For many years, the investment options offered in company-sponsored 401(k) plans were limited to mutual funds and annuity contracts, along with one or more guaranteed accounts and, perhaps, the company’s stock. But some plans now allow participants to buy and sell securities inside their 401(k)s in the same manner as with a retail brokerage account. This new alternative has raised many eyebrows in fiduciary circles, as it allows investors to take much greater risks with their retirement savings than they previously could with even the most aggressive fund choices. 401(k) participants who have this option available to them need to carefully evaluate the possible gains – and losses – that they may sustain from their trades.
How It Works
Employers who offer brokerage accounts in their 401(k)s must pick a specific firm to use, such as ETrade or Charles Schwab, and list this account along with the other investment choices in the plan. In some cases, participants may have a specified window of time each year to move money from their general omnibus account in the plan into the brokerage account. Plan participants can then buy and sell stocks, bonds, ETFs and mutual funds in the normal manner, albeit with no tax consequences. However, some types of higher-risk trades are prohibited, such as trading on margin, and buying put or call options or futures contracts. Covered call writing is permissible unless the plan charter forbids it.
As of 2012, brokerage accounts were available in just under a third of all 401(k) plans in the U.S. A few 403(b) plans now also offer this feature; their number may increase in the future.
Pros and Cons
It is fairly easy to see both the benefits and drawbacks of using brokerage accounts in 401(k) plans. In their favor, brokerage accounts allow investors to choose from a vast array of investment choices, choices that permit them to invest in specific sectors, subsectors or other elements of the market that may be very difficult to duplicate with traditional plan alternatives. Participants who wish to invest in frontier markets will quickly be able to find an appropriate stock or ETF that fits their investment objective.
Of course, having that level of freedom is not always good. Because 401(k) plans are nondiscriminatory by nature, most plan charters require that these accounts must be offered to all employees in a company – including those with little or no knowledge or experience with investments. In many cases, the plan feature was added because a few top-level employees lobbied for it, and then paid for and followed the advice or strategy of a professional money manager. "It was a standard plan design, especially for law firms, historically," says David Wray, president of the Plan Sponsor Council of America, which represents companies that offer 401(k) and profit-sharing plans. Even today, "the people who use [brokerage windows] are typically highly paid – not your typical 401(k) participant going into a target-date fund," he adds.
The vast range of investment alternatives available inside a brokerage account can make it harder to construct a sound portfolio, and numerous transactions with their corresponding fees and commissions will inevitably erode the returns received by participants. Those who do not have a predetermined investment plan also risk allowing their investment decisions to be driven by their emotions, which can lead to chasing “hot” stocks or funds, and buying high and selling low.
Plan sponsors that offer brokerage accounts should carefully analyze the potential liability of substantial losses sustained by novice investors. Many sponsors believe that they cannot be held responsible for what happens in these accounts, but many benefits experts and attorneys say otherwise. All other investment options inside qualified plans are required to meet certain fiduciary characteristics, even if they are aggressive in nature. But a large percentage of the investment options that participants can purchase in a brokerage account will fail to meet this standard.
Winners and Losers
It is easy to see who could come out ahead by trading securities in a 401(k) brokerage account. Highly educated investors, such as medical professionals and specialists, engineers, accountants and those with previous trading and investing experience, can use these accounts to achieve returns far beyond what they might be able to achieve using traditional plan options, such as mutual funds. But lower-income participants – factory workers, retail or food-service employees or others who work on the bottom rungs of the company ladder – will not likely have access to the same level of information or have the type of knowledge that those above them enjoy. Employees without adequate guidance could easily be enticed into making foolhardy choices, such as buying and selling mutual funds with front or back-end sales charges or choosing investments options that contain risks they do not understand.
So far, most studies and data released on this subject seem to indicate that a relatively small percentage of employees choose to invest material amounts of their plan savings into brokerage accounts. Vanguard, Fidelity and Schwab have all stated that only a very small fraction of their customers with access to brokerage accounts inside qualified plans have signed up for them.
Coming Soon: More Protection?
Changes are likely coming for qualified plans that contain brokerage accounts, regardless of their current levels of participation. The Department of Labor announced in spring 2014 that it will probably pursue greater restriction on the type and number of investment choices that can be offered inside qualified-plan brokerage accounts, and require greater education and disclosures for participants who choose to use them. They will also most likely prohibit sponsors from offering brokerage accounts as the sole choice in a plan.
The Bottom Line
Brokerage accounts can be a good idea for 401(k) plan participants who are experienced and knowledgeable investors, but employees who lack the education to make sound investment decisions by themselves should probably think twice before taking this path. One good way to limit risk with these accounts is by restricting the amount of money that goes into them; participants who allocate the majority of their plan assets into other investment alternatives and trade sparingly may see much better results. For more information on the use of brokerage accounts inside qualified plans, consult your company plan sponsor or financial advisor.