The Quiet Revolution Taking Shape in 401(k)s

Golden nest egg. (Dreamstime)

About the author: Anna Paglia is the executive vice president and chief business officer for State Street Investment Management.

Most people don’t stay up at night thinking about share-class structures. If you do, you probably work in asset management like me.

What people do worry about, however, is whether they will have enough savings for a comfortable retirement and whether their 401(k) will give them a fair shot at getting there.

That is why I was encouraged by the Securities and Exchange Commission’s recent announcement that it intends to grant exemptive relief on the dual-share-class structure. This means mutual fund and exchange-traded fund investors could share the same underlying portfolio of assets, but access it through different vehicles. One underlying portfolio, two different ways to invest. This could significantly expand ETF access for millions of everyday investors, especially participants in 401(k) plans.

For more than two decades, ETFs have been the defining growth story of the asset management industry, delivering choice, transparency, and efficiency. They have attracted nearly $10 trillion in the U.S. alone, up from $302 billion 20 years ago. Yet most 401(k)s and other defined-contribution plans don’t offer ETFs—not because plan sponsors or participants don’t want them, but because the infrastructure of the retirement system wasn’t built for them.

Record-keepers designed their systems around mutual funds: daily net asset value calculations, fractional shares and payroll deductions. ETFs, with their intraday trading and whole-share settlement, don’t neatly fit into that system. Yet increasingly, the most innovative investment ideas or strategies are being packaged as ETFs, not mutual funds.

Most of the investment industry has focused its dual-share-class enthusiasm on adding ETF share classes to mutual funds, which make up nearly $6 trillion of the $13 trillion defined-contribution plan industry. But the quiet yet powerful innovation on the horizon is actually the reverse: mutual fund share classes of ETFs. It is a way for 401(k) retirement investors to invest in an ETF strategy but through the mutual fund format they are already used to**.**

Plan menus, payroll contributions, and record-keeping would all stay the same. But underneath, mutual fund share classes of ETFs could benefit from the power of the ETF engine, with its larger scale, cost discipline, and efficient “in-kind” flows in the underlying shared portfolio.

While ETFs’ tax efficiency isn’t necessarily a benefit for investors in 401(k) plans since those accounts are already tax-deferred, their in-kind flows can still work to the advantage of plan participants. That is because when large institutions redeem ETF shares, ETFs aren’t forced to sell investments to raise cash like mutual funds. Instead, ETF issuers can transfer securities directly to these large institutions, typically market makers or broker-dealers, through “in-kind” redemptions. By avoiding selling in the open market, this process helps lower turnover and associated trading costs in the underlying portfolio—efficiencies that benefit investors in all share classes.

In addition, the portfolio manager can opportunistically use mutual fund cash flows to rebalance positions, which may help further reduce tracking error relative to a mutual fund. These combined efficiencies—lower costs and the added scale that comes from pooling ETF and defined-contribution plan assets together—can potentially improve net performance for plan participants over time with lower expenses.

The SEC’s announcement is a landmark development for the industry, profound in its implications even if it sounds technical. Retirement savers, or plan participants, would no longer have to watch the ETF revolution from the sidelines. They would benefit from access to a much greater number of investment options in the ETF market, as well as some of the efficiencies driving ETF growth, but through the mutual fund wrapper their plans already support.

Mutual fund share classes on ETFs aren’t the most talked-about structure. But they could be a faster and rewarding path forward for millions of retirement savers.

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