Will ETFs Ever Break Into the Retirement Plan Space?

The factors that make exchange-traded funds popular with individual investors and financial advisers might be moot points in most DC plans.

Exchange-traded funds (ETFs) have failed to gain widespread use in defined contribution (DC) plans, although they have become popular among individual investors.

Morningstar Director of Personal Finance Christine Benz has developed a series of hypothetical portfolios for savers and retirees, and explained in a recent article that while they all posted strong gains last year in absolute terms, “the ETF portfolios crushed their mutual fund counterparts.” Given such results, would retirement plan participants fare better with ETFs than with mutual funds?

Morningstar Head of Global ETF Research Ben Johnson says the article is making single ETF and single mutual fund comparisons, so investors can’t make generalizations about ETF performance based on that. However, he says a generalization that Morningstar can see and say with a high degree of confidence is that over longer periods of time, lower fees lead to better outcomes.

“ETFs tend to have lower fees than many mutual funds, which might lead to longer-term outperformance,” Johnson says. “But that’s not unique to ETFs. There are low-cost mutual funds, especially in retirement plans.”

Kristen Carlisle, general manager of Betterment’s 401(k) business, says mutual funds have higher fees than ETFs, and many mutual funds in DC plans are actively managed and require in-depth analysis. She adds that research has shown there’s rarely a big improvement in performance from active management.

“A majority of actively managed funds lag in performance compared to passively managed funds over nearly every time period,” Carlisle says. She adds that ETFs allow for more diversification in investors’ portfolios.” ETFs allow for far more diversification than single stocks and must adhere to the same diversification requirements as mutual funds,” she explains. “Because ETFs typically aren’t over-concentrated in any specific company, sector, or country (unless specifically called out in the fund offering prospectus) you’ll be spreading your investments across multiple assets and therefore limiting your exposure to specific risks.”

A few DC plan providers offer all-ETF 401(k)s, including Betterment. Carlisle says the biggest reason ETFs typically aren’t included in employer-sponsored plans is that the market is dominated by players incentivized to offer certain funds.

“Many retirement plan providers are mutual fund companies, and plans are sold through their distribution partners,” she explains. “There are fees embedded in mutual funds that facilitate payments to every party involved in the sale. That structure has been in place nearly since the inception of 401(k)s.”

Carlisle says there are also existing technology limitations. “Most recordkeeping systems were built decades ago and are designed to handle batch trading, not intraday trading,” she says.

Johnson also cites the operational issue that has prevented widespread availability of ETFs in DC plans. “Because ETFs trade like stocks throughout the day, the mechanics of trading, clearing and allowing for investments in fractional shares is difficult to solve in traditional recordkeeping platforms,” he says.

However, Carlisle says technology is catching up and there is rising interest from younger and newer investors to include ETFs in their retirement plans.

Still, according to Johnson, there are two issues with ETF use in DC plans that will persist. “The first, more fundamental issue is that many of the benefits of ETFs go away when used in the confines of a tax-deferred retirement account,” he says. “A reason ETFs appeal to many individual investors and financial advisers is they tend to be more tax-efficient than open-ended mutual funds. But that becomes a moot point in a tax-deferred account.”

Lower fees are still a benefit of ETFs, but they might be less of a benefit inside a DC plan where many investment menus already feature low-cost index funds, Johnson adds. “So if a DC plan uses ETFs instead, it might be just getting a like-for-like swap, so there wouldn’t be a reason to move out of low-cost index funds.”

Another thing to keep in mind, according to Johnson, is that many plan sponsors are moving away from mutual funds toward collective investment trusts (CITs), which also boast lower fees. “There’s a tug of war between mutual funds and CITs, and CITs are winning,” he says.

The other issue with using ETFs in DC plans is liquidity, Johnson says. “ETFs trade like stocks so they can be exchanged all day long,” he explains. “That might be viewed unfavorably by sponsors because they don’t want to see participants day-trading their nest eggs.

“For all these reasons, we’ve long been skeptical ETFs will make it in the DC plan space,” Johnson says.

Asked about the concern over retirement plan participants day-trading with their savings, Carlisle says Betterment’s solution addresses that through goal-based investing, taking out the guesswork for participants about how to invest their funds. Betterment’s platform includes personalized investment advice for participants.

“We guide them to think about what life they want in retirement and we tell them how best to get there rather than leaving it up to them to pick their own funds, as traditional recordkeepers do,” she says. “There are arguments that ETFs are confusing and that they can be distracting because of intraday trading, but technology can eliminate those concerns.”

Johnson says, in his opinion, ETFs could have a role in smaller plans—those that might not have sufficient assets to qualify for the lowest-cost share classes of mutual funds. “And there’s no minimum investment requirements for ETFs,” he adds.

A way ETFs might find their way into the DC plan space more broadly is through target-date funds (TDFs), Johnson says, noting that at least one fund provider is offering ETFs in TDFs. He says the product was specifically designed to cater to smaller plan sponsors.

To get ETFs to break into DC plans comes down to who is asking for it and demanding it, Carlisle says. “As I said, younger and newer investors want ETFs in their retirement plans,” she says. She also says it will take “continued education for plan sponsors about the value of ETFs and how they differ from mutual funds, and about making choices that are best for employees.”

Carlisle adds that cost is another factor in favor of ETFs in DC plans. “People are paying attention to their retirement plan fees and litigation is on the rise,” she says. “This will put a spotlight on the difference between fees for ETFs and for mutual funds.”

“Plan sponsors should understand it’s important to pay attention to cost. It affects how much participants can save for the future,” Carlisle says. “We believe in ETFs because they are low cost without sacrificing performance.”