As an alternative to target retirement date or risk based mutual funds, many open architecture 401(k) providers allow retirement plan advisors to create their own managed models for inclusion within a plan’s investment menu. One of the reasons for doing so is the ability to create an asset allocation strategy that utilizes investments from multiple investment managers. A number of these advisor-managed models often include a passive investment component, i.e., index mutual funds. The popularity of these ‘passively managed’ offerings–beyond their ability to consistently generate market-like returns–lies in their relatively low cost.

Whereas retirement plan advisors have historically only had the option of using index mutual funds as the passive component of their managed models, many retirement plan providers have recently made exchange-traded funds (ETFs) available for inclusion in a 401(k) plan’s investment lineup.

Like index mutual funds, passively managed ETFs effectively track their benchmark and have low expense ratios.

One of the primary differences between ETFs and index mutual funds is that ETFs in taxable accounts can be traded intraday like stocks. However, most retirement plan platforms only price ETFs once a day. In this regard, they trade exactly like mutual funds. The primary benefit, then, of choosing an ETF over an index mutual fund in a retirement plan would seem to be its lower expense ratio. But while one might assume that, all things being equal, the option with the lower expense ratio would be the better investment choice, all things in this situation are not equal. We can’t forget that an ETF in a retirement plan is likely to charge a commission for both the purchase and the sale of the ETF whereas a majority of index mutual funds are “no load” and do not charge a purchase commission. That is not to say the ETF may not be the better choice–it very well could be depending on the advisor’s investment management strategy for the model.

If you are evaluating whether an ETF or an index mutual fund is better suited for your managed models, you should consider the following:
ETF commissions charged by the plan provider: A 00 investment into an index mutual fund will result in a 00 balance. However, if your plan provider charges a commission to purchase an ETF, a 00 purchase will result in less than a 00 balance since the commission amount will reduce the amount of the proceeds. There will also be a subsequent commission charge to sell the ETF.
ETF share price: If your open architecture 401(k) plan recordkeeper charges a commission to buy and sell an ETF, the ETF with the higher share price will result in a lower commission charge. For example, assume there are two S&P 500 ETFs that you are considering with identical expense ratios, you are seeking to purchase 00 worth of ETFs for your plan, and your retirement plan provider charges a .05 per share commission. If one of the ETFs is trading at 0 and the other is trading at , your commission amount will be double for the per share ETF since you will be purchasing twice as many shares. Whereas the share price of a mutual fund is rarely a factor used in evaluating an option, the same cannot be said for an ETF.
Expense ratios of both products: Assuming the ETF has a lower expense ratio, but also charges a commission, it is likely that you will have to hold the ETF a longer time period for its superior performance (due to the lower expense ratio) to compensate for the purchase and sale commissions. The time period will be a direct result of how much lower the expense ratio of the ETF is than that of the index mutual fund.
Availability of the product to track the desired index: Whereas both index mutual funds and ETFs have products that track common market indexes like the S&P 500, Russell 2000, and the Dow Jones Industrial Index, ETFs typically have more specialized funds available. Some examples include funds that invest solely in the China Small Cap, Consumer Stables, Biotechnology, and Malaysia indices.

One of the primary benefits of using an open architecture 401(k) plan provider is the ability to include either ETFs or index mutual funds in the plan’s core investment lineup or within a managed model. You will not be limited to proprietary products or to those that only pay revenue sharing. If your plan’s investment menu is not limited in this regard, a plan advisor should be able to implement strategies similar to those used in non retirement accounts to best achieve the stated investment goal of the model.

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401 K plan is a retirement plan that is on offer in US and some other countries. This plan offers tax deferred savings to the employees and encourages them to save for retirement. It is also referred to as employer sponsored retirement plan.

A 401 K plan offers several tax deduction benefits to the employees. These benefits can be availed by all citizens (except in certain cases where the employer can impose certain restrictions). In cases of people with less than 1 year of service, non US citizens or part time workers, contributions to a 401 K plan depends upon the employer. For others the rules are common.

401 K plan offers tax deductions to the contributors. Under this plan all the contributions are tax deductible, that is, tax is not levied on the contributions. Even though contributions are made from non taxed salary, it is not entirely exempted from taxation. The funds (or tax deductions) are taxed at prevalent rates at the time of withdrawal. Therefore the savings are only tax deferred and not tax exempted.

401 K funds (or the tax deductions) are generally monitored by a third party. The annual contributions can be invested in a variety of stocks, funds, certificates and bonds. But it is up to the employer to provide these options to his/her employees. He has the sole discretionary power over the management of 401 K plan. The contributions to the plan can be matched by the employer also. He/she can contribute to the 401 K plan of his/her employees. This is generally done by the employers to retain the employees. Employer contributions are not included in the maximum limit on annual contributions of employees. Therefore they are over and above the salary of an employee.

The employer can provide the option of buying company stocks from these annual contributions. But investing the entire in amount in a single companies stocks, specially the one in which one is working, is not advisable. This would mean unnecessary risk and therefore should be avoided.

Usually this plan is offered by big companies only. This is because of the enormous costs involved in the administration of the plan. However, simpler options are available for self employed and former government entities also.

The maximum tax deductions possible are limited and set by the government. The employer can also impose his/her own limits for maximum employee contribution (or tax deductions). For example a firm may restrict the maximum contribution to 10% of the employees income. The governmental limit on maximum contribution generally depends on the inflation rate and varies every year. For people over 50 years of age, catch up limits are allowed. This allows people over 50 years to contribute more than others. For the year 2007, the maximum contribution limit for people below 50 years of age was $15,000. For people above 50 years of age this limit was set at $15,500.