Mutual Funds Vs. ETFs In Retirement

[This article appears in our October 2019 issue of ETFR.]

Since the birth of the 401(k) in 1978, mutual funds have been the dominant investment choice in defined contribution plans.

ETFs have made some inroads, but for the most part, they represent a very small part of investors’ retirement portfolios. Reasons are varied—part of it is the plan’s structure, part of it is plan sponsors’ comfort with using mutual funds over ETFs, and part of that is the mutual fund industry’s size.

The story is a little different when looking at individual retirement accounts. Mutual funds continue to hold most of the U.S. investment assets, but ETFs are gaining market share, as it appears that people who are more comfortable making their own investment decisions are selecting more ETFs.

When talking about ETFs only capturing a small part of the retirement ecosystem, a little perspective is needed. The Investment Company Institute’s 2019 Factbook, reflecting data as of the end of 2018, reported total U.S. retirement market assets reached $27.1 trillion in regulated open-end funds, which include mutual funds, ETFs and institutional funds. Of that total, there was $8.2 trillion in mutual funds in IRA and defined contribution plans, about 30% of the market.

Although the group did not break out ETFs and institutional funds, the size of mutual funds in retirement plans alone is more than twice as big as the entire ETF universe, which it estimates at $3.4 trillion.

Advantage: Mutual Funds
Sources familiar with mutual funds, ETFs and retirement plans say that, right now, it’s unlikely ETFs will become bigger parts of 401(k) plans. When looking at the pros and cons of these two instruments for retirement plans, a few structural factors give mutual funds the edge.

The plumbing is set for mutual funds, for one thing.

Just because mutual funds dominate doesn’t mean they will forever, but basic 401(k) architecture favors mutual funds, observes Greg Friedman, head of ETF management and strategy at Fidelity.

“Could the ETF conceivably fit into the 401(k) platform one day? Absolutely. I think some of the challenges to date have been the plumbing—some of the systems and the technology” have hindered adoption, he said.

One of those “plumbing” issues is pricing, he remarks. The 401(k) platform is designed to price end-of-day net asset value. Since ETFs trade all day, they’re priced at the last-traded price.

Intraday Trading Problem

Jack Towarnicky, executive director of The Plan Sponsor Council of America, concurs. He points out that most plans aren’t set up to administer intraday trading, as most plans preclude daily transactions or multiple transactions in a single day.

“Using an ETF that permits intraday trading could be a detriment in terms of fund performance to those participants where a plan trades only at the end-of-day NAV,” he said.

Rich Powers, head of ETF management, Vanguard, elaborates, noting ETFs settle at T-plus 2 (trade date plus two days), whereas mutual funds and collective investment trusts settle at T-plus 1. “There’s a complexity from a system standpoint,” he noted.

There’s another way ETFs’ intraday trading aspect makes plan sponsors cautious. Friedman says that plan sponsors may have an impression their 401(k) clients would trade more often if they had ETFs. Since the average 401(k) plan likely comprises people who might not be investing savvy, Powers suggests plan sponsors may feel a fiduciary responsibility to keep easily tradable products out of the plan.

Towarnicky points to ICI data showing households that invest in ETFs are more likely to accept greater investment risks. One response that some plan sponsors have made to the individuals who want more options in their 401(k)s is to provide access to ETFs through self-directed brokerage accounts. These are “subject to greater disclosures, and often (require) a specific participant acknowledgment that they are investing in (products) … that do not receive regular review by plan fiduciaries,” he said.

PSCA data shows greater ETF usage in these self-directed brokerage accounts, accounting for 14% of fund structures in 2017, up from 12.8% in 2016. Mutual funds still dominate this fund type, at 64.7%.

Fractional Shares
Another factor in mutual funds’ favor is this structure allows fractional share purchases, while ETFs can only be purchased in whole shares, Friedman and Powers note. Since 401(k) participants are usually sending in specific dollar amounts every paycheck because of automatic investing, it’s easier to divvy up a mutual fund to match that monetary figure.

“Within a mutual fund, if the client wants to stay fully invested in whatever strategy—be it fixed income or equity markets—the mutual fund enables that very easily,” Powers said.

Where ETFs Excel
ETFs have benefits. Towarnicky notes the dramatic fall in fees for index funds works in ETFs’ favor, especially for people who choose growth and international stocks.

Powers points out the big 401(k) plans that use institutional share class pricing have access to lower expense ratios, but in smaller plans without access to institutional share classes, or in collective trusts, ETFs could be the cheaper option versus a conventional investor class.

Plus, there’s the daily transparency of ETFs versus mutual funds that favors ETFs, Towarnicky adds.

Target-date funds hold the bulk of 401(k) assets, being the default setting for many plan sponsors, Powers notes, and there aren’t many ETF options similar to this structure. Mike Dickson, head of portfolio management at Horizon Investments, says that could change.

Target-date funds put users on a glide path to retirement, automatically tweaking the mix of stocks and bonds as the holder nears retirement. Dickson believes ETFs can do the same, but better.

His firm handles ETF managed accounts for many clients, and believes these could be a good alternative to target-date mutual funds in 401(k)s. These could allow for more tailored account management that not only accounts for retirement age, but also the client’s desired spending rate in retirement.

“We could adjust the asset allocation accordingly,” Dickson said. “I feel that’s taking it one step further.”

IRAs See More ETF Usage
When it comes to IRAs, ETFs are gaining ground. ICI data showed IRA assets totaled $8.8 trillion at year-end 2018 (see Figure 1), accounting for 33% of U.S. retirement assets, with mutual funds comprising 45% of IRA assets. The other 44% were made up of ETFs, closed-end funds, individual stocks and bonds, and other non-mutual fund securities held through brokerage accounts.

The ICI data notes ETF-owning households are more likely to own IRAs than households that own mutual funds and individual stocks, and they have higher educational levels and greater financial assets (see Figure 2).

Friedman says that it makes sense to see ETFs making inroads in IRAs: “People are more in control. You don’t necessarily have to have a plan sponsor dictating to you what products are available.  . . . And there are a lot of third-party [retirement] models out there that use ETFs.”

ETFs may make further inroads into 401(k) plans, but it will be gradual, as Towarnicky observes that changes in retirement savings are evolutionary.

“Most plan fiduciaries and plan sponsors are not first movers, or even fast followers,” he said.

Friedman acknowledges that customers and clients are changing, and that could change retirement savings: “I think what customers are looking for in terms of their advice and solutions and strategies are changing. So I think the 401(k) market will eventually change with it.”