The Markets June 30, 2014

Lifecycle Investing Through Managed Accounts and ETFs

Target-date funds (TDFs) are an important tool for workplace retirement investors, says Steven Anderson, of Schwab Retirement Plan Services, but more efficient methods of delegated lifecycle investing are emerging.
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Anderson, an executive vice president at Schwab RPS, says Schwab is working hard to get retirement plan sponsors to consider the opportunities presented by combining a 401(k) plan based on exchange-traded funds (ETFs) with an independent managed account service from a trusted plan adviser. Building plans in this style can significantly reduce expenses for participants and brings more transparency to sponsors and other fiduciaries, he contends.

Whereas TDFs are typically built to suit wide swaths of investors—based heavily on the single metric of participant age—the ETF/managed account approach allows each workplace investor to create a portfolio that’s directly relevant to his personal financial outlook, according to Anderson. Extensive salary data, outside assets and specific risk tolerance considerations can be factored into the asset-allocation strategy. For plan sponsors, there is the added benefit of cutting out share class considerations that come along with mutual funds, he adds. Unlike mutual funds, which come in different share classes (i.e., with different expense ratios) depending on the size of the investment, ETF shares are generally priced equally.

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But the biggest selling point is clearly the lower cost of ETF investments, Anderson explains. He says retirement plans using an all-ETFs lineup can push the aggregate investment expenses ratio below 10 basis points. Plans utilizing only mutual funds typically require billions of dollars in assets before they can access share classes with such low expense ratios.

“We’ve really shown that ETFs are the most efficient option you can get when you aren’t a multi-billion dollar plan,” Anderson tells PLANADVISER. “Even the federal Thrift Savings Plan, one of the largest purchasers of investment products out there, sees about 2.7 basis points for the aggregate operating expense. ETFs allow much smaller plans to pay similar pricing.”

When fund expenses are this low, Anderson explains, the client can then hire a top-performing independent adviser to give advice about how to build an ETF-based portfolio. Or the client will pay the adviser a little more to take on full discretionary oversight of the retirement account.”

“And these independent advisers will be encouraging a good savings rate and other positive investing behaviors,” he adds. “All this comes for less than the expense of a lot of TDFs out there.”

Schwab RPS is working hard to educate existing and potential clients about the benefits of using ETFs in retirement plans. The firm launched an all-ETF 401(k) platform earlier this year, and Anderson says uptake has been solid so far (see “Schwab Introduces All-ETF 401(k) Platform”). He says about one-third of 401(k) participants currently on the platform have hired an independent, fee-based adviser to manage their accounts. These advisers, in turn, are leveraging the platform’s open brokerage window to build highly customized risk- and age-based portfolios for clients that can stand in the place of traditional TDFs. 

All-in fees for the ETF version of Schwab Index Advantage would be 45 to 55 basis points, he adds.

“One interesting trend is that many advisers are going down a more conservative path with the brokerage windows, building individualized bond ladders and selecting different types of underlying fixed-income securities to create an income-based, defensive portfolio for clients,” Anderson explains. “It’s rare to hear about the brokerage window as a conservative asset-allocation tool, but it’s something we are seeing more and more.”

Anderson says the industry is “more used to thinking about brokerage windows and ETFs as a tool for people to be overly aggressive in terms of buying and selling.” (See “ETFs in DC Plans: Will worries about excessive trading stall adoption?”) “But it’s really an excellent vehicle for individuals who are more engaged in the investment process and who have specific goals and income needs,” Anderson adds, “or those who want to delegate their portfolio to a fee based independent adviser.”

This style of investing is also gaining traction among Schwab clients outside the all-ETF platform, according to Charles Schwab’s institutional "SDBA Indicators Report," which benchmarks retirement plan participant investment activity within self-directed brokerage accounts (SBDAs). The research shows investors allocated 14% of their total SBDA portfolios to ETFs in the first quarter of 2014. That represents an increase of two percentage points compared to the same period a year ago.

As the researchers explain, SBDAs are brokerage accounts built into retirement plans, including 401(k) and other types of retirement plans, which participants can use to invest in stocks, bonds, ETFs, mutual funds and other securities that are not part of their plan's core investment offerings. According to the Schwab data, ETFs were the only investment category to see an increase in net asset allocation year-over-year during the sample period. Asset allocations in mutual funds held steady in the quarter, comprising 41% of overall portfolio allocation. Allocations in individual equities remained unchanged at 25%, while SDBA participants decreased their cash positions to 18%.

Anderson says another force driving this interest in ETFs is widespread media coverage of 401(k) fee litigation (see “Fee Suit Litigator Discusses Best Practices”). Sponsors can open themselves up to substantial liability if they are not pushing for the lowest possible expenses from mutual fund providers. 

“The idea of utilizing an ETF 401(k) plan as a way to either protect from or address share class risk is very prevalent today,” Anderson says. “Sponsors hear a lot about class action law suits that really challenge plan sponsors and providers for not taking proactive steps to bring the best share classes possible to the plans.

