Based on the most recent data available, 401k assets total over $2 trillion which represent 15-20% of the total US retirement market. Approximately half of those assets are held in mutual funds with the remaining assets primarily held by banks and insurance companies.

For the past decade, there has been an extraordinary growth in Plans where Employees, the Plan Participants, direct their own investments, usually from a menu of investment choices offered by the Plan thru the financial institution that custodies the assets.

In most 401k Plans, Participants also have the ability, among other features, to access their accounts and change their investments on a daily basis, using a pension administration term commonly referred to as "daily valuation".

Growth of ETF's

ETF assets have soared to about $250 billion which is, however, dwarfed by the mutual fund industry. In 2004 alone, ETF assets grew by about 50%.

ETF's are baskets of stocks that track stock indexes. There are ETF's that mirror domestic and foreign indexes, stocks and bonds, sectors, etc. Unlike mutual funds, ETF's trade constantly throughout the day like stocks and carry ultra-low internal expenses.

Differences between ETF fees and actively managed fund fees are typically 1% per year which has dramatic implications when compounded annually. ETF fees are also an average 10 basis points cheaper than a comparable index mutual fund.

The above fees do not take into account the trading costs associated with the investment.

The Challenge

The perceived advantages ETF's enjoy over mutual funds in non-retirement investments -low expenses, low turnover, short selling, trading options, tax efficiency, transparency, among others - can be negated in the 401k daily valuation arena by -

1) the need for a proper long-term investment philosophy in a retirement plan; and

2) the associated trading costs and brokerage commissions that are generated by daily valuation and the frequent purchases required by 401k contributions thru payroll deduction.

The Solution

To counter the negatives above, the record keeping abilities of the 401k daily valuation platform must include

1) a managed investment philosophy that Participants can choose from, e.g., a menu of lifestyle choices comprised solely of ETF's that also allows the Plan to comply with ERISA 404(c) guidelines. The philosophy can be expanded to allow for quarterly rebalancing of the strategies. (More on rebalancing in my next article); and

2) establishing wrap fee pricing with the financial institution acting as Custodian to incorporate all investment fees including trading costs, brokerage commissions, etc.

With the above solution, the ETF industry can market itself aggressively as a very attractive retirement asset in a well-thought out and operational daily valuation platform.

(Alvin H. Rapp is COO of 401k Retirement Solutions LLC, the Company that created "the solution" to ETF's in retirement plans.)