HR Administration

A Dangerous Leap Through the Brokerage Window

By Roger Levy

Apr. 28, 2010

In its survey, Trends and Experience in 401(k) Plans for 2009, Hewitt Associates noted that more plan sponsors were offering employees the option of a self-directed brokerage window. Hewitt indicated that usage had grown by 44 percent since 2007 and that, as of 2009, 26 percent of plan sponsors were offering this investment option.

This trend is alarming to those who believe that self-directed brokerage windows represent a fiduciary quagmire and see it as the antithesis of investment prudence, running counter to the emerging view of many investment experts that participants should be removed entirely from the investment process. Letting participants jump through the brokerage window is tantamount to giving the inmates run of the asylum.

A self-directed brokerage window is an arrangement allowing participants to establish a brokerage account as an investment option within their 401(k) plans. Originally favored by professional firms, the windows provide those wishing to actively manage their own investments the opportunity to select mutual funds not otherwise offered as core investment options.

Indeed, except for a few investments foreclosed by the Employee Retirement Income Security Act of 1974, such as options, commodities, short selling and margined transactions, few restrictions apply to brokerage windows unless they are imposed by the plan sponsor. These restrictions might place further limits on investments available through the window or limit the percentage of a participant’s total account that the brokerage window may represent. Given that some arrangements place minimums on initial investment or impose additional setup and/or recurring fees, brokerage windows do not appeal to every participant, but clearly there is sufficient demand that they should warrant attention among plan sponsors.

Regulations under Section 404(c) of ERISA relieve the plan sponsor and other fiduciaries from liability for participants’ investment decisions, provided certain conditions are met. One of these is that the plan offers a “broad range of investment alternatives” from which a participant may select in order to meet different investment objectives and avoid the risk of large losses.

The brokerage industry and other proponents argue that a self-directed brokerage window is inherently compliant with the section because it essentially offers unrestricted access to the entire universe of investment alternatives. While nothing in the regulation specifically speaks to this, this is the thinking that underpins the marketing of brokerage windows. Indeed, there may be some merit to that claim as discussed below.

The selection of an investment option for inclusion in a plan’s investment menu is a fiduciary function and requires that the plan fiduciaries act prudently in evaluating the option and how it may be used to assist participants in achieving retirement income security. Once selected, the fiduciaries must monitor and evaluate the performance of each investment option within the plan to ensure that it continues to conform to the plan’s selection criteria. The requirement is no less applicable to a brokerage window than it is to a mutual fund. However, in the case of a brokerage window, no meaningful evaluation can take place without examining the investment activity within the brokerage account of each participant who takes advantage of this investment option.

Some will say that if the plan conforms to ERISA section 404(c), the participants are responsible for their own investment selection among plan options and the fiduciaries are relieved of liability for losses. But this relief applies only to the extent that losses incurred by a participant result from the participant’s “exercise of control” over the assets in his or her account, and not if losses result from imprudent selection of the investment option by the fiduciaries. Therefore, fiduciaries remain responsible for prudently selecting, monitoring and evaluating an investment option. One is left with the conclusion that if evaluation is to have any meaning from a prudence perspective, fiduciaries have no choice but to monitor how participants are making use of the brokerage window.

As an example, let’s say a plan has 200 participants and 15 percent of them use the brokerage window. That means in monitoring the investment performance of the plan investments, the fiduciaries must evaluate 30 separate accounts in addition to the plan’s other options. Getting monthly or quarterly statements from the plan’s brokerage window provider should be relatively easy, and a quick review will identify how participants are making use of the broad flexibility that the brokerage window affords. The more difficult issue is what to do with the results of the review.

A fiduciary has no obligation to provide participants with investment advice and may incur liability for doing so. ERISA does not permit the plan to refuse to implement a participant’s investment direction simply because the plan fiduciaries think the participant is making imprudent choices. So if participants are making imprudent use of the brokerage window, the only prudent solution is to cease offering this as an investment option. Recognizing this potential outcome in advance, wouldn’t prudence suggest that plans should avoid brokerage windows altogether?

Some will argue just the opposite: that section 404(c) was intended to extend relief from liability to fiduciaries of plans that offer brokerage windows, irrespective of whether or not prudent use is made of that investment option, and that removing both the right of a plan to interfere with a participant’s investment direction and the obligation to provide investment advice are part of the regulatory relief regimen. This argument has merit, but a court has yet to support it and, in the meantime, fiduciaries that ignore the activity within participants’ 401(k) brokerage accounts do so at their peril.

Finally, leaving aside the issue of regulatory relief from liability, should an employer who is truly committed to ensuring that employees use their 401(k) plans to achieve a secure retirement income offer an investment vehicle that— more likely than not—will thwart that goal? Would it ever be prudent to offer generally unsophisticated investors, who might not otherwise have a brokerage account, so much latitude with their retirement nest eggs?

Consider the participant who does not take advantage of the breadth of diversification offered by a brokerage window but instead invests his entire brokerage account in the stock of a single issuer that goes belly up? What’s the prudence of such a strategy, which is entirely feasible within the brokerage window? Consequently, from a best practices or “prudent expert” standpoint, does a brokerage window make sense?

A study conducted by Vanguard, “Red, Yellow and Green: A Taxonomy of 401(k) Portfolio Choices” (June 2007, the Pension Research Council), found that 57 percent of 401(k) participants make asset allocation errors in terms of diversification and/or equity weighting (meaning they are too aggressive or not aggressive enough). This suggests that such errors may arise, if not multiply, within a brokerage window.

Lifestyle and target-date funds point the way to placing investment decisions in the hands of professional managers, and many experts argue that 401(k) plan participants should no longer have the right to direct their investments. This stands in stark contrast to the use of a brokerage window. But even if one does not go so far as to remove participants from the investment process, there are clear questions of prudence that employers should consider when evaluating a brokerage window. They must decide whether this option will truly help employees achieve retirement income security.

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