Is the Fiduciary Liability of Self-Directed Brokerage Options Too Great for 401k Plan Sponsors?

June 11
02:26 2013

Holmes Osborne, principal of Osborne Global Investors, Inc. in Santa Monica, California, is about to meet with a heavy equipment company that wants a self-directed plan. As he typically finds, the desire for a self-directed plan stems 612222_15396230_noose_stock_xchng_royalty_free_300from one of the executives wanting to buy individual stocks. “I’m completely for self-directed plans,” says Osborne, who plans to recommend a self-directed platform from a major mutual fund company that features low-fee funds. He adds, “When you take all fees, including my 25 basis points, some participants will be in at under 40 basis points. This is pretty reasonable.” Osborne feels comfortable with his recommendation. “As for self-directed,” he says, “I don’t see that being a liability for plan sponsor. There are trillions of dollars in online trading accounts. This is the same thing.”

Or is it?

According to Brooks Herman, Head of Data and Research at BrightScope, Inc. in San Diego, California, “brokerage windows on 401k plans really give investors unlimited (and ultimately the ability to select some very risky assets) investment choice. It appears to be a feature that is increasing over time.” Herman looked at the number of 401k plans that filed their Form 5500 with a service code indicating that they offer a self-directed  brokerage option and fund the number has nearly doubled from 2006 to 2011 (the most recent year available to the public. While there were nearly 52,000 401k plans offering a self-directed brokerage option in 2011, there were only 519 403(b) plans doing the same. But don’t let that small number dissuade you. “403(b) plans just started becoming ERISA compliant in 2009,” says Herman, who points out “there are far fewer 403(b) plans than 401k plans.” Still from 2009 to 2011, the number of 403(b) plans offering a brokerage window increased more than 35%.

It’s clear Osborne is not alone in his enthusiasm for self-directed options. More plans are offering the self-directed options, but are employees taking the bait? Dan Cassidy leads P-Solve Cassidy – a consulting firm focused on enterprise risk management of retirement plans located in Waltham, Massachusetts. He says self-directed brokerage accounts are “still not a very common option in plans.” Cassidy has seen, even when offered, participation in these options is very low (“about 1%”).

Others attest to the rarity of these options. Gabriel Potter, Senior Researcher, Westminster Consulting, Rochester, New York, says, “Self-direction options are the exception, not the rule, for most 401k plans.” Susan Conrad, vice president of Plancorp Retirement Plan Advisors in St. Louis, Missouri says, “About 20% of our prospects offer self-directed brokerage accounts as investment alternatives.” But, she warns, even this number “might be above average because we have a high concentration of medical practices. In my experience, physicians and engineers offer self-directed brokerage accounts more than other employers.”

Potter says the types of employees that generally use self-directed options are “highly engaged employees” like “highly compensated individuals and those working with a separate investment adviser.” He describes the typical characteristics of plans that offer self-directed brokerage options in this way: “Plans with self-directed options can come from very large companies with thousands of employees looking to maximize their options to wide variety of participant needs. Conversely, they can also come from very small companies looking to provide maximum flexibility without the burden of selecting investment options. (For instance, some small companies can forgo the 401(k) structure entirely in favor of a Simple IRA retirement option, leaving plan participants completely responsible for retirement investment decisions.)”

Most feel the push towards self-direction comes from only a few employees. Cassidy says, “the most common reason we see plans add it is to appease a small vocal group – usually an executive or two – who have an outside financial advisor who does not like the options in the plan, and wants to do something else with the executive’s account.”

Herman says, “The verdict is still out on whether a plan sponsor is fulfilling their fiduciary duty with a brokerage window:  it gives them cover because the plan is not limited to two dozen pre-selected assets, but opens them up to exposure if their participants are buying” highly leveraged ETFs, for example.

Indeed, the lure of the “ultimate” choice may be enough to entrap employees and even 401k plan sponsors. Conrad says, “Plan Sponsors often think they are offering participants a benefit by allowing them to invest in any security they choose. The results however, are often destructive for inexperienced investors.” She explains, “Participants purchasing individual stocks significantly increase their risk as compared to broadly diversified mutual funds and self-directed brokerage accounts fees are generally higher. Retirement plans often leverage the entire plan balance to qualify for lower cost mutual funds. Investments acquired through self-directed brokerage accounts are purchased at retail which can be significantly more expensive. Higher fees and increased risk can position participants for unfavorable results.”