“When you start taking the share classes out of the underlying funds and you drive the cost down to the lowest possible asset management fees, as you do with ETFs, you’re creating a more efficient and fair plan that is more transparent,” he says.

Compliance June 27, 2014

Making Sure Plan Fees Are Reasonable

When it comes to retirement plan fees, recent regulatory changes and litigation have highlighted the importance of plan sponsors and fiduciaries ensuring that such fees are reasonable.
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Phil Fiore, senior vice president of UBS Institutional Consulting, recently discussed some best practices in this area, for plan sponsors and fiduciaries, with PLANADVISER. Christopher Thomas, director of Corporate Retirement Plans for Planning Solutions Group, based in Fulton, Maryland, also offered recommendations on the subject.

Review the investment policy statement (IPS) at least annually.

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In terms of particular items to review, the Stamford, Connecticut-based Fiore says, “A good best practice is to have more concrete metrics for evaluating funds, which leads to better process outcomes. This way, there is a mechanism or repeatable process by which investment committees and plan sponsors can look at each fund. We know that everyone is on the same page in terms of how the fund is being evaluated.”

Thomas adds, “Part of the criteria that should certainly be addressed in the IPS is acceptable fees for the investment options to be included in the plan. This can be done by setting a ceiling or maximum acceptable fund expense.”

Fiore also emphasizes that the IPS is a living document that needs to be updated to reflect changes in the real world. “Don’t just write the statement, file it and never review it again. It’s like a blueprint for building a home. Inevitably, changes will need to be made,” he says.

Document the rationale for adding or removing investments from the plan.

Fiore says, “It’s about making sure that the decisionmaking process is well documented. It is imperative that processes be properly maintained.”

Review plan fees periodically through requests for information (RFIs) and requests for proposal (RFPs).

“I believe it’s the obligation of plan sponsors to ensure that plan-related fees are reasonable,” Fiore says. To that end, he suggests that every three to five years, plans sponsors and fiduciaries send out RFIs and RFPs to recordkeepers in order to benchmark the fees and services the plan is receiving.

Plan sponsors and fiduciaries should also pay close attention to proprietary investments such as target-date fund suites, says Fiore. “Make sure that it’s the right suite from a fee standpoint and the right one from a participant demographic standpoint.” Also, Fiore advises that the Department of Labor (DOL) website (www.dol.gov) be consulted for the agency’s tips on evaluating target-date funds. This way, if the DOL ever audits the retirement plan, plan sponsors and fiduciaries will be able to clearly articulate why they chose that particular suite of funds.

Review periodic benchmark studies to determine if the plan’s fees continue to be reasonable.

Fiore says, “Benchmarks give a good estimate as to whether your plan is comparable to others. Don’t be afraid to take your recordkeeper to task and ask them to justify why fees are the way they are. If a fee is high, understand why that’s so.”

Continuously run the plan in the best interest of participants.

Fiore says that it is the duty of plan sponsors and fiduciaries to ensure that the plan operates in the best interest of participants and not favor other parties such as recordkeepers or investment managers. “Plans are under more scrutiny these days, not less. Plan sponsors need to look at the overseeing of fees and investment option choices as a significant fiduciary duty,” Fiore says.

Until the last several years, fees were primarily monitored or re-assessed as the asset size of the plan grew, notes Thomas. “Now plans might be able to lower their fees without a substantial change in their demographics because of two forces:  regulations that have improved fee transparency (Employee Retirement Income Security Act (ERISA), Sections 408(b)(2) and 404(a)(5)) and increased competition from low-cost ETFs [exchange-traded funds] and passively managed funds.”

ERISA disclosure requirements have brought about greater fee transparency to employer-sponsored retirement plans (see “FeeSuit Litigator Discusses Best Practices”).

Establish a checklist for the plan’s investment committee.

Fiore says, “A plan’s investment committee should meet at least quarterly and the more disciplined the process is, the better. There should be a consistent outline or checklist of how funds and fees are going to be evaluated. Decisions also need to be made with an eye toward be able to defend them if need be.”

Thomas recommends that plan sponsors and fiduciaries should: (1) know what the plan’s expenses are; (2) have an IPS tailored to the plan’s size and demographics; (3) review the IPS with an retirement plan consultant to determine if the fee parameters need to be adjusted because of plan asset growth and/or competitive forces in the investment manager universe; and (4) understand that the lowest fee fund is not always the best solution.

Plan sponsors should also look to an independent retirement plan consultant for objective research on funds to support their ultimate decisions made for investment choices and fees, says Thomas. “It also has to be kept in mind that fee parameters will change as the investment universe continues to evolve and the participant demographics change,” Thomas says.

“Your plan consultant should help identify which investment managers’ track records warrant paying a higher expense versus a lower expense alternative,” Thomas explains.

In establishing fee parameters, says Thomas, plan sponsors and fiduciaries need to determine maximum expense ratios allowable, as well as gearing parameters to different asset classes. For example, he explains, a 1% expense ratio might work best for a small-cap fund, while 60 basis points may be appropriate as a limit for a core bond fund.

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