Charles Schwab, Vanguard: A costly cash choice on 401(k)s, IRAs
Moving money from an employer-sponsored 401(k) to an Individual Retirement Account (IRA) can be one of the most significant financial milestones people experience, my personal finance reporting has shown me over the years. A look at how investment companies Vanguard and Charles Schwab design these ...
Overview
Moving money from an employer-sponsored 401(k) to an Individual Retirement Account (IRA) can be one of the most significant financial milestones people experience, my personal finance reporting has shown me over the years.
A look at how investment companies Vanguard and Charles Schwab design these accounts highlights two distinct approaches and what they mean for individuals managing their 401(k) rollovers to an IRA.
For many everyday workers, the transition marks a shift from decades of steady saving to the high-stakes reality of relying on that accumulated wealth.
A person's primary focus during this process is selecting the right mix of investments to survive inflation and fund their lifestyle. But the question of what happens to that nest egg while it sits between investments is worth examining.
When a rollover occurs, the capital usually lands in what is known as a "settlement" or "sweep" account.
This is a temporary staging ground where uninvested cash rests while a person decides what to do with their money next. Unfortunately, for a variety of reasons, people hesitate to take action and the money often remains in these accounts longer than anticipated.
While it may sound like a minor administrative step, different financial services firms handle this money in fundamentally different ways. As I'll illustrate later, fully understanding these differences is important to Americans' finances.
Charles Schwab, Vanguard react differently to cash from 401(k)s
While both companies offer multiple ways of handling the new cash that comes out of a 401(k) rollover, Charles Schwab defaults to low‑yield cash sweeps unless one manually chooses a money market fund, while Vanguard defaults to a money market fund or high-yield sweep option for idle cash.
Schwab, a publicly traded banking corporation, warns that the order and timing of poorly performing investments can have a large impact on how long one's retirement savings last.
"One approach is to maintain a short-term reserve of low-risk liquid investments that you can use to cover your expenses while you avoid tapping your stocks," Schwab wrote.
"We suggest keeping a year's worth of expenses after accounting for other income sources, including Social Security, in cash investments and another two to four years' worth of expenses in high-quality short-term bonds or short-term bond funds," Schwab continued.
Vanguard, not publicly traded, acknowledges that cash investments and savings products help keep money safer from market risk, but that holding too much cash can make it hard to reach long-term savings goals.
"Money markets are low-risk investments that allow you to earn income while you're saving for short-term goals, deciding where you want to invest your cash, or preserving your emergency fund," Vanguard wrote.
Details
"Money market funds invest in the lowest-risk assets, like U.S. Treasury bills and CDs, which makes them one of the safest investments," Vanguard added. "In addition, money market funds may yield higher returns than what you'd earn from traditional savings accounts."
The active 401(k) rollover responsibility for retirees
This variance in default settings is an important detail for retirement account holders to be aware of.
With the low-yield cash sweep default, those who wish to execute a money market order using their newly liquid cash must do so actively.
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For sophisticated traders who watch the markets daily, this dynamic is a non-issue. They can quickly navigate the system, capture higher yields, and manually redeploy that cash when buying opportunities arise.
However, for average workers managing the logistics of retirement, this requirement has the potential to result in substantial missed opportunities.
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A scenario involving 401(k) rollover cash
For a thought excercise on this topic, I put together the following scenario.
Imagine two retirees, Person A and Person B, who each sell a stock in their individual retirement accounts on the exact same day, resulting in $100,000 of cash sitting in each of their accounts.
The brokerage firm they use automatically routes all new, uninvested cash into a default low-yield cash sweep paying just 1% interest, but it gives account holders the option to manually redirect that cash into a high-yield money market fund paying 5%.
Person A is a sophisticated investor who closely monitors the markets and portfolio logistics daily. As soon as the stock sale settles, Person A navigates the system, identifies that the cash is sitting in the low-yield default setting, and actively enters a trade order to move the entire $100,000 into the 5% money market fund to capture the higher yield.
Person B, an average worker managing the complex logistics of everyday life and retirement, assumes that cash is handled optimally by the institution and leaves the account alone. Because Person B does not take manual action to execute a new order, the $100,000 remains parked in the brokerage's automated, low-yield cash sweep default setting.
One year later, neither individual has bought new investments and interest rates have remained steady, but a large disparity has formed between the two accounts based entirely on that single default setting.
Person A checks the account and sees that the active decision to move into the money market fund generated $5,000 in interest over the course of the year, bringing the total idle cash balance to $105,000.
Person B logs in and finds that the money left in the default sweep account only grew at the 1% rate, yielding a meager $1,000 in interest and leaving a total balance of $101,000.
Ultimately, Person B missed out on $4,000 of entirely risk-free growth simply because of the requirement to actively execute a money market order, illustrating how a lack of awareness regarding low-yield default settings can result in substantial missed opportunities for everyday retirement account holders.
Related: Dave Ramsey, Vanguard at odds on key 401(k), IRA strategy
Source
Originally published at www.thestreet.com.
