As the investment landscape evolves, exchange-traded funds (ETFs) have increasingly gained traction among individual investors and wealth management accounts. However, they seem to have stagnated in workplace retirement plans like 401(k)s. Despite the remarkable growth of ETFs since their introduction in the early 1990s, penetrating the 401(k) space appears to be a formidable challenge. With about $7.4 trillion invested in 401(k) plans by the end of 2023, this segment represents an enticing but elusive opportunity for ETF providers.
At present, mutual funds command a significant presence in workplace retirement plans, representing around 65% of 401(k) assets. The Investment Company Institute (ICI) reports that while ETFs have gained market share overall—growing from a mere 14% a decade ago to 32% by the end of 2023—they have yet to break through in 401(k) deployments. The latest data shows that even among the small percentage of assets allocated to ETFs within retirement accounts, they are predominantly utilized for narrowly defined investments such as sector and commodity funds.
The Plan Sponsor Council of America’s (PSCA) analysis reflects this, stating that participants in 401(k) plans rarely opt for ETFs when there are numerous mutual funds available. Given that mutual funds are already well-established and familiar to plan sponsors and participants, the inertia to adopt ETFs appears strong. The vast number of mutual fund choices and the robust support behind them present a significant hurdle for ETFs, which, while offering innovative features, haven’t yet established similar levels of trust and comfort within the collective investment space.
One key factor behind the limited adoption of ETFs in 401(k) plans lies in the decision-making dynamics that govern retirement offerings. Employers are the gatekeepers who decide which funds will be made available to employees. This critical layer of decision-making means that even if employees express interest in exploring ETFs, they may not find them on the list of available options. When 401(k) plans are structured primarily around mutual funds, there’s little incentive for employers to start introducing ETFs into their portfolios, especially when participants have become accustomed to the traditional products.
In this regard, numerous systemic issues also hinder ETF adoption. The operational foundations of 401(k) plans were not designed for the intraday trading capabilities that ETFs offer. The traditional framework caters to pricing mutual funds once a day, which contrasts sharply with the ongoing trading that ETFs can provide. Without a significant overhaul of the existing infrastructure, integrating ETFs will remain a daunting challenge.
While ETFs are often lauded for their tax efficiency and the flexibility of trading, these benefits lose significance within the context of 401(k) plans. Since 401(k) accounts already provide favorable tax treatment, the capital gains advantages that ETFs typically possess do not resonate with investors operating within this structure. David Blanchett, head of retirement research at PGIM, emphasizes that the nature of 401(k) plans being predominantly long-term accounts nullifies the relevance of frequent trading. The vast majority of 401(k) investors—only about 11%—engaged in trades in their accounts last year, further indicating that low turnover aligns poorly with the characteristics of ETFs.
Moreover, the perception of fees associated with mutual funds plays into the narrative. The complex fee structures that accompany mutual funds often obscure the actual costs charged to investors. In fact, many employees may feel more comfortable with the traditional model simply because the nuances of these fees are less apparent. Interestingly, the transparency of ETF fee structures—while crucial to a savvy investor—can deter those who prefer a simplified and consolidated view of their expenses.
Despite the current barriers, there remains a compelling case for adopting ETFs within 401(k) plans. The potential benefits—such as lower expense ratios, tax efficiencies, and diversified investment strategies—could be harnessed effectively with the appropriate structural adjustments. If industry leaders can navigate the operational and regulatory complexities to integrate ETFs seamlessly into workplace retirement plans, we may witness a significant shift in the investment strategies employed by 401(k) participants.
Infrastructure advancements, coupled with increased education on ETFs’ advantages versus mutual funds, could pave the way for breaking down existing perceptions and facilitating adoption. The future of retirement investing could see ETFs becoming a mainstay, aligning closely with the 21st-century investor’s quest for efficiency, flexibility, and performance. Nevertheless, to achieve this transition, all participants in the investment landscape—employers, providers, and investors—must embrace a proactive approach to reexamining traditional investment models. Only then can we unlock the potential that ETFs hold within the vast landscape of workplace retirement accounts.