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ETFs making headway in 401(k)s

"The average cost of using our software for these models varies from 25 basis points at a low to 45 basis points at a high, versus the average lifestyle fund, which has an expense ratio of over 100 basis points and the average equity fund, which is 150 basis points."

But ETFs are getting the cold shoulder from many in the 401(k) industry, especially larger companies that might qualify for low, institutional expense ratios.

"The 401(k) investment approach is pretty settled," says David Wray, president of the Profit Sharing/401(k) Council of America. "They use a mutual fund-type program and companies are reluctant to change a system that's working well. Companies aren't looking to add new alternatives. In fact, they're talking about reducing the number of alternatives. At one point more was seen as better, but that's no longer the case."

Vanguard, the giant fund company, makes its ETFs available to retirement plans through Abrahamson's Invest n Retire, but doesn't include them in Vanguard's 401(k) plans that don't have a brokerage option.

"If it's not broke don't fix it," says Noel Archard, principal with the Vanguard Financial Advisors Group. "Operationally, the 401(k) market grew up around the mutual fund structure. It's not really meant for something that trades like an individual security. We have seen some funds trying to tackle this issue, but there's not always a clear expense ratio advantage. Some 401(k) plans qualify for institutional share expense ratios, and for a comparable benchmark it might be lower than an ETF.

"It's something that's in the early days and there's some evolutionary work to be done. It has to make sense for the participant. There are plenty of diversified, low-cost products out there."

An interesting aspect of the newly enacted Pension Protection Act of 2006 is that employers are encouraged to automatically enroll workers in defined contribution plans and increase the employee's contribution annually. When an employee is automatically enrolled in a 401(k) someone else has to choose the investment options for them. Wray says ETFs could be attractive as the default.

"We're moving from a system where more choice was good to one where the predominant choice will be the employer-determined solution. It's a 180 degree turn. The point is that in the future the move to a default approach will have an impact on what's utilized as an investment option in 401(k) plans. There has to be a catalyst for change and this is a big one."

It's estimated that up to 30 percent of eligible employees don't sign up for 401(k) plans. Wray's Profit Sharing/401(k) Council of America is a nonprofit association of companies that sponsors more than 1,100 profit sharing and 401(k) plans for more than 6 million employees. Wray says 10.5 percent of the companies had automatic enrollment in 2004 and that percentage jumped to almost 17 percent in 2005.

Perhaps not all employees can expect access to ETFs in their 401(k) soon, but if you work for a small company with a 401(k) plan that's weighed down by fees, talk to your employer about ETF options.

Everyone who participates in a defined contribution plan should be well-aware of the fees. If you're paying expense ratios of 1.5 percent to 2 percent for equity funds, it might be time to look at alternatives.

-- Posted: Nov. 1, 2006
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