Reducing Costs of 401(k) Plans with ETFs and Commingled Trusts

Publication Date: July 2010

Publisher: Center for Retirement Research at Boston College

Author(s): Richard Kopcke; Francis M. Vitagliano; Zhenya S. Karamcheva

Research Area: Economics

Keywords: private pensions

Type: Report

Coverage: United States

Abstract:

Increasingly, employers who provide their employees with a retirement plan are relying on 401(k) and similar defined contribution plans instead of defined benefit plans. As a result, participants are paying more of the cost of managing their pension plans, which can take a substantial toll on their retirement savings. Over a 30-year career, for example, an annual fee of 0.7 percent of assets reduces the purchasing power of a participant’s balance at the time of retirement by more than one-eighth.

This brief considers the potential savings that sponsors can achieve in their 401(k) plans by reducing the “trading costs” embedded in the investment options that are often included in their plans. Most of the money invested in equity within 401(k) plans is held in actively-managed mutual funds. Although the investment objectives of these funds can offer more promising returns than the passive investment strategies of broad index funds, actively-managed funds can be costly. Without giving up the investment objectives of actively-managed funds, 401(k) plans can achieve substantial savings by shifting to exchange-traded funds (ETFs) and commingled trusts.

The first section describes the nature of trading costs in the overall fees paid by 401(k) participants. The second section estimates the burden of trading costs within popular equity mutual funds. The third section describes how adopting the investment options often used by other institutional investors – specifically, ETFs and commingled trusts – could increase total returns within 401(k) plans by reducing costs. The final section concludes that participants in average 401(k) plans who hold balances in actively-managed domestic equity mutual funds could reduce their fees and costs by 0.70 percent of assets, or more. About one-third of this savings can be achieved by changing just the structure of plans’ investment options to reduce the fees they pay their financial service providers. About two-thirds of this savings would result from reductions in trading costs made possible by restructuring.