Despite the impressive growth of ETF assets over the past several years hardly any of it has come from retirement plans like 401(k)s.

Critics claim that ETFs have no business inside 401(k) plans, but are they right? Will ETFs shakeup the slow-moving 401(k) market?

Let’s analyze why ETF(k) retirement plans make sense. 

Today’s 401(k) Market

Defined contribution (DC) plans like 401(k) plans, 403(b) plans and profit-sharing plans are today dominated by mutual funds or company stock. At the end of 2009, employer-sponsored DC plans held $4.1 trillion in assets, with the largest share in 401(k) plans ($2.75 trillion in assets), according to the Investment Company Institute.

Last year investors poured $118 billion into ETFs, according to Strategic Insight, and total assets in both ETFs and ETNs in the U.S. are projected to reach $1 trillion by 2012. Just how much ETF(k) plans will contribute to that asset growth in the future is up for debate, but defined contribution plans are a huge opportunity.

Despite the proliferation of ETFs, most 401(k) plans have not yet adopted them. Why? It’s because today’s 401(k) market is mostly built on outdated legacy retirement platforms that only accommodate mutual funds. For that reason, the Ford Edsel is a good analogy to today’s 401(k) marketplace. It’s an expensive, burdensome and inefficient jalopy. And just like the Edsel, will oblivion be written on the tombstone of 401(k) service providers that don’t change? 

Lower Investment Costs

There are many components to a 401(k) plan that result in many fees. But the single largest cost within most 401(k)’s is investment-related charges.

The annual investment fees for ETFs are often 75% to 90% lower compared to actively managed mutual funds. But in the context of large corporate 401(k) plans with price negotiating power, those fees may narrow, especially if the plan is using index mutual funds. However, ETFs unlike mutual funds do not have hidden pay schemes like 12b-1 fees attached to them. This results in lower costs for 401(k) participants.

ETFs inside 401(k) plans are also reducing expenses in another surprising area: Trading costs. In this regard, ETFs and commingled trusts can save people a bundle.

“By holding a selection of suitable ETFs, trusts can mimic closely the returns for any large mutual fund’s investment objective without having to trade as aggressively as actively-managed mutual funds,” said the Center for Retirement Research at Boston College in a report titled Reducing Costs of 401(k) Plans with ETFs and Commingled Trusts.
“Consequently, compared with the median trading cost of 0.66% of assets in our sample of equity mutual funds, ETFs can cut investors’ annual expenses by as much as 0.5% of assets.

For ETF(k) plans using a brokerage window, ETF trading costs are further diminished because major brokerage platforms like Charles Schwab, Fidelity, Vanguard and TD Ameritrade now offer commission-free ETF trading.

Broader Investment Choices

Have you ever come across someone who loathes their 401(k) plan’s investment menu? Maybe it’s you! There are an untold number of people in this predicament. Many individuals complain they’re being boxed in by their employer and 401(k) plan administrator with mutual fund choices that only offer stocks or bonds.

A major advantage of ETFs over traditional mutual funds is broader asset coverage which in turn can help 401(k) participants to build more efficient and diversified portfolios. In fact, ETFs cover important investment categories that mutual funds consistently miss.

Examples include key areas like commodities (NYSE: GSG), gold (NYSE: GLD), international small cap value (NYSE: SCHC) international TIPS (NYSE: WIP) international real estate (NYSE: RWX) and U.S. REITs (NYSE: VNQ).

Thankfully, more 401(k) plan sponsors are becoming educated and aware of the need to have broader investment choices for their employees. “I think access to less-traditional asset classes and strategies is going to slowly become more important in DC plans, but we’re not there yet,” says Loren Fox, Senior Research Analyst at Strategic Insight.

Conclusion

While ETFs inside 401(k) plans makes definite sense, adding them to a 401(k) requires altering the plan’s record-keeping system. Unfortunately, most 401(k) legacy record-keeping systems are designed to trade mutual funds and not ETFs.

Regardless of these obstacles, ETFs have already been a disruptive force inside the mutual fund industry and are just starting to shake up the stodgy 401(k) market.

ETF(k) plans have become a serious competitive threat to traditional mutual fund-only 401(k) plans by lowering plan fees and offering more diversified investment choices. In the long run, this potent combination should increase the bottom-line performance for 401(k) investors.

While it’s still too early to say which ETF(k) platforms will achieve FaceBook like domination, the clear losers will be the companies and financial advisors that resist progress.

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