ETFs Better Than Mutual Funds For 401(k)

December 22, 2015

This article 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 features Dan Egan, director of behavioral finance and investing at the New York-based automated investing service Betterment.

Let’s say I’m a water salesperson, and my job is to sell water to people in homes and offices everywhere.

I may know that the best option would be to drink regular tap water; many objective experts say it’s just as good as bottled water, the lack of packaging is better for the environment, the fluoride makes it better for my customers’ teeth, and—perhaps most importantly—it’s more affordable.

But I make a commission on bottled water. So even though I know it’s probably in my customers’ best interests to go with the tap water, it’s in my best interests to encourage them to go with the bottled. So, I sell bottled water.

The Sales Conflict

This isn’t far from how 401(k)s work. In the 401(k) world, the water salesperson is a third-party investment advisor, the bottled water is a mutual fund, and the tap water is an exchange-traded fund. Third parties may try to sell a mutual fund because they get a cut of the fees, even though the ETF might be cheaper and better for the plan participant.

Not only that, but the fact that this is happening, and the amount the third party is getting paid, are often buried in the fine print. This makes it hard for plan sponsors to evaluate the truly best plan for participants, and it makes it even harder for plan participants to see where their money is going.

To be clear, not all investment advisors or other third parties are compensated in this way. Implementing a 401(k) is complicated, and it requires various third parties to make it work. However, it’s important for plan sponsors to understand the true costs so they can make the best decisions for their participants.

One way to avoid these issues is to use ETFs, which are usually more cost-effective. ETFs are better choices for a 401(k) because they’re far more likely to be passive, which usually correlates with lower cost. And the incentive structure behind them is completely transparent, making them less likely to have conflicts of interest due to hidden fees.

Mutual Fund Fees Can Be Buried

Administering a 401(k) plan involves various functions, as outlined in the table below. Sometimes a single party might perform more than one of these functions, while other times, a different one performs each one. But each function is associated with a cost, which is embedded into the plan.

Often, one or more of these parties are compensated in some way by the mutual fund companies that the sponsor selects (with the investment advisor’s help). Compensation often comes in the form of revenue-sharing arrangements, including:

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