October 05, 2007 at 2:00 pm by Tom Lydon
We spoke with Darwin Abrahamson, the CEO of Invest n Retire, and asked him about why ETFs should be in 401(k) plans and what his firm is doing to make it happen.
Aside from the usual reasons (transparency, liquidity, low cost, etc.), why are ETFs better investment options for managed accounts (asset allocation models) than mutual funds?
There are several advantages ETFs have over mutual funds as investments for asset allocation models. Primarily, ETFs are required to maintain a 99% correlation to their index. Mutual funds average 4-5% in cash, which creates a cash drag on the returns and have style drift from the index.
As an example, the AIM Mid-Cap has only 73% of its assets in mid-cap stocks, 6% in cash and 21% international stocks. Therefore, the fund has different returns (style drift) than the mid-cap index. Using mutual funds in asset allocation models corrupts the asset allocation model.
Do ETFs reduce the fiduciary liability for fiduciaries?
Yes. Language contained in the American Law Institute’s Restatement of the Law Third, Trusts, which serves as the basis for the Uniform Prudent Investor Act states: “A trustee’s departure from valid passive strategies may actually increase the trustee’s burden of justification and continuous monitoring.”
Don Trone, president of the Foundation for Fiduciary Studies stated, “One could argue that the failure to at least consider ETFs could be deemed a breach of fiduciary responsibility.”
With the GAO report, congressional hearings, the DOL 408 project and class action suits on revenue sharing with mutual funds, what advantage do ETFs have?
(In November 2006, the United States Government Accountability Office (GAO) published a report titled Changes Needed to Provide 401(k) Plan Participants and the DOL Better Information on Fees. The GAO did the study because of concerns about the effects of fees on participants’ retirement savings. The GAO recommended that Congress should amend the Employee Retirement Income Security Act (ERISA) to require fee disclosure to participants and plan sponsors by 401(k) service providers.
The DOL 408(b)(2) project requires plan sponsors to disclose indirect compensation on their 5500s starting in 2008 and require service providers, such as advisers and record-keepers, to disclose indirect compensation to plan sponsors and will mandate disclosure of indirect compensation to plan participants.)
ETFs do not have any of the baggage of hidden fees that mutual funds have. The hidden fees include 12(b)1 fees, revenue sharing (sub-TA fees), multiple share classes and internal brokerage costs. Therefore, disclosure and cost of disclosure of hidden fees is eliminated.
Target date funds – a fund that matures by a target date of your choosing and, as you near that date, becomes incrementally more conservative – are the hottest investment option in 401(k) plans. What is creating this growth?
Mutual fund companies are increasing their fees and increasing assets by limiting the funds in the target date funds exclusively to their own funds. The average target date fund has a fee of 0.93% compared to 0.50% on the core funds. Example: the BGI LifePath 2040 portfolio’s total expense ratio is 1.19% and the ETFs used in this fund have an expense ratio of 0.35%. Therefore, a participant in the LifePath 2040 fund is paying BGI 0.84% more in fees. LifePath funds are a great cash cow for Barclay’s, but not for the investor.
Why are current providers such as Vanguard and Fidelity not offering ETFs in 401(k) plans?
There are two reasons. The first and foremost reason is revenue stream to the mutual fund companies and providers is much greater with mutual funds. The second is that other providers – except for Invest n Retire – do not have the technology to trade and record-keep with ETFs in 401(k) plans.
Gus Sauter, chief financial officer at Vanguard stated in an interview, “Our ETFs typically have a lower expense ratio than our conventional share classes. If a record keeper just offers ETFs alone, how will the record keeper get enough?”
The press continually quotes mutual fund companies that claim there is no demand from plan sponsors for ETFs. It is the mutual fund companies that do not want to offer ETFs in 401(k) plans, not the plan sponsors. Mutual fund companies have every reason to discourage ETFs in 401(k) plans.
The low cost of ETFs, which makes them very attractive to investors, makes their distribution into 401(k) plans unattractive to mutual fund companies. ETFs do not generate cash flow to their preparatory funds, nor can they receive revenue-sharing from other fund companies.
The way business is done in the mutual fund industry is to add fees to the “traditional” mutual funds in order to compensate intermediaries for distributing the funds. Distribution fees are paid in the form of 12b-1 fees, sub-transfer fees and find’s fee – known collectively as revenue-sharing fees. ETFs do not have any built-in structures for payment of revenue-sharing.
October 6th, 2007 at 2:58 pm
Darwin’s comments are right on. 100% index-based 401(k) plan supported with ETFs makes a lot of sense. ShareBuilder 401(k) is another 100% ETF solution targeted at business of less than a 100.
October 10th, 2007 at 12:59 pm
Comments are not “right on”. The are a misrepresentation of the overall 401(k) industry and a plain and simple sales pitch. Shame on Mr. Darwin.
October 15th, 2007 at 7:08 am
Lance is correct — Mr. Abrahamson is selling his product. Notice how he does not account for who will cover the costs of recordkeeping a sponsor’s plan when the revenue streams are so low? With ETF’s a financial advisor and/or third party adminstrator would be required…meaning separate fees to the Plan Sponsor that would likely incur a higher overall cost than using mutual funds from a bundled service provider. Who’s interests would this really serve?
October 31st, 2007 at 1:33 pm
Will’s comments are the same comments that Congress is hearing from the mutual fund companies in their hearings on fee disclosure. The usual suspects are claiming that revenue sharing and hidden fees are necessary in 401(k) plans. As SIFMA testified, “Revenue sharing covers an administrative expense the plan otherwise would have to bear. Moving away from nonproprietary options with revenue sharing can make it more difficult for plan providers to maintain profitability.” Jim Wiandt stated the truth in his article Happy Birthday 401(k)! 25 Years of Mediocrity, “The 401(k) business is a cash cow for the mutual fund companies.” The mutual fund companies and brokers are making money at the expense of participants they should be helping. I do not have a product I provide a service that reduces the total fees to both the participants and the plan sponsor. Our service is not to help the participants have an adequate retirement income and not to help brokers and providers get rich on participants contributions. Darwin
November 1st, 2007 at 8:29 am
Let’s not lose track of the bottom line: how can we put more money in the pockets of participants. THis can be done two ways: (1) lower fees and (2) better returns on investments. ETFs offer two advantages in this regard: (1) lower fees and full transparancy and (2) the ability to create pure asset classes to provide for proper diversification in asset modeling. Adding RIAs, while adding cost, is not a negative. It improves the quality of the investments being offered (whether ETFs or otherwise), adds fiduciary protection and almost certainly reduces overall investment costs. As for recordkeeping and administration costs, what’s wrong with paying directly for the service instead of indirectly through 12b-1s or other other forms of hidden fees? Everyone should be looking at this objectively and asking: what is best for the participant?