Broker Check

Does Your 401(k) Have One of These?

| March 30, 2016
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401(k) Investment Managment

Self-directed brokerage accounts have been around for quite some time but don’t be surprised if your company’s human resources department and other plan literature doesn’t offer much information about it.  The reason: the company who hosts your 401(k) plan is often not the company who handles the self-directed brokerage account.  Therefore, when participants opt to allocate assets to the brokerage window, the core plan’s custodian loses out on the fees they earn on those dollars. 

But that should not be a reason not to use it.  Self-directed brokerage accounts are a great way to diversify your retirement account and gain access to stocks, bonds, mutual funds, exchange traded funds, and even add your financial advisor to your account for oversight and personalized service.  The investments available in the core plan are usually limited to a list of 5-20 different mutual funds.  Within the self-directed brokerage account, there are thousands.

Every employer offering a self-directed brokerage account has implemented different rules surrounding the use of the self-directed brokerage account.  To understand the basics, first consider your 401(k) plan as having two separate compartments; the core account and the self-directed account.  These are both within the 401(k) so do not worry that using the self-directed brokerage account is somehow creating a taxable event by taking a withdrawal[1]

The core account is the one that you’re probably accustomed to using.  It commonly consists of 5-20 pre-selected mutual funds that are (hopefully) periodically reviewed and occasionally replaced for poor performance.  This lineup will hopefully cover some of the spectrum of investments and include some U.S. large company stocks, U.S. small company stocks, international stocks, corporate bonds and government bonds.  Almost always, these investments are in the form of mutual funds; active and passive (index).  Commonly, 401(k) plans core accounts will offer target-date retirement funds that are supposed to be a single solution that simplifies investing.  By selecting the target retirement date fund near your target year of retirement, you get a pre-made mix of investments.  While these may help you to get a better mix of investments, there are shortcomings to this approach as well.  A primary critique of these solutions are their often high management fees.

Most plans that offer self-directed brokerage accounts will require that your contributions be made to the core account at all times.  So, you will still need an allocation for these dollars until you accumulate enough to meet the minimum transfer requirement, which is also a nuance to every employer plan.  Some plans will allow you to transfer as little as you like to the self-directed account while others may require your transfer be a more sizeable amount, such as $5,000 or even more. 

401(k) plans offering self-directed accounts also restrict how much of your total balance can be allocated to the self-directed account.  Some will allow you to allocate the majority while others will allow you to only allocate 50% of your total balance to the self-managed account.  What makes the most sense is a personal decision and definitely something that you should discuss with an objective third party professional.  Understand that the 401(k) representative may not be a very big advocate of you moving funds to the self-managed account because his or her paycheck is directly tied to the amount of assets in the core account.  That’s what we call a conflict of interest.  Ask an independent financial advisor for their help in making this decision.

Regarding fees… yