In late March, Don Amsden switched his company's retirement savings plan to an all-exchange-traded funds platform.

The owner of Lafayette Copier Sales & Service Inc. in Lafayette, Ind., had been using a 401(k) plan only offering mutual funds. But about a month ago, the plan's service provider worked out a system that allows participants to create their own portfolios and freely transact using any iShares ETFs currently on the market.

The more flexible system represents a big change for retirement markets. Up until recently, traditional record-keeping processes and transactional accounting systems for funds in 401(k) plans have been geared to work with mutual funds. That meant back-office processes were built for investment vehicles that trade only once a day—at the end—and deal in full shares.

ETFs, of course, trade throughout the day and can be bought in fractional shares.

"In the past, people in 401(k) plans could only invest indirectly in ETFs, typically through third-party unitized funds or collective trusts. That meant you couldn't actually own shares of a stock or ETF—you had to buy a predetermined portfolio sold through a trust," said Greg Moerchen, a partner at ETF Advisor k LLC, the provider of Lafayette Copier's retirement plan.

An exception has been systems allowing employees access to most anything sold through large brokerage houses. In those so-called "self-directed" plans, participants can buy whatever stocks, mutual funds or ETFs they want. But such plans are few and far between. And they can still impose stiff limits on transactions and tack on rather hefty fee structures that are similar to less-flexible 401(k) plans.

Openings For Change

Amsden says neither is the case with Lafayette Copier's new plan. Not only does it offer significantly lower fees, but the plan lets participants trade daily—although it limits transactions to one a day.

"Ideally, that's not what they're going to be doing," said Amsden. "This is retirement money and we're educating our employees on the value of long-term investing. But it's nice that they can tailor their ETF portfolios to their individual needs."

His company, which has about $500,000 in total assets invested in its 401(k) plan, is one of the first to take advantage of upgraded back-office systems.

Since the end of February, ETF Advisor k's outside custodians and back-office specialists say they've ironed out the kinks to handle ETF shares. The back-office provider, Mid Atlantic Trust Capital, expanded its systems with the help of iShares sponsor Barclays Global Investors. The plan's record-keeper and third-party administrator is FutureBenefits of America LLC.

"In the last 30 days, we've been rolling out a next-generation 401(k) platform for ETFs," said Moerchen, whose Fort Wayne, Ind.-based retirement service provider works with about 500 different companies across the country. "Consultants and advisers have been asking for something like this for years."

The firm began marketing its new ETF platform last week. "We've been inundated with calls from advisers," said Moerchen. "This is absolutely the next big wave in 401(k) plans. And it's just starting to take place in a big way now."

ETF Advisor k's sweet spot is small- to midsize plans. It works with fee-based advisers and consultants hired by plan sponsors to help employees build portfolios and make investment choices. Moerchen says his plan's total cost to participants averages around 1.50% a year.

That's within the range BGI says it's expecting most ETF-based 401(k) plans to wind up charging. Studies estimate that plans at smaller companies using mutual funds are averaging around 2.5–3.5% in total expenses, notes Darek Wojnar, head of iShares' product research and strategy group.

"We've seen demand for low-cost 401(k) plans rising, particularly in small companies," he said. "The upside for ETFs in the retirement market is huge. Opportunities to introduce wider adoption of ETFs in the workplace are just starting to emerge."

Wojnar adds that while technological roadblocks existed in the past for using ETFs in 401(k) plans, developments in automating back-office systems in the past 18 months appear to have finally come to a head. "Those impediments now have largely been overcome," he said.

Besides ETF Advisor k, only a handful of other plans are offering similarly flexible ETF options, Wojnar estimates. And almost all of those providers are targeting smaller plans.

"We've heard a number of inquiries from consultants to larger plans," said Wojnar. "But their interest is more unique and specific—they're interested in adding ETF options for alternative asset classes or target-date retirement funds. But with micro- and small-sized plans, the interest we're seeing is very broad in terms of types and numbers of ETFs."

Since many smaller companies are new to the 401(k) process, the bulk of growth in retirement plan assets is expected to be driven by those sized firms, he points out. Wojnar says that various estimates put small plans' growth rates at 7–10% a year.

Along those same lines, Cerulli Associates is projecting that by 2012, the combined size of the small-plan 401(k) market could reach $1.2 trillion.

"At this point, penetration by ETFs into the 401(k) market is less than 5%," said Wojnar. "As a result, we're expecting to see a period of strong growth for ETFs in retirement plans in the next several years."

Back-Office Automation Here

Jerry Bramlett, chief executive of NextStep, agrees. In the past three months, his record-keeping firm has started rolling out a fully automated system for plans to deal with ETFs.

"The problem was that there were too many manual functions that couldn't scale to handle ETF transactions. But our process has recently been automated so that we've put in place a very scalable, fully automated system that can add any amount of ETF transactions necessary," said Bramlett, whose firm recently changed its name from BenefitStreet.

The San Ramon, Calif.-based record-keeper works with about 1,400 different retirement plans. Bramlett says that BGI, which he estimates works with some 150,000 fee-based advisers through its iShares family, is driving back-office adoption of ETFs in 401(k) plans. NextStep doesn't work directly with BGI.

"We don't see any real limitations now using ETFs in 401(k) plans," said Bramlett. "From a technical standpoint, ETFs are ready to become a major part of the retirement landscape."

Still, he believes this year will be relatively slow, as plan administrators take their time learning and understanding how to use ETFs in a timelier and mainstream fashion. Also, Bramlett says that back-office firms will move forward very conservatively.  

That includes NextStep.

"From a technological standpoint, our systems are 100% ready to handle ETFs," said Bramlett. "But we're not encouraging a ton of new ETF business right now. That's because we've got to continue to educate our service personnel and expand in a controlled fashion."

After all, he adds: "We're like a lot of record-keeping companies, trying to make sure we've laid enough track so we're not run over by a hard-charging ETF locomotive. Demand should really take off in 401(k) plans over the next two years."