401(K) Plans Are the Final Frontier for Exchange-Traded Funds

While exchange-traded funds (ETFs) have gained popularity among investors, they have yet to make significant inroads with 401(k) plan participants.

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ETFs were introduced in the early 1990s and have since amassed approximately $10 trillion in assets under management. In comparison, mutual funds dominate the market with around $20 trillion in assets. However, ETFs have steadily increased their market share, capturing 32% of the market relative to mutual funds, a notable rise from 14% a decade ago, according to data from Morningstar Direct.

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David Blanchett, head of retirement research at PGIM, the investment management division of Prudential, notes that “ETFs are becoming the novel structure to be used in wealth-management-type accounts.” Despite this trend, the enthusiasm for ETFs has not translated to workplace retirement plans, presenting a significant, largely untapped opportunity for the ETF industry.

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As of the end of 2023, 401(k) plans held a staggering $7.4 trillion in assets, as reported by the Investment Company Institute (ICI), with over 70 million participants. Additional 401(k)-style plans, which include those for employees of universities and local governments, accounted for an extra $3 trillion, according to ICI data. However, experts assert that a minimal portion of these assets is allocated to ETFs.

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“There’s a lot of money in workplace plans, and there’s going to be more,” said Philip Chao, a certified financial planner who advises companies on their retirement strategies. He added, “It’s the final frontier for ETFs, in the sense of trying to capture the next big pool of money.” Chao is the founder of Experiential Wealth, based in Cabin John, Maryland.

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Data from ICI indicates that approximately 65% of 401(k) assets were invested in mutual funds by the end of 2023. While ICI does not provide a direct comparison for ETFs, a separate report from the Plan Sponsor Council of America (PSCA) suggests that ETFs represent only a small fraction of the remaining 401(k) assets.

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The PSCA report analyzes the popularity of different investment structures, including mutual funds and ETFs, across about 20 categories, ranging from stock to bond and real estate funds, in 2022. The findings revealed that while ETFs were primarily utilized for sector and commodity funds in 401(k) plans, they were still only chosen 3% of the time.

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Although ETFs offer various advantages, such as tax efficiency and the ability to trade throughout the day, these benefits are often deemed “irrelevant” in the context of 401(k) plans, according to Blanchett. He points out that 401(k) accounts already enjoy favorable tax treatment, nullifying the tax advantages associated with ETFs compared to mutual funds.

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Additionally, the nature of 401(k) plans—designed for long-term investment—means that frequent trading is generally discouraged. Data from Vanguard shows that only 11% of 401(k) investors executed a trade or exchange in their accounts in 2023.

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Another critical factor is the decision-making process regarding fund selection in workplace retirement plans. Employers determine which investment options are available to their employees, which means that participants interested in ETFs may find them unavailable in their plans. This limitation highlights the lack of choice faced by investors in workplace retirement accounts.

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Experts also point out technological barriers that complicate the integration of ETFs into workplace plans. The infrastructure that supports these retirement plans was not initially designed to accommodate intraday trading, which is essential for ETFs. According to Mariah Marquardt, capital markets strategy and operations manager at Betterment for Work, mutual fund orders are priced once a day, at market close, while ETFs are traded throughout the trading day.

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There are entrenched payment and distribution structures associated with mutual funds that make them difficult for ETFs to compete with. Mutual funds typically have multiple share classes, and the total fees that investors pay can include costs for various players in the 401(k) ecosystem, including investment managers, plan administrators, financial advisors, and other third parties.

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These fees are usually bundled and distributed among the different parties involved, often without being clearly visible to investors on their account statements. In contrast, ETFs consist of a single share class, which does not allow for the bundling of distribution fees. This lack of bundling results in expenses appearing as separate line items on investors' statements, making costs more transparent.

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Chao remarked, “A lot of people like to have just one item; you feel like you’re not paying any more fees.” He further emphasized that this situation can create a scenario where “ignorance is bliss,” as investors may prefer to overlook the complexities associated with mutual fund fees.

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Conclusion
The current landscape of workplace retirement plans presents a significant opportunity for the ETF industry to expand. While ETFs have gained traction in individual investment accounts, they have not yet found a foothold in the 401(k) market. Addressing the barriers to entry, including technological constraints and the decision-making authority of employers, will be crucial for ETFs to capture a larger share of the retirement savings market.

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As the financial landscape continues to evolve, both ETF providers and retirement plan sponsors will need to explore innovative strategies to engage 401(k) participants and offer investment options that align with their preferences for modern investment vehicles like ETFs.

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