From the September 2005 issue of Investment Advisor • Subscribe!

The Lower Cost 401(k) Option

ETFs are finding their way into retirement plans for all the right reasons

Using exchange-traded funds (ETFs) as investing options in 401(k) plans is becoming increasingly popular as firms realize that ETFs offer participants a lower-cost option than mutual funds. Last month, Fiserv Invest- ment Support Services teamed up with the Institute for Wealth Management (IWM) to provide plan sponsors who hold assets at Fiserv with ETF portfolios that use research provided by well-known institutional money managers.

The trend now is to create managed portfolios for 401(k) plans using ETFs instead of traditional mutual funds. More and more advisors are also acting as investment consultants for fairly large plans--those with $10 million to $50 million in assets--and want to bring an institutional portfolio solution to those plans. In some cases, however, the advisor "will choose not to manage the portfolios himself, but rather will find the best institutional management solution for the plan," says John Newman, VP of the product management group at Fiserv.

Come the third quarter, Fiserv plans to allow advisors to access institutionally managed portfolios through the IWM, which includes Neuberger Berman and Wilmington Trust. IWM is an RIA that evaluates and monitors portfolios on behalf of the advisor and plan sponsor. To help accommodate the new ETF business, Fiserv last year "developed new portfolio accounting services capabilities, so we can now accommodate all types of portfolios and all types of securities," Newman says.

Fiserv says it will track the assets of, and calculate a daily net asset value (NAV) for, each ETF investment portfolio. The daily NAV will then be reported back into the third-party administrator's participant recordkeeping system alongside all mutual fund NAVs for the plan.

Fiserv's offering with IWM is the "first of multiple institutional manager and ETF portfolio solutions" that Fiserv will be offering, according to Newman. The other offerings will include "additional institutional managers and they will include true separate accounts on behalf of plans."

The Virtues of ETFs . . .

Christopher Traulsen, a senior analyst at Morningstar, says ETFs are generally cheaper because, unlike mutual funds, "they don't deal directly with investors and don't have all the shareholder servicing costs of a mutual fund." ETFs are also more tax efficient than a mutual fund following the same index, and ETFs can be traded intraday, he says. But to Traulsen, the cost benefits of ETFs aren't "particularly clear cut these days," given the fact that mutual fund firms like Fidelity have index funds that charge 10 basis points, "which is less than what a lot of ETFs charge." He also wonders whether participants in a 401(k) plan would be charged brokerage commissions for buying and selling ETFs in the plan.

Not at Fiserv, Newman says, because the trading is handled at the portfolio level, not by participants. "There are no transaction charges for participants to move in and out of the ETF portfolios," Newman says. "The portfolio itself is trading the ETF position, and then when we have multiple portfolios trading the same ETF positions, we can block up those trades and allocate the shares back to the portfolios." He adds: "The portfolio incurs the trading expense, and when it's blocked up across multiple portfolios, participants are incurring [only] a portion of the trading expense."

. . . and Their Disadvantages

It's important to note, Newman says, that ETFs can actually be cost prohibitive for small plans with $1 million or less in assets. If such a small plan wants to offer several ETF portfolios, "those portfolios are only going to attract a certain percentage of that $1 million," he says. "The resulting portfolio trading and custody expense will result in a significant basis-point charge" to the participant. Newman says plans with more than $5 million are setting up ETF portfolios, and he'd say that's the smallest a plan should be. Newman adds that one of the sets of managed ETF portfolios that Fiserv offers through AssetMark Investment Services has a $10 million plan minimum. Through a deal inked in July, third-party administrators and recordkeepers working with Fiserv can now provide plan sponsors with ETF portfolios offered through AssetMark.

Sam Campbell, a research analyst at Financial Research Corp. in Boston, says that when placed in retirement vehicles like 401(k)s, ETFs also lose some of their inherent advantages. The tax advantage is lost, but taxes become irrelevant when an ETF is placed in a qualified plan anyway. You also lose the ability to trade ETFs intraday and the ability to leverage the ETFs and sell them short. But Morningstar's Traulsen argues that intraday trading is not necessarily a perk, and should not be encouraged, especially in a qualified plan, because participants can lose money by trading rapidly.

ETFs and 401(k)s

David Nolte, principal with Fulcrum Financial, a CPA firm and RIA in Los Angeles, agrees that it's not ideal for a plan participant to "trade half a dozen times in a single day." His firm, which serves as a plan administrator for 401(k) plans and at the end of 2004 started offering only ETFs as investing options, says Fulcrum avoids the late trading that has affected mutual funds because ETFs trade in the middle of the day at market prices.

ETFs also become different investing vehicles when they are offered through a 401(k) than when they are offered directly to investors, says Campbell with FRC. This is true because most firms are "effectively building trusts or their own mutual funds with ETFs as the underlying investments," says Nolte, "so you're not able to get customized investment selection at the individual investor level." But this isn't the case at Fulcrum, he says. "Our 401(k) participants are getting an actual fractional share of the retail ETF--through a commingled trust--but we end up allocating those fractional shares to individual participants and they are the owner of that fractional interest."

ETFs take a segment of the market that an investor wants to buy into, and within that segment, the ETF is matching the market, Nolte explains. By offering a group of ETFs, he says, Fulcrum "allows an investor to select a piece of the market that they want so they can get differentiated performance." But we're not trying to "actively manage the portfolio and select company A over company B," he says, because over a period of decades, which is the timeframe over which retirement funds are being invested, it's impossible. What Fulcrum provides with its ETF offerings is the ability for plan sponsors and participants to "invest in market-matching performance on a customized basis while reducing cost."

But Campbell with FRC is skeptical that ETFs actually provide a cheaper way to go than index mutual funds. "I suspect that all in all, the pricing of the [ETF] platform to the end investor is very similar, or maybe even slightly more expensive, than what it would look like if the platform was using all index mutual funds," he says. "The cost associated with offering the ETF is a benefit, but if you were to compare it truly to what it would be competing against on the mutual fund side, I think it would be similar or maybe even more expensive."

Nolte disagrees. Fulcrum, he says, charges a 75 basis point fee to cover all the 401(k) plan administration and compliance, as well as plan participants' needs. The firm also provides, free of charge, investment advice to plan participants. "The cost of our fee combined with the cost of the ETF is still significantly less than what people are paying with actively managed mutual funds--at least 1% per year for each participant," Nolte says.

Washington Bureau Chief Melanie Waddell can be reached at mwaddell@investmentadvisor.com.

Reprints Discuss this story
This is where the comments go.