Focus on fees in 401(k)s

Exchange-traded funds have a way to go before they become a mainstay on 401(k) menus, but greater awareness of fees is encouraging advisers and plan sponsors to consider them.

Fee disclosure regulations instituted by the Labor Department last July require service providers, including record keepers and advisers, to spell out their fees and services for the plans they serve. A companion regulation followed in August making those disclosures to retirement plan participants mandatory.

Since then, the conversation about reducing those fees has been heating up — and passively managed vehicles, such as most ETFs, have been thrust into the spotlight.

“A growing number of clients were asking about it,” said Skip Schweiss, president of TD Ameritrade Trust Co. The firm began offering ETF-based 401(k)s in 2011. Other providers using ETFs in retirement plans include Invest n Retire LLC and ShareBuilder.

SCHWAB SET TO LAUNCH

The Charles Schwab Corp. will launch the ETF version of its Schwab Index Advantage 401(k) in the fourth quarter. The original version, which was launched last year and uses index mutual funds, has been selected by 50 retirement plans. It cuts down the average operating expense ratio for investments by 77% to $14.78 per $10,000 invested, according to Schwab.

The Center for Retirement Research at Boston College supports the concept of moving to lower fee structures. In a paper released last month, the organization’s director, Alicia H. Munnell, proposed banning high-fee actively managed mutual funds from 401(k)s and rollover IRAs. “Virtually all researchers agree that most actively managed equity funds can be expected to underperform index funds once fees are considered,” she wrote. “It makes no sense to expose the average participant to these options.”

Cost savings aside, ETFs currently make up only a small portion of 401(k)s. Mr. Schweiss said they account for about 3% of TD Ameritrade’s 401(k) client assets.

WHAT’S THE HOLDUP?

Because the record-keeping infrastructure for 401(k)s is based largely on the use of mutual funds, service providers have difficulty administering ETFs on these systems. For example, workers can’t own fractional shares of ETFs in their accounts. Further, most plans are built to accommodate end-of-day trading for mutual funds, but not the intraday trades that can take place with ETFs. There’s also the matter of transaction fees imposed each time a worker contributes to the plan. Dealing with those hitches is a daunting task for providers.

“If small participant accounts are investing in ETFs every two weeks, they could have their investments eaten by commissions if you don’t build the system correctly,” Mr. Schweiss said, noting that TD charges a flat fee instead of a transaction cost.

Plan advisers and other ob-servers said there’s a right way and a wrong way to make ETFs part of a 401(k) plan.

For instance, advisers who use the funds prefer to slot them into customized age- or risk-based portfolios. This way, employers can deter workers from impulsive intraday trading or keep them from investing whole-hog in any one ETF.

Richard C. Wolfe, a principal at Saddle River Capital Management LLC, works with Invest n Retire to provide plan clients with customized ETF portfolios.

The typical plan has five portfolios holding a blend of investments, including commodities, global equities, fixed income and real estate. He can provide the portfolios alongside his services as a fiduciary investment manager. “We think we’re better off acting as a manager,” Mr. Wolfe said. “The overwhelming number of participants want to have someone managing the investments for them.”

Invest n Retire, a record keeper, has relationships with about a dozen fiduciary investment managers, according to chief executive Darwin Abrahamson.

“Plan sponsors are hiring investment managers because they want two things: to transfer fiduciary responsibilities on selecting and monitoring investments and to give their workers better performance through professional management,” he said.

While a traditional mutual fund structure could cost as much as 150 basis points, Mr. Wolfe noted that his process can shave off close to 40 basis points from that expense — even including his own services as an adviser. Accounting for intraday trading fees, which equal about 10 basis points, the typical plan pays about 110 basis points all-in.

COLLECTIVE FUNDS

Gerald Wernette, principal at Rehmann Financial, places ETFs in collective funds. The advantage is that by doing so, workers don’t have to grapple with stand-alone versions of the fund in the plan menu.

“We can bring a lot of asset classes to the table that we may not want to bring to a traditional core lineup within a plan,” he added. “If I’m trying to build a lineup, how difficult will it be to explain an ETF that’s very narrowly focused — say an arbitrage ETF or one that focuses on currencies?”

Despite the fact that ETFs permit intraday trading, in reality, workers don’t trade much.

Mr. Schweiss noted that when ETFs are provided as a core plan menu option, those trades can be executed only at the end of the day. The funds also are available as components of portfolios managed by advisers or as a brokerage window option — which permits intraday trading and charges the cost to the employee.

“Employers want people doing their jobs, not trading all day,” Mr. Schweiss said.