Regardless of what you’ve read or been told, the usually calm 401(k) marketplace is facing a barrage of scrutiny that it’s never experienced in its 26-year history.
The first 401(k) plan was designed by Ted Benna in 1981. Today, traditional pensions and other defined benefit plans are on the decline, while about 47 million 401(k) participants have approximately $2.5 trillion of retirement money saved in defined contribution plans.
However, what was originally thought of as a relatively good place to sock away retirement money has now turned out to be an all out focus on the suitability of investment options inside these plans — along with the fees being levied upon plan participants. Over the past several months, Congress and federal regulators have been looking into whether 401(k) fees are justified and whether the disclosures about them are sufficient.
As if none of that was enough, a whirlwind of new laws, government white papers and class action lawsuits is shaking the 401(k) business like never before.
Had it not been for a Government Accounting Office (GAO) report released in November with the bold title “Changes Needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” Congressional hearings on 401(k) fees might not have happened. Barbara Bovbjerg, GAO’s director for education, workforce and income security issues, recently testified before a government panel stating that more than 80 percent of the 47 million 401(k) participants do not know how much they pay in investment, record-keeping and other maintenance fees.
Even if fees aren’t a problem, a lousy lineup of mutual fund choices often clouds the situation. Indeed, the investment options that some of America’s largest 401(k) plans contain can be downright dazzling to a casual investor. On the other hand, many plans offer an insufficient menu of investment options. Regardless of the employer’s or investment advisor’s personal investment philosophy, shouldn’t 401(k) participants be allowed a broad mix of investment options, even low cost index funds? Those 401(k) plans that go beyond the usual proprietary funds are simply charged extra for the benefit of having a wider menu of funds. Ultimately, it’s the participants themselves who get penalized.
Since investment management fees account for the bulk of 401(k) expenses, what’s the solution? The two possibilities offered by the GAO report were institutional mutual funds or index mutual funds, which are noted for their low expense ratios. But another important alternative promises to make its mark: exchange-traded funds (ETFs).
The Etf Invasion
Even though most ETF providers are now focused on new product development, they have already begun eyeing the lucrative 401(k) marketplace. Contrary to what many have been led to believe, ETFs are a good retirement plan choice. Properly applied, ETF 401(k) plans can help employers offer an excellent long-term savings vehicle and satisfy ERISA 404(c) guidelines, which govern retirement plans.
One of the benefits ETFs offer a 401(k) plan is a wider mix of investment options. The U.S. ETF market, which encompasses nearly 425 funds, covers virtually the entire asset class universe, including domestic and international stocks, bonds, real estate and even commodities. In many instances, ETFs offer even better asset class exposure at a fraction of the price of traditional mutual funds.
High portfolio turnover continues to plague the mutual fund industry. The average equity fund has roughly 100 percent annual turnover in its holdings. This creates a ripple effect by increasing a fund’s trading costs, which in turn erodes shareholder returns. Many investors aren’t even aware of the fact that brokerage costs are an additional cost burden over and above the expense ratio, deducted dierctly from a fund’s net asset value (NAV).
Of course, the mutual fund industry will deny the importance of brokerage costs, but the facts say otherwise. A recent study estimated that as much as 0.27 to 0.75 percent of a fund’s assets are forfeited as a result of brokerage expenses incurred by hyperactive portfolio managers! Again, these expenses are added to already sky-high expense ratios. In contrast, ETFs tend to have lower portfolio turnover versus active mutual funds, which in turn leads to a significant cost savings for all investors.
It’s not surprising that the lobby against ETFs in 401(k) plans is both loud and large. From mutual fund companies to record keepers and even fund rating agencies, the ones fighting the hardest against ETFs in 401(k) plans stand to lose the most.
However, market forces are usually more powerful than the players. A first quarter online poll conducted by ETFguide.com showed that out of 105 respondents, 95 percent want ETFs as an investment plan option.
Barriers To Entry
The main challenge that ETFs face is the fact that most 401(k) plans are set up for dollar-cost averaging. In this setting, mutual funds are a natural fit, but buying and selling ETFs adds brokerage costs that can wipe out the benefits of their low expense ratios.
Nevertheless, ETFs are making their way into 401(k) plans with affordable and viable solutions.