Products May 23, 2014

Schwab Says Index Investing Gets Short Shrift

May 23, 2014 (PLANSPONSOR.com) – Don’t call index investing passive. Charles Schwab, founder and chairman of Charles Schwab, says that does a real disservice to investors.
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Schwab is so passionate about the value of index investing that the Schwab Center for Financial Research released “The Wealth-Building Power of Equities and the Elegance of Indexing,” a report to help investors better understand index investing and its role in wealth accumulation.

Index funds have a false reputation of being static, Schwab says. A number of the stocks in the Schwab 1000 change annually. The fund may not be as dynamic as a managed account, he says, but it is active and he would stack the outcomes against those of managed funds, especially when the reasonable costs are factored in.

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Schwab says the time for this report is critical, given growing concern about the inadequacy of retirement savings. “Not enough people are participating in the market, but it is the cheapest, easiest way for Americans to build a portfolio and build personal wealth,” he says.

 Schwab feels the media has been unfair to index investing, and has ignored its cost efficiency, cheap diversification and the emotional safety net that is so important to people. “It’s a cheap way to get into the market,” he says.

 The only asset that truly grows is company stock, Schwab says. Of course not every company experiences growth, but he says that every board he’s ever served on—some six or seven S&P 500 companies—always discussed growth. If the management is not actually growing the firm, it is generally replaced. “It doesn’t happen in any other vehicle,” he says. Not land, agriculture or real estate.

Using real estate as an example, Schwab points out a 100,000-square-foot building will always be precisely that. He called corporations “the greatest thing in the world,” and said that inviting people to participate in the growth of companies is a low-cost way for average people to build personal wealth.

A longtime believer in the power of index investing, which he calls a “most brilliant approach” in his letter, Schwab spearheaded the firm’s launch of the Schwab 1000 Index and mutual fund in 1991 to give investors a lower-cost diversified alternative to investing in individual stocks. “I believe indexing is unfairly perceived as unsophisticated,” he says. “Sometimes the most straightforward and simple approach is best.”

The report outlines the key features of indexing, from diversification, cost- and tax-efficiency to its disciplined, rules-based approach that enables better predictability of outcomes. While actively managed funds have an individual manager who assesses and selects securities, index mutual funds and exchange-traded funds (ETFs) follow a stock or bond index. This enables them to own a basket of securities that change periodically based on specific, pre-established rules.

Indexing, including traditional market-capitalization indexes as well as fundamentally weighted strategies, can form the core of an investor’s portfolio, the report contends. Market capitalization indexes, which the report calls Indexing 1.0, rank companies based on the total market value of their stock, offering diversification and cost-effective exposure to virtually every segment of the market.

With Indexing 2.0, or fundamentally weighted indexes, stocks are screened and weighted based on economic factors such as a company’s adjusted sales, cash flow, dividend history and share repurchase. These strategies capture many of the positive attributes of both traditional market-capitalization indexing and active management, and can add another layer of diversification.

The report uses the Schwab 1000 Index and other widely recognized benchmarks to distinguish market capitalization indexes from those that are fundamentally weighted, and to show how differences in construction, reconstitution and rebalancing can lead to very different results over time.

 It is difficult for active managers to consistently outperform their benchmarks over the long-term, especially when factoring in fees, the report contends. Between 2004 and 2013, just one actively managed equity mutual fund was able to rank in the top performance quartile for more than seven years, according to data from the Schwab Center for Financial Research.

Index funds are an incredibly low-cost way for someone to buy into 1,000 companies for $1,000, Schwab says. The cost is just $3 a year for oversight—an efficient way for the average American to buy into the growth of companies.

The full white paper is available at http://schwab.com/indexing.

