The Battle for 401(k) Accounts

That ETF providers have not managed to dig their paws very far into the 401(k) honey pot is hardly surprising, since the primary advantages that make ETFs attractive to investors in taxable accounts, tax efficiency and intraday pricing, vanish in a retirement account. The fact that ETFs are able to avoid the capital gains liabilities that mutual funds incur by dumping low cost-basis shares to fund redemptions is meaningless in a 401(k) account, which isn’t subject to capital gains tax. Also, most 401(k) plans do not allow participants to make intraday trades, negating the advantage of intraday exchange trading.

Furthermore, many investors value ETFs for the ability to trade from either the long or the short side and the easy access they provide to more exotic investment strategies, including futures, options, and leverage. While there is no specific rule that prohibits any of these assets from being held in a 401(k) account, the Internal Revenue Service does not allow 401(k) assets to be used as collateral for loans, thereby prohibiting margin accounts, a must for short sellers and margin buyers. Also, since a 2008 Supreme Court ruling explicitly stated that employers are responsible for losses in 401(k) accounts caused by mismanagement, it would be unlikely that employers would allow those ETFs in their 401(k) plans.

The Cost Issue

Even the issue of cost, where ETFs generally have their strongest appeal, becomes muddled in a retirement account setting. ETFs in general have lower annual expense ratios than identical mutual funds, a powerful advantage when they are held for the long term as retirement assets usually are, but investors still must pay a brokerage commission to buy ETF shares, which could become a significant cost if the purchase involves frequent purchases of a relatively small number of shares, as 401(k) accounts usually do. (It should be noted that some major brokerage platforms, notably Schwab and Fidelity, now offer a variety of commission-free trading on certain ETF). S&P Equity Research uses an ETF’s and a mutual fund’s expense ratio in generating a ranking for the investment, favoring those that are below average.

Lastly, all 401(k) accounts–whether or not they include ETFs–incur administrative costs for services such as record keeping, accounting, legal, and trustee services. In some plans, these fees are subsidized by the management fees or 12(b)-1 “marketing” fees and investment management fees that fund providers already charge. The ultra-low annual expense of owning an ETF, in some cases less than 0.1%, would have to rise to pay for administrative expenses, eroding much of their cost advantage.

Whether ETF sponsors can eventually crack the 401(k) market will depend on their abilit y to undercut mutual funds on cost while still offering an attractive variety of investment choices in retirement plans, as they do for taxable accounts. Until that happens, the effort to gain access to the 401(k) market is really a solution in search of a problem.

---

S&P Senior Financial Writer Vaughan Scully can be reached at [email protected]. Send him your ideas for ETF story topics.