Is There a Place for ETFs in Retirement Plans?

Exchange-traded funds offer benefits for both DB and DC plan investors, and, with advanced technology in recordkeeping systems, sources foresee a growing use of ETFs in DC plans.

Millennials favor exchange-traded funds (ETFs) more than other generations, according to a report by Charles Schwab about trends in retirement plan self-directed brokerage accounts (SDBAs). Millennials are a considerable portion of the U.S. workforce.

The low cost of ETFs is often cited as a positive feature of the funds. Yet, even as retirement plan fees are driven down and have been the subject of much litigation, ETFs have not been widely accepted by defined contribution (DC) plan sponsors. Tom Skrobe, head of product solutions at WisdomTree Asset Management, says ETFs are not very popular in DC plans for a variety of reasons, including recordkeeping hurdles and fiduciary concerns about allowing intra-day trading. Some worry that intra-day trading could distract participants from long-term investing goals.

However, Edward Gottfried, director of product at Betterment for Business, says the majority of assets in 401(k)s are invested with legacy platforms that were built with the assumption that only mutual funds were available to them. He adds that the DC plan recordkeeping platforms that existed early on were built on the backs of mutual fund trading systems. “They were built to recordkeep mutual funds and can’t handle the intra-day trading of ETFs,” he says. “The reason ETFs are not mainstream for DC plans has nothing to do with retirement investors. It is purely about who has been recordkeeping 401(k)s for the last 30 years.”

Gottfried continues on to say that there are no issues natively posed by ETFs to prevent them from being used in retirement plans. In fact, Betterment is one of several providers that has built its own recordkeeping and custody platforms for an all-ETF 401(k).

“We believe this is better for retirement plan investors. ETFs have lower fees and expense ratios than mutual funds in general,” he says. “Also, the ETFs are independently offered from Betterment so there is no possibility of conflicts of interest. As a result, plan sponsors can feel confident in fulfilling their fiduciary responsibilities.”

Collective investment trusts (CITs) and separate accounts are often touted as low-cost alternatives to mutual funds for DC plan investors, but Gottfried says ETFs are different from CITs and separate accounts. “We stress for plan sponsors and individuals that ETFs are accessible, flexible and low-cost, and they are highly liquid—designed to track mass market movement. There are diversified ETF offerings and because they are flexible, participants have the ability to buy in at fractional shares,” he says. “In addition, we believe that through ETFs, participants get access to underlying investment vehicles that are easier to understand, which creates less stress for them when selecting investments.”

ETFs enjoy more popularity in defined benefit (DB) plans than DC plans. Skrobe says very large, or mega, DB plans can access beta products inexpensively through separate accounts and commingled trusts, so ETFs aren’t used extensively by larger plans. However, for other DB plans, ETFs can be a great way to access a variety of investment themes and styles in an efficient way and at a lower cost, he says.

Skrobe says there is definitely a place for ETFs in retirement plans. “Plans come in all types and sizes, and, depending on the objective, an ETF product can be a great solution for a plan sponsor,” he says. “For example, if a mid-size DB plan wants to access an emerging markets equity fund, an ETF may be the right way to put that in motion because of the cost, efficiency and broad exposure of the asset class in one ticker.”

Adam Levine, investments director within Aberdeen Standard Investments’ Client Solutions Group, says he has seen more DB plan sponsors show an interest in ETFs as they’re in need of cheap, liquid products following the pandemic. In particular, some ETFs can offer exposure to private markets, which make them attractive.

“The use of ETFs is indeed growing due to its simplicity, liquidity and transparency and will likely continue to grow,” Levine says. “They offer easier access to investments that are more customized than broad indices, as well as additional flexibility allowing for intra-day trading.  ETFs also have lower fees relative to actively managed funds, which is a benefit for both DB and DC plan investors.”

Gottfried says he believes the use of ETFs in DC plans will continue to grow. “One positive trend we’ve seen is a strong competition in the 401(k) space that drives fees down, and the lower the fees, the greater the retirement benefit for participants,” he says. “Price pressure is not just about recordkeeping costs, but also investment fees. ETFs by nature have very low fees, and there will be continued movement of money from high fee mutual funds.

“We’ve seen many providers share talking points about why mutual funds are preferable investments, but that’s not about what’s in the best interest of participants—it’s about what providers can do,” Gottfried says. “Plan fiduciaries have a duty to make sure fees are reasonable and that means looking at a variety of vehicles.”