Benefits May 23, 2014

ERISA Offers Best Practices for K-12 403(b)s

May 23, 2014 (PLANSPONSOR.com) - Emulating fiduciary principles of the Employee Retirement Income Security Act (ERISA) can help K-12 public school retirement plan sponsors improve outcomes for participants.
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Because public K-12 403(b) plans are exempted from ERISA, vendors are in many cases unregulated in key cost, investment and fiduciary areas of plan management, according to “Emulating ERISA: Providing a safety net for public K-12 educators,” a white paper from TIAA-CREF. “This leaves them in many unfortunate circumstances free to market questionable products on educators, in some cases with hidden and hefty fees,” the paper says.

“The most important single element is to get the advice piece right,” Bruce Corcoran, managing director and head of the K-12 segment at TIAA-CREF in Charlotte, North Carolina, tells PLANSPONSOR. “So if providing access to investment products and services, get the conflicts of high commissions out and make sure investment advice is objective.”

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The paper notes that being exempted from ERISA, means public K-12 plan sponsors’ employees are operating without the safety nets the law provides, which may ultimately leave them less prepared for retirement. But, Corcoran says TIAA-CREF is seeing these plan sponsors start to apply ERISA principles such as the “prudent expert rule,” which holds that a fiduciary must act “with the care, skill, prudence and diligence” in administering plans under the law that a reasonable person “familiar with such matters” would use, as well as the “exclusive benefit rule,” which states that a plan’s fiduciary must act solely in a participant’s or beneficiary’s best interest (see “Meeting Expectations of the DOL”).

Applying those principles and the ERISA requirement to diversify investments has a significant potential economic impact to educators, and the biggest benefit to K-12 plan sponsors, according to Corcoran, is it helps them attract a globally competitive work force and have less financially stressed employees who can do their jobs better.

The K-12 retirement plan market has traditionally been dominated by insurance providers offering fixed annuity products. While fixed annuities do belong in a retirement portfolio and help K-12 educators save and prepare for retirement, the TIAA-CREF paper contends, when they stand alone as an investment strategy, employees lack diversification and long-term risk management benefits. Corcoran says he is a big advocate of the products, “but if K-12 employees also have a pension and are able to get Social Security benefits, locking into a high-cost annuity for 30 years has a staggering economic price.”

The paper offers a hypothetical case of two California teachers, both age 35, who save 5% of their income each year and at age 65 begin taking monthly withdrawals of $2,500. The first has 100% of her assets in a fixed annuity product. The other is in a portfolio that has an evenly split allocation between fixed annuities and equities (the 50/50 portfolio), with periodic rebalancing to maintain that allocation. A set of calculations—based on actual results of the equity and fixed income markets—shows the 50/50 portfolio generates $427,000 by the time that teacher retires at 65. The 100% fixed annuity solution generates only $296,000. That $130,000 difference represents approximately 40% more in retirement assets and widens even further to more than $600,000 by the time the teachers reach age 77, at which time the 100% fixed annuity investor is projected to run out of money.

So, what steps can K-12 plan sponsors take to emulate ERISA principles? Corcoran says TIAA-CREF is seeing some establishing plan committees just as their 401(k) counterparts have. In addition, many are starting to competitively bid their programs, moving towards an institutional design, as well as pare down to a single-vendor administration model. Some are also outsourcing administration and investment decisions as internal staff do not have the expertise.

TIAA-CREF also sees consultants and advisers becoming more active with K-12 plan sponsors, offering sponsors their experience and voice in the market, according to Corcoran. And, some states are addressing high costs and sales models of 403(b) vendors.

Corcoran says higher cost-structure providers and distributors are using fear to oppose these better structures, telling plan sponsors “If you take control of changes, products and processes to improve outcomes, you will create liability for employee choices.” But, these plans will never be subject to ERISA. Some states do have fiduciary statutes that overlay K-12; “Just use a little caution as plan sponsor,” Corcoran suggests.

For the best guidelines for K-12 employers, “look at the best practices of ERISA,” Corcoran concludes. “If you have a process, you’re better off than with no process at all, and improving [employees’ retirement savings] outcomes will help everyone.”

The TIAA-CREF paper is at https://www.tiaa-cref.org/public/pdf/emulating_ERISA.pdf.

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