Many retirement plan advisors are looking at ways to reduce the overall cost of their 401(k) plans. According to a study by Deloitte and the Investment Company Institute2, over 74% of a plan’s cost is attributable to investment expenses. Thus, one of the best ways of reducing cost is to seek lower cost investment options. Whereas retirement plan advisors have historically only had the option of using index mutual funds as a passive component in their plans, many retirement plan providers have recently made exchange-traded funds (ETFs) available in a 401(k) plan’s investment lineup. Like index mutual funds, passively managed ETFs effectively track their benchmark and have low expense ratios.
One of the primary differences between ETFs in 401(k) Plans and index mutual funds is that ETFs in taxable accounts can be traded intraday like stocks. However, most retirement plan platforms only price ETFs once a day. In this regard, they trade exactly like mutual funds. The primary benefit, then, of choosing ETFs over index funds in a 401(k) plan would seem to be its lower expense ratio. But while one might assume that, all things being equal, the option with the lower expense ratio would be the better investment choice, all things in this situation are not equal. We can’t forget that an ETF in a retirement plan is likely to charge a commission for both the purchase and the sale of the ETF whereas a majority of index mutual funds are “no load” and do not charge a purchase commission. That is not to say the ETF may not be the better choice–it very well could be depending on the advisor’s investment management strategy for the model. However, both products are good choices for creating a low cost 401(k) plan.
If you are evaluating whether an ETF or an index mutual fund is better suited for your 401(k) plan, you should consider the following:
- 1. ETF commissions charged by the plan provider: A $1000 investment into an index mutual fund will result in a $1000 balance. However, if your plan provider charges a commission to purchase an ETF, a $1000 purchase will result in less than a $1000 balance since the commission amount will reduce the amount of the proceeds. There will also be a subsequent commission charge to sell the ETF.
- 2. ETF share price: If your open architecture 401(k) plan recordkeeper charges a commission to buy and sell an ETF, the ETF with the higher share price will result in a lower commission charge. For example, assume there are two S&P 500 ETFs that you are considering with identical expense ratios, you are seeking to purchase $1000 worth of ETFs for your plan, and your retirement plan provider charges a $0.05 per share commission. If one of the ETFs is trading at $100 and the other is trading at $50, your commission amount will be double for the $50 per share ETF since you will be purchasing twice as many shares. Whereas the share price of a mutual fund is rarely a factor used in evaluating an option, the same cannot be said for an ETF.
- 3. Expense ratios of both products: Assuming the ETF has a lower expense ratio, but also charges a commission, it is likely that you will have to hold the ETF a longer time period for its superior performance (due to the lower expense ratio) to compensate for the purchase and sale commissions. The time period will be a direct result of how much lower the expense ratio of the ETF is than that of the index mutual fund.
- 4. Availability of the product to track the desired index: Whereas both index mutual funds and ETFs have products that track common market indexes like the S&P 500, Russell 2000, and the Dow Jones Industrial Index, ETFs typically have more specialized funds available. Some examples include funds that invest solely in the China Small Cap, Consumer Stables, Biotechnology, and Malaysia indices.
One of the primary benefits of using an open architecture 401(k) plan provider is the ability to include either ETFs or index mutual funds in the plan’s investment; You will not be limited to proprietary products or to those that only pay revenue sharing, allowing you to truly create a low cost 401(k) plan.