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.
“Progress is being made as more and more firms focus on integrating ETFs into the defined-contribution market,” says Jill Iacono, director of national accounts for State Street Global Advisors.
One company that’s been capitalizing on the trend is Portland, Ore.-based Invest n Retire, which is run by CEO and founder Darwin Abrahamson. The company has developed a proprietary retirement system that accommodates both mutual funds and ETFs.
In the past, 401(k) sponsors had to go through the clumsy process of establishing brokerage accounts for participants, paying brokerage fees for each ETF transaction. Invest n Retire’s proprietary software interfaces with the three major stock exchanges to provide best execution and reduce the impact of dollar-cost averaging. As a result, the company’s ETF portfolios are substantially less expensive to manage and offer performance returns that rival comparable mutual funds, Abrahamson says.
Target-date retirement portfolios have been a huge success in the 401(k) business, so New York City-based XTF Advisors has rolled out a suite of retirement-dated mutual funds that invest in ETFs. Drawbacks of this approach include additional fees layered over ETF expense ratios; XTF counters that its funds are still cheaper than similar offerings.
Another potential player is BenefitStreet of San Ramon, Calif., which administers more than 7,000 pension retirement plans and is planning to introduce a pure ETF 401(k) plan to the independent advisor channel this summer.
Is Your Client’s Plan Fireproof?
Unfortunately, the heat is being turned up on financial advisors as well as the fund companies and 401(k) providers. Instead of being viewed as a source of the problem, you can be viewed as an ally. Help your retirement clients get a grip on the sweeping 401(k) changes that will no doubt affect the way they manage their retirement plan. Help your 401(k) clients eliminate unnecessary costs that may be plaguing their plan. If you refuse to do this, be aware that one of your competitors is all too willing.
What about next generation 401(k) solutions that utilize ETFs? It’s likely these types of plans won’t completely eliminate all mutual fund plans, but instead will be offered alongside them. Help your clients take advantage of these solutions and get better and more affordable investment options. Lastly, don’t worry about your check; the money will be there.
Weathering the 401(k) Firestorm
Step 1: 401(k) clients should view you as the solution, not the problem.
Step 2: Always have a 100 percent transparent and full investment fee disclosure policy.
Step 3: Help clients to uncover their 401(k) costs; if high costs are an issue, help them to identify better alternatives.
Step 4: Get a head start on the competition; aim to incorporate next generation 401(k) solutions that utilize ETFs in your practice.
Ron DeLegge is the editor of www.etfguide.com.