Are ETFs suitable for 401(k) plans?

Exchange-traded funds (ETFs) have become an important part of the investment field, and their popularity continues to grow. The ability to buy and sell ETFs throughout the trading day, the low cost of many index ETFs, and their transparency make them the investment products of choice for many individual investors and financial advisors.

ETF as a 401(k) Featured

ETFs provide investors with many advantages. However, some of these advantages have nothing to do with 401(k) settings. The ability to trade ETFs during the day is unlikely to appeal to employers who do not want employees to sit in front of a computer during working hours to watch or trade their assets. Depending on the platform, program participants may or may not provide the option of real-time transactions, as many 401(k) providers will aggregate transactions at the end of the working day. In any case, retirement plans are not really designed for day trading. They should be long-term investments.

Many ETFs provide tax efficiency due to their structure. This is not a related feature in tax-deferred retirement plans such as 401(k). ETFs are similar to mutual funds. If your 401(k) options include an ETF (or any mutual fund) that you think is a good choice, there is no reason not to choose it.

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All ETF 401(k) products

So far, ETFs have not made significant progress in the 401(k) market. The robot consultant Betterment launched a 401(k) product. It will use all the ETF portfolios provided in its core services as the managed accounts of 401(k) participants. The company promises a maximum total cost of 60 basis points of management and 10 basis points of ETF fees. For plans with assets in excess of US$1 billion, this fee will be reduced to 10 basis points.

Although this approach may gain some traction in the market, in general, the hype surrounding the ETF in the 401(k) plan is just hype. Charles Schwab launched an all-ETF 401(k) product, and the results so far are clearly mixed.

Index mutual funds

Generally, common index mutual funds provide the low cost and style purity of index ETF products. For example, Vanguard Total Stock Market Index ETF (VTI) has an ultra-low expense ratio of 0.05%. The mutual fund version of Vanguard Total Stock Market Index also has an expense ratio of 0.05%.

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As far as Vanguard is concerned, ETFs are just additional share classes of its mutual funds. Although there is indeed an ETF price war between certain providers, this only matters if the ETF being sold is an ETF that your company provides to plan participants.

Complexity and cost disclosure

Due to the structure of many ETFs, the use of ETFs makes the issue of cost disclosure for plan sponsors more difficult.

One problem is that the bid-ask spread may change during the trading day. Although it is not part of the ETF’s fee structure, it does represent the cost of participants.

There may also be problems with intraday trading. This may result in different end-of-day values ​​of the same holdings between participants.

The reality is that participants do talk to each other, and any similar situation will inevitably surface. This is just a headache that the plan sponsor does not need.

Partial shares

ETFs are traded as whole shares on various exchanges. Small investment is the norm in 401(k) plans and will definitely lead to a reduction in ETF shares. Although record-keeping technology has been or will be developed at some point to deal with this problem, there may be additional costs somewhere here. Some shares are the norm for mutual funds.

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ETF and actively managed funds

One of the arguments in favor of a full ETF plan I have read is that index ETFs are cheaper than actively managed mutual funds.

This may be true, but it is not really relevant to retirement accounts. Many excellent low-cost 401(k) plans offer a combination of index funds and actively managed funds.

ETF management account

Where ETFs may play the best role in a 401(k) plan is in the area of ​​managed accounts. These may be provided instead of the target date funds currently provided by the main management account.

However, the plan sponsor still needs to review these accounts and ensure that they are suitable for their participants. They also want to ensure that they can be used as a qualified default investment alternative.

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