ETFs Shunned By Many 401(k) Plans

(Dow Jones) The investing world's current darlings, exchange-traded funds, get no love from 401(k) plans.

Investment advisors like ETFs for a bunch of reasons: They carry lower fees than most mutual funds, offer tax advantages and can trade like stocks. What's more, an ETF price war broke out among big financial firms this spring--driving expenses and commissions even lower.

So why aren't advisors, many of whom consult to corporate retirement plans, pushing to include ETFs in 401(k) portfolios? By the most generous estimates, only 5% of the $830 billion invested in ETFs is held within 401(k) plans.

Many advisors say the problem is simple: ETFs just aren't a good match for 401(k)s. The big advantages that the funds offer get lost inside 401(k)s, these advisors say, and ETFs can bring technical headaches for the companies that manage the plans, so many don't want to offer them.

Ary Rosenbaum, a retirement-plan lawyer in Garden City, N.Y., is among the skeptics. While he uses ETFs for his own investments, Rosenbaum says he can't get the numbers for ETFs in 401(k) plans to add up. "Index mutual funds are already low cost," he says, one reason they are popular in 401(k)s.

While ETFs can have similar or lower expenses--sometimes under 0.2% or even 0.1% of assets a year--investors generally must pay brokerage commissions to buy or sell them, unlike most funds in a corporate plan. (The total cost of a 401(k) plan can run above 1.5% of assets.)

Further, in a 401(k), investors typically won't be able to take advantage of one of the key appeals of ETFs--the fact that they trade all day long rather than just once a day, as is the case for mutual-fund shares.

Likewise, Roger Wohlner, a Chicago-based financial planner, likes ETFs but hasn't seen a reason to include them in the nine retirement plans he advises. While he generally recommends one or more index mutual funds to his clients, the ETF inclusion "feels like a solution looking for a problem," he says.

Vanguard Group, which manages two of the 10 largest ETFs in the U.S., is of similar mind. In a September research note, the Vanguard Center for Retirement Research said that, while index ETFs may be a substitution for "high-cost actively managed funds," in 401(k) plans, the true advantages of an ETF--intraday trading and tax efficiency--are less relevant to a tax-sheltered retirement account.

ETFs add more complications. An ETF that tracks an index can see its price vary from the value of the underlying securities if the index is thinly followed or if there's low demand for the ETF itself. Recent events have also set the ETF faithful back a few steps. More than two-thirds of the securities that saw aberrant trading during the May 6 "flash crash" were ETFs, for reasons that remain unclear.

Those aren't the only roadblocks ETFs face. Large corporate plans have access to the lowest-cost mutual funds, negating a large part of ETFs' price advantage. They also have access to collective trusts--very-low-cost institutional accounts managed by banks.

At smaller companies, the obstacle is operating costs. Traditional mutual funds offer an easy way to pass costs along to participants: Many funds have special classes of shares for retirement plans that have extra fees built in to compensate advisors and service providers, as well as paying for record keeping and administration.

Such fees, including 12b-1 fees earmarked for marketing and distribution, can run to 0.5% or more of assets per year. ETFs generally don't have 12b-1 fees, so they don't offer that kind of bundling.

What's more, it's much tougher for third-party administrators of retirement plans to tackle trading and acquisition of ETF shares on behalf of the plan participants, as well as managing the record keeping for fractional-share ownership.

Still, a number of companies see opportunities to offer ETF-based 401(k) plans.

Darek Wojnar, managing director of product strategy for BlackRock Inc.'s iShares unit, the biggest issuer of ETFs, is working with third-party administrators to overcome the largest technical barriers to holding ETFs in the plans. So far, 60 administrators--in an industry of about 1,600 overall, according to Judy Diamond Associates--are set up to handle ETF transactions.

As for investor assets, iShares had $2.7 billion of its overall $352 billion in ETFs housed in 401(k) plans at the end of June.

In March, Folio Investments launched Folio(k), a series of 401(k) offerings structured around ETFs. In the program--as with similar programs from other providers--participants can mix and match ETFs as they wish, or choose among portfolios of index ETFs in specific risk- or age-based allocations.

Several other firms, including ING Direct and Ascensus, are catering to plans looking to incorporate ETFs.

Some smaller players are getting in on the game, too. Brenda Wille-Cope, a managing partner at First Financial Strategies in Denver, moved her company's own plan to risk-based ETF model portfolios constructed by 3D Asset Management of East Hartford, Conn.

Wille-Cope says the new plan has cut roughly a half percentage point from their retirement-investment costs. And "you see exactly what is charged against your account," she says.