In early 2012, Charles Schwab came out with a 401K where the fund line-up was composed entirely of low-cost index funds such as Schwab's own Total Stock Market Index Fund and the Vanguard Small Cap Value Index Fund. This is a move to be applauded. It is a little hard to tell whether this is in response to other 401K providers (such as Vanguard) offering low-cost 401Ks filled with low-cost index funds to investors who are now much more aware of the impact of fees especially in this low yield environment, or whether Schwab just wants to do the right thing and actually lower its fees. But either way, kudos to them and to the 401K providers and committees that are implementing this plan in many companies across the nation.
Schwab's implementation of this Index Advantage plan, however, deserves a little closer scrutiny. Along with the change from high-cost actively managed funds to low-cost index funds, comes the opportunity for 401K participants to get advice on the asset allocation of the mutual funds inside their 401K. This advice is provided by Schwab employees armed with a computer program designed by a company called GuidedChoice. Starting this year, you can also choose to have your allocation provided by Morningstar. The theory behind this is that 401K participants are always asking for help in choosing their allocations. Many participants know so little about investing that they don't contribute enough, they choose silly asset allocations, they rarely if ever rebalance, and worse, they change their asset allocation in response to changes in market conditions. If you believe Schwab, they're trying to provide a solution to 401K providers to help their participants have more success in their investments. If you're a bit more cynical like me, it looks like Schwab is finding a way to replace the fees lost from the higher cost actively managed funds that were replaced by index funds.
My 401K Fees
Participants in my 401K may be paying as many as 5 separate fees, none of which is particularly outrageous, but in total they may have a huge impact on the investing returns of participants.
- Mutual Fund Expense Ratios. These start at 0.09% for the Schwab Total Stock Market Index Fund, range from 0.10% to 0.24% for various Vanguard index funds and top out at about 0.45% for the PIMCO Total Return Bond Fund, a bit of a holdover from our previous 401K. The average for a reasonable allocation is probably about 0.15%, which is darn good for a 401K.
- MedAmerica Fee. This starts at 0.4% and decreases as more assets are put under management. Our plan is paying around 0.32% right now.
- Schwab Recordkeeping Fee. This is 0.05%.
- Independent Advisor Fee. Many participants in the plan have hired an independent financial advisor or asset manager. Fees of 0.6-1% are common among my partners.
- GuidedChoice Fee. This is 0.43% currently. I'm not sure how much the Morningstar option will be.
All together, these fees for a typical 401K user total a minimum of 0.52%. Not horrible, but every basis point paid is a basis point that comes out of the participant's pocket. It's actually possible to reduce these fees even further with my plan, since participants are given the option to basically opt out of the committee-selected mutual funds using Schwab's Personal Choice Retirement Account (PCRA) option. Instead of paying the MedAmerica and Recordkeeping AUM fees, you can just pay $200 a year ($500 if over $500K in assets.) This gives you full access to a Schwab brokerage account. Through the account you can buy Schwab ETFs commission free or buy Vanguard ETFs for just $8.95 a trade. I probably spend about $250 a year total, which works out to about 0.17% a year and dropping for my 401K fees. Combined with an average ER for my selected ETFs of about 0.10%, I'm at a total of 0.27%, which I find downright reasonable.
But for someone who is less fee conscious, even with a great 401K like this one, he could be paying as much as 1.95%, nearly 8 times as much as I'm paying.
Issues With GuidedChoice
One problem with this GuidedChoice advisory service is that it is opt-out, not opt-in. If you do nothing, you automatically get their service and pay their fees. If you don't call them and give them some financial details, they'll just pick one of their 11 model allocations for you. They try to do so based on how aggressive you appeared to be in the old 401K funds and on your age. Not surprisingly, these allocations are hardly personalized. The opt-in nature is supposed to be a benefit, so that the chumps you work with who know nothing about investing will at least have some kind of reasonable allocation, at least for the dollars in their 401K.
The second problem with GuidedChoice is that it cannot fully take into account your other assets. They say they can, if you'll just call them and inform them of your other assets, but the fact remains that they only have 11 different allocations. So if you have a Roth IRA that has your small value and emerging markets in it, how can they come up with an allocation that is not only an appropriate risk level for you, but that also takes in to account your other accounts when there are only 11 models to choose from? They can't. They call it personalized, but just how personal can it be when it is exactly the same as 9% of their other clients? Our 401K committee noticed that the various model allocations that people in our 401K were actually placed into were remarkably similar, despite varying ages, risk tolerance, and outside assets. Hopefully the 500 models that Morningstar is planning to use will allow for better personalization.
