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Salmon: Beware Schwab's High-Cost Index-Fund 401(k)

Tickers in this article: SCHW
NEW YORK ( Reuters Blogs ) -- 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% 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 4% 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 that 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.