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Exchange-Traded Funds Target 401(k) Plans

May 27, 2009
Related Topics: Retirement/Pensions, Benefit Design and Communication, Featured Article, Compensation
With mounting concerns about the fees associated with 401(k) plan investment options, a growing number of plan sponsors are reviewing the funds they offer to employees. And some are thinking about adding exchange-traded funds to their plans as a lower-cost option to mutual funds.

Proponents of ETFs argue that these products are not only less expensive, but that they are also more transparent than their mutual fund counterparts, making them particularly attractive to investors in today’s market environment.

“If anything, the weak economy has highlighted the importance for investors to know what they are paying for,” says Darek Wojnar, head of product strategy and research for iShares, a line of exchange-traded funds offered by Barclays Global Investors.

Critics, however, contend that the cost differential may not be evident for most large plan sponsors. They also advise employers to do their homework before offering the funds to employees.

Exchange-traded funds trade like stocks and are largely passive investments that track indexes. The expense ratio for exchange-traded funds can be as low as seven to 10 basis points, compared with 60 basis points for an indexed mutual fund.

Not only do ETFs cost less than mutual funds, but the fees involved are much more transparent than are the fees for mutual funds, Wojnar says.

“ETFs bring transparency of both investments as well as transparency of pricing,” he says. “It is very clear to plan sponsors what services are included in the fees. iShares don’t have any fees other than the investment management fees.”

While ETFs are low-cost, most midsize to large plan sponsors, or those with 2,000 to 4,000 participants, already get a discount on indexed mutual funds in their plans, says Pam Hess, director of retirement research at Hewitt Associates. Generally, companies of this size pay five to 10 basis points for indexed mutual funds, according to Hewitt.

On top of that, ETFs carry transaction costs so that anytime a plan participant buys or sells ETFs, they have to pay a fee, experts say.

That means that the employee who is putting in $100 to $200 into their 401(k) every other week could pay a $10 transaction fee [at a discount broker] to buy ETFs, says Paul Justice, ETF strategist at Morningstar, a Chicago-based fund research company that covers mutual funds.

“To make ETFs competitive with mutual funds, you would have to have no trading costs,” he says.

However, employees who buy ETFs within a 401(k) plan don’t pay full transaction costs as if they were buying as individuals, says Lance Berg, a spokesman for San Francisco-based Barclays Global Investors.

“These trades are put together in aggregate, so the fees an employee would pay are in pennies, not dollars,” he says. However, employees who buy and sell ETFs through a self-directed brokerage window—which experts say is the primary way that 401(k) plans offer ETFs today—do pay full fees. Barclays has around 3,000 plan-sponsor clients that have iShares as core options within their 401(k) plans, Berg says.

Employers also may face record-keeping issues. While 401(k) record keepers are equipped to handle mutual fund transactions, ETFs are different, and many providers can’t accommodate them, experts say.

To address this, Barclays recently launched the “iShares in 401(k) Program,” which identifies a number of record keepers and administrators that allow iShares with mutual funds on their platforms, according to Wojnar. There are more than 100 record keepers identified through the program so far.

And Barclays' soon-to-be new owner, BlackRock, has said that it plans to use its influence to get BGI's ETFs into more retirement plans. BlackRock announced June 12 that it was buying Barclays Global Investors for $13.5 billion.

Despite these recent efforts to make ETFs more compatible with a 401(k) plan environment, consultants at Watson Wyatt Worldwide and Hewitt Associates say they don’t know of any clients that offer ETFs as a core option within their plans.

“It has got to be less than 1 percent of plans that offer this,” Hess says.

But one way that plans can offer ETFs that may make sense is through collective trusts, she says.

This is a particularly good option for small to midsize 401(k) plans, which can’t get the institutional pricing of indexed mutual funds that larger plans can access, Hess says.

And collective trusts made up of ETFs are low-cost, ranging around 15 to 20 basis points, she says.

Along those lines, Portland, Oregon-based Invest n Retire has built a business on setting up managed accounts invested in ETFs. The company serves as the record keeper, working with independent fiduciaries to manage the products, which follow target-date strategies and cost around 40 basis points, says Darwin Abrahamson, the firm’s CEO.

Invest n Retire has 103 plan sponsors as clients and $500 million in assets under management.

Employers that do decide to offer ETFs in their 401(k) plans should emphasize to participants that although these products can be traded like stocks, they should think about them as long-term investment options, experts say.

And despite the market’s volatility this year, plan participants need to remember the importance of thinking in years, not days or weeks, says Sue Walton, an investment consultant with Watson Wyatt. “Buy and hold over the long term does work,” she says.

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