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. However, 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. Those 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.
- Self-directed brokerage 401(k) accounts allow for investing in a much wider array of alternatives.
- Fees for the increased amount of transactions can cut into profits.
- People who restrict the amount of money they put into such an account generally fare better.
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, according to a study by HR consulting firm Aon Hewitt. Some 19% of the plans Vanguard administers offer a brokerage window, according to the mutual fund company’s How America Saves 2019 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.
Vanguard reports that 19% of its 401(k) accounts offer a brokerage window, but only 1% of participants take advantage of it.
Pros and Cons of Using 401(k) Brokerage Accounts
It is fairly easy to see both the benefits and drawbacks of using brokerage accounts in 401(k) plans.
Wider range of investment choices than regular 401(k)s, including stocks, ETFs and bonds.
Can invest in multiple sectors or subsectors
Successful investors may earn far more than they would through investment vehicles available in traditional employer plans.
Employees who aren't experienced investors can lose significant retirement money through badly chosen trades.
More difficult to construct a sound portfolio, especially given transaction fees and commissions.
Higher risk of emotion-driven trading, which can lead to buying high and selling low.
In their favor, brokerage accounts allow investors to choose from a vast array of investment choices, ones 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. Those who choose wisely may be able to grow their retirement portfolio faster than through the choices available to members of a company-organized 401(k) plan.
Risky for inexperienced investors
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 they 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, 2019 data from Charles Schwab, a leading provider of SDBAs, shows that average advised balance for self-directed brokerage accounts as of March 31, 2019 was $436,593.
More difficult to create sound retirement portfolio
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 by the Employee Retirement Income Security Act of 1974 (ERISA) to meet certain fiduciary characteristics, even if they are aggressive in nature. Nevertheless, a large percentage of the investment options that participants can purchase in a brokerage account will fail to meet this standard.
To manage a self-directed brokerage account successfully takes a great deal of knowledge and expertise.
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, and others who work in jobs that don’t require such skills—likely will not have the same education and expertise. And plenty of people with higher incomes and more education don't know much about investing, either. Employees without adequate knowledge and 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 (for Vanguard the figure is 1%, according to its How America Saves 2019 Report).
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.