“Ideally, a 401k retirement committee or investment committee must vet the options and monitor them on an ongoing basis to satisfy their fiduciary requirements,” says Potter. The dangers of self-directed brokerage accounts mean “unsophisticated individual investors working outside of the vetted options can easily select imprudent investments,” he says.

It’s not as though 401k plan sponsors had no liability, though. “Prior to 408(b)(2), plan sponsors assumed there were no fiduciary concerns,” says Ary Rosenbaum, Managing Attorney, The Rosenbaum Law Firm P.C. He suggests this might not have been totally true because “if you read ERISA 404(c), plan sponsors still could have been on the hook for liability because the information that plan sponsors typically provided to participants selecting these windows were slim to none.”

Once July 2012 occurred, it got much worse for plan sponsors. Fred Reish tells, “Last year, in guidance about participant disclosures, the DOL said that plan fiduciaries must prudently select the providers of participant brokerage accounts, that is, the broker-dealers. As with the selection of any provider, that would include evaluating the costs and services. That guidance came as a bit of a shock to the private sector, since many – maybe most – plan sponsors had believed that was the participants’ responsibility. As the DOL position becomes better known, some plan sponsors may be reluctant to include brokerage accounts in their plans.  The guidance was in DOL Field Assistance Bulletin (FAB) 2012-02R.”

Besides the need for 401k plan sponsors to be prudent in selecting the providers of the brokerage account and stating that a brokerage account is not an investment alternative, Rosenbaum says plan sponsors who opt for the self-directed brokerage window must disclose the following to plan participants:

  • “Information on how the window works, such as how and to whom to give investment instructions, account balance requirements, if any, restrictions or limits on trading, how the window differs from the plan’s Default Investment Alternative, and who to contact with questions.
  • “An explanation of fees and expenses that may be charged individually in connection with the window including start up fees, on‐going fees, and any fees or commissions charged in connection with the purchase and sale of a security, including front‐end and back‐end loads.
  • “A quarterly recap of the fees that that were charged and the services to which they relate.”

Rosenbaum has never been a fan of the brokerage windows. “I believe participants do better with investing in the plan’s core fund lineup than if they use a brokerage account,” he says. “In addition, plan sponsors who offer it sometimes don’t offer it to all employees, which might violate the IRS’ rule on benefits, rights, and features discrimination rule. Finally, I don’t think the issue of liability is settled and I’m afraid it will be tested in court. The issue of whether plan sponsors need to monitor the investments in these brokerage accounts won’t go away.”

Conrad is even more forthright. She says, “We encourage plan sponsors to reduce their fiduciary liability by removing the self-directed brokerage accounts as an investment vehicle. Investors that so choose can buy individual stocks and bonds in their personal accounts. Retirement plans should be designed from a fiduciary perspective.”

We’ll leave you to ponder this sage advice of Harlan Platt, PhD, Economist and Professor of Finance at Northeastern’s D-Amore-McKim School of Business in Boston: “The tendency for nonprofessional investors is to get into the market at the top and sellout at the bottom. Obviously this is counterintuitive or nonproductive. On the other hand, most professionals are merely momentum followers. This seems to put the 401(k) investor into a precarious position. I think most 401(k) investors would be better served by putting their funds into a large investment house and having the money invested in one of their balanced, (i.e., equities and fixed income), funds.” To some, this sounds strikingly similar to the “one portfolio” option, the choice of many fiduciary advisers.

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s new book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. The book also contains a series of chapters on this subject, including how to create an investment policy statement that defines a set of menu options consistent with the “one portfolio” concept (as well as leaving room for those few remaining do-it-yourselfers).

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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  1. earl
    earl June 11, 14:29

    most of your objections are non-starters (IMHO). the big liability i see that you don’t seem to mention is that, under 404c, fiduciaries are not responsible for choices participants make. that leaves open “what if participant never makes a choice?” 100% in the MMkt for 5 years. what fiduciary responsibility is there for the plan sponsor for those accounts?

  2. Michael McMorris
    Michael McMorris June 11, 14:41

    I think it’s worth pointing out that there are two different scenarios where self-directed brokerage accounts are used in 401(k) plans:

    1. An investment platform is offered with core investment options (DIA), primarily mutual funds, and a QDIA. IN ADDITION, an optional brokerage account “window” is available to those participants who want it (and usually are willing to pay an additional fee). This “window” arrangement is primarily what this article, other articles and the DOL FAB addressed.

