Why Most 401(k) Plans Don’t Offer ETFs

According to the Investment Company Institute (ICI), “[ETFs] accounted for 13 percent of total net assets managed by long-term mutual funds, ETFs, closed-end funds, and unit investment trusts at the end of 2014.”1

If ETFs have managed to garner 13 percent of the market for pooled fund-type investments, the question must be asked, why has there been almost no ETF penetration of the 401(k) marketplace, which is entirely dominated by pooled funds?

After all, ETFs are generally:

(1)     Less expensive;

(2)     Have no built-in 12(b)1 distribution fees

(3)     Have no surrender penalties for early redemptions

Looked at this way, ETFs seem like they should be the Goldilocks investment for retirement plans.

The reason for this lack of traction is that the vast majority of the $6 trillion in defined contribution assets in the U.S.², are administered on 30+ year old recordkeeping systems that are incapable of accounting for investments that may be traded more than once per day and only after market close.  This is hard to believe, especially in the year 2016, but it’s true.

Typically technology helps move us forward. With respect to the lack of ETFs in retirement plans, technology is holding us back. The old technology being used by the majority of recordkeeping systems effectively locks them into offering only NAV-based investments, typically mutual funds or Common Trust Funds.

Issues arise when technology lags

Legacy recordkeeping systems require that within a given investment CUSIP, all buys and sells for the day must be executed after hours, at the exact same price, across all participants transacting in that CUSIP.  There are exceptions to this rule on some systems when it comes to trading and pricing company stock.  In these cases, however, the solution is so “shoe-horned” into the record keeper’s manual processes, there’s no way the process would scale effectively if all the investments on the system were managed the same way.

Design flaws limit options in legacy systems

Two design flaws in legacy recordkeeping systems have sealed their fate, preventing them from trading non-mutual fund securities while the markets are open.

1. A fundamental lack of awareness of cash
   Today’s recordkeeping systems were not designed to be custodial accounting systems.  They were created as “balance forward” systems to simply keep a record of how much of a given investment a participant owned, after another system actually made the purchases or redemptions.As a result, the concept of cash as either a legitimate form of property or a medium of exchange was never planned on, and is prohibitively complex to engineer into these systems 30+ years after the fact.
2. Absence of proper securities processing
   In general, any type of transaction involves exchanging one form of property for another.  When transacting in financial securities in particular, we exchange cash for shares when buying, and shares for cash when selling.When an accounting system has no awareness of cash at its core, as discussed above, it makes it very difficult―or dare we say impossible―to participate in electronic marketplaces with counter-parties when buying and selling securities.This lack of standard securities processing makes it impossible to buy non-unitized ETFs using today’s recordkeeping systems.

Today’s workaround given these design flaws

To hold ETFs in DC plans today, the workaround is to unitize them in common trust fund-like vehicles where NAVs are struck on the trust funds once per day.  This allows the ETF to “masquerade” as a traditional mutual fund, from the recordkeeping system’s perspective.

This is far from ideal:

(1)         It introduces yet another service provider into the servicing supply chain―the extra custodian doing the unitization and ultimately holding the ETF in their trust or separate account

(2)       It costs additional money to do the unitization―typically five basis points or more

(3)       Very importantly, the unitization process itself adds a layer of non-transparency that the retirement industry is trying to move away from, given the DOL’s recent fiduciary mandate

New technology can deliver solutions 

Traditional mutual funds were an outstanding improvement in the efforts to bring professional investment outcomes to the masses.  They introduced economies of scale and efficiencies that were all but impossible to deliver to account holders with small balances, and for that mutual funds should be revered.

Times have changed, however, and the retirement industry needs to change as well.  ETFs take the already brilliant concept of mutual funds to the next level and deliver a number of improvements on the basic concept of asset pooling and collective investing.

Just as the investment manufacturing industry has had to adapt and change to the market for mass-supplied investment management, so too, the retirement industry need to change to accommodate that new management.

Plan sponsors and advisors need to stay abreast of technology innovations that can expand their DC plan investment horizons and bring the plans into the 21st century.

Brad Kuhlin

Brad Kuhlin is co-founder and chief software architect for Vertical Management Systems.

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