Years ago, a smattering of mutual fund companies launched self-directed 401(k)s that allowed participants to invest in just about anything they liked rather than a short list of funds picked by their employer. Gradually, this option has gone mainstream with many employers offering brokerage accounts to employees who want more choice.
But although freedom, flexibility and speedy transactions sound good, experts caution that these accounts are not for everyone.
For example, the Florida Retirement System, a plan for state employees, tells participants that its self-directed accounts are recommended only for experienced investors.
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The 401(k) has been around since 1978. Typically, the employer and brokerage, fund company or bank that serves as plan administrator settle on a list of stock and bond mutual funds to offer employees.
Underlying this system is a belief that employees should not tinker too much with investments designed for retirement that may not begin for decades.
But this approach isn’t perfect. A stable of funds suited to the average employee may not be best for those with unusual situations or better than average investing skill. Some plans have been slammed for denying workers the opportunity to bet on narrow slices of the market like real estate. And there have long been complaints that fees are too high in many plans, and that plans limit investment options to funds offered by the fund firm even if competitors have better ones.
Even IRAs, which by their nature allow investors much latitude, typically limit the investor to mutual funds offered by the fund company that holds the account.
So the provider industry responded by offering self-directed accounts that were more wide open. Like ordinary brokerage accounts and IRAs, these “brokerage windows” allowed account holders to choose just about any security they could find, including individual stocks and funds from other providers. There are some limitations compared to ordinary taxable accounts, though: active trading and fringe securities, options and futures may be barred, and there typically is no trading on margin.
Today there’s a good chance your brokerage or fund company offers a similar brokerage program. In recent years, about a quarter of 401(k)s offer this option, says Hattie Greenan, director of research and communications at the Plan Sponsor Council of America.
Vanguard, which made its name in buy-and-hold fund investing for ordinary folk, has recently been encouraging customers to switch to the brokerage option.
“This was a broad Vanguard initiative to enhance the experience for Vanguard clients who hold both brokerage and mutual fund accounts,” says spokesman Timothy Stokes.
For many fund firms, revenue is a motive as well, says Kenneth A. Raskin, PSCA’s chairman.
“There’s definitely something in it for them. When you make a trade they make a fee,” says Raskin, a partner at King & Spalding law firm in New York City and specialist in employee benefits and executive compensation. The fund providers do not earn commissions when plan participants switch from fund to fund in a typical 401(k), he adds.
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Experts say that in many cases brokerage options are offered to rank and file employees because highly paid executives want more choice and federal rules require that employees get the same deal given the bosses.
Many advisors say that a key question for anyone thinking of becoming a more active investor: how much time are you willing to devote? Reading prospectuses and annual reports can be tedious and requires close scrutiny of footnotes and management discussions. It’s dangerous to skip the work and bet on a tip from your brother-in-law.
“So who uses that brokerage window? It’s generally people that have investment advisors themselves, and they have the investment advisor help them” choose what to buy and sell, Raskin says.
For safety’s sake, many plans limit window investing to 25 percent of the account or less, he says.
Window-using customers also typically want an investment not offered in the regular account, like a socially responsible fund, and a good candidate will have better than average investing skill, he says.
Keep these things in mind before jumping in with both feet:
What are you trying to accomplish? If you’re really unhappy with the investing options in your basic plan, a brokerage account could let you break free. So what companies, sectors or geographical regions do you want to bet on that are not in the options you already have?
A broad international fund you already have may well put some of your money to work in emerging markets. Commodities may be represented in funds that own stocks like oil and grain firms. The home builders in your broad-based fund may be a good enough bet on that market without adding a real estate investment trust.
Look for alternatives. 401(k) choices typically focus on a few broad mutual funds, like index funds that own large-company stocks in the Standard & Poor’s 500. A brokerage option opens the door to similar funds that may have lower fees, like exchange-traded funds tracking the same index.
Consider costs. Savings from switching to investments with lower fees, can be offset by broker’s commissions charged when you buy and sell through the brokerage window. Your provider may offer a set number of commission-free trades at the start, but commissions could add up if you trade more than that later. Will you pay a commission when you put new money to work? Be sure you won’t be charged for merely reinvesting dividends and capital gains distributions.
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Think of risks. The opportunity to invest in virtually anything carries a temptation to follow the latest fad or to do the opposite and bull ahead with securities that are out of favor. Experts say investors who would not do this in their ordinary taxable accounts may not be skilled enough to do so in their 401(k)s.
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Self-Directed Funds Not for All Investors originally appeared on usnews.com
