ETFs for ERISA Plans: Operational Barriers and Potential Benefits

Exchange-traded funds (ETFs) have gained an increasing foothold in the wealth-management investment universe, with ETF assets under management currently about half the assets under management of mutual funds. As the ETF market grows and ETFs continue to chip away at the dominance of mutual funds, there has been a building conversation in the employer retirement plan community (including plans regulated by the Employee Retirement Income Security Act of 1974, or ERISA plans) about whether ETFs can be added to such plans and, if so, whether they should be.

As background, ETFs are similar to mutual funds in that they are publicly available investment funds that hold a collection of assets such as stocks or bonds. However, unlike mutual funds, shares of ETFs trade throughout the day on an exchange like stocks, at prices that fluctuate throughout the day.

With respect to retirement plans, ETFs are not prohibited investment options for private employer retirement plans (i.e., ERISA plans), but until recently ETFs generally have been underused as investments in ERISA plans. There appear to be two primary reasons as to why ERISA plans have been slow to invest in ETFs: first, ETFs may not easily fit within ERISA plan recordkeeping platforms and, second, some of the advantages of ETFs may not apply to ERISA plans, or apply as readily.

Accordingly, while there is no prohibition on adding ETFs as ERISA plan investment options (subject to the terms of the plan and its investment policies), any fiduciaries considering adding ETFs may want to consider the “fit” challenges related to direct ETF investments. Any decision to move forward with ETFs, notwithstanding these challenges, should be documented, including a determination that it is in the interest of the plan’s participants to do so.

The “fit” challenges related to direct ETFs with respect to ERISA plans include the following:

• A primary consideration for ERISA plans, especially defined contribution plans such as 401(k) plans, is a timing misalignment. Whereas ETFs trade on an intraday basis, most ERISA recordkeeping platforms were designed primarily for mutual funds and generally trade and value participant accounts solely on a daily basis. This may be less of an obstacle for defined benefits plans, which are less likely to have daily trading restrictions.
• ETFs must be purchased in whole shares whereas mutual funds can be purchased in fractional shares. This allows for fractional investing by ERISA plans, which has advantages particularly for participant-directed plans. What’s more, because ETFs are purchased in whole shares, there typically is cash left after an ETF trade is completed, and ERISA plan recordkeeping systems may have difficulty administering that cash, which may, among other things, result in performance drag for participants and generate unintended benefits to the recordkeeper in the form of float compensation.
• ETFs must publish their portfolio every trading day whereas mutual funds are only required to report their portfolio holdings quarterly, on a 60-day delayed basis. Particularly with respect to actively managed investment strategies, daily portfolio transparency presents the risk of front-running by others in the market who are able to reverse engineer an ETF’s trading strategy. Accordingly, before adding ETFs as an option for ERISA plans, plan fiduciaries might consider whether the ETF structure presents any novel risks that mutual funds would not.
• Not all ETFs are an eligible investment for certain ERISA plans, such as non-church 403(b) plans.

There are also advantages of ETFs that may not apply to ERISA plans, which, from a fiduciary loyalty perspective, raises questions around the benefit of ETFs for ERISA plans:

• While the intraday trading feature of ETFs may be considered a benefit to nonretirement investors who prefer to “day-trade” ETFs to take advantage of short-term price movements, that benefit may not apply to most ERISA plans, which typically seek long-term investment. In fact, for many defined contribution plans daily trading is disfavored or discouraged.
• Another benefit of ETFs is that, due to how their in-kind portfolio trading with broker-dealers is treated from a tax perspective, they often avoid making capital gain distributions to shareholders, which creates tax deferral for shareholders subject to tax. For taxable shareholders, this can make ETFs much more attractive than mutual funds, which generally are less likely to be able to trade on a similar in-kind basis. That said, ERISA plans are generally not subject to tax on capital gain distributions, making any such tax advantages of ETFs largely irrelevant.
• An additional benefit of ETFs is that they often have lower fees than mutual funds. But that advantage may be reduced for ERISA plans, which often have access to lower-cost institutional share classes of mutual funds and collective investment trusts. As such, what would otherwise be a benefit of ETFs for regular, nonretirement investors may not make a meaningful difference for ERISA plans. (On the other hand, because of their ability to trade significantly on an in-kind basis, many ETFs have embedded transaction costs that are lower than their mutual fund counterparts. Accordingly, even if the total expense ratio of ETFs and institutional shares of mutual funds within a given strategy or asset class may be substantially similar, there could still be cost benefits that ETFs would offer over mutual funds.)

A plan fiduciary that is considering introducing ETFs into a plan’s lineup may want to consider these potential challenges and evaluate the role ETFs may play in the plan’s and plan participants’ overall investment strategy.

Finally, it is worth noting that there are increasing efforts to make ETFs available to ERISA plans indirectly through collective investment trusts or mutual funds that hold ETFs or through self-directed brokerage accounts. Such structures may address some of the considerations outlined above.

In this regard, we note that the US Securities and Exchange Commission and its Staff are currently reviewing more than 50 applications for exemptive relief that have been filed by asset managers that would permit mutual funds to offer ETFs as a share class of the mutual fund (or vice versa). Even if the SEC approves the applications in the near term (which appears very possible), there will still be operational issues that the market will have to resolve before such structures become widely available. Nonetheless, it seems more likely than not that plan fiduciaries will be faced with evaluating the challenges and benefits of such structures in the future.

HOW WE CAN HELP

We stand ready to assist with any plan or fiduciary considering ETF investments, including navigating the considerations set out in the memorandum. If you require assistance, please reach out to the authors of this post or your primary Morgan Lewis contact.