NEW YORK | Wed Jul 25, 2012 4:59pm EDT (Reuters) — Target date funds, the most popular investment option in 401(k) plans, are increasing their exposure to exchange traded funds (ETFs), which are rarely used in retirement savings accounts.

Franklin Templeton Investments, Manning & Napier and Lincoln Financial Group are among a number of target date fund managers turning to ETFs, something they say will help them to more easily manage volatile markets and access niche investment strategies – at lower costs than using mutual funds.

For ETF providers, this trend could be their ticket into the $3.4 trillion 401(k) market. For investors it could mean lower costs and better returns, experts said. ETFs, baskets of securities that trade on exchanges like individual stocks, are cheaper than mutual funds. ETFs come in a number of different flavors covering areas such as equities, fixed income and commodities.

Target date funds – portfolios that adjust their allocations based on a target retirement date, becoming more conservative by shifting more assets from equities into fixed income over time – are in 70% of 401(k) plans, according to San Francisco-based retirement plan consultant Callan Associates.

Employers and retirement plan consultants like target date funds because they do not require employees to reallocate their portfolios, which most never do.

Meanwhile, ETFs, which have $1.2 trillion in assets in the U.S., have been slow to gain traction in the 401(k) plan market. Only 2.5% of 401(k) plans offer ETFs of any type as a direct investment choice in their plans as of January this year, according to Callan.

Many retirement plan consultants say that the pace of trading that underpins ETFs is not appropriate for 401(k) plan investors, whose goals are longer-term. The tax advantages of ETFs also don’t benefit 401(k) investors since contributions to the plans are tax deferred.

But even so, ETFs are now making their way into 401(k) plans through target date funds.

Manning & Napier and Lincoln Financial have both introduced ETF-only target date funds in the past few months and Franklin Templeton is looking to increase its funds’ exposure to ETFs.

Overall, 46% of target date fund managers used ETFs as of last year, up from 40% in 2010, according to Cerulli Associates. And experts predict that with recent U.S. Department of Labor rules requiring greater fee disclosure of 401(k) plans, this number will grow. Small plans that do not qualify for the cheaper institutional shares of mutual funds, in particular, are looking for less costly target date alternatives.

“ETFs ... are low-cost ways of accessing certain areas of the market,” said Paul Justice, an ETF analyst at Morningstar Inc, who believes more target date fund managers will use them.

To be sure, the trend is still emerging. The three largest target date fund providers, Fidelity Investments, T. Rowe Price and The Vanguard Group, do not use ETFs in their funds.

“Without Fidelity, Vanguard and T. Rowe using them they cannot make up a big part of the market,” said Brooks Herman, head of research 401(k) plan research firm BrightScope Inc.

A Fidelity spokeswoman said that while its target date series, the Fidelity Freedom Funds, does not currently invest in ETFs, they could in the future. “By prospectus the underlying funds have the possibility of investing in ETFs,” she said in an e-mailed statement.

Cost was a main driver behind Fairport, New York-based Manning & Napier’s introduction of an ETF-only target date fund series in June.

The firm, which has $44.7 billion in assets under management, has offered target date funds for more than a decade, and launched an ETF-only version as a way of lowering its fees and accessing certain sectors of the market easily, said CEO Patrick Cunningham.

Manning’s ETF-only Goal CIT funds cost investors 52 to 55 basis points. The cheapest share class of its mutual fund-based target date fund series costs 69 basis points.

Similarly, Radnor, Pa.-based Lincoln Financial in November introduced its first ETF-only target date fund series to better manage market volatility at a lower cost, said Dan Hayes, head of funds management for Lincoln.

The expense ratio for the ETF-only Protected Presidential Profile Target Date Funds which includes a capital protection overlay is 65 to 67 basis points, compared to 74 to 83 basis points for its traditional target date funds.

For some target date fund managers, like Franklin Templeton, a unit of Franklin Resources, using ETFs makes it easier than with mutual funds to get in and out of positions quickly.

“Markets have been more volatile over the past couple of years and as a consequence we wanted to add the flexibility to adjust those portfolios,” said Tony Coffey, vice president, portfolio manager for Franklin Templeton Multi-Asset Strategies.

San Mateo, California-based Franklin Templeton has been using ETFs in its target date funds for a couple of years to access areas of the market where it does not have proprietary funds. The firm invests 5% of its target date funds in ETFs, the maximum allowed under regulations, but is seeking permission from regulators to raise that allocation to 10%, Coffey said.

(Reporting by Jessica Toonkel; Editing by Alden Bentley)

© 2011 Thomson Reuters. Click for Restrictions.

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