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Risk of 401(k) plans with a brokerage window

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Want to buy stocks in your 401(k) plan? It’s not impossible. The self-directed brokerage window is increasingly opening up as an option for 401(k) plan participants. It lets retirement investors break out of the curated investment options in their employer-sponsored plan and into the wide wilderness of investing possibilities.

According to mutual fund giant Vanguard, the number of Vanguard participants offered the brokerage option increased between 2011 and 2012, from 23 percent to 25 percent. In both years only 1 percent of participants used the feature.

Fidelity Investments also reports an increase: “Nine percent of our plans are using them — up from 6 percent three years ago,” says Kevin O’Fee, Fidelity’s vice president in defined contribution product management.

That may be a good thing: While the self-directed option allows experienced investors to refine their investing strategy with hand-picked investments, newbies may find themselves lost in a jungle of stocks, mutual funds and other instruments. Without some direction, it’s easy to get tangled by the morass of fees and commissions.

Opening a window

The self-directed brokerage option is only available if the plan sponsor — the employer — elects to offer it. Access may be restricted by asset level, only well-compensated employees might have access, or it might be open to all employees. The plan sponsor may also restrict the times money can move to or from the brokerage account in addition to stipulating the percentage of total assets participants can put into the brokerage option.

You’ll likely have an annual window when you can move the money into the brokerage account, and you might have to put all of your money into the self-directed account and not just do a partial move, says Greg Carpenter, founder and CEO of Employee Fiduciary, a 401(k) plan service provider. “It creates certain accounting nightmares when you try to mix and match the self-directed brokerage account and the core mutual fund investments.”

The plan document determines what kinds of investing activities are allowed. Plans may restrict the types of investments participants can invest in. For instance, plans may disallow purchases of individual stocks and insist that employees purchase only mutual funds and exchange-traded funds.

The Internal Revenue Service has some rules as well. For instance, the use of margin or leverage is forbidden in qualified accounts, including 401(k) plans. Participants can do some lower-risk options trading, such as writing covered calls, as long as the plan sponsor does not specifically forbid it, according to Craig Morningstar, chief operating officer at Dynamic Wealth Advisors in Scottsdale, Ariz.

“The brokerage firm would still need to review and approve the account holder for options,” he says. Options approval is generally based on investing experience, time horizon, goals and net worth.

Unless the plan specifies otherwise, long investments in stocks, bonds, ETFs and mutual funds are all up for grabs under the rules governing the accounts.

What’s good about the brokerage option

For people who have investment experience, the brokerage option offers the opportunity to fine-tune an asset-allocation strategy.

“In the hands of the right people, it can be a very cost-effective and precise way to manage your money,” Carpenter says.

Even excellent 401(k) plans may not have great options for every single asset class out there.

In one situation, an employer-sponsored plan “did not have a small-cap value (fund), and the plan participant was comfortable and confident in their research and wanted to be in that asset class. So they opened up a brokerage window through their 401(k) and were able to get access to the asset class that normally they would not have,” says Morningstar.

What’s bad about the brokerage option

Ample research shows that having a multitude of investment choices does not lead to better outcomes for most 401(k) participants. Brokerage windows can enable investors to choose from thousands of investment options. The sheer numbers make it more difficult for inexperienced investors to choose suitable investments.

“Unless you actually have a well-thought-out strategy, having all the investment options in the world isn’t going to help you,” says O’Fee.

People who do use the brokerage option without a good plan fall into predictable traps: chasing performance and buying hot stocks.

Questionable investment choices aren’t the only pitfall: Trading costs can also undermine a retirement plan. Making purchases in a brokerage account incurs trading costs, which can make the brokerage option pricey, particularly for low-balance accounts.

“Let’s say you buy an ETF, and it’s going to cost $10 to make that purchase regardless of how much you buy. If I’m buying $100 of that ETF, paying $10 to buy $100 worth of an investment is really expensive. But if I’m buying $100,000 worth of it, then $10 is really cheap,” says Carpenter. “I would be way better off just going into a core mutual fund where the transaction fees are zero. You can buy fractional shares in whatever de minimus amount you have to put in.”

While mutual fund purchases within 401(k) plans are generally available without transaction costs, also keep in mind that many 401(k) plans offer funds with a cheaper share class that is typically only offered to big investors, known as the institutional share class. If you buy a fund outside of the core 401(k) plan, you may lose the advantage of purchasing institutional shares. Retail shares often come with higher expense ratios, which ultimately impact your investment return.

Finally, the brokerage window incurs administrative costs as well, typically around $100 or $200 per account per year, according to Carpenter. Depending on how it’s managed, the self-directed brokerage account can be a good way to control costs, or it can be a good way to pay a lot more than necessary.

When it comes to your retirement account, freedom can be a double-edged sword. For sophisticated investors, it makes perfect sense to give them the autonomy to tailor their ideal portfolio. If investing comes as naturally to you as breathing underwater, sticking to the core investments in your 401(k) is likely the wisest choice.


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