The third problem with GuidedChoice is that they don't seem to have any insight into the fact that no allocation is perfect. There is simply no way to know which allocation will be best going forward. That's why it is best for an investor to pick a reasonable allocation, and then stick with it. But when you talk to them they spend all their time talking about how they've optimized everything using Monte Carlo simulations. Monte Carlo simulations are wonderful, as long as the future resembles the past, which it never seems to do. It seems every advisor has “models” these days, based on extended Monte Carlo testing. Too many of them need to develop a little humility with regards to their models. They can't all be exactly right, can they? GuidedChoice, for instance, doesn't like overweighting REITs. That's fine, everyone is entitled to their opinion. But iIt doesn't do our 401K participants a bit of good for us to have the Vanguard REIT Index Fund (signal shares too) in the 401K if they're using GuidedChoice. All their models also have an allocation to 3% cash, which seems odd to me, not only because the cash option is paying 0.20%, but also because a 3% allocation to anything really doesn't do anything. It simply isn't a big enough chunk of the portfolio to matter.
The fourth problem with GuidedChoice is that it charges too much for what it does for the vast majority of participants. Our 401K committee decided to implement it in the hopes that it would help our participants to save more, choose a reasonable personalized allocation, stick with it, and rebalance periodically. The committee figured it was worth the 43 basis points to help the doctors not do stupid stuff with their 401K. But the vast majority of people using it aren't contacting GuidedChoice at all. 0.43% isn't a bad fee for asset management. But it is way too much money to stick someone into one of 11 models based on their age and rebalance once a quarter. You can program a computer to do that and charge 2 basis points for it. Betterment offers a similar model for IRAs and taxable accounts. Fees start at 0.35%, but at $10K drop to 0.25%, and at $100K drop to 0.15%. They're clearly making a profit at 0.15%, so the service can obviously be done for less than that. I don't see why Schwab/GuidedChoice can't match those fees on a much higher amount of money. It seems to be a similar amount of work and personalization to me.
Fifth, I asked the Schwab representative what the education and training was for the people who answer the phone when you call up to get this financial advice you're paying 43 basis points for. He was quick to point out that all of them have their Series 7 license (takes about a week) and receive some training from Schwab. Some (not all) are even CFPs. It's not set up so you get the same advisor every time you call, although he said if you asked for that it could be arranged.
Sixth, the driving reason for adopting GuidedChoice into our 401K was to provide automatic help to those who most need it, even if they never contact anyone for it. That help was already available through MedAmerica. They would provide model asset allocations using the funds in the plan that were perfectly fine for someone who just needs something reasonable for just their 401K. They were willing to meet with the physicians regularly to help choose among the 401K funds, and would have been able to personalize the allocations a lot more effectively in these one on one meetings. Few physicians took them up on it (just like few are taking up Schwab/GuidedChoice on it), because most doctors either have a financial advisor, do their investing themselves, or just don't care. It seems the goal of the committee, to ensure plan participants are allocated in some reasonable manner, could easily be done by MedAmerica using a handful of reasonable asset allocation models for the fees that are already being paid. Yes, MedAmerica and the docs on the committee have a fiduciary duty to the plan participants, but it can be met in a much more fee-savvy way than by using GuidedChoice.
Last, the whole set-up just seemed sneaky, and Felix Salmon agrees. It was pitched along with a decrease in expense ratios on the funds as a huge savings in fees. But the decreased ERs were essentially replaced by a new fee. The opt-out process was surprisingly complex and difficult to communicate. It was not entirely clear to most participants exactly what the new fee was for. I read everything sent to me and everything I could find on the web, and consider myself reasonably financially literate, and it still took me a little while to recognize the GuidedChoice option for what it was.
GuidedChoice = Hiring a Bad Advisor
Being enrolled in GuidedChoice is hiring an investment advisor, but an advisor with significant limitations:
- The advisor can only work with your 401K assets
- The advisor may have no more formal education and training than acquiring a Series 7 license
- You get a different advisor every time you call (unless you demand otherwise)
- The advisor is still hired and paid even if you never actually speak to him
- The advisor is limited to only 11 different asset allocations
Now, 0.43% isn't a bad price for solid asset management, but who wants to pay anything for the asset management service described above? You can hire FPL for $1000 a year, Cardiff for $3000 a year, or Portfolio Solutions for 0.35% (minimum of $3500) a year and a plethora of excellent advisors for 0.5-1% per year. If you really need an investment advisor, I think you'd be better off with one of these firms.
3 Types Of People In 401Ks
This type of arrangement isn't Schwab-specific and I'm not trying to bash GuidedChoice or Morningstar.. I recently helped a family member with his 401K allocation. Upon logging in, we found out he had inadvertently hired an investment advisor no different than GuidedChoice who did nothing but put him into an asset allocation without ever talking to him and rebalance it regularly for 30 or 40 basis points a year.
There are basically three types of people in a typical 401K, those with advisors, do-it-yourselfers, and do-nothingers. Those with advisors don't need this advice or these fees. Do-it-yourselfers don't need this advice or these fees. Do-nothingers can be served just as well by a depersonalized default option for a whole lot less than 0.43% per year, and probably for nothing. Maybe if they were charging 10 basis points or less for choosing an allocation for you and rebalancing regularly I could stomach it, but not for 43 basis points.
Schwab brags that 80-90% of participants are choosing to use GuidedChoice. I think as participants become more informed they'll see that number drop to the single digits. It just isn't the right solution for the vast majority of 401K participants. They either need more personalized and comprehensive advice, or they need lower fees.