With lawsuits continuing to be lodged against defined contribution (DC) retirement plan fiduciaries over what the plaintiffs claim are excessive fees, it may be incumbent on retirement plan sponsors to consider offering exchange-traded funds (ETFs) in their investment lineup.
However, experts are mixed as to whether ETFs that charge single-digit basis point fees offer an advantage over institutionally priced index funds. They say recordkeeping systems lack the capacity to handle ETF trades; the advantages of ETFs are negated in a qualified, long-term account; and making intraday trading an option for participants could serve as a distraction at work.
Currently, 91.7% of retirement plans have traditional ’40 Act mutual funds on their investment lineup, according to the 2018 PLANSPONSOR Defined Contribution Survey Benchmarking Report. A mere 13% of retirement plans offer ETFs in their lineup.
But it is worth considering participants’ growing interest in ETFs and their explosive growth in assets in the past decade. Assets in ETFs in the U.S. increased seven-fold from $716 billion in 2008 to $5.02 trillion in 2018, according to Statista, a provider of statistics, consumer survey results and industry studies.
Two retirement plan platforms that were launched with the express interest in offering ETFs are from Vestwell and Betterment. Aaron Schumm, chief executive officer of Vestwell, based in New York, specifically wanted to offer ETFs on the Vestwell platform that went live in 2018 because ETFs have “become household names, and are more liquid and lower cost than mutual funds. Plus, you don’t have to worry about the share class issues you have in the mutual fund world, such as 12b-1 or other back-end revenue-share fees.”
Betterment launched its recordkeeping platform in 2010, starting off exclusively as an ETF investing platform, says Adam Grealish, director of investing, based in New York. The reason Betterment wanted to offer ETFs is because its platform supports savings goals other than retirement.
“Many people are saving for retirement in a taxable account, or saving for other goals in a taxable account,” Grealish notes. “The tax efficiency that is structural to an ETF product is a major benefit. For the qualified accounts, this is not going to matter, but for the taxable accounts, it does.”
ETFs incur substantially less capital gains than mutual funds, he explains. “Mutual fund shareholders’ taxes are influenced by redemptions from other shareholders,” he says. “The fund has to sell shares to meet redemptions, which in turn hits investors with capital gains. ETF shares, on the other hand, are bought and sold on the secondary market.”
There are a few reasons why industry insiders think ETFs offer benefits to retirement plan participants other than their growing interest in them. Fund accounting and plan administration provider Nottingham, in Rocky Mount, North Carolina, has ETFs in its own retirement plan. The firm included them to offer participants exposure to niche sections of the market that some ETFs track, specifically “different parts of the economy, different geographic areas of the world, and different industries,” says Kip Meadows, chief executive officer.
“If you want to be diversified, these solutions make a lot of sense,” he adds. “Now that the ETF market has become mature, as more employers hear from their employees that they want to invest in them, their plan administrators will make that happen.”
Small plans that do not have access to the low-cost institutional share classes of mutual funds could also benefit from including ETFs in their lineup, says Mitch Reiner, chief operating officer of Capital Investment Advisors in Atlanta.
Issues with recordkeeping ETFs
Other than these upsides, it is important for plan sponsors to realize that the many of the benefits of ETFs are cancelled out when included in qualified accounts, Brian Kraus, head of investment consulting and internal sales at Hartford Funds, says. “They ability to trade throughout the day, their tax advantages and their transparency to their underlying holdings are less of an advantage in the defined contribution world, because [DC retirement plan] accounts are long-term and buy-and-hold driven.”Reiner also contends that if participants were to day-trade ETFs, that would be a major distraction from their work.
Vestwell and Betterment aside, industry insiders say that traditional recordkeeping platforms are ill-equipped to handle ETF trades.
Global X, an ETF provider in New York, has a few clients that manage money on behalf of retirement plans, says Rohan Reddy, a research analyst with the firm. However, most of the interest is coming from international pension funds, rather than U.S.-based pensions or retirement plans.
“The biggest hesitancy to offering ETFs in a retirement plan is that ETF trading can be difficult to manage,” Reddy says. “ETFs offer fractional shares, limit orders and intraday trading.”
Kraus agrees that the recordkeeping infrastructure that was built mainly to support end-of-day net asset values (NAVs) for mutual funds is a major impediment to the adoption of ETFs in retirement plans. “The infrastructure of the recordkeeping business was effectively designed prior to the launch of ETFs,” he says. “It was not set up for some of the schematics of ETFs, so I would say there are more headwinds than tailwinds.”