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401(k) Fee Scrutiny Boosts ETFs: If You Can't Join Em, Beat Em

Despite growing popularity and public awareness, exchange-traded funds still struggle to get onto 401(k) and other retirement plan platforms.

But ETF providers aren't waiting around. Instead, companies like Santa Monica, Calif.-based National Planning Corp. have adopted an if-you-can't join-them-beat-them approach, creating platforms of their own.

"I believe that this initiative will change the way the 401(k) is delivered to plan participants in the future," said Stuart Paris, an NPC representative and president of Great Neck, N.Y.-based Paris International.

The driving force behind platforms for cost-conscious alternative products is investors' increased awareness-and regulators' intensified scrutiny-of 401(k) fees.

"Almost all participants in 401(k) plans do not know how to account for soft-dollar fees, 12b-1 fees, variable annuity wrap fees, sub-transfer agent fees or investment management fees that might come out of their assets," said Chad Parks, founder and chief executive of The Online 401(k) of San Francisco.

Besides 12b-1 fees, some companies choose which share classes to include in their plans based on revenue-sharing agreements, while others create funds-of-funds using proprietary funds only, and still others pass along charges for services meant to be borne by the sponsor-such as advice-to investors in the form of asset-based charges.

Parks this month issued a press release launching "a public crusade to spotlight hidden 401(k) fees."

Parks is not alone in urging investors and their fiduciary sponsors to examine what they are really buying into. The Securities and Exchange Commission has probed fee structures for years, while the Pension Protection Act has attracted renewed rhetoric from politicians. Last November, the Government Accountability Office issued a report that called for better fee disclosure to be provided to participants and the Department of Labor.

For its part, The Online 401(k) plans to roll out a rebate program for 12b-1 fees and to adopt a fee structure based on the number of employees, not the assets under management.

When it comes to looking for low-cost tools to include in these plans, ETFs have led the charge.

"With ETFs, all of these hidden fees in mutual funds and other types of products do not exist," Paris said.

Launched nationally last week, NPC's platform is the newest of a cadre of ETF-oriented platforms, such as those from XTF in New York and Invest n Retire in Portland Ore., that looks much like the mutual fund-based retirement models to which investors and plan sponsors are already accustomed.

NPC's product is designed as a collective trust, where assets are held in an omnibus account and priced once at the end of the day. This avoids challenges such as intra-day pricing, prohibitions against buying partial shares and the added wrap-fee applied to ETF-comprised funds-of-funds sold on traditional mutual fund platforms. Targeting small- to mid-size companies with plans under $10 million, Paris said the structure allows regular investors access to alternative tools that high-net-worth investors have used for years.

"ETFs are going to penetrate all investment vehicles," he said.

Besides the traditional index-based and inexpensive ETFs, NPC's platform includes actively managed products for those searching for added alpha, and ETF-based variable annuity offerings through partnerships with Avatar Investments in New York and Jackson National Life Insurance in Denver, respectively.

"ETFs are here to stay," Paris said. As a $400 billion industry, "they are where mutual funds were 20 years ago, and they are exploding," he said.

But the problem is that most sponsors won't offer ETFs until they begin feeling pressure from participants, said Susan Menke, a senior financial analyst with Chicago-based financial marketing and research firm Mintel.

"And most people don't know what the heck they are," she said. The majority of ETF inflows, she added, are coming from institutional, not retail, investors.

As of December 2005, only 19% of retail investors understood enough about ETFs to even consider in investing in them in the future, according to Mintel research.

As news of ETFs trickles into the mainstream media, that awareness is rising, but Menke still does not see a groundswell of pent-up demand. After all, she said, 35% of mutual fund owners told Mintel they had no idea which funds they owned.

That's not to say the growth of ETFs will not go unchecked.

"Mutual funds have been the elephant in the room for so long that they've been slow to adopt [alternative products]," Menke said. "In the last year or so, they've been scrambling because they realize that this is a force to be reckoned with."

In some cases, companies that wouldn't put pure ETFs on their own platforms yet, still profit from the growing market by acting as custodians for companies like XTF and NPC.