automatically enrolls you into. But actually, “the average worker in a 401(k) plan” is never going to wind up with an extra $115,000 at retirement just by switching to index funds.
If you look at the assumptions behind that $115,000 figure, you’ll find that our “average worker” is, in fact, very far from average. For one thing, she starts saving money at age 25, when she’s already earning $50,000 per year. That’s pretty much the median income for a US household, within just a couple of years of entering the workforce. Well done, that person! She then gets a 3% raise every year for the next 30 years — and once she’s in her 30s, she manages to sock away a full 10% of her income into her 401(k) account every year until retirement. Oh, and she managed to save 66bp by switching to index funds: that’s significantly larger than the real-world 50bp that we saw with the Schwab participants. And all the while her investments are growing by 7.5% per year, even when she’s near retirement and ought by rights to have switched largely to bonds.
But all of these assumptions are deeply buried and hard to find. As far as Schwab is concerned, the main thing to do is to come up with a large headline figure, something which will make it easier to sell the new index-fund retirement service to the less-sophisticated end of the HR spectrum. Schwab is pretty well positioned in this market: it’s known mainly as a discount broker, which means that the brand comes with connotations of low fees and low margins. But if you want to sign your employees up for an index-based 401(k) plan, which is a good idea, then the Schwab plan is not the right way to go, since it’s quite possibly the highest-fee index-fund plan out there, once all those advice fees are taken into consideration.
I work for an enormous company with a very financially-literate HR department; they’re not going to fall for this kind of pitch. But we shouldn’t live in a world where every medium-sized company needs to have people who can navigate the hard sell from people like Schwab offering fabulous new 401(k) plans. Right now, it’s incredibly difficult and time-consuming to choose between them, and it’s easy to see why plan administrators might easily just plump for a known name like Schwab. There really should be some reliable and impartial resource for those administrators. But I’m not holding my breath.