[This article appears in our October 2018 issue of ETF Report.]
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.”