Why 401(k) plans are the “final frontier” for exchange-traded funds

Although many investors have flocked to exchange-traded funds, they haven’t gained much traction among 401(k) plan participants.

Exchange-traded funds, or ETFs, debuted in the early 1990s and have since captured approximately $10 trillion.

Mutual funds hold about $20 trillion, but ETFs have reduced their dominance: ETFs have a 32% market share of mutual fund assets, up from 14% a decade ago, according to data from Morningstar Direct.

“ETFs are becoming the new structure to use in wealth management type accounts,” said David Blanchett, head of retirement research at PGIM, the investment management arm of Prudential.

However, this same zeal has not been true for investors in occupational pension schemes, a huge and largely untapped potential for the ETF sector.

At the end of 2023, 401(k) plans held $7.4 trillion, according to at the Investment Company Institute, or ICI, and had more than 70 million participants. Other 401(k) plans, such as those for college and local government workers, held another $3 trillion, according to ICI data.

But virtually none of these assets are in ETFs, experts say.

“There is a lot of money [in workplace plans]and there will be more,” said Philip Chao, a certified financial planner who consults with companies about their retirement plans.

“This is the last frontier [for ETFs]in the sense of trying to capture the next big pool of money,” said Chao, the founder of Experiential Wealth, based in Cabin John, Maryland.

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About 65% of 401(k) assets were invested in mutual funds at the end of 2023, according to ICI data. The group does not publish corresponding statistics for ETFs.

A separate report from the Plan Sponsor Council of America, a trade group representing employers, suggests that ETFs hold only a tiny fraction of the remaining share of 401(k) assets.

The PSCA report examines the relative popularity of investment structures, such as mutual funds and ETFs, across approximately 20 types of investment classes, from stock funds to bond and real estate funds, in 2022. The report revealed that 401(k) plans use ETFs. most commonly for sector and commodity funds – but even then they only did so 3% of the time.

Mutual funds, collective investment trust funds and separately managed accounts held the lion’s share of 401(k) assets across all investment categories, according to PSCA data.

Such investment vehicles serve the same basic function: they are legal structures that pool investors’ money.

There are, however, some differences.

For example, ETFs have certain advantages for investors over mutual funds, such as tax advantages and the ability to transact intraday, experts say.

However, these benefits are “irrelevant” in 401(k) plans, Blanchett said.

The tax code already gives 401(k) accounts preferential tax treatment, making ETFs’ advantage over capital gains tax a moot point, he said.

Blanchett said 401(k) plans are also long-term accounts in which frequent trading is generally not encouraged. Only 11% of 401(k) investors made a trade or exchange in their account in 2023, according to Vanguard data.

Furthermore, in occupational pension plans, there is a decision-making level between the funds and the investors: the employer.

Company officials choose which investment funds they offer to their 401(k) participants, meaning investors who want ETFs may not have them available.

There may also be technological barriers to change, experts say.

The traditional infrastructure that underpins workplace retirement plans wasn’t built to handle intraday trading, which means it wasn’t built for ETFs, Mariah Marquardt wrote, head of capital markets strategy and operations at Betterment for Work, in a 2023 article. analysis. Investor orders for mutual funds are evaluated only once per day, at market close.

There are also well-established payment and distribution arrangements in mutual funds that ETFs cannot accommodate, experts say.

Mutual funds offer many different share classes. Depending on the class, the total mutual fund fees paid by an investor can include fees for many different players in the 401(k) ecosystem: the investment manager, the plan administrator, the financial advisor and others. other third parties, for example.

These mutual fund net fees are split and distributed to these different parties, but investors generally don’t see these line items on their account statements, Chao said.

Conversely, ETFs only have one share class. They don’t have the ability to consolidate these distribution fees, which means investors’ expenses appear as multiple line items, Chao said.

“A lot of people like to have just one item,” Chao said. “It feels like we’re no longer paying fees.”

“It’s almost like ignorance is bliss,” he said.