Why 401(k) plans are the ‘last frontier’ for exchange-traded funds

Although many investors have flocked to exchange-traded funds, they have not gained much traction among 401(k) plan participants.

Exchange-traded funds, or ETFs, debuted in the early 1990s and have since earned about $10 trillion.

Mutual funds own about $20 trillion, but ETFs have lost their dominance: ETFs have a 32% market share of mutual fund assets, up from 14% a decade ago, according to data from Morningstar Direct.

“ETFs are becoming the new structure to use in asset management accounts,” said David Blanchett, head of pension research at PGIM, Prudential’s investment management arm.

However, the same zeal did not apply to investors in corporate pension plans, a huge pot of largely untapped potential for the ETF industry.

At the end of 2023, 401(k) plans were worth $7.4 trillion, according to at the Investment Company Institute, or ICI, and had more than 70 million participants. Other 401(k)-type plans, such as those for college and local government employees, include another $3 trillion, ICI data show.

But virtually none of these assets are in ETFs, experts say.

‘There’s a lot of money [in workplace plans]and more to come,” said Philip Chao, a certified financial planner who advises companies on their retirement plans.

‘It’s the final frontier [for ETFs]in the sense of trying to capture the next big pool of money,” says Chao, the founder of Experiential Wealth, based in Cabin John, Maryland.

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About 65% of 401(k) assets were invested in mutual funds at the end of 2023, according to ICI data. The group does not report a corresponding statistic for ETFs.

A separate report from the Plan Sponsor Council of America, a trade group that represents employers, suggests that ETFs hold only a small portion of the remaining 401(k) assets.

The PSCA report examines the relative popularity of investment structures, such as mutual funds and ETFs, across approximately 20 types of asset classes, from stock funds to bond and real estate funds, in 2022. The report found that 401(k) plans used ETFs most readily by sector and commodity funds – but even then they only did this 3% of the time.

Investment funds, collective investment trust funds and separately managed accounts held the lion’s share of 401(k) assets across all asset classes, PSCA data shows.

Such investment vehicles perform the same basic function: they are legal structures that pool investors’ money.

However, there are some differences.

For example, ETFs have certain advantages for investors over mutual funds, such as tax benefits and the ability to do intraday trading, experts said.

However, these benefits are “irrelevant” in 401(k) plans, Blanchett said.

The tax code already gives 401(k) accounts preferential tax treatment, making an ETF advantage over capital gains taxes a moot point, he said.

Blanchett said 401(k) plans are also long-term accounts in which frequent trading is generally not encouraged. According to data from Vanguard, only 11% of 401(k) investors will have made a trade or exchange in their account in 2023.

Furthermore, in workplace pension schemes there is a decision-making layer between funds and investors: the employer.

Company officials choose which mutual funds to offer their 401(k) participants — meaning investors who want ETFs may not have them available.

There may also be technological barriers to change, experts say.

The traditional infrastructure underpinning workplace retirement plans wasn’t designed to handle intraday trading, meaning it wasn’t built for ETFs, Mariah Marquardt, capital markets strategy and operations manager at Betterment for Work, wrote in a report 2023 analysis. Investor orders for mutual funds are priced only once a day, when the market closes.

There are also deep-rooted payment and distribution arrangements in mutual funds that ETFs can’t address, experts say.

Mutual funds have many different share classes. Depending on the class, the total mutual fund compensation an investor pays may include fees for many different players in the 401(k) ecosystem: for example, the investment manager, plan administrator, financial advisor and other third parties.

That net mutual fund fee is divided and distributed among those different parties, but investors largely don’t see those line items on their account statements, Chao said.

Conversely, ETFs have only one share class. They don’t have the ability to bundle these distribution costs, meaning investors’ expenses appear as multiple line items, Chao said.

“A lot of people like to have just one item,” Chao said. “You have the feeling that you are no longer paying costs.”

“It’s almost like ignorance is bliss,” he said.