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INVESTING

How ETFs might help retirees better manage distributions

With some exceptions, distributions from both defined benefit and defined contribution plans are made in cash, and either in the form of an annuity or as a lump sum.

But could the increasing use of exchange-traded funds for transitions and liquidity in pension plans, and the emerging trend of ETFs in smaller 401(k) plans change that calculus?

Although many legal boundaries stand in the way, instead of receiving a cash lump sum, retirees could instead receive a balanced portfolio of ETFs allocated based on a specific risk profile.

With the onset of digital advice from independent platforms as well as from traditional brokerage firms and wealth managers, the barriers to integrating an ETF portfolio into a beneficiary's new or existing account are falling.

According to Morningstar Inc.'s Q1 2017 ETF Managed Portfolios Landscape Report, as of March 31, 169 advisory firms managed 950 primarily ETF strategies with total assets of $99.7 billion. Large ETF issuers The Vanguard Group; State Street Global Advisors, a unit of State Street Corp. (STT); BlackRock (BLK) Inc. (BLK); and Charles Schwab Corp. (including Windhaven Investment Management) manage 30% of the assets in portfolios tracked by Morningstar.

And Morningstar's data do not include more flexible, customized portfolios from services such as Vanguard Personal Advisors Services, Betterment LLC or Wealthfront Inc., which have made index funds and ETFs part of their core offerings.

Yet, how liquid assets in a pension portfolio or ETF holdings in a defined contribution plan might match up with existing ETF-portfolio offerings, or the beneficiary's current or preferred portfolio, complicates the notion of an "in-kind" transfer of ETFs.

Cash remains the logical default for most distributions and rollovers, but does it have to be?

"Most people have no idea what to do with lump sums when they get them and there's a depressing record of investing them in high-cost products, or not investing them at all," said Joshua Gotbaum, guest scholar in the Brookings Institution's Retirement Security Project.

"It would be far better if the default were payment in a balanced portfolio of ETFs," said Mr. Gotbaum. "Achieving that would require the Department of Labor not to punish 401(k)s sponsors by saying that allowing such portfolio payouts makes them a fiduciary." Over the past few years, as ETF assets have grown to more than $2.9 trillion in the United States, "many institutions are introducing (ETFs) into their portfolios to enhance liquidity and reduce costs," wrote Greenwich Associates in its 2016 U.S. Exchange-Traded Funds Study. For both bond and equity ETFs, survey respondents cited liquidity and ease of use as the top benefits of integrating ETFs into their asset management process.

But why not carry that liquidity beyond the plan, particularly for lump sums?

Alex Benke, vice president of advice products for Betterment LLC in New York, said his firm already takes lump-sum cash distributions directly into traditional individual retirement accounts and immediately invests that cash "into our ETF portfolio according to the user's goals, benefiting from (Betterment's) asset location feature" that optimizes holdings based on tax status.

"A barrier in working with pension plan distributions is the spousal signoff, as an IRA accepting the funds could specify a different beneficiary," said Mr. Benke. On the defined contribution side, Mr. Benke acknowledges the challenges in accepting company stock within a plan, which must be transferred into a taxable brokerage account in order to benefit from the treatment of net unrealized appreciation.

One area where ETFs are enabling external pension transactions is in pension risk transfers between funds and insurance companies, said Michael Schlachter, U.S. wealth defined benefit segment leader for Mercer Investment Consulting. "Fewer securities transferred between the two parties could potentially lower costs," said Mr. Schlachter.

For a lump-sum distribution directly to a beneficiary, however, there is no requirement for the plan to assist with the management of assets or cash after the distribution. "What's the societal risk attached to a beneficiary receiving a lump sum for a payment that was supposed to be an annuity?" asked Mr. Schlacter. "The education need is significant."

Clearly, operational issues abound, said Mr. Schlachter. If the beneficiary was promised a certain cash payment, what happens if a portfolio of securities including ETFs quickly deviates from that promised cash level? How would basis be considered? And what about the commercial relationships with a broker or adviser — who would make those decisions?

"It's a lot to consider for the pension fund to save a handful of basis points in order to deliver an ETF portfolio," said Mr. Schlachter.

Peter Ehret, director of internal credit at $26.5 billion Employees Retirement System of Texas, Austin, acknowledged that transferring the exposure of the $1.6 billion portfolio he manages would be a challenge in an in-kind distribution setting, similarly for other less-liquid pension investments such as real estate and private equity.

Mr. Ehret, however, suggested that a broadening of distribution options for beneficiaries, including the potential for re-investment in the plan, would also be interesting to consider.