Commentary: The role of ETFs in qualified retirement plans

The total value of company-sponsored defined contribution plans was about $5 trillion as of early 2018, according to the Investment Company Institute. The ICI estimates more than $3.4 trillion of that amount is held in open-end traditional mutual funds, while ETFs represent only a fraction of the remaining $1.6 trillion.

With the recent growth in ETFs among the general investing public (investors added $315.4 billion to ETFs in 2018 alone), paired with the outflows and flatlined growth in open-end funds, the obvious question is: "Why are ETFs not more popular in retirement plan accounts?"

The answer appears to be a combination of factors.

Retail investors have focused on ETFs, at least thus far, for tax efficiency and ease of use in shorter-term trading strategies. However, retirement plans are by structure tax efficient, negating any benefit of this ETF attribute. Additionally, short-term trading is ill-advised in retirement plan accounts, and most retirement plans make short-term trading difficult to implement, so again this ETF attribute is irrelevant in a retirement plan structure.

There are also some technical and logistical issues that have historically kept ETFs from being an easy option for most retirement plan participants.

A major issue is the platforms used by retirement plan administrators. For nearly 30 years, the mutual fund industry and its trading infrastructure through the DTCC Fund/SERV platform has made mutual fund investing seamless with reporting and record keepers. ETFs, by comparison, trade like equities through a broker-dealer platform.

In order to include ETFs, a qualified plan would have to have access to a brokerage account, often called a "window" in industry parlance. The plan's record keeper would require accurate interfaces to update ETF positions, if held. While there does not appear to be a database that tracks the number of current active retirement plans that have access to brokerage windows, most industry pros acknowledge the percentage is currently small.

There is also a mathematical issue, or perhaps better stated as a trading issue, in utilization of ETFs in qualified plans. Most retirement plan contributions are made as a percentage of salary, which multiplies out to be an uneven dollar amount. Open-end traditional mutual funds can easily be purchased in a specified dollar amount, with fractional shares issued for the contributed amount. ETFs, on the other hand, trade like stocks, so shares are purchased in even share amounts. This can result in the retirement plan contribution not being fully invested as the computation comes out uneven.

One way of handling this disparity is with omnibus accounts for the retirement plan as a whole, whereby the broker-dealer purchasing shares for the retirement plan does the subaccounting for the participants. The total dollar amount of each ETF would be at the plan level rather than the individual level, with the cash differential being minimal in the aggregate.

That said, there are various characteristics to ETFs that make them an attractive option for retirement plan accounts moving forward.

A key component of ETF analysis is the expense ratio, which is typically lower than a comparable open-end mutual fund. The inexpensive aspect of ETFs remains an advantage in any type of account and will probably lead to greater popularity of ETFs in the future. As the ETF industry continues to mature, the variety and targeted nature of ETFs will also remain an important attribute and attraction for retirement accounts.

Another aspect of ETFs becoming more attractive to the qualified plan community is product mix. There are many mutual fund programs tailored to retirement planning, target-date and lifestyle investment objectives where the fund investment policies are designed to match the future retirement timing and goals of the plan participant. While ETFs can certainly mimic these styles, there is a distribution component to what investment options are utilized by retirement plan sponsors. The current network of wealth managers and retirement planning consultants have a long history of utilizing existing mutual fund programs. The adage, "if it ain't broke, why fix it?" does apply.

In order to effectively compete for the attention of these plan advisers, there will need to be something of a paradigm shift, or at least an addition to the marketing strategy of the ETF industry. There will likely emerge both fund families and independent consulting firms that shift more of their focus to creating lifestyle and target-date strategies using ETFs as the underlying vehicle. In fact, many of the mutual fund strategies use underlying ETFs to accomplish the investment goals.

Like most business changes, plan administrators and platform providers will make these additional features available when there is sufficient demand to justify the increased cost of adding another channel of investment options.

Kip Meadows is the founder and CEO of Nottingham, a Rocky Mount, N.C.-based fund administration firm and white-label ETF issuer. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.