Is the Fiduciary Liability of Self-Directed Brokerage Options Too Great for 401k Plan Sponsors?
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 from 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 FiduciaryNews.com, “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).