For most savers – especially when it comes to retirement – there’s one vehicle that gets the lion’s share of investor assets. And that’s the retirement plans. 401(k)s, 403(b)s and 457 plans are likely to do most of the heavy lifting when it comes to retirement planning and investing. For many investors, these plans will be the single largest account they have.
However, something is strangely missing from these accounts. We’re talking about exchange-traded funds (ETFs).
Despite having trillions in assets, retirement plans are a bit old fashioned and both passive and active ETFs haven’t cracked “this pot of gold” yet.
But that could be changing. Thanks to the new focus on fiduciary duty and fees, index and active ETFs could be coming to a 401(k) plan near you.
See our Active ETFs Channel to learn more about this investment vehicle and its suitability for your portfolio.
Strangely Absent
According to the latest Investment Company Institute (ICI) report as of June 30, 2021, 401(k) retirement accounts held a staggering $7.3 trillion in assets. That’s about one fifth of the total retirement pie and represents the single largest piece of the U.S. retirement market of defined benefit (pensions) and defined contribution (401(k), 403(b) and 457) plans. Moreover, excluding rollovers, these accounts are often the single largest vehicle in which investors conduct their retirement savings, and they also represent the largest piece of a saver’s nest egg.
The composition of 401(k) plans is pretty straight forward.
According to the ICI, about 66% of these assets were in mutual funds, with the remaining chunk deployed in company stock, individual stocks, bonds, pooled investment products, such as funds set-up exclusively for the plan, and guaranteed investment contracts. Strangely absent from the equation have been ETFs.
The reasons for such a composition have also been mixed.
For one thing, retirement plans tend to be dollar-based investing. A certain percentage of our paychecks go into these plans each month. As a result, we are buying a dollar amount of a fund. Mutual funds have been set up to accept fractional shares based on dollar amounts. ETFs, on the other hand, are tradable on an exchange and have historically required that investors buy at least one full share.
Secondly, because of their tradability, plan sponsors have worried that their duties to the plan’s investors would be violated. Worries have long persisted that investors in 401(k) plans would become day traders and buy/sell assets on a constant basis.
Finally, the tax efficiency of ETFs is a moot point in a tax-deferred, tax-free plan like a 401(k). Capital gains and dividend taxes don’t really matter when you don’t have to pay them.
As such, ETFs have been absent for 401(k)s, and similar plans, despite cropping up everywhere.
Change Could Be Coming
However, the days of ETFs – specifically active ETFs – in retirement plans could be coming sooner than later. The so-called “pot of gold” could finally be found.
A big part of that comes down to legislation. The Employee Retirement Income Security Act (ERISA) of 1974 requires that sponsors act solely in the interests of the plan’s participants when selecting investments. In recent years, that fiduciary duty has been reinforced with various other pieces of the legislation, such as the SECURE Act and Department of Labor rules, as well as a series of lawsuits against plan sponsors by participants. Much of these lawsuits have focused on fees and costs for plans. As a result, many plans now feature low-cost index funds as a core part of their mixes.
Here is where ETFs could finally grab the holy grail, specifically on the active side of the equation. Many plans still feature active mutual funds as part of their investment menu – and plenty of investors still use them. Active ETFs still offer the same benefits of potentially better returns and increased alpha at much lower costs.
When comparing index mutual funds to index ETFs, fees are generally in line with each other. The cost difference between the Vanguard 500 Index Fund Admiral Shares (VFIAX) and Vanguard S&P 500 ETF (VOO) is negligible. However, the expense difference from an active mutual fund to an active ETF can be nearly an entire percentage point. Better still is the trend of many managers now offering ETF versions of their popular mutual funds. This makes it an easy one-for-one switch in a plan line up.
Secondly, technology and trade settlement times make it easier for plan sponsors to record-keep and offer fractional ETF trading. The SECURE Act adds a whole host of new requirements on this front. Plan sponsors are already making the moves, and adding ETFs to their investment mix are now a no brainer.
There’s plenty of incentive for plan sponsors to switch to active ETFs in their plans.
Don’t forget to explore our Dividend Guide where you can access all the relevant content and tools available on Dividend.com based on your unique requirements.
We Could Finally See ETFs In Most Retirement Plans
There’s a surge in new active ETFs and a focus on lower fees by plan sponsors that are finally helping ETFs get into more retirement plans. While many of the benefits of ETFs, like tax efficiency, are muted in such plans, the comparatively lower costs of active ETFs are something that truly can be exploited by plan sponsors. And in that, we should see more migration of investment menus towards them. Given the lawsuits and other “nudging” in this direction, the change could be swift.
At that point, ETFs may truly arrive and be the top investment vehicle for savers.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.