Arthur: Saving 401(k)s With ETFs

December 10, 2013

Managed ETF solutions could save the 401(k) market from its own shortcomings.

This is part of a regular series of thought-leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is co-authored by Kim Arthur, chief executive officer and founding partner of San Francisco-based Main Management, and Hafeez Esmail, Main’s director of marketing.

It’s that time of year again—open enrollment season where employees have the option to join employer-sponsored retirement plans.

However, for most retirement plans, it’s the same old ineffective structure that has failed the current crop of retirees. To be blunt, defined contribution (DC) retirement plans have proven to be a disaster for the vast majority of plan participants.

Dalbar, the financial industry research firm, estimates that the average DC participant has underperformed the S&P 500 Index by almost 4 percent per year over the past 20 years. That return differential may amount to the difference between a comfortable retirement and one that’s far less appealing.

It’s our view at Main Management that ETFs are going to be—in fact, already are—part of the solution. More specifically, we’re talking about so-called managed ETF solutions involving advisors playing the role of portfolio manager and fiduciary on behalf of retirement investors.

About $5.2 trillion, or a quarter of the nearly $21 trillion in U.S. retirement assets, are in defined contribution plans, and the vast majority of those DC assets are in relatively expensive open end mutual funds. Comparatively, DC assets in the managed ETF solutions universe remain miniscule, though they are clearly growing.

Below, we’ll get into how much less investors are likely to pay and how much better their portfolios are likely to perform with their DC retirement assets integrated into a managed ETF platform solutions platform. That is, after all, what’s at stake.

But first, a bit more on the defined contribution train wreck unfolding before us now.

An Accident In The Making

About 30 years ago, prior to defined contribution plans, the retirement landscape was dominated by defined benefit (DB) plans. The problem was that companies tended to use the DB plan as a private piggy bank during more difficult stretches, something that would dramatically affect the ability of the DB plan to meet its obligations.

Accordingly, DC plans were a positive step forward because each plan participant had a distinct, separate account in his or her name. It was an idea that offered promise, but had a key shortcoming.

DB plans had a professional money manager investing the entire retirement pool. By contrast, DC plans placed the choice of investments in the hands of the plan participant. Although well intended, it actually imposed the obligation on the plan participant of becoming the portfolio manager for his or her retirement assets.

Given that 80 percent of plan participants have never logged onto their online retirement accounts, they are effectively managing their retirement in absentia. Is it any surprise that the outcome of this experiment has been so poor so far?


Perhaps a bigger surprise is that the failing status quo has prevailed for so long?

It’s time for retirement plan participants to recognize that the allocation decisions they make are the most important component of their investment returns. Furthermore, it’s important to acknowledge that most plan participants lack the time or resources to actively manage or sufficiently diversify their retirement assets.

Accordingly, it makes sense to examine a return to placing allocation decisions back in the hands of a professional asset manager.

There are some who argue that “target-date funds” are an ideal solution that already provides a viable alternative. While a step in the right direction, the lack of transparency in the world of target-date funds is a critical flaw.

Let’s remember that in 2008, the average target-date 2010 fund designed for participants two years from retirement was down an average of 24 percent.

Clearly, several people were asleep at the wheel. However, with little transparency as to the underlying holdings, how is a plan participant to know?

The ETF Managed Solution

By contrast, consider an age-based, ETF-managed solution with four portfolios for plan participants with differing risk parameters.

The age-based solution may be designed to have greater volatility—and higher return potential—for younger participants and less for those at, or approaching, retirement.

Portfolio allocations would be determined by an experienced asset management team with extensive ETF experience.

Most notably, plan participants would be able to view the underlying ETF allocations on a daily basis. They may not be managing the assets, but they would have a clear idea of what’s being done, unlike in target-date funds.

How might the cost of this type of managed ETF option stack up?

The expense ratio for mutual funds in retirement plans with under $10 million in total assets typically averages around 1 percent, or $100 for each $10,000 invested.

Many plan participants fail to appreciate that they’re paying a full percentage point of their invested assets for a portfolio that they have to manage themselves. Moreover, many don’t really have a clue that, as the Dalbar numbers suggest, they have done a very poor job of doing so.

By contrast, a competent ETF asset manager can compile four well-thought-out age-based portfolios, diversified across an array of asset classes, at a blended cost of about 0.30 percent. That manager might opt to charge a management fee in the range of 0.50 percent.

Together, the all-in cost would amount to 80 basis points, or $80 for each $10,000 invested.

As a result, for the same cost or at less cost than a “do it yourself” plan, a professionally managed ETF solution, with complete transparency, is a compelling alternative.

Early, Early Innings

As we noted above, although the retirement landscape is still dominated by bloated mutual fund plans, ETF managed solutions are already an actionable idea that’s beginning to establish a foothold. (Full disclosure: Main Management LLC offers ETF managed solutions to its retirement clients for both 401(k) and 403(b) plans).

Custodians such as Mid-Atlantic Trust, TD Ameritrade Trust and Matrix have solved the fractional share issue associated with mutual funds and are the go-to players for third-party administrators (TPA)/record keepers looking to offer a more innovative option to their clients.

There is a long list of TPA record keepers, from the likes of national players like Ascensus and Professional Capital Services, to regional firms such as Primark in Northern California, that use custodians such as the ones we named above for managed ETF plans.

For a bit of perspective, ETFs in 401(k) plans are a little bit like the ETF industry 10 years ago—very small, but growing at a rapid clip because the value proposition is quite compelling.

The smart money is already in motion.

A managed ETF solution provides plan participants with considerably better odds of a successful retirement outcome than a self-directed option.

Surely it makes sense for business owners and benefit plan administrators—who are fiduciaries obligated to act in the best interest of plan participants—to closely evaluate an ETF managed option.

So far, too few of them have done so, despite the glaring shortcomings of the status quo. We think that’s likely to change in the coming years.

A pioneer in managing all-ETF portfolios, Main Management, LLC is committed to delivering transparent, cost-efficient, and customized investment solutions. By combining asset allocation insights with smart implementation vehicles, Main Management offers a unique approach that translates into distinct advantages for our clients, including diversification, cost efficiency, tax awareness and transparency.


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