ETFs may show up in small-sized plans, or if a plan allows
a brokerage account, but when it comes to midsize and large plans, ETFs are
largely absent. This discrepancy is really a tale of two types of plan
sponsors: larger plans and smaller plans that can’t get the institutional
pricing offered to larger plans. It’s also a tale of how plans process
investments, whether they use new record-keeping technology that makes it
easier to use ETFs, or if they still use legacy products.
But even in small plans, ETFs are hard to find. Data from
the Plan Sponsor Council of America (PSCA), a nonprofit trade association
supporting employer-sponsored retirement plans, show that in plans of any size,
ETFs generally represent less than 10% of investment vehicles in the different
investment categories available. Mutual funds have the lion’s share of
business.
There’s also the fact that some of ETFs’ most touted
benefits, their intraday trading and their tax efficiency, are largely
irrelevant in all kinds of retirement accounts, which tend to be designed for
buy-and-hold strategies and which are tax advantaged. Daily transparency,
another much-vaunted advantage that ETFs have over mutual funds is also largely
irrelevant to a retirement investor. When your investment horizon is decades
long, the requirement for quarterly portfolio disclosure for mutual funds isn’t
that offputting.
Cost & Infrastructure Obstacles
ETFs’ availability in 401(k)s comes down to cost and infrastructure, as the
other traditional ETF benefits are mostly unnecessary in 401(k)s. People
familiar with ETFs and defined contribution plans say they don’t rule out ETFs
ever making inroads into the plans, but they also don’t see these vehicles
being among the offerings anytime soon for the bigger plans.
Richard Powers, head of ETF product management in
Vanguard’s Portfolio Review department, says ETF costs keep ETFs out of the
larger 401(k)s. That might sound surprising, since ETFs’ low costs versus
mutual funds are a top ETF selling point when it comes to brokerage accounts.
For example, the popular Vanguard Total Stock Market ETF
(VTI)has an expense ratio of 0.4%. Vanguard’s Total Stock Market mutual
fund (VTSMX) cost is 0.14% and requires a minimum investment of $3,000. The
Admiral Shares version, VTSAX, has a 0.04% cost, but also a $10,000 minimum
investment.
However, those are retail prices. Vanguard also has three
tiers of institutional pricing. For a $5 million minimum investment in the
Vanguard Total Stock Market mutual fund, the institutional cost is
0.035%. For Institutional Plus, which requires a $100 million minimum
investment, the cost is 0.02%, while that expense ratio drops to 0.01% for
Institutional Select, which requires a $5 billion minimum investment.
Those fees show the difference between the products, says
Sarah Parker, senior managing director at Hartland, who works as an investment
consultant to plan sponsors and is on the investment committee for PSCA.
“It’s two different investors,” she said. “It’s the
retail versus the institutional. And the institutional world has institutional
pricing.”
Tom Conlon, head of client relations at Betterment for
Business—Betterment’s 401(k) business line that uses ETFs for its clients—agrees
it’s hard to touch Vanguard’s pricing at the large institutional level. But for
smaller plans like the ones they service—plans with 50 to 1,500
participants—they’re more likely to incur higher costs with a traditional
401(k) that uses mutual funds.
More Problems To Consider
Kweku Obed, managing director at Marquette Associates and vice chair of PSCA’s
investment committee, says that aside from smaller plans not having the
economies of scale to take advantage of cheaper mutual funds, they typically
won’t have an institutional investment consultant working with them to devise
the qualified plan.
“An institutional investment consultant will typically not
push for ETFs,” Obed said, “whereas financial advisors will typically advise
some of the smaller plans, and I think advisors like ETFs a lot more for it.”
Even though ETF costs are continuing to inch to the nearly
zero level, there’s more than just the expense ratio, Powers says. There’s also
the commission cost and any bid/ask spread costs. If the 401(k) participant has
26 contributions to their 401(k) and commissions are $7 each, that ends up
being about $200 in commissions, not counting the spread, he adds.
“If you’re maybe only making contributions to the amount of
$2,000 [annually], all of a sudden that’s 1% of your investment gone because of
commission,” Powers noted. “This is a generic example, but it certainly can add
up.”
Commission costs to buy ETFs for 401(k)s will vary
depending on the firm, but Conlon says Betterment’s all-in costs for users are
closer to 35 bps. He says what’s often hidden in mutual funds used in 401(k)s
are costs like 12-b-1 fees, sub TA fees and other fees that go to pay service
providers who worked on the plan. Those can add up to 100 bps, he points out.
Designed For Mutual Funds
Then there’s the infrastructure of 401(k)s, the sources say. The 401(k)
infrastructure came about prior to the creation of ETFs, and many were designed
to work with mutual funds and commingled funds.
Parker says the majority of record-keeping systems need
daily net asset value, which are readily available for mutual funds.
“Record-keeping systems aren’t set up to deal with a vehicle that can be traded
multiple times a day with multiple different prices,” she explained, although
there are ways around it.
Colon agrees that companies using legacy systems will have
difficulty using ETFs. To use ETFs easily and accommodate their intraday
pricing requires new platforms, but Obed says there is more open architecture
available to create new platforms, and it’s easier for smaller firms to use
those, versus larger firms with systems in place.
Powers says some 401(k) plans that have brokerage accounts
allow participants to use ETFs, which has been a popular option, but he says
some plans that Vanguard has worked with are eliminating those options because
of concerns about risks and litigation.
“If [they] can avoid the risk of having investors trading
throughout the day in the 401(k), they’re probably going to avoid that,” he
said.
Fractional shares are another issue. While mutual funds
offer them, ETFs are sold only as whole shares. That’s problematic for a
retirement account, which may receive regular and small influxes of cash. The
issue can be resolved, but it adds another layer of complexity – and therefore
adds to costs.
Demands Of The Mainstream
While Parker and Obed say ETFs are unlikely to make major inroads to bigger
plans for now, they don’t rule it out. ETFs can offer access to smaller niche
investment areas where a mutual fund might not exist, so an ETF could be a good
substitute for some temporary exposure, Obed says.
But the world of 401(k)s is more about mainstream
investing, rather than special situations, they say.
“What’s most important in the design of the plan is
attracting assets for retirement. It’s not necessarily offering the latest and
greatest ETF in a certain sector,” Parker said. “That isn’t going to
necessarily drive the needle … to attract a participant to allocate more money
into their retirement. Ultimately, what’s going to help everyone save for
retirement is simplification and attracting more dollars and more
participants.”
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