From the July 2011 issue of Investment Advisor • Subscribe!

ETFs At Last: The Future of 401(k)s

Investments in traditional 401(k) plans have been limited to mutual funds representing a variety of asset classes. However, exchange-traded funds (ETFs) are beginning to attract greater attention for participant-directed individual account plans, especially since the introduction of a new fee disclosure mandate and greater interest in ETF-based 401(k)s from big-name brokerage firms.

Mutual funds tend to have higher costs and potentially overweight specific sectors or stocks. The higher costs associated with mutual funds come from the active management fees allocated to conduct research and trade securities.

It is no big surprise that ETFs are becoming the go-to alternative for 401(k)s. ETFs have been lauded for their low expenses and diversification, which have become key selling points for ETF-based 401(k) plans.

Since the passive management of index-based funds incurs low costs, ETFs can have much lower expense ratios as compared to mutual funds. Through low-cost investment options such as ETFs, expenses in participant-directed individual account plans may be reduced by half or more.

The New Labor Department Ruling
A new piece of legislation regarding fee disclosures will give employers more clarity into 401(k) plans through complete transparency of all holdings and investments within the plan.

The U.S. Department of Labor’s Employee Benefits Security Administration (EBSA) will implement the new Employee Retirement Income Security Act (ERISA) Section 408(b)(2) regulation on Jan. 1, 2012; however, employers have been given 120 days after the effective date to comply with the disclosure of fees and expense information to participants.

“This action will provide that plan fiduciaries have all required information from service providers before they must disclose information to their workers, ensuring that workers receive accurate information about their retirement plan and investment costs,” stated Phyllis Borzi, assistant labor secretary for EBSA.

The main point of the regulation will require plan sponsors to develop and distribute a comparative chart that outlines investment-related information, such as fees and expenses.

The first section of the chart will list the name of each investment option, the website for each option, average annual total return of past performances in varying time periods and the rates of return on a comparable benchmark index in the varying time periods. The second section of the chart will include each investment option, along with the total operating expenses and fees charged.

Additionally, employers are required to disclose to participants the dollar amount charged to their accounts in the preceding quarter for administrative expenses on a quarterly basis.

Existing ETF 401(k) Options
ING Direct’s ShareBuilder 401(k) has been offering ETF-based 401(k)s for the past five years.

While most company plans with mutual funds issue expense ratios in excess of 1.25%, ShareBuilder includes an investment line-up with low ETF expense ratios, and historical performances that outperform comparable mutual funds over a period of five or more years. The disparity in performances between the plans with mutual funds compared to ETFs is much more noticeable when accounting for annual compounding.

Big-Name Brokerages Enter the Fray
More recently, brokerage firms Charles Schwab and TD Ameritrade announced their entry into the ETF-based 401(k) space.

Schwab plans on rolling out its offering in two steps. In the first quarter of 2012, Schwab will provide an offering of indexed mutual funds along with managed accounts. The company will then launch another offering later on in the year that will be combined with ETFs.

In April, TD Ameritrade started offering ETFs to plan sponsors and 401(k) participants.

With established players like ShareBuilder, and new name-recognizable firms entering the market, the ETF-based 401(k) space will likely experience greater exposure and wider acceptance within the marketplace. Over the next few years, the budding growth of ETF-based plans may become an industry norm.

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