Detractors claim that ETFs have no business inside 401(k) plans, but are they right? Will ETFs shake up the slow-moving 401(k) market by lowering fees and offering more diversified investment choices? And which companies are at the forefront of the trend towards ETF(k) plans and how can financial advisors capitalize? Let’s analyze these questions.
Trillions Up for Grabs
Defined-contribution (DC) plans such as 401(k) plans, 403(b) plans and profit-sharing plans today are dominated by mutual funds or company stock. At the end of 2008, the latest year for which the industry has figures, employer-sponsored DC plans held $3.5 trillion in assets, with the largest share in 401(k) plans ($2.4 trillion in assets), according to the Investment Company Institute. Of that $3.5 trillion in DC plans, some $1.5 trillion, or 43 percent, was invested in mutual funds.
Last year investors poured $118 billion into ETFs, according to Strategic Insight, and total assets in both ETFs and ETNs in the U.S. are projected to reach $1 trillion by 2012. Just how much ETF(k) plans will contribute to that asset growth is up for debate, but if ETFs are able to force their way into DC plans it could be a huge opportunity.
The actual size of the ETF(k) market is not known. Obtaining industry-wide asset inflow/outflow data is still largely impossible because it would require the participation of all third-party record-keepers that offer ETFs, which is a daunting prospect. As the ETF(k) market matures, accurately measuring its asset growth is likely to become more important to key industry players.
Today’s DC Market
The 2009 PlanSponsor DC survey, found that just 1 percent of DC plan sponsors — including 401(k) plans, 403(b) plans, Simple IRA plans, etc. — offered ETFs as an investment option for employees. And of those DC plans that offered ETFs, 79 percent had $50 million in assets or less. In other words, today’s ETF(k) market is focused on smaller retirement plans.
Large DC plans with $500 million in AUM don’t typically use ETFs because they’re able to get less expensive institutional priced shares. And what can be said about ETFs covering important asset classes like commodities that mutual funds miss? “I think access to less-traditional asset classes and strategies is going to slowly become more important in DC plans, but we’re not there yet,” says Loren Fox, senior research analyst at Strategic Insight.
Meanwhile, it’s the smaller DC plans that are most likely to benefit from the cost advantages of ETFs, because they’re too tiny to negotiate institutional pricing on index funds. As a result, BlackRock’s iShares has focused its attention on the small and micro DC plan market.
Another reason more DC plans don’t offer ETFs is because of operational issues and absent financial incentives on the recordkeeping side.
Most DC platforms were built long before ETFs arrived on the investment scene and are thus oriented towards mutual funds. While mutual funds can be traded on these platforms commission-free, the same cannot be said of ETFs. Likewise, next-day settlement for mutual fund trades is standard on these platforms, but three-day settlement with ETFs isn’t and neither are partial share investments. Furthermore, since ETFs don’t offer revenue sharing like mutual funds, there’s a strong disincentive by most record-keepers to dismantle their retirement platforms to embrace ETFs.
Now, let’s evaluate the retirement platforms that use ETFs.
Similar to mutual funds, collective trusts typically pool assets from multiple clients. Because they fall under banking regulations, collective trusts are not regulated by the Securities and Exchange Commission and they have fewer reporting requirements compared to mutual funds. Banks, trust companies or money managers are the main users of the collective trust structure.
Among the benefits of collective trusts are fewer regulatory hurdles, investment flexibility and a competitive fee structure.
One company that’s successfully employed ETFs inside collective trusts is ValMark Advisers. The Akron, Ohio-based investment firm has amassed $750 million inside ten trusts. TD Ameritrade serves as the trust provider and ValMark manages the assets. Six of the trusts are risk-based whereas the other four use a target date strategy. Each of the trusts only uses ETFs, with the exception of small cash positions. In addition, ValMark makes its trusts available on eight different custodial platforms. They’re listed on NSCC with CUSIPs.