Exchange Traded Funds in 401(k)s: Can ETFs Make Their Case and Claim Their Place?

The rapid growth of the exchange-traded fund industry is hardly a secret. Today, there are approximately 1,700 ETFs available.

“Over the last 10 years, it’s been about a 25 percent growth annually,” says Tom Lydon, president of Global Trends Invest­ments and editor and proprietor of ETFtrends.com.

Lydon estimates current ETF assets at $2.1 trillion. What’s more, larger firms continue to enter the space, includings Goldman Sachs, JP Morgan, T.Rowe Price and John Hancock.

“[These are] companies that were dyed-in-the wool mutual fund com­panies or Wall Street brokers and banks,” Lydon adds.

So far, very few ETFs have made their way into 401(k) plans, but Lydon thinks that’s changing.

“There’s been an explosion of offerings among the big brokerage houses to offer ETF trading for no transaction fee or no commission,” he notes. “You’ve got Charles Schwab, Fidelity, TD Ameritrade that pro­vide a whole list of no-transaction-fee ETFs that are available. Here you are getting great diversification, tax efficiency, for a very, very low price within the product.”

The result, he argues, is that commis­sion-free products could remove one of the biggest barriers to including ETFs in 401(k)s.

Lydon also believes one of the reasons ETFs are thriving is that a strong market in post-recession years has made more Americans eager to invest, and the trend has favored cost-effective, index-related strategies that emphasize tax efficiency. The ETF industry is responding with remarkable creativity, introducing “smart beta” products, currency hedging products, and ETFs that address intriguing, thinly sliced sectors.

“There’s kind of a rock-star status for ETFs right now,” he explains, adding that their popularity could be harnessed to boost participation in 401(k) plans, something that he himself has done with his own firm.

“In our company, six years ago, we transferred our 401(k) plan over to ING Direct because they offered ETFs, and we’ve been thrilled with the fact that they’ve been available. I felt obligated, as we were pushing to have ETFs within 401(k) plans, that we make that move.”

More choices, more competition, and rock-star status; what’s not to like?

ASSESSING ETF CHALLENGES

Not so fast, says Rick Ferri, CFA. He ap­preciates ETFs, which he says have “helped drive down the price of all fund manage­ment, not just exchange traded funds but mutual funds as well.”

Nonetheless, Ferri, author, blogger, managing partner of Portfolio Solutions and self-described “purist,” is not a fan of ETFs in 401(k) plans.

“You can get all the (same) stuff through an open-end mutual fund very inexpensive­ly,” he says. “The only difference is, you’re trading at the end of the day, as opposed to (ETFs) trading during the day. As an em­ployer …the last thing I want my employees to do is be trading their ETFs during the day. I’d rather have them working.”

Ferri also feels ETFs add complexity and confusion to the 401(k) world, and that’s not likely to make the Department of Labor happy. He admires the Thrift Savings Plan created for federal employees—basic stock and bond index funds. If plan participants want access to commodities and other “non-traditional” asset classes that ETFs offer, he suggests they open a Roth IRA.

“They’re not the trustee; I am,” Ferri says. “I have to do what’s in the best interest of the entire plan and the company to make sure I don’t get sued by my employees later on. If my employees come to me and say, ‘We want this commodity ETF, we want these currency ETFs, how about this tri­ple-leverage short ETF?’ No.”

“ERISA’s pretty picky about cost disclo­sure,” Dave Nadig, vice president and direc­tor of ETFs for FactSet Research Systems, adds. As his title—director of exchange traded funds—implies, he’s a fan of ETFs in general. But Nadig believes layering an ETF structure on top of a 401(k) structure can make disclosure and participant communi­cation murky.

“I do think there are some risks just from the plan sponsor’s perspective,” he says.

Nadig encourages plan sponsors and advisors who work with them to be skep­tical “just like you would about any other investment vehicle you’re putting out there for plan participants.”

DEALING WITH INTRADAY TRADING

Because ETF investors can trade through­out the day, in a 401(k) context, it raises questions regarding inconsistent pricing and determining exactly when trades settle.

“Part of the hidden costs in ETFs at times are the bid-ask spreads,” says Joshua P. Itzoe, CFP, AIF, a partner and managing director of Greenspring Wealth Management’s Insti­tutional Client Group.

Lydon acknowledges there are trading issues: “On top of that you have a reporting issue, because somebody might have done a trade in the morning, somebody might have done something in the afternoon—they’re not going to be the same—where with a mutual fund, everybody gets that day’s closing price.”

But Lydon doesn’t believe the problem is insoluble. Limits can be placed that discour­age frequent trading, he says, adding, “There’s always the ability to offer trading in batches toward the end of the day.”

HANDLING MODELS CAREFULLY

There are numerous caveats when it comes to using ETFs in 401(k)s, accord­ing to Jason C. Roberts Esq. Roberts works with many retirement plan sponsors and service providers as CEO of Pension Resource Institute LLC. and a founding partner in Retirement Law Group PC.

“We tend to see ETFs used [in 401(k)s] when the RIA that’s advising the plan may have an ETF strategy for their wealth man­agement or their high-worth clients, and they want to map the same strategy over into the plan,” Roberts says.

One way to do that is through a managed solution, an increasingly popular method that bundles ETFs under an asset model or asset allocation portfolio. Such a strategy can give the advisor an “economies of scale” advantage, he believes, because the “research and the effort that goes into creating and monitoring and allocating and reallocating and rebalancing the model is spread across more clients.”

