Exchange-traded funds are a popular investment choice for many investors because of their benefits and low costs. For this reason, they have also been added to some retirement plans so that retirement planners have more to choose from.
There are advantages and disadvantages to using ETFs in a 401(k), so they might be a good fit for your retirement planning; however, they may not, depending on your goals, strategies, and financial circ*mstances. Here are some finer points to help you decide whether ETFs fit your 401(k).
Key Takeaways
- ETFs offer advantages such as low expense ratios, intraday trading, and diversification within a 401(k) plan.
- They are less popular in 401(k)s due to the traditional prevalence of mutual funds, which are more familiar to participants and have several benefits.
- ETFs' intraday trading capability can encourage excessive trading behavior and market timing, which plan sponsors aim to deter.
- ETFs introduce complexities in record-keeping and may require different operational processes within 401(k) plans.
- As the popularity of ETFs grows and participant preferences change, more 401(k) plans are beginning to incorporate them to provide additional investment choices.
Understanding ETFs in 401(k)s
There are generally two types of ETFs: passively managed and actively managed. Many ETFs are passively managed because they track an index or benchmark, which keeps activity—and thus costs—from the fund managers to a minimum.
For example, the actively managed Vanguard U.S. Minimum Volatility ETF (VFMV) has a low expense ratio of 0.13%. VFMV doesn't track an index but is benchmarked against the Russell 3000 Index. The Vanguard Russell 3000 ETF (VTHR) is passively managed and has an expense ratio of 0.10%.
These low fees make a difference in the overall returns of the ETF to investors and are one of the primary reasons ETFs became available in 401(k)s. Another reason for their availability is that they have been gaining in popularity since they were first introduced, so there is a demand for them. Plan sponsors, therefore, designed plans with ETFs to give participants more choices in their retirement planning.
The U.S. Census Bureau issued a 2021 survey for retirement plan participants. It found that 58% of baby boomers (age 56 to 64) had a retirement account, yet only 7.7% of Generation Z survey participants had a retirement account.
Advantages of ETFs in 401(k)s
Among the popular arguments favoring ETF plans is that index ETFs are less expensive than actively managed mutual funds. This may be true, but many excellent low-cost 401(k) plans offer a mix of index funds and actively managed funds.
Passively managed exchange-traded funds offer tax advantages because there is less trading activity within the fund. Minimal activity means there are fewer capital gains events triggered, which directly affect the fund's profitability. The fewer taxable events there are in a fund, the lower the overall cost is to the investor.
ETFs offer as much diversification as mutual funds because they are securitized baskets of funds.
The place where ETFs might work the best in a 401(k) plan is in the area of managed accounts. These might be offered instead of the target date funds customarily the staple managed account offering. However, it would still be up to the plan sponsor to vet these accounts and ensure they are appropriate for their participants. They would also want to ensure they can be used as qualified default investment alternatives.
For retirement planners who would prefer to have the choice to include nothing but ETFs in their plans, some sponsors have created plans that accomplish this. For example, robo-advisor Betterment launched a 401(k) product using all the ETF portfolios offered in its core service as managed accounts for 401(k) participants. The company offers a variety of portfolio plans ranging in offerings (e.g., the Essential, the Pro, and the Flagship plan), and each plan has a monthly base fee along with a "per participant" assessment charge.
Disadvantages of ETFs in 401(k)s
The use of ETFs makes the issue of cost disclosure that much tougher for plan sponsors due to the structure of many ETFs. One issue is the bid-ask spreads that can vary during the trading day. While not part of the ETF’s expense structure, this does represent a cost to the participants.
The issue of intra-day trading could also be problematic. This could result in different end-of-day values for the same holding among participants. The reality is that participants do talk to each other, and any situation like this is bound to surface, as participants could view it as unfair.
Concerns about ETFs in 401(k)s
Some ETF advantages are irrelevant in a 401(k) setting. For example, the ability to trade ETFs during the day is unlikely to appeal to employers who don't want employees sitting at their computers watching or trading their holdings during work hours.
Additionally, the option to trade in real time may or may not be available to plan participants, as 401(k) providers are likely to aggregate trades at the end of the business day to alleviate intraday trading expenses and employer concerns. In any case, retirement plans are not really designed for intraday trading. They are supposed to be long-term investments.
Many ETFs offer tax efficiency due to their structure, but this becomes irrelevant in a tax-deferred retirement plan such as a 401(k). It might be more tax-efficient to choose non-tax-deferrable investments to use in a 401(k) and keep ETFs in the investing portion of your portfolio.
How Do ETFs Differ From Mutual Funds in a 401(k) Context?
ETFs differ from mutual funds in several ways. ETFs trade on stock exchanges, which means you can buy and sell them throughout the trading day at market prices. Mutual funds are typically priced once a day after the market closes. ETFs also often have lower expense ratios than mutual funds and, in most cases, can provide more transparency into their holdings.
How Liquid Are ETFs, and Can I Trade Them Intraday?
ETFs are generally highly liquid because they are traded on stock exchanges. You can buy and sell ETFs throughout the trading day at market prices. Unfortunately, this benefit is usually lost among 401(k) investors, who are likelier not to want to trade securities often and throughout the day.
Are There Any Tax Considerations When Using ETFs in a 401(k)?
In a 401(k), tax considerations are generally less relevant because contributions and earnings can grow tax-deferred if contributions are made pre-tax. For after-tax contributions, taxes are deferred until you withdraw funds from the account (i.e. when you retire).
What Asset Classes Can I Access Using ETFs in My 401(k?
You can access various asset classes through ETFs in your 401(k), including domestic and international stocks, bonds, real estate investment trusts (REITs), commodities, and more. There are thousands of ETFs, but what is available to you depends on your plan's offerings.
The Bottom Line
ETFs are investment vehicles that allow 401(k) participants to invest in a diversified portfolio of assets. However, ETFs lag behind mutual funds in 401(k) plans because their intraday trading features and tax benefits, while appealing to some investors, seem to appear less attractive to others.
