Exchange-Traded Funds (ETFs) have emerged as a significant vehicle for investment, amassing around $10 trillion in assets since their inception in the early 1990s. In stark contrast, 401(k) plan participants have yet to embrace these innovative investment tools. As mutual funds continue to dominate retirement savings with a hefty $20 trillion in assets, ETFs have gradually earned a larger slice of the total investment market, now capturing 32% of the market share, up from 14% a decade ago, according to Morningstar Direct. Despite this impressive growth in general market appeal, ETFs remain surprisingly underutilized in workplace retirement plans.
The potential for ETFs to revolutionize retirement savings is evident when you consider the monetary scale involved. As of the end of 2023, 401(k) plans alone held approximately $7.4 trillion, boasting over 70 million participants, according to the Investment Company Institute (ICI). Moreover, additional 401(k) type plans, such as those for university employees and local government workers, hold around $3 trillion. Yet, despite this vast reservoir of funds, the incorporation of ETFs within these accounts remains negligible. Philip Chao, a certified financial planner and founder of Experiential Wealth, asserts that the 401(k) space represents “the final frontier” for ETFs, calling it a largely untapped goldmine for the industry.
A staggering 65% of 401(k) assets are currently allocated to mutual funds, leaving ETFs with a mere fraction of the market share; their presence in these retirement plans is often restricted to specialized investments, such as sector and commodity funds. A report from the Plan Sponsor Council of America (PSCA) underscores just how minimal the use of ETFs is among the various investment structures. Even at their highest usage, ETFs are only employed in about 3% of 401(k) investments. The dominance of mutual funds, collective investment trusts, and separately managed accounts underscores the uphill battle that ETFs face in establishing a foothold in workplace retirement plans.
One of the primary advantages of ETFs is their flexibility. They offer tax benefits and the ability to trade throughout the day, appealing to a wide range of investors. However, when one delves into workplace retirement plans, many of the advantages that make ETFs attractive lose their significance. David Blanchett, head of retirement research at PGIM, points out that the preferential tax treatment provided by the 401(k) structure negates the capital gains tax advantages that ETFs might offer. Furthermore, the long-term orientation of these accounts discourages frequent trading, as evidenced by Vanguard’s data indicating that only 11% of 401(k) participants engaged in any trading activity in 2023.
Another significant factor limiting ETF adoption within 401(k) plans lies in the decision-making structure inherent to these retirement accounts. Employers essentially dictate which investment options are available to employees. As a result, even if an employee is keen on investing in ETFs, they may not be included in their employer’s chosen investment lineup. The involvement of employers creates an additional layer of complexity and may prevent ETF options from making an entry into workplace retirement plans.
Technological and Structural Barriers
The traditional framework supporting workplace retirement plans presents technological hurdles that further hinder the expansion of ETFs. According to Mariah Marquardt, Capital Markets Strategy and Operations Manager at Betterment for Work, the systems currently in place were not designed to accommodate the nuances of intraday trading, a distinct characteristic of ETFs. In contrast, mutual funds are priced only once at the end of the trading day, making them easier to manage within existing structures.
Moreover, mutual funds benefit from various share classes tailored to different expenses, which allows for the distribution of fees among multiple parties involved in the 401(k) ecosystem—features that ETFs lack. Because ETFs typically only have one share class, the breakdown of expenses can send shockwaves through the perception of cost among investors, even if these fees are ultimately lower.
The stark contrast between the rapid growth of ETFs in general investments and their sluggish adoption in 401(k) plans raises important questions about the future of workplace retirement. While ETFs possess numerous advantages, structural and psychological barriers remain substantial. As the investment landscape evolves, stakeholders must address these impediments to realize the full potential of ETFs in workplace retirement plans. Until then, the 401(k) landscape continues to be dominated by mutual funds—a realm that ETFs have yet to conquer.