The downside of self-directed brokerage accounts

By Marijoyce Ryan

The Daily Record Newswire

Profit sharing and 401(k) plan participants often expect that self-directed brokerage accounts will provide more choices and wealthier retirement prospects than do managed (model) portfolios. At the same time, plan sponsors might expect reduced liability with more investment choices. However, the substantial underperformance, costs and liabilities dictate caution.

In addition to a core menu of funds, many 401(k) sponsors now offer participants the option of self-directed brokerage accounts. During the bull market of the 1990s, when irrational exuberance was at its peak, participants pushed for more choice because of a build up in overconfidence in their own trading skills. Also, with more powerful technology being developed, participants were eager to have daily access to account balances and online trading capabilities.

A survey conducted by Hewitt Associates shows that only 7 percent of large plans in 1999 offered brokerage accounts compared to more than 50 percent now. Of this group, 75 percent cited employee demand as the primary force for adding the option. Interestingly, only about 6 percent of employees with this feature actually use it.

In terms of successful retirement outcomes, the performance is generally lower with self-directed accounts compared to managed portfolios. This translates into low real rates of return and higher retirement failure rates.

Further studies indicate that the most prevalent behavioral trait in individuals who use their self-directed accounts is overconfidence. These investors tend to have higher turnover rates that far exceed the trading rates for "rational" investors. (Rational investors make periodic additions and withdrawals and re-balance their portfolios on a regular basis.)

The tendency for plan participants to trade more often in their self-directed accounts directly impacts their performance. This is due to higher fees and emotionally-driven decisions.

Psychologists find that in areas of finance, men tend to be more overconfident than women. This leads men to trade more and have lower performance than women (almost directly proportional to higher trading fees). Also, in general, investors with self-directed brokerage accounts have a tendency to chase past performance. On average, stocks they purchased had higher returns the previous two years than did the stocks they sold.

From the employer's perspective, they have been led to believe by the brokerage industry that adding self-directed brokerage accounts reduces fiduciary liability because it helps remove most investment restrictions.

This is a myth! The fact is that more investment options create greater fiduciary responsibilities relative to evaluating and communicating retirement plan investment options prudently.

ERISA imposes on plan fiduciaries the responsibility of acting prudently and in the sole interest of the plan participants. The Department of Labor has opined that fiduciaries must consider the nature of the workforce in selecting 401(k) investments and whether participants have the education, experience and ability to make intelligent buy-and-sell decisions about individual securities. If fiduciaries do not keep these considerations in mind, offering self-directed brokerage accounts may actually be a breach of their duty.

Department of Labor regulations make it clear that plan sponsors need to review the investments that participants purchase in their self-directed brokerage accounts. This is in addition to their responsibility to evaluate and monitor funds that are offered by the plan. Fiduciaries need to conduct periodic reviews of the self-directed accounts to eliminate inappropriate investments. Your investment policy statement should outline the universe of appropriate or inappropriate investments.

Many fiduciaries do not understand the extent of their duties -- or, if they understand them, they do not have the time to fulfill them. Adding self-directed brokerage accounts adds another layer of complexity to fiduciaries' responsibilities.

Why add extra features to plans that will cost more, increase fiduciary liability and create an environment where participants will experience below average returns? Savvy employers are learning that keeping their retirement plans simple and maintaining proper fiduciary oversight leads to successful overall results.


Marijoyce Ryan, CPP, is vice president of fiduciary services for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully's Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.

Published: Thu, Jun 28, 2012