ETFs in 401(k)s – The Future is Now

In recent months there has been much misinformation swirling about in the media regarding the usefulness of ETFs in 401(k) plans.   Irrational trepidation and technical impediments have prevented more widespread usage of ETFs in 401(k)s.

ETFs are a valuable tool that can easily be incorporated into retirement plans.  For those who seek out select administrators, options are extremely cost effective.

Much of the reluctance of the marketplace toward utilizing ETFs in 401(k)s can certainly be attributed to the fear of the unknown. Advisors have been timid to put retirement plans at what they erroneously perceive as risk; using an investment vehicle in an unproven system. Mutual funds have long been the industry standard for 401(k) plans, but only for lack of alternate options. With the advent of ETFs, financial professionals can now exert greater control over the plans they administer, incur lower costs, and have greater access to more diverse investment opportunities.

As an added bonus for advisors, unlike mutual funds, the transparency of indices and ETFs allow their long-term historical returns to easily be verified. ETFs allow Financial Advisors and RIAs to offer an array of sound investment options to their clients and to know the precise makeup of the holdings in plan portfolios. This allows for true diversification. For an industry pleading for greater independence, transparency and disclosure, and increased access to open-architecture platforms, ETFs are ideal.


Much scrutiny in the press has been focused on the fees generally associated with the acquisition of and divestiture of ETFs. To rebut the argument that these fees impact ETF feasibility in retirement plans, it should first be stated that there are always fees involved with all transactions. Those who argue that mutual funds do not charge fees for every trade and transaction are oblivious to the fact that fund holders do, in fact, pay those fees.  Those costs are listed as line item expenses in annual reports, if they are disclosed at all. ETFs simply have the (mis)fortune of transparency. The question must always be asked,  Who eats the costs?   In the case of mutual funds, it is the participant. Not so in the case of ETFs. The financial institutions that use RPG’s platform incorporate all of these trading costs in their Custodial Fee. Because the cost savings of ETFs are so significant when compared to the average investment expenses of mutual funds, the plan will still pass along substantial savings to the plan participants.

Administrators get compensated independent of the investment options chosen by the sponsor; whether mutual funds, ETFs, or a combination of the two are selected. So why would an administrator navigate the complexities of creating an ETF-capable platform?  A short answer would be that plan sponsors, Financial Advisors, and participants are pleading for such options. Plan sponsors or Financial Advisors do not want to be held culpable for not advocating fully on their charges behalves. The longer answer would involve the implications of the Department of Labor (DOL) legislation and guidance mandated by the Pension Protection Act discussed in greater detail below.  If there are more efficient options in the marketplace, Financial Advisors and plan sponsors have an obligation to investigate them.

Other Costs

Several other factors that have routinely lead to derision of ETFs as useful 401(k) tools are the so-called cash drag factor, the lost opportunity of the monies kept in cash accounts for distributions; and the inability of ETFs to be traded as partial shares. To address the latter concern, RPG has customized their software and procedures to resolve the specific issues pertaining to the requirements of exclusively trading ETFs in whole shares. As for the cash drag liability, RPG and the financial institutions that custody assets for RPG’s platform do not maintain surplus cash accounts for distributions, but rather RPG authorizes the financial institutions to sell the ETFs only upon requests for distributions. While it is true that custodians holding mutual funds in retirement plans do not have to maintain cash funds for distributions, mutual funds themselves generally do, adding once again to their implicit costs, further rebutting the argument against ETF usage in favor of mutual funds.

Another perceived deficiency of utilizing ETFs rather than mutual funds is the cost associated with spreads, known as slippage. The spread, referring to the differential between the asking and selling prices of equities, such as ETFs, is a profit center for most trading houses. The average expense of 4 bps between the two values is an implicit cost to buyers and to sellers. What ETF detractors fail to comprehend is that mutual funds also incur these costs. These costs, like many other costs, are incurred by holders of mutual funds, but not explicitly. The costs are only disclosed as line items on statements or they are not disclosed at all.  In the process of buying and selling of all underlying mutual fund equities, costs must always be incurred. While similar in the aforementioned sense, ETFs exert the advantage of minimizing overall spread expenses, by aggregating the buying and selling for a group of underlying stocks, rather than separately buying and selling individual stocks. Though they are likely to benefit from bulk rate purchasing and selling, mutual funds are still subject to some spread costs for individual stocks, thus eroding gains.

While it remains true that the superior tax-efficiency of ETFs in relation to mutual funds is a non-factor in retirement plans, ETFs still maintain a host of benefits that mutual funds cannot boast. ETFs enjoy significant cost advantages over mutual funds by not being subject to 12b-1, purchase, redemption, exchange, high management, and account fees. Passive ETFs claim no interim buying and selling expenses which are implicit and rarely disclosed costs to mutual fund holders.

Legislative Imperative

With the proposed DOL legislation poised to go into effect in January 2009, plan custodians and administrators will have greater incentive than ever to reduce fees charged to participants. The nascent regulation would require plan fiduciaries to disclose plan and investment-related information, including data on fees and expenses, to participants and beneficiaries in participant-directed individual account plans (including 401k plans). The regulations, when finalized, would be effective for plan years beginning on or after January 1, 2009. New requirements for participant statements would contain identifying information including the names of investment alternatives, website addresses for those investment alternatives, investment category, and management type (e.g., active or passive), past performance data for variable return investments, comparable benchmark returns, and fee and expense information.

The effect of the impending legislation will certainly bolster the ongoing shift toward greater transparency and disclosure in retirement plans, which in turn will lead to more efficient investing in retirement platforms, sending an increasing percentage of dollars to ETF-intensive plans. While ETFs currently comprise only a small fraction of all retirement investment allocations, that share is now growing rapidly. Trendsetters like RPG who have invested in creating platforms that allow the inclusion of ETFs will inevitably be joined by others wanting to capitalize on the unavoidable movement. But, at the moment, few providers exist capable of offering an ETF-capable platform for technical reasons, for simplicity in offerings reasons, and for lack of investment in new systems. ETFs in 401(k)s are feasible, practical, but foremost, economical. ETFs are valuable investment vehicles that will undeniably play an important role in the future of retirement investing.

Alvin Rapp is the founding partner of RPG Consultants.  Mr. Rapp is an accomplished Retirement Plan Consultant and Third Party Administrator and has been involved in the industry for over twenty years.  Since its founding, RPG Consultants, has offered innovative retirement plan consulting, actuarial, administration and recordkeeping services.  RPG is one of the first companies in the country to bring to the marketplace a true open-architecture, daily valuation, recordkeeping platform that allows the use of ETF’s as an investment choice. For questions or comments on this article, the author can be reached at

– September 3, 2008