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Self-Directed Brokerage Accounts in 401(k) Plans: Part I – A Lose-Lose Proposition


Self-Directed Brokerage Accounts (SDBAs) inside 401(k) plans offer participants a "brokerage window" where they can trade investments (stocks, bonds, mutual funds, etc) that aren’t in a plan’s official investment line up. While that may sound like an idea worth considering, in a nutshell, I’m not a fan. Not after we bust a number of myths regarding them. Not only is fiduciary liability increased for the sponsor, the participants historically invest poorly inside their brokerage accounts. This equates to increased cost (additional liability for you) for decreased benefit (poor investment results for them).

SDBAs Today: An Overview

In a 401(k) plan, each participant is responsible for directing the investments inside his or her account. The sponsor is responsible for selecting and monitoring a line-up of designated investment alternatives (DIAs) from which participants make their investment decisions. DIAs are usually mutual funds, exchange traded funds or various insurance products.

The plan sponsor may also choose to include an SDBA in addition to or in lieu of the fund line-up. In fact the number of plans offering an SDBA more than doubled from 12% in 2001 to 29% in 2011 according to Aon Hewitt, Lincolnshire Ill. In 2011, for plans offering an SDBA, the option accounted for an average 6% of total plan assets. (Source: “DOL rule threatens DC plan brokerage windows,” Pensions & Investments, May 28, 2012)

SDBAs and Plan Sponsor Fiduciary Liability: The Monitoring “Gotcha”

Let’s begin with the liability issue. In my experience, the broker will suggest to the plan sponsor that liability is reduced by offering an SDBA. The argument goes that the sponsor has clearly met his or her responsibility under ERISA to offer a minimum of three investment options, each with varying degrees of risk and return characteristics. I’ll give them that. If plan participants have access to 50,000 stocks, bonds and funds via an SDBA, this requirement must be met. However isn’t this hurdle a simple one to clear without access to the SDBA? Plan fiduciaries meet this requirement when they offer a diverse core line-up of funds.

But what about the fiduciary’s responsibility to perform due diligence and monitoring on plan investments, if each participant conjures up his or her own, unique list of investments? While a colleague may not sue the plan fiduciary, what about a divorcing spouse or a beneficiary? And practically speaking, why would a plan fiduciary want to monitor every investment their participants choose inside the SDBA? That’s an invitation to a headache.

ERISA Section 404(c): Only Partial Protection

Sometimes the broker will tell plan sponsors that, as long as they meet ERISA section 404(c) disclosure requirements, they are free from liability if the participant’s investment account performs poorly. But there is confusion here. 404(c) only says that the fiduciary is free from liability from the participant’s investment decisions if certain disclosures have been made. That is, if the sponsor has given the employee information necessary to make good investment decisions. The fiduciary is still responsible for the investments inside the plan. The fiduciary must limit the investment options inside the brokerage account. Otherwise, even the limited protection 404(c) offers will be lost. Then any “stock-drop” issue a participant experiences can come back to haunt the fiduciary for allowing the investment inside the plan in the first place.

Defining Fiduciary Prudence, ERISA-Style

ERISA requires that plan fiduciaries act prudently and in the best interest of their plan participants. According to an article published in the Winter 2005 Journal of Pension Benefits, “A reasonable interpretation of that general requirement [of prudent action] is that plan fiduciaries must decide whether it is prudent to offer brokerage accounts to participants.”

Of particular concern is the plan that ONLY offers the SDBA, with no core fund line-up. Are your average employees going to invest wisely inside their brokerage accounts? Or is it more likely they will be overwhelmed with the number of investment options and just leave the money in the money market during their entire employment period? If they don’t prudently participate in the market according to their personal goals and risk tolerances, their real investment return is likely doomed to failure. 

I can easily imagine the employee or a beneficiary suing the fiduciaries for plan restoration on the logical argument that the fiduciaries didn’t provide the education necessary for the participant to avoid the investing mistake. What would be the sponsor’s defense? In the aforementioned Pensions & Investments article, Department of Labor (DOL) spokesman Michael Trupo said, “The fiduciary obligation to designate a manageable number of investment options is a critical part of making these retirement plans work for America’s workers.”

Fees, Inglorious Fees

What about the fiduciary’s responsibility to ensure only reasonable fees are charged inside the plan? Inside SDBAs, the participants will each incur varying fees depending on what they invest in. And it’s likely they will be charged retail pricing, not institutional. When participants who are paying retail commissions and expense ratios could be paying institutional costs, that could well be a fee lawsuit in the making. (This very argument was the crux of the widely publicized 2011 class action lawsuit settlement by Wal-Mart Stores and Merrill Lynch. In addition to a $13.5 million payout, the firms agreed to remove some of their plan’s costly retail funds and consider beefing up on its index fund offerings.)  

404(a)(5) Participant Disclosures: The Smoke Clears

What about the new 404(a)(5) fee disclosure requirements? Is the SDBA broker going to meet the fiduciary’s responsibility for them, by disclosing all of the fees from all of the investments each participant has selected? Or is the fiduciary going to be up late every quarter-end, calculating the fees charged in each participant account and annually listing all of the fees that could possibly be incurred by any participant?

Bottom Line: Fiduciary Is as Fiduciary Does

Lastly, remember what it means to be a fiduciary to a retirement plan. You must act in the best interests of the plan participants and their beneficiaries. Study after study after study demonstrate how poorly individual investors invest compared with professionally managed resources such as a model asset allocation portfolio, or some sort of balanced mutual fund or properly structured target date fund (as covered in my previous blogs on the subject of target date funds). What is ultimate “success” for your plan? My definition is that the participants reach their retirement goals. Give them the tools they need to do so, not rope to hang themselves with.

Next week I will comment on how the Department of Labor is threatening SDBAs.

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Comment   |  5 years, 8 months ago from Woodbridge, VA