The Making of an All-ETF 401(k) Plan

July 16th at 1:00pm by Tom Lydon

In less than 20 years, the exchange traded fund (ETF) industry has grown from a fledgling outlier with just a few funds to a rapidly growing behemoth with nearly $800 billion in assets in the United States alone. Now that they cover the majority of sectors and asset classes, the attention has turned to a new frontier: the 401(k) plan.

It’s been said that if ETFs were able to crack this market the way mutual funds have, the industry’s growth would be all but unstoppable. While that hasn’t yet happened, there are still a few 401(k) providers on the front lines who do offer all-ETF plans. [401(k)s: The Last Hurdle.]

We caught up with Stuart Robertson, General Manager and Principal at ShareBuilder 401(k), to talk about how ETF 401(k) plans are constructed, why they include what they do and what a safe, responsible plan would look like.

Why 401(k) Plans Look the Way They Do

Robertson says that from a regulatory standpoint, there are two things 401(k) providers need to do:

  • They need to act in the best interest of the employees.
  • They need to offer diverse investments that help minimize the risk of huge losses. Every plan needs to have at least three fund types, such as a mix of bonds, equities and cash.

401(k) plans – ETF or otherwise – won’t contain every investment option available simply because it wouldn’t serve the first purpose well. “When you have 800 ETFs,” says Robertson, “you can almost lop off the risky or narrowly defined ones.” [The All-ETF 401(k) - It's Happening Now.]

From there, providers will often select a few ETFs to cover the major asset classes, a few specialty funds for the more sophisticated users, and perhaps some Treasury funds.

The second rule, that there needs to be a mix of fund types in a 401(k) plan, was one that was written years ago. “There are thousands of options – major asset classes, equities, money markets, specialty markets,” he says. In assembling a plan, providers should be thinking about what benefits its participants most.

The reason the pickings are kept on the slim side are for multiple reasons, the main ones being that it minimizes the chance for a large loss and it helps plan participants succeed. Another point, Robertson says, is that giving people too many choices ultimately overwhelms them and 401(k) participation rates decline. [401(k)s Shift to the Younger Set.]

“You have to keep it simple,” he says.

The Market Meltdown

In 2008, the market took a nasty turn that ultimately led to the so-called Great Recession that caused many investors to lose 40%, 50% and even 60% of their retirement plan’s value. If 401(k) plans should be designed to protect their investors, what went wrong?

Aside from the fact that the S&P was down 38% that year, another issue might have been inappropriate allocations.

In most plans, Robertson says, the company gives participants a series of options that fit the general regulatory requirements. After that, they’re left to fend for themselves and many may have made choices that were inappropriate for their age.

“It had been a nice run of 20 years and it was easy to be an investor,” he says. For that reason, there were many older investors feel secure enough to have heavy allocations to equities and just 20% in bonds. “Had they been in bonds, they would not have taken as big a hit.”

Why ETFs Make More Sense

Robertson believes that ETFs generally are a better fit for 401(k) plans than mutual funds.

The mutual fund industry has an array of different share classes, expense ratios and what they cost relative to what people get in return. “If you think about long-term performance, I don’t understand why there aren’t more index-based approaches,” he says.

The numbers bear this out: ETFs have $788 billion, while mutual funds still dwarf that with $11 trillion. Though the industry is seeing outflows, ETFs have a long way to go before they have any hope of turning the tables.

Many people believe they’re going to beat the market, Robertson says, and there’s a growing segment of the market that gets that it’s not consistently possibly. The rest of the market is still going to high-cost actively managed mutual funds.

Your 401(k) Plan: Where Do You Start?

Though it would be nice if most investors sat down and looked at their 401(k) plans and came up with an asset allocation plan that was appropriate for their goals and their age, Robertson says this is just simply not the average participant.

“The average participant says: How much should I put in and, okay, now what do I do?”

Robertson says 10% is a good place to start, though some put in more, others put in less.

ShareBuilder 401(k) offers 16 funds to choose from, though they suggest looking at the model portfolios first, which range from very stable to very aggressive. Participants should choose the portfolio that looks most like where they are.

“We’re trying to make it difficult for participants to get off on the wrong foot,” Robertson says, since as registered investment advisors, they share the fiduciary responsibility by managing the investment lineup and the portfolio allocations so companies can limit their investment fiduciary risks. “If we think a fund doesn’t fit anymore, we’ll take it out.

Although ETFs in 401(k) plans might be relatively rare these days, there are several providers offering them. If you know of any others, please tell us in the comments:

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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