In the blue-sky United States of the late 1940s, Preston Tucker drew upon technology he had learned in racing autos and building aircraft and applied it to passenger cars. He designed a new generation of sedans—equipped with seat belts, padded dashboards, and protected passenger compartments—that were safer and faster than the competition of the day, and ran 35 miles on a gallon of gas. Innovation and determination were enough to get Tucker started, but he lacked the resources to get much beyond design stage. After producing 51 cars in 1948, Tucker ran out of money, into trouble, and slipped out of sight.
An innovation of the last 10 years, exchange-traded funds hold an important place in the tactical toolbox of institutions, hedge funds, and other high-powered investors and traders. A handful of renegade companies have found a new application for them, in building low-cost retirement plans that offer cheap and flexible ETFs instead of fee-laden mutual funds. Like Tucker’s next-generation car, the ETF-based plans have advantages, as well as imperfections. However, it is still early: Will these companies’ new plan structure become a curiosity like the Tucker Torpedo, or a mass-produced, low-cost, Everyman vehicle like Ford’s Model T?
The most alluring feature of ETF-based retirement accounts is their cost advantage. Darwin Abrahamson, CEO of Invest n Retire in Portland, Oregon, and a 401(k) innovator, contends he is able to deliver a plan for a combined cost to participants and sponsors of between 65 and 105 basis points per year, depending on the size of the plan. (Embedded in that total are the management fees inherent in the ETFs, usually from 20 to 30 basis points; the balance, 45 to 75 basis points, is Invest n Retire’s fees for recordkeeping, custody, and advice to participants on asset allocation.) The cost of conventional 401(k) plans averages an added 60 to 85 basis points annually, says David Huntley, principal of Baltimore-based industry researchers 401kSource.com.
CEO Greg Carpenter, whose Mobile, Alabama-based Employee Fiduciary Corporation also offers an ETF-based 401(k) plan, points out that the new design is free from the baggage of mutual funds: 12b-1 fees; revenue-sharing among sponsor, provider, and asset manager; and the conflicts of interest that interfere with even-handed plan pricing and selection of investment options.
Lower costs make ETFs an attractive proposition, but substituting them for mutual funds is not trivial, reports Gerry Rocchi, who oversees intermediary relationships for ETFs with Barclays Global Investors (BGI), a major sponsor of ETFs. “There aren’t any show-stopper reasons that you can’t have ETFs in a defined contribution plan, but there are several wrinkles that have to be ironed out.”
One obstacle is potentially higher transaction costs of ETFs—brokerage commissions to buy incremental shares in each pay period—that can offset their lower management fees. Providers of the new plans have figured out several ways around this: Invest n Retire combines all of each plan’s trades for a pay period in one omnibus transaction, and doles out shares purchased in bulk to individual participants’ accounts. Employee Fiduciary has devised a unitized portfolio structure, where a custodian aggregates all client assets in one overarching account, and participants own interests in the portfolio, rather than the ETFs directly. Carpenter concedes that, in exchange for the lower fees, participants give up the easy trading, switching, and real-time valuation that they now enjoy with mutual fund-based accounts. Participants can trade daily in these accounts, although the deadline currently is established at noon ET to allow trades to happen during market hours, though Carpenter says the cutoff could be later, so long as it provides time to group the orders and do the trades.
Another snag in an all-ETF platform, points out BGI’s Rocchi, is arranging payment for recordkeeping. In a traditional platform, the recordkeeper’s compensation is buried in the fees collected on proprietary products, or drawn from fees of the mutual funds on the platform. However, in an all-ETF world with transparent costs, he explains, there is no way to extract an extra 10 or 15 basis points from the fund. Therefore, the recordkeeper would need to charge a distinct, nontraditional fee to the participant or sponsor, not in line with existing business models. Large recordkeepers would expend an enormous effort to make their current systems and customer relationships ETF-friendly.
The ETF-based innovators are planning to come up with their own recordkeeping systems, but 401kSource.com’s Huntley reminds them of the practical difficulties.
“Recordkeeping is not a commodity; it’s the third rail of the 401(k) business,’ he explains. “Being able to deliver a good experience to sponsors and participants is a tremendous differentiator.’ Competing on cost, through lower investment expenses, therefore, may not be enough to drive herds of sponsors to ETF-based plans.
The ETF-based innovators concede that, at this point, interest in their plans is limited. At Employee Fiduciary, Carpenter says the firm has developed a profile that should be drawn to their offering: “They may not have a lot of assets, but they’re waiting for the variable annuity someone sold them five years ago to expire, so they don’t have to pay the surrender charges. They don’t want an advisor,’ Carpenter continues, “just funds to get the participants exposure to the markets, and they don’t want to pay a lot for it.’ The firm now oversees about 60 clients, most with less than $750,000 in assets. A plan with 50 participants pays about $1,500 a year for administration.
“Those most interested in our product are top-heavy plans of private companies, where the business owner is the trustee and owns most of the money in the plan,’ reports another ETF maverick, David Nolte, a principal at Fulcrum Financial Inquiry LLP of Los Angeles. His firm’s product offers ETFs in a master trust. “They quickly understand that I can save them 1% a year. It’s more difficult to sell to a sponsor where no one person has a lot of money in the plan, the decisionmaker is someone in human resources and, for them, the idea of changing the plan only represents a headache.’
An ETF-based retirement plan may look good on paper but, lower costs notwithstanding, the world is not yet asking for them. “We may have seen a few RFPs requesting ETFs, but it’s not a trend,’ reports Steven Zients, senior vice president in client services with T. Rowe Price of Baltimore. “Our sponsors are much more concerned with longer-term issues: getting participants enrolled in their plans, and seeing that they are invested in the right things.’ He observes that sponsors fear that participants are confused already. “A shift to exchange-traded funds would be a complication,’ he adds.
On the other hand, notes Huntley, the recent price-cutting on index mutual funds by Fidelity could be a move anticipating the arrival of ETFs to the 401(k) world. BGI’s Rocchi also disagrees with Zients’s assessment of demand: “Every recordkeeper we’ve talked to says that sponsors are asking whether they offer ETFs, and how they carry it out.’ Demand will come through when sponsors decide they need real cost transparency, Rocchi says. “We think industry adoption will occur over the next couple of years, but I can tell you that the large recordkeepers are working hard to answer those questions right now.’
Preston Tucker made only 51 automobiles in 1948, but 47 of them are still around today, and every car on the road today incorporates at least a few of his ideas. Perhaps today’s small innovators will have the same sort of impact on 401(k)s.
(reprinted with permission from PLANSPONSOR magazine)