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.

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.

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.