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. The option is known as a self-directed brokerage account (SDBA) or a 401(k) brokerage window.
This 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 a 401(K) Self-Directed Brokerage Account Works
Employers who offer brokerage accounts in their 401(k)s must pick a specific firm to use, such as E*Trade 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's charter forbids it.
As of 2015, 40% of U.S. employers offered brokerage windows in their 401(k) account, a study by HR consulting firm Aon Hewitt showed. Some 17% percent of the plans Vanguard administers offer a brokerage window, according to the mutual fund company's 2017 annual 401(k) report. The Plan Sponsor Council of America’s 60th Annual Survey of Profit Sharing and 401(k) Plans, released in 2018, indicated that about a quarter of the plans offered by 590 plan sponsors featured a brokerage window. Some 403(b) plans now also offer this feature.
Pros and Cons of 401(k) Brokerage Accounts
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 (PSCA), 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. Indeed, the most recent data from Charles Schwab, a leading provider of SDBAs, shows that average balance for self-directed brokerage accounts was $449,552.
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.
Fiduciary Issues With 401(k) Brokerage Accounts
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 With 401(k) Brokerage Accounts
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. Only about 3% to 4% of those with access to a 401(k) brokerage window use it, the Aon Hewitt study found; the PSCA survey reported that only 1.3% of total plan assets are accounted for by investments through brokerage windows. 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.
The Bottom Line
Brokerage accounts can be a good idea for 401(k) plan participants who are experienced and knowledgeable investors. Employees who lack the education to make sound investment decisions by themselves should probably think twice before taking this path. Investors also should watch extra fees that could be assessed when taking this route.
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.