Defined contribution plans keep distance from ETF options

Despite significant overall growth in exchange-traded funds, ETFs barely register in 401(k) plans.

Consultants, researchers and ETF providers say executives at plans larger than $100 million have shown little interest, primarily because the fees they pay for investment options such as institutional shares of index funds, collective trusts and separate accounts are as cheap or cheaper than those of ETFs. In larger defined contribution plans, ETFs might be included in a self-directed brokerage account, but they are rarely offered as core fund options.

“I don't see ETFs as a core investment in the foreseeable future,” said Robert Benish, executive director and interim president of the Plan Sponsor Council of America, Chicago.

“There's a long road ahead for ETFs in 401(k) plans,” said Alec Papazian, associate director at Cerulli Associates, Boston.

Several independent surveys show ETF use is still relatively rare among DC plans, and some also reflect doubts that ETFs will make immediate gains in the 401(k) universe.

• A PSCA survey published last October found no ETF use among 401(k) plans with 5,000 or more participants and little usage among plans with fewer participants. Of 15 investment approaches respondents were asked about, ETFs were used by less than 1% in 12 approaches and between 1.8% and 3.6% in the other three among plans with less than 5,000 participants.


• A January report by Callan Associates Inc., San Francisco, said its annual surveys of DC executives showed 2.3% of DC plans offered ETFs in 2012 vs. 2.5% in 2011 and zero in 2010. “All plans that use ETFs have less than $200 million in assets,” the report said.


• A Cerulli survey, published in May, found 401(k) assets accounted for only 0.2%, or $6 billion, of the $1.05 trillion in ETF assets at year-end 2011, the latest year for which Cerulli compared total and 401(k) assets. Overall ETF assets doubled between 2008 and 2011. The survey of ETF providers, accounting for more than 75% of ETF assets, showed they are more likely to target DC plans with less than $50 million in assets.

Cerulli's Mr. Papazian said “there are a lot of administrative complications” that represent “significant hurdles” for the use of ETFs in 401(k) plans. For example, he said 401(k) plans have been built to accommodate the end-of-trading-day accounting for mutual funds — not the intraday trading of ETFs. Also, mutual funds allow the purchase of fractional shares, but ETFs do not. And ETF trading fees can reduce or remove any cost advantage to participants, he said.

Although some record keepers have been able to address these various complications, Mr. Papazian said Cerulli's survey shows that improvements in technology haven't been enough to make ETFs attractive to large plans.

“These methods to incorporate ETFs likely come at substantial administrative costs,” said a Cerulli report on the survey. “A large ETF sponsor expressed that firms will have to come up with a way to offset these expenses similar to 12b-1 fees charged by mutual funds. Otherwise, significant traction in the 401(k) market will not occur.”

The Cerulli survey said only 25% of ETF providers cited 401(k) plans as a “major driver” of growth for this year, while 38% said 401(k) plans wouldn't be a source of growth. Another 38% said 401(k) plans would be a moderate source of growth.

Most of Aon Hewitt's DC record-keeping clients are big plans, but even those with assets of $100 million or more haven't expressed interest, said Winfield Evens, a partner at the Lincolnshire, Ill., firm. “It never comes from our clients,” said Mr. Evens, referring to inquiries about ETFs. “It never comes from consultants who serve our clients. It only comes from the press.”

Toni Brown, director of U.S. client consulting for Mercer in San Francisco, said she gets ETF inquiries from clients about twice a year. Once she shows them fees for ETFs vs. index-based strategies in institutional shares of mutual funds, collective trusts or separate accounts, however, “the discussion is over,” she said.

Of Vanguard's $287 billion in overall ETF assets, less than $1 billion is in DC plans for which Vanguard is the record keeper, said Joel Dickson, principal and senior ETF strategist in Malvern, Pa. “We don't see a huge percentage (of ETF business) coming from the 401(k) space,” he said.

Vanguard is record keeper for $320 billion in total DC assets.

Mr. Dickson expects exchange-traded funds' popularity to grow among plans with assets of less than $25 million. “It's not clear that the cost proposition for ETFs is compelling in large plans,” he said.

Gregory Porteous, director and head of defined contribution intermediary relationships for the U.S. and Canada at BlackRock Inc., New York, said BlackRock's “sweet spot” for DC plans using its ETFs is plans with $100 million in assets or less.

BlackRock has an institutional-plan DC team and an adviser-sold DC team. For the former, “we talk (to DC plan executives) about ETFs on the edges to complement a portfolio — but not so much on the core,” he said.

For plans using advisers, Mr. Porteous said the trend has been toward advisers building ETF portfolios — such as conservative, moderate or aggressive — for a fee rather than plans offering separate ETFs as core holdings.

Despite the paucity of ETF penetration in the DC market, Cerulli's Mr. Papazian said a potential “game changer” is the anticipated rollout later this year of an all-ETF program for 401(k) plans from Charles Schwab Corp., San Francisco.

Although Schwab hasn't offered many details, the ETF program will be modeled on the company's all-index mutual fund approach that was launched early last year.

The Schwab Index Advantage offers Schwab index mutual funds and other index mutual funds as core investment options, plus a professional advice service for participants. Depending on the sponsor, this program also can include a self-directed brokerage account.

Steven Anderson, executive vice president of Schwab Retirement Plan Services, said the ETF version would contain the advice component, allow for a self-directed brokerage account and offer ETFs from Schwab and from other firms. Like the index mutual fund program, the ETF program won't have trading fees, Mr. Anderson said.

He said the program will be aimed at 401(k) plans with assets ranging from $20 million to $5 billion — the same target as the index mutual fund program and Schwab's traditional 401(k) market. So far, the largest 401(k) plan using the Schwab Index Advantage has $480 million in assets.

Mr. Anderson said the program's record-keeping platform is being constructed to accommodate intraday trading and address such issues as fractional shares. “We're still in the buildout stage,” he said.

ETFs “will play a more dominant position over time (in DC plans) — but not immediately,” he added.