RIAs that decide to augment a plan’s core investments with an ETF model portfolio should be prepared for additional reporting and disclosure requirements under ERISA Rule 404(a)(5), Roberts says. Rules orig­inally written for mutual fund companies may be tough for RIAs who lack necessary tools, yet some providers help facilitate the additional compliance burden.

If you’re evaluating someone else’s mod­el, be aware that it could mask inherent weaknesses in individual sector ETFs and commodities—a misleading gold fund, for example.

“The unsuspecting participant may see double-digit returns and jump all in to something that’s extremely volatile and not necessarily a long-term retirement investment option,” Roberts says. He urges advisors to be especially mindful of their fiduciary duty and avoid inadvertently pre­senting participants with faulty models.

CHANGING FEE STRUCTURES

Although it sounds ironic, Nadig thinks one reason mutual funds have been popular in 401(k) platforms is that they are more expensive.

“But that extra expense has allowed mutual funds to [pay for] record-keeping expenses and administration expenses in countless 401(k)s,” he says. “When you start thinking about ETFs in that context and you’re putting an eight- or nine-basis-point ETF in your portfolio, that’s probably not going to fund the pure cost of managing that 401(k) plan or tending to your state­ments or keeping the website up.”

Roberts notes that traditional mutual funds may generate some degree of revenue sharing, such as 12b-1 or sub-transfer agent fees. Smaller plans often are drawn to that model because they can use the fees to off­set costs of providing services to the plan.

“If you’re an RIA, you’re going to be able to negotiate a fee with that plan sponsor, and so, the revenue generated from funds is less of a consideration,” Roberts says.

But plan sponsors may be reluctant to adopt an all-ETF strategy, even if part of the cost is paid out of participant accounts. Such debiting of accounts is subject to ERISA’s 404(a)(5) Participant-Level Fee Disclosure. Plan participants who think they’ve been paying no fees may be stunned when height­ened disclosure suddenly shows their plan charges in hard dollars on their statements.

“Even if it is cheaper, a lot of times par­ticipants start complaining or it raises a lotof questions and creates some potential risks there, even if you’ve done something that’s actually in their best interest,” Roberts says.

Itzoe goes so far as to argue 401(k)s negate some of the very qualities that make ETFs popular.

“I think ETFs are really effective in a taxable account,” he adds, but within a tax-deferred defined-contribution plan, ETF tax efficiency doesn’t apply. “It’s much more sizzle than steak with ETFs in 401(k) plans. We don’t have ETFs in any plan and we’re not getting demand for it.”

He believes the same goals can be achieved with index mutual funds, many of which are virtually identical to their ETF counterparts.

“If you look at the Vanguard S&P 500 ETF, it’s got an expense ratio of 0.05 per­cent,” Itzoe says. “If you go to the Vanguard 500 Index Fund Admiral Shares, which is what we tend to use for our clients, it’s got an expense of 0.05 percent; it’s exactly the same, and with the Vanguard 500 Fund, you’re not paying commissions on the trade.”

Itzoe believes ETFs encourage a day-trading attitude, adding “I don’t think that’s great from a participant behavior standpoint.” From what he’s observed, vendors who offer ETFs in retirement plans usually aggregate all of the trades for end-of-day purchasing.

“[It’s] just like a mutual fund,” he says, “so why would you not just use a mutual fund for that? In some ways, the industry’s creating products that allow people to go from speculating on individual stocks to speculating on sectors. Having sector funds in a 401(k) plan is stupid.”

He thinks many ETF sectors are too esoteric and narrowly defined (a quick Internet search reveals sectors ranging from livestock and cop­per to fertilizer and the gaming industry).

“From a fiduciary perspective, we advise all our clients to provide broad index funds, don’t provide sectors—you’re just encouraging your participants to make really dumb investment decisions,” Itzoe adds. “In the same way that I would advise clients, from a fiduciary perspective, ‘Don’t put a health care mutual fund in your plan,’ I’d say ‘Don’t put a healthcare ETF in your plan either.’”

He suspects technology may not have caught up with the idea of ETFs in 401(k) s. It’s one thing to place an isolated trade within an individual’s brokerage account or IRA, and another thing to place hundreds of thousands of trades for 401(k) plan participants. He encourages advisors to ask, “How is the provider managing the place­ment of trades within the plan?”

“I think there are real potential risks to using … ETFs the wrong way, from a fidu­ciary perspective,” Itzoe says. He thinks the trend is for plan sponsors to hire more ex­perienced consultants and advisors, focusing more on 401(k) specialists, who he thinks would be less likely to recommend adoption of ETFs in 401(k) plans.

“ETFs provide tracking exposure to an index, low costs and tax efficiency,” he ar­gues. “And when I look at 401(k) plans, in­dex mutual funds provide tracking exposure to an index, low costs—in fact lower costs in many cases (because) in 401(k) plans, you’re not paying commissions on your trades—and you don’t need tax efficiency.”

LOOKING TO THE FUTURE

After all that, it’s not surprising that Itzoe expects ETFs to remain a “fringe product” in 401(k)s for the next two to five years. However, he agrees with other advisors in­terviewed that wider adoption of ETFs into 401(k)s is probably inevitable.

“In the case of some 401(k) providers, they’re just not motivated because change costs money (and) change probably translates into lower expenses,” Lydon concedes. Yet he remains hopeful: Technology will improve; reporting software will be refined; pricing and trading issues will yield to new methodology.

“The firms coming in to compete have some very deep pockets,” he concludes.

Lance Ritchlin is former editor of the Journal of Financial Planning and now a freelance writer and marketing consultant.