    2. The plan only allows investments within self-directed brokerage accounts, so every participant has one. There usually isn’t a core lineup of funds. Most of these plans use one broker/dealer firm and is usually serviced by one broker of record. But some plans allow participants to use their own broker from any broker/dealer. This arrangement hasn’t been widely discussed in terms of fee disclosures and new fiduciary definitions

    In either case, what are the special fiduciary concerns and disclosure requirements, if any, if a broker or fiduciary is limiting the options available to a participant within the brokerage account? For example, if only certain funds or managed products are available. What are the DIA/QDIA?

    In either case, a plan shouldn’t set a minimum balance requirement to qualify for a brokerage account or any other investment option, or else they may run into a benefits/rights/features discrimination violation.

    As noted in the article, many small businesses, especially medical/professional groups, use brokerage accounts. Some as an option, others as the only option. Usually this is because those participants with high balances (usually owners/doctors/lawyers/execs) would like to have more investment options (stocks, bonds, ETFs, managed portfolios, etc.) than just a lineup of mutual funds, and those participants can afford the additional cost and administrative work associated with the brokerage account. So I think it’s important to note that not every employer is alike, and so not all 401(k) plans should be alike. In some cases, the plan’s fiduciaries may be prudent in limiting the employees’ options to a strong lineup of mutual funds. But in other cases, it may be more prudent (even if more expensive and cumbersome) to allow more options. Attorneys and risk managers may sleep better if all plans produce safe returns of 2-8% with low volatility. But some investors are looking for bigger returns and understand the risk of aiming higher, or they may simply have an aversion to mutual funds for whatever reason. Many young employees have relatively low balances but are perfectly capable of making informed investment decisions with the help of an investment advisor, so why limit them to a list of 10 mutual funds?

    Brokerage accounts have been provided to many plan participants for decades. And the majority of most workers’ savings are in 401(k) plans. Many workers don’t have enough savings outside their plan account to invest effectively in individual stocks/bonds, or in portfolios available to higher balances. So, as long as the broker of record is available to answer questions about the options, and the plan’s named fiduciaries make it clear that investing in anything available under the brokerage sun can be a risky venture, and the fiduciaries/broker disclose the applicable fees/expenses, isn’t the AVAILABILITY of a brokerage account a good thing for some participants? At what point do we draw the line on blind paternalism and introduce a bit of personal responsibility in the name of achieving great participant outcomes?

    Just asking questions.

  3. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author June 11, 22:47

    Michael – thanks for your comprehensive comment. To be fair to the folks interviewed, they did bring up the point about plans where self-directed options are the only option. Since this article pertains only to 401k plans (and, by extension, 403(b) plans), I made the editorial decision to leave the discussion of self-directed-only plans (very often a form of an IRA) for another article.

  4. John Henry
    John Henry June 20, 15:52

    “under 404c, fiduciaries are not responsible for choices participants make”

    Under 404(c) fiduciaries are not LIABLE for for any losses which result from choices a participant makes, provided ALL the required disclosures are made. That is not the same as “not responsible”. Fiduciaries are responsible for the investment funds that are placed within in the plan.

  5. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author June 20, 16:55


    Thank you very much. That’s a distinction worth noting.

  6. Philip Koehler
    Philip Koehler June 23, 09:43

    The appropriate place for brokerage window arrangements is, at best, a non qualified wraparound or 401(k) mirror plan financed through a “Rabbi” trust for the top paid executives only.

  7. Brian Kehm
    Brian Kehm August 11, 16:12

    In 2006 a research paper on 403(b) under diversification was published, “What’s in Your 403(b)? Academic Retirement Plans and the Costs of Underdiversification.” The paper quantified the returns of diversification with the current investment options compared to an expanded menu. In their research they found, with optimal rebalancing over a forty year work life, an employee could lose more than half of terminal wealth, compared to investing in the expanded menu.

    A catch 22

    Preventing the potential loss from continued under diversification requires an offering of many new funds. This could allow the inexperienced investors in 401(k) and 403(b) to take on highly risky investment strategies from the core funds offered. Keeping the current core funds and adding a brokerage window could allow the investment knowledgeable employee as well as the professionally advised employee to properly diversify, while other employees may avoid using the brokerage window since they would be unfamiliar with the choices available there.

  8. Maureen Horner
    Maureen Horner March 20, 12:00

    Brokerage Windows and Fiduciary Liability

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