Exchange traded funds (ETFs) offer a variety of benefits as an investment vehicle. They generally have lower fees than most mutual funds, offer tax advantages and can trade like stocks, and, thanks to an ongoing price war, commissions on trading them are lower than ever. There’s just one big market left to really crack: the 401(K) market.
The majority of 401(k) plans are very different from ETF-based 401(k) plans. The traditional 401(k) plan is made up of mutual funds that focus on U.S. stocks and bonds, and international stocks from developed nations. These categories are limiting, not to mention expensive. These higher expenses would be fine if evidence supported that actively-managed funds were consistently outperforming the indexes. But overall, they’re not. ETF-based 401(k) plans are almost universally taking an index-based approach to investing.
Take the Facts Over the Myths
Despite the fact that most investors would be better served with them, ETFs in 401(k)s aren’t catching on as quickly as some feel they ought to. Some advisors complain that the advantages funds offer get lost inside 401(k)s and that ETFs can bring technical headaches for the companies that manage the plans. However, many plan providers have argued that those problems cited aren’t that big of a deal and their plans are evidence of that fact.
Another frequent argument against ETFs in 401(k) plans is the charge that investors won’t be able to take advantage of the intraday liquidity of ETFs. The facts show that this is more or less a non-issue, since most 401(k) plan participants only log in a couple times a year – they’re hardly day trading.
Additionally, a few advisors see that investors typically won’t be able to take advantage of ETFs’ ability to trade all day long rather than just once a day, as is the case for mutual funds, but this fact is more of a non-issue because the majority of plan participants don’t log in more than a few times each year and don’t consider intraday trading.
Many of the larger plan providers have shut down the idea of using ETFs on a 401(k) platform. The argument is that ETFs are not suitable for long-term retirement savings. On the contrary, lower fees could mean the difference between an okay retirement and a very nice one over the long-term.
One might think that large corporate plans have access to the lowest-cost mutual funds, stripping the price edge from ETFs. But there are several problems with this assumption:
- First, 12b-1s (operational expenses) and other “hidden” fees are often tacked on.
- Second, many of those mutual funds still have a focus on beating the market rather than tracking it.
- Third, just because the corporation qualifies for the lowest-cost share class doesn’t mean that’s what’s actually in the plan – corporations have to remember to review the funds and work with the provider if there are better share classes to be had.
- Lastly, professional managers have a difficult time at best trying to beat the indexes over the long-term. Corporations may still have access to the lowest-cost share classes, but they’re still mutual funds.
Putting ETFs to Work in Your 401(k)s
If you or your clients are looking to move an account, cashing out is a bad idea – you’ll get socked with hefty penalties if you’re below a certain age. Instead, consider an IRA rollover or an ETF-only 401(k) plan for your retirement.
Some financial advisors are recommending people to look at ETFs outside of clients’ corporate retirement plans as a low-cost way to round out investment portfolios. The assumption is that corporations offer better 401(k) plans because they have access to the best and lowest-cost products, but this isn’t always the case. Looking elsewhere for alternatives may be a better bet.
ETF-only 401(k) plans differ in some key ways from regular ETF investing:
- There are no transaction fees associated with some ETFs in 401(k) plans. Transaction fees are common in retail, but are not typical in 401(k) plans. The lack of transaction fees also makes 401(k) plans that use ETFs ideal for dollar-cost averaging – putting in smaller amounts over periods of time.
- 401(k) plans generally are geared toward long-term investing strategies, instead of more frequent types of trading. Although there’s freedom to make moves and changes, participants in 401(k) plans are largely buying and holding.
- In the retail space, you can choose between hundreds upon hundreds of ETFs. Not so with most 401(k) plans. Employers take on a fiduciary responsibility to offer the best available funds to their participants, and research shows the more options available leads to fewer people that participate in the 401(k) plan. Both drive the need for a focused lineup of funds in 401(k) plans.
Although ETFs in 401(k) plans might be relatively rare these days, there are several providers offering them, including: