How To Include ETFs In A Client's 401(k)

Exchange-traded funds (ETFs) continue to grow in popularity. According to the Investment Company Institute, at year-end 2006, ETF assets totaled $422.6 billion compared to $65.6 billion in 2000. There were also 359 funds available to investors compared with just 80 at year-end 2000. However, these versatile funds have not made it into many retirement accounts. 

Traditionally there have been two things keeping ETFs out of 401(k) accounts:

1. The unavailability of cost-effective trading software that allows participants to perform the necessary tracking. 
2. An inability to own whole and fractional shares of ETFs in their acounts (outside of self-directed brokerage accounts).

This meant that many people missed out on the opportunity to hold these low-cost funds in their retirement plan accounts. Read on as we examine the benefits of and problems with adding ETFs to a clients 401(k) plan. We'll then examine one possible solution to help advisors in clearing ETF transactions in retirement accounts at affordable costs.

Why ETFs?
The growing popularity of ETFs among consumers is not in question. Financial advisors want to provide their clients with the most suitable products and services, but the question for them is, "Why provide ETFs?" One key reason is because advisors want to look out for the best interest of the client. The other is self preservation through protection against lawsuit from dissatisfied participants and public interest groups.

Benefits for Clients
While both mutual funds and ETFs are composed of securities in their underlying indexes, there are marked differences that make ETFs more consumer-attractive. These include trading features and pricing. (To learn more, see Advantages Of Exchange-Traded Funds.)

Over time, high fees can significantly reduce the balance in a participant's retirement account. A large percentage of these fees are trade-related and annual fees that often amount to an average of 1% of a participant's 401(k) balance. ETFs provide a solution to these high costs, primarily because they do not have the redemption and management fees often associated with mutual funds. (To learn more about mutual fund fees, see Mutual Funds: The Costs.)

--	Mutual Funds	ETFs
Stock Exchange Listed	No	Yes
Trading Medium	Direct through the mutual fund company Through a brokerage account	Stock exchange Through brokerage account Electronic exchanges
Pricing	NAV - Commission = Price NAV calculated daily at the close of markets All investors received the same NAV, regardless of the time of the day the fund is traded	NAV calculated every 15 seconds. Price fluctuates on the value of the underlying stocks, and also according to the changes in market supply and demand Share price may be different from NAV

Benefit for Financial Advisors
For financial advisors, one key attraction of ETFs is the higher level of protection it provides for plan fiduciaries. With all the litigation and fee disclosure requirements, ETFs are said to be the cleanest investment vehicle to use for investment and fiduciary purposes. They cost less than mutual funds and index funds and have no short-term redemption fees. In short, they come without the "fee baggage" that goes along with other kinds of funds. Therefore, they are a fiduciary's dream investment vehicle. (For more insight, read Don't Let Brokerage Fees Undermine Your Returns.)

Mutual funds held in 401(k) plans usually have higher fees than those held outside of 401(k) plans, because those held in the plans are usually special class funds, such as R-Shares (For more on this mutual fund class, check out the Forbes article by William Barrett, "R-Shares, Competitive - But For Whom?"). As such, advisors can often build better asset allocation models with ETFs than with mutual funds, hence the popularity with advisors who work with wealthy clients.

Commissions and Tracking Requirements Keep ETFs from 401(k) Plans 
While ETFs are becoming increasingly popular in 401(k) plans, the progress is slow because of the commission that is usually applied to each trade. This cost is a deterrent for participants who trade frequently by investing periodic salary-deferral contributions made to their 401(k) accounts though payroll deduction. For most participants, the frequency can be as often as weekly, monthly and semi-monthly. Also, because  the contributions are often systematically invested upon being credited to their 401(k) accounts, there is usually no opportunity to accumulate contributions and make "bulk" trades, instead of multiple trades.

Additionally, third-party administrators are faced with the challenge of finding software that is properly designed to allow ETFs to trade in 401(k) plans outside of a brokerage account environment, while tracking the performance of participants' portfolios and tracking transaction fees.

In order for financial advisors to overcome these challenges, they need to be able to partner with a firm that is able to provide solution to these issues. These solutions are currently being developed, including proprietary software to build asset allocation models with ETFs, and change asset allocation between ETFs without incurring any redemption fees.

Conclusion
The opportunity to provide an asset allocation model, with costs lower than those associated with traditional investments such as mutual funds, is a key asset-gathering and asset-retention tool. In addition, it helps to provide peace of mind for fiduciaries in what has become an area of concern - fees reducing participants' return on investments in their 401(k) accounts. ETFs, offered through a platform that allows the institutional trading of participants' shares, helps to provide the solution to these issues.

-With files from Darwin Abrahamson, the founder of Invest n Retire.
 

by Denise Appleby (Contact Author | Biography)

Denise Appleby is a retirement plans consultant, freelance writer and editor. Before starting her own business, Appleby Retirement Consulting, Denise worked for Pershing LLC for almost 10 years. While at Pershing, Denise rose to the rank of vice president, and held many positions including retirement plans product manager, manager of the retirement plans technical assistance group and retirement plans training manager. Appleby Retirement Consulting provides technical assistance to financial institutions and financial professionals; content for newsletters, websites and magazines; and technical editing services for books and other retirement plans material. Denise holds several retirement professional designations.