Think A 401(k) Brokerage Window Can Eliminate Your Fiduciary Responsibilities? Think Again.

October 5, 2017 by Healy Jones
401(k) brokerage window

Is a brokerage window, also known as a self-directed option or account, a smart option for your company’s 401(k) plan?

These days, there are some conflicting trends circulating in the 401(k) marketplace. On the one hand, academics have found that too many 401(k) investment options can lead to “choice overload.” That can cause employees to simply avoid making an investment selection and neglect investing for retirement. Reducing information overload is a big reason we like 401(k) automatic enrollment – done right, it can make getting into a retirement plan simple and easy. Researchers with the Pension Research Council talk a bit more about such behavioral biases, including avoiding decisions due to “information overload,” in a blog post “How Much Choice is Too Much? Contributions to 401(k) Retirement Plans.”

But too many investment options do more than give employees a headache. Option-heavy 401(k)s have led to lawsuits against plan sponsors. The plaintiffs claimed that offering too many options was a dereliction of fiduciary duty. (Similar lawsuits are now making their way into the 403(b) space.)

Anyone who has lost track of time in the cereal aisle or searching for a movie on Netflix can understand how too many choices might work against conscientious investing. Yet, despite increased awareness of the risks associated with a large number of investment options, a contrary trend has emerged: more plan sponsors are offering a brokerage window. According to Aon Hewitt, 40% of companies offer a self-directed brokerage window, up from just 16% in 2005.

A brokerage window allows participants to choose from a wide variety of investment options. Although the plan sponsor can limit the options available from the window, for example by prohibiting purchases of individual stocks, the intent is to expand the number of investment options available.

While some employees embrace the chance to build a portfolio from a wide universe of choices, few employees actually take advantage of the opportunity. The same Aon Hewitt research reveals that only 3% of participants took advantage of the self-directed option when it was available.

The reluctance of employees to expand their choices seems to go hand in hand with the growing preference to invest in a limited number of target date funds. These “set it and forget” funds tweak asset allocations as investors move toward retirement.

In fact many investors invest in only a single a target fund. After all, these funds represent a balanced approach to long term investment, and can be one of the best 401(k) investment options. Consider that 46% of all participants that receive recordkeeping services from Vanguard are invested in a single target date fund – either a fund the participant chose or one that was a default option.

Fiduciary risks due to a self-directed brokerage

Self-directed brokerages create risks for both employees and employers.

Risks to investors from self-directed brokerage

The obvious risk plan participants face when choosing among the universe of stocks, bonds, mutual funds and ETFs is the chance a lack of expertise results in a risky portfolio with poor performance. But there are other risks associated with the brokerage window that may be less obvious.

One of these risks is that of over-trading. Employees who are allowed to buy stocks for their own account may trade so often that commissions take a big bite out of their investment returns. That’s aside from the risk of chasing the latest hot stock or sector, only to buy at the top and sell at the bottom. And while active fund managers are often criticized for failing to measure up to their benchmarks, can anything more be expected of individuals offered access to individual stocks or esoteric ETFs? (In short – no, the research is pretty clear; read our article on how active trading reduces investment returns.)

Risks to plan sponsors from self-directed brokerage

The Department of Labor does not specifically prohibit sponsors from offering a brokerage window in 401(k) plans. However, the brokerage window should be available to all employees if offered, not just the experienced investors. While such ERISA and IRS rules against discrimination are designed to make sure that all participants benefit from the 401(k), in the case of self-directed brokerage, this principal can work against novice investors.

Plan sponsors should be aware, however, if a brokerage window will require increased recordkeeping costs, result in higher audit fees, or in any way add to plan expenses. The high fees may be justified, but if so, the plan sponsor should be able to explain and defend these expenses if necessary.

While the DOL may not spell out a prohibition against the brokerage window, the department has clearly become more interested in this investment option in recent years. Back in May 2012 the DOL issued a “Field Assistance Bulletin” that effectively warned sponsors not to use a brokerage window as a way to shirk fiduciary responsibilities regarding the appropriateness of a typical investment line-up. The Department of Labor does not want plan sponsors offering self-directed brokerage windows as a means to get out of fiduciary responsibilities.

Then in 2014 the DOL published a request for information on brokerage windows. The DOL wanted to learn more about what options are typically found in brokerage windows, who used it, what was the process for selecting the provider, and how much did these self-directed options cost.

According to DOL, their goal in issuing the request for information was to “determine whether, and to what extent, regulatory standards or other guidance concerning the use of brokerage windows may be necessary to adequately protect participants’ retirement savings.”

Given their interest, the DOL could eventually adopt regulations based on the responses. In 2016 the DOL actually called for more reporting on brokerage windows with a comment period following the announcement.

The uncertainty surrounding self-directed accounts hasn’t stopped lawsuits challenging them. In a suit against Charles Schwab, the plaintiff challenged the revenue sharing fees Schwab received from third party ETFs and mutual funds. The plaintiff also alleged that Schwab made no effort to determine if a brokerage window was a prudent option.

Open or close the direct brokerage window?

Despite the risks inherent in offering participants self-directed brokerage, such an option may be entirely appropriate for your employees. The key is to determine whether or not such a platform is a good fit for your plan.

At ForUsAll our goal is to craft a low-cost retirement plan by finding you the right fund lineup and recordkeeper. We are happy to offer a brokerage window if it is right for your plan, alongside a low cost fund-lineup anchored with risk appropriate target date funds. Why not chat now with our 401(k) specialists today?

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Healy Jones
Healy joined ForUsAll because he believes that all Americans deserve a fulfilling retirement. As the head of marketing, he’s focused on spreading the word that small businesses can offer their employees a great 401k plan. Prior to ForUsAll, he ran the acquisition marketing team at Sunrun, the nation’s largest dedicated residential solar provider, where he lead the direct to consumer team to hundreds of percent year over year growth. He began his career in financial services, working for JP Morgan, Summit Partners, and Atlas Venture. Healy has an A.B. from Dartmouth College and an M.B.A. from Wharton. When he’s not working, Healy and his wife enjoy taking their daughter rock climbing and filling their wine fridge. When he finally retires, he hopes to start emptying the wine fridge.
Healy Jones

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