The Case for Including ETFs in Your 401(k) Plan
At Betterment, we firmly believe Exchange-traded funds (ETFs) are better for 401(k) plan participants. Wondering if ETFs may be appropriate for your plan?
Mutual funds dominate the retirement investment landscape, but in recent years, exchange-traded funds (ETFs) have become increasingly popular—and for good reason. They are cost-effective, highly flexible, and technologically sophisticated. And at Betterment, we firmly believe they’re also better for 401(k) plan participants. Wondering if ETFs may be appropriate for your 401(k) plan? Read on.
What’s the difference between mutual funds and ETFs?
Let’s start with what ETFs and mutual funds have in common. Both consist of a mix of many different assets, which helps investors diversify their portfolios. However, they have three key differences:
- ETFs can be traded like stocks. However, mutual funds may only be purchased at the end of each trading day based on a calculated price.
- Mutual funds are either actively managed by a fund manager who decides how to allocate assets or passively managed by tracking a specific market index (such as the S&P 500). However, ETFs are usually passively managed.
- Mutual funds tend to have higher fees and higher expense ratios than ETFs.
Why do mutual funds cost so much more than ETFs?
Many mutual funds are actively managed—requiring in-depth analysis and research—which drives the costs up. However, while active managers claim to outperform popular benchmarks, research conclusively shows that they rarely succeed in doing so. See what we mean.
Mutual fund providers generate revenues from both stated management fees, as well as less direct forms of compensation, for example:
- Revenue sharing agreements—These agreements among 401(k) plan providers and mutual fund companies include:
- 12(b)-1 fees, which are disclosed in a fund’s expense ratios and are annual distribution or marketing fees
- Sub Transfer Agent (Sub-TA) fees for maintaining records of a mutual fund’s shareholders
- Internal fund trading expenses—The buying and selling of internal, underlying assets in a mutual fund are another cost to investors. However, unlike the conspicuous fees in a fund’s expense ratio, these brokerage expenses are not disclosed and actual amounts may never be known. Instead, the costs of trading underlying shares are simply paid out of the mutual fund’s assets, which results in overall lower returns for investors.
- Soft-dollar arrangements—These commission arrangements, sometimes called excess commissions, exacerbate the problem of hidden expenses because the mutual fund manager engages a broker-dealer to do more than just execute trades for the fund. These services could include nearly anything—securities research, hardware, or even an accounting firm’s conference hotel costs!
All of these costs mean that mutual funds are usually more expensive than ETFs. These higher expenses come out of investors’ pockets. That helps to explain why a majority of actively managed funds lag the net performance of passively managed funds, which lag the net performance of ETFs with the same investment objective over nearly every time period. Want to know more about mutual funds’ hidden fees?
What else didn’t I realize about mutual funds?
Often, there are conflicts of interest with mutual funds. The 401(k) market is largely dominated by players who are incentivized to offer certain funds: Some service providers are, at their core, mutual fund companies. And therefore, some investment advisors are incentivized to promote certain funds.
This means that the fund family providing 401(k) services and the advisor who sells the plans may have a conflict of interest. As noted in a report by the Center for Retirement Research (CRC), 76% of plans had trustees affiliated with mutual fund management companies, which creates a conflict of interest.
Why is it unusual to see ETFs in 401(k)s?
Mutual funds continue to make up the majority of assets in 401(k) plans for various reasons, not despite these hidden fees and conflicts of interest, but because of them. Plans are often sold through distribution partners, which can include brokers, advisors, recordkeepers or third-party administrators. The fees embedded in mutual funds help offset expenses and facilitate payment of every party involved in the sale. However, it’s challenging for employers and employees because the fees aren’t easy to understand even with the mandated disclosure requirements.
Another reason why it’s unusual to see ETFs in a 401(k) is existing technology limitations. Most 401(k) recordkeeping systems were built decades ago and designed to handle once-per-day trading, not intra-day trading (the way ETFs are traded)—so these systems can’t handle ETFs on the platform (at all).
However, times are changing. ETFs are gaining traction in the general marketplace and companies like Betterment are leading the way by offering ETFs.
Why should I consider ETFs for our company’s 401(k)?
Simply put, ETFs are the next level in access, flexibility, and cost. Here’s a look at key attributes that may make ETFs right for your 401(k) plan:
- Low cost—As we’ve described, ETFs generally cost far less than mutual funds.
- Diversified—Most exchange-traded funds—and all ETFs used by Betterment—are considered a form of mutual fund under the Investment Company Act of 1940, which means they have explicit diversification requirements. Appropriate diversification ensures that you’re not overly exposed to individual stocks, bonds, sectors, or countries—which may mean better returns in the long run.
- Flexible—ETFs are extremely versatile. They can be accessed by anyone with a brokerage account and just enough money to buy at least one share (and sometimes less—at Betterment we trade fractional shares, allowing our customers to diversify as little as $10 across a portfolio of 12 ETFs.)
- Sophisticated—ETFs take advantage of decades of technological advances in buying, selling, and pricing securities. Learn more about these five attributes now.
What’s even better than ETFs?
At Betterment, we believe that a portfolio of ETFs in conjunction with personalized, unbiased advice is the ideal solution for today’s retirement savers. Our retirement advice adapts to your employees’ desired retirement timeline and can be customized if they’re more conservative or aggressive investors.
Not only that, we also link employees’ outside investments, savings accounts, IRAs—even spousal/partner assets—to create a real-time snapshot of their finances. It makes saving for retirement (and any other short- or long-term goals) even easier.
You may be wondering: What about target-date funds? Well, target-date funds are still popular, but financial advice has progressed far beyond using one data point—employees’ desired retirement age—to determine their investing strategy. Here’s how:
- Target-date funds are only in five-year increments (for example, 2045 Fund or 2050 Fund). Betterment can tailor our advice to the exact year your employees want to retire.
- Target-date funds ignore how much employees have saved. At Betterment, we can tell your employees if they‘re on or off track, factoring in all of their retirement savings, Social Security, pensions, and more.
- Target-date funds only contain that company’s underlying investments (for example, Vanguard target-date funds only have Vanguard investments). No single company is the best at every type of investment, so don’t limit your employees’ retirement to just one company’s investments.
Smart, savvy advice for today’s retirement savers
Betterment’s automated advice engine and portfolio selection are guided by a human team of experts on our investment committee. They are free to select the best investments we can find, regardless of who makes them.
You may be thinking: it’s time to have a heart-to-heart with your 401(k) provider or plan’s investment advisor. If so, here’s a list of questions to ask:
- Do you offer ETFs? If not, why not?
- What are the fees associated with our funds?
- Are there revenue sharing agreements in place?
- Are there any soft-dollar arrangements we should be aware of?
- Are you incentivized to offer certain funds?
- Are there any conflicts of interests that we should be aware of?