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Page 6 of 6
Living On The Wild Side
An additional appeal of ETFs is the ability to gain more specialized investment exposures to such sectors as Technology and/or Energy, or to single countries (e.g., China) and/or more-focused (e.g., high-dividend funds) investing strategies. While there are mutual funds available with similar specialized investment exposures, the low costs of the ETFs coupled with a few vocal participants may entice a plan fiduciary to include these specialized ETFs, along with the plain-vanilla ETFs, in 401(k) plan investment lineups. ETFs are indexes after all, and you can’t go wrong buying an index, right? Well, not exactly. Just because an investment follows a passive investing strategy doesn’t mean it’s a prudent investment for a 401(k) plan. The prudence requirement under ERISA §404(a)(1)(b) states that a fiduciary:
discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.
When selecting investments for a 401(k) plan, a plan fiduciary must consider the nature of the workforce and whether or not participants have the education, experience and ability to make intelligent investment decisions [Reish et al. 2001]. Selecting an ETF because it has great recent performance (e.g., Technology in the 1990s or Emerging Markets today) doesn’t mean it belongs in a 401(k) and is necessarily a prudent investment. A number of studies have shown that participants are poor investors and are ill-suited to make proper investment decisions (see for example [Hancock 2006], [Kasten 2005] and [Munnell et al. 2006]).
An example of a "specialized" investment abused by 401(k) plan participants is investment in their employer’s company stock. A Hewitt Associates study of 401(k) plan participants found that more than 27 percent of the nearly 1.5 million employees surveyed who could invest in company stock had 50 percent or more of their 401(k) plan assets invested in those shares. A participant who invests more than half of his or her account balance in his or her employer’s stock is not only violating some of the basic tenets of investing, but also common sense as well (i.e., don’t put all your eggs in one basket).
Overall, including specialized investments in a 401(k) is a lose-lose situation for a plan fiduciary. A participant (and his or her attorney) is only likely to sue if the investment returns poorly and if that participant loses money, yet the plan fiduciary receives little benefit if things go right. While a plan fiduciary may think that ERISA §404(c) provides a defense for imprudent investing at the participant level, §404(c) does not provide protection with respect to the overall prudence of an investment. For those readers not familiar with §404(c), it offers a plan sponsor and its fiduciaries a defense for losses or lack of gains realized by participants who exercise independent discretionary investment control over their individual account balances (for additional information on §404(c), see "ERISA §404(c) Best Practices: Myths versus Facts" by David J. Witz). A plan can be §404(c)-compliant, yet still have investments that are deemed imprudent under §404(a).
Conclusion
Given current technology, the cost savings from ETFs in 401(k) plans appear to be minimal. While the expense ratios for ETFs may be less than their respective indexed mutual fund peers, this lower cost is materially eroded by the explicit and implicit costs associated with making the ETFs "401(k)-ready." In fact, it is likely that an ETF 401(k) strategy would end up being more expensive than a mutual fund strategy after all the costs are considered.
Minimizing plan expenses is an important consideration for a plan sponsor and plan fiduciaries, but it doesn’t take ETFs for this to happen. Plan sponsors can select index mutual funds as low-cost investment solutions for participants in an attempt to minimize overall plan fees. It’s important to remember that the purpose of a retirement plan is to help employees and participants retire, not to necessarily have funds that outperform their peers. While a discussion of the benefits of active versus passive management is beyond the scope of this paper, it is always important to note that index investing is a much easier strategy to defend (in court) and to monitor than a strategy that involves trying to find next year’s top active manager (and rarely succeeding).
[A version of this article first appeared in the Journal of Pension Benefits, Winter, 2007.]
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