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Exchange-Traded Funds: Less Expensive 401(k) Plans

By Brian OConnell and Stephen Miller  6/22/2005
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Updated February 2012

As the venerable 401(k) plan celebrates its 25th anniversary, new, more sophisticated wrinkles like exchange-traded funds (ETFs) are beginning to pop up on 401(k) plan management screens.

What's an ETF?

Put succinctly, ETFs are passive investments designed to track the performance of a broad range of market indexes including stock, bond, broad market, equity sector and international indexesand to deliver benchmark returns. Unlike mutual funds, ETFs trade all day on the New York, American or Nasdaq stock exchanges. And their unique structure permits rock-bottom management fees that have led a growing number of plan sponsors to select ETFs as a lower-cost alternative to mutual funds.

How much cost savings do ETFs provide over traditional index funds? As an example, the annual management fee or "expense ratio" of T. Rowe Price's S&P 500 index-tracking mutual fund is .35 percent, while the expense ratio for Barclays Global Investor's S&P 500-tracking ETF is a mere .09 percent. That's part of the reason why some proponents claim ETFs could cut costs associated with managing 401(k) plans by up to 60 percent.

A report in the July/August 2005 issue of the Journal of Indexes shows that among nine equity indexes analyzed, ETFs that tracked them had a lower expense ratio than corresponding index funds in every case. ETFs also had superior three-year returns in seven out of nine cases.

ETFs also promise far more diversified portfolios in 401(k) accounts. A study by professors of finance at New York University and Fordham University shows that regardless of the number of fund options, 62 percent of 401(k) plans fail to provide a sufficient range of asset cl asses in which to invest, causing portfolios to underperform because they aren't diversified enough. ETFs offer low-cost coverage of the full array of asset class indexes.

Lee Kranefuss, who heads the ETF business at Barclays, the biggest ETF provider, predicts that larger 401(k) plan sponsors will be adding ETFs to their lineups within a year. That may be a bit optimistic, but there are signs ETFs are beginning to have an impact.

Catching on Quickly

One 401(k) service provider that has embraced ETFs is Portland, Ore.-based Invest n Retire LLC, which offers record-keeping, trading and bundled services for qualified plans, working through pension consultants and advisers to plan sponsors. 

"We are definitely seeing more interest in having ETFs in retirement plans," says CEO Darwin Abrahamson. "Participants are paying exorbitant fees for their 401(k) planswith the investment costs coming out of the participants' accounts."

The firm works with registered investment advisers (RIAs) to provide managed accounts using ETF-based asset allocation models, with an average cost typically as low as .15 basis points to .30 basis points, "depending on the mix that a particular adviser puts together," according to CEO Darwin Abrahamson.

"Our ETFs have no revenue sharing, no hidden fees," Abrahamson says. "Many providers hide their costs within the investment options; that's where you'll find 70 to 90 percent of the cost of any 401(k) plan. Many mutual funds even have special share classes just for 401(k) plans that charge additional 12b-1 marketing fees."

But "what we're accomplishing is more than just cutting the costs," says Abrahamson. "With ETFs, you have the ability to provide access to all the major indexes necessary to build asset allocation models. We have the tools to build more efficient models than we can with open-ended mutual funds."

Over the past decade, index-tracking vehicles such as ETFs and index funds have outperformed actively managed funds that target the same asset class (i.e., large capitalization "growth" stocks or small capitalization "value" stocks, for example). The odds of beating the benchmark with actively managed funds "is about the same as playing the lottery," says Abrahamson, whose firm now has some $200 million under management in ETFs, with many times that amount "in the pipeline."

"We have more investment options on which to build efficient asset allocation models, and there are no short-term redemption fees, which are becoming a real problem in the 401(k) business, driving up record-keeping expenses and adding another layer of costs for participants," says Abrahamson.

One plan sponsor who agrees is Bob Bauder, CFO of Navmar Applied Science Corp. in Chester, Penn. Navmar's plan, with about 140 participants, uses ETF-based asset allocation models provided by KDB Resources Inc., a pension management firm based in Media, Penn., that in turn using recording-keeping and software services provided by Invest n Retire.

"We looked at all the embedded fees in traditional mutual funds," Bauder says. "With ETFs, the fees that the investment manager charges were on average just .20 basis points" of the underlying assets. "Even with record keeping, total fees were lower than 1 percent."

Bauder adds that his pension consultant provides structured portfolios for participants using modern portfolio theory "to get us the best risk/reward tradeoffs." Five model portfolios are available, going from conservative to aggressive, using different blends of asset classes.

"As the plan sponsor, we're ensuring that our participants at least meet the benchmark" of a given asset class, Bauder says. "Essentially, ETFs are designed to mirror the index. As a company, you're exposing participants to less risk."

He reflects, though, that providing "broad asset allocation is what's primary," and that whether it's through traditional index funds or ETFs, "the mechanics of how you achieve asset allocation are really secondary."

Critics Not Convinced

Critics point out that ETFs' low management fees are offset by higher brokerage commissions. But some providers are coming up with ways to include ETFs in 401(k) plans without passing trading costs on to plan participants. Invest n Retire, for example, offers a platform that bundles trades together to reduce brokerage fees, charging participants only a fraction of the trading commission costs and avoiding any need to incorporate self-directed brokerage accounts into the plan.

Another service provider, Los Angeles-based Fulcrum Financial, offers plans that are solely ETF-based. Says Fulcrum's founding principal David Nolte, ETFs help plan sponsors avoid "serious issues of mutual fund costs and poor investment results," and thus better meet the goal of garnering market performance returns at lower overall cost.

And because ETFs are index-tracking products, they "allow us to efficiently create broad and non-overlapping diversification of holdings," Nolte says. "We don't have to worry about mutual fund investment style drifts, or complicated and ever-changing analyses of underlying holdings."

But ETF skeptic Douglas Klein, director of the West Caldwell, N.J.-based, charges that when you toss ETFs into the 401(k) mix, you create problems. Because ETFs can be bought and sold during the trading day, "thats hard to monitor, whether you approve of 401(k) investors trading like that or not.

Nolte has a different perspective, claiming that because of the required transparency of their underlying assets, "ETFs make it easy to know where the money is invested. Consequently, both we and the participants can more easily see and track the investments."

Change in the Air?

Critics charge that the growth of newer, more complex investment options, including ETFs, is due to aggressive marketing campaigns from financial services providers looking to sell more investment vehicles to plan sponsors. "When you see non-traditional investment options being included in 401(k) plans, you start to wonder whether employers arent the recipients of 'push' campaigns from financial services firms," Klein says. "I dont think theres a huge demand for ETFs from plan participants."

He alleges that "the evidence is indisputable that the average person does not have the capability or aptitude to manage their own investment accounts let alone understand new things like ETFs or managed accounts."

Howard Gerrin, a chartered financial advisor at the Boston-based Patriot Financial Group, concursto a point. "You have to wonder if the average 401(k) investor even knows what an exchange traded fund is," he cautions, adding, "Not that ETFs arent good ideas, but if I was a human resources director Id be concerned that my employees may not be able to keep up with the expanding number of options available with their 401(k) plans."

But counters plan sponsor Bauder, "Quite a few of our people didn't have a sophisticated approach to picking mutual funds. Often, people would get their statement and want to chase after the fund that did the best, buying high and selling low. ETFs stop them from chasing after the hot manager. Instead, participants using the asset allocation models can go on cruise control, with quarterly rebalancing done automatically so they're selling high and buying low."

Yet the very strengths of ETFs may create a barrier to their widespread adoption in 401(k) plans. Observes ETF-booster Abrahamson, many third-party administrators (TPAs) will steer clear of ETFs for the very reason that "all of their business comes from brokers that receive revenue-sharing and 12b(1) fees from the retail fund families"fees that are, of course, ultimately borne by plan participants.

Brian OConnell is a freelance writer specializing in financial, health care and career management issues. His articles have appeared in The Wall Street Journal , the Boston Herald , USA Weekend , CFO and other publications.

Stephen Miller is the manager of SHRM's Compensation & Benefits Forum.

Related ArticlesExternal:

Are ETFs and 401(k) Plans a Bad Fit? Not Necessarily, The Wall Street Journal, April 2012

Apple Leading Charge in all-ETF 401(k) Plan,, March 2012

Related ArticlesSHRM:

Most 401(k) Participants Confounded by New Investment Offerings, SHRM Online Benefits Discipline, February 2006

Collective Investment Funds for 401(k)s: Lower Fees, But Less Transparency, SHRM Online Benefits Discipline, February 2006

401(k) Brokerage Windows,SHRM Online Benefits Discipline, April 2004

Quick Links:

SHRM Online Benefits Discipline

SHRM Online Retirement Plans Resource Page 

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