Products May 23, 2014

Schwab Says Index Investing Gets Short Shrift

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.

The reputation of Index funds as static is false, 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.”

Indexing the Advantages

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 schwab.com/indexing.

Data & Research May 22, 2014

Roth Growth Far Outpaces Traditional IRAs

Roth IRA balances grew at twice the rate of traditional individual retirement accounts (IRAs) between 2010 and 2012, according to a new analysis from the Employee Benefit Research Institute (EBRI).
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The analysis looks at the investment behaviors of Roth and traditional IRA owners, as tracked by the EBRI IRA Database, and finds the median asset increase for Roth owners was 16.6% between the start of 2010 and year-end 2012. Traditional IRA owners, on the other hand, saw assets grow just 7.9% during the same period.

A major factor in the different rates of increase, according to EBRI, was that new contributions made up a larger proportion of the Roth IRA balances due to the smaller average starting balances of Roth IRAs. Additionally, Roth owners were somewhat more consistent at making contributions each year, which had the impact of further magnifying Roth contributions over those made to traditional IRAs, EBRI explains.

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Researchers found that Roth IRA balances grew faster than traditional IRAs across each age group and for each gender. Looking at individuals who maintained an IRA account in the database throughout the three-year period, the overall average balance increased each year—from $95,431 in 2010 to $95,547 in 2011 and to $106,205 in 2012.

Interestingly, IRA owners whose balances originated as a rollover from another tax-qualified retirement plan also showed consistent growth, EBRI says, challenging the common assumption that IRAs founded with a rollover often fail to receive regular ongoing contributions (see “For IRAs, It’s All About the Rollover”). Only IRA owners age 70 and older—i.e., those who are legally required to start making withdrawals—saw balances decline from 2010 to 2012, EBRI says.

Craig Copeland, a senior research associate at EBRI and an author of the analysis, says EBRI’s IRA Database offers important insights for retirement planning professionals because it tracks IRA contributions longitudinally—not just as a snapshot in time. This allows for deeper insights into the behaviors of individuals in the sample, Copeland says.

For example, among traditional IRA owners, a snapshot analysis shows approximately 6% of IRA owners contributed to their IRA each year, but EBRI’s longitudinal data shows that over the three-year period approximately 10% of traditional IRA owners contributed in at least one year. Among Roth IRA owners, approximately 25% contributed in any one year, compared with 35% who contributed at some point over the three-year period.

“An annual snapshot of those contributing to IRAs doesn’t allow you to assess whether the same individuals were contributing on a regular basis, or if different people contributed in different years, whereas a consistent longitudinal sample of IRA owners does allow for this examination,” Copeland explains.

Other major findings from the EBRI IRA study include the following:

  • The overall average IRA account balance in 2012 was $81,660, while the average IRA individual balance (all accounts from the same person combined) was $105,001. Overall, the cumulative IRA average balance was 29% larger than the unique account balance, EBRI says.
  • Rollovers overwhelmingly outweighed new contributions in dollar terms. While almost 2.4 million accounts received contributions, compared with the 1.3 million accounts that received rollovers in 2012, EBRI says about 10 times as much was added to IRAs through rollovers, compared with contributions.
  • The average individual IRA balance increased with age for owners ages 25 or older, from $11,009 for those ages 25-29 to $192,961 for those ages 70 or older.
  • IRA owners were more likely to be male. In particular, those with an IRA originally opened by a rollover, or a SEP/SIMPLE IRA were more likely to be men. EBRI says men also had higher individual average and median balances than women. However, the likelihood of contributing to an IRA did not significantly differ by gender within the database.
  • Younger Roth IRA owners were much more likely to contribute to the Roth IRA than were older Roth IRA owners, with 43% of Roth owners ages 25 to 29 contributing to their Roth in 2012, compared with 21% of Roth owners ages 60 to 64.

The full report, “Individual Retirement Account Balances, Contributions, and Rollovers, 2012; With Longitudinal Results 2010–2012: The EBRI IRA Database,” is published in the May 2014 EBRI Issue Brief and is available online at www.ebri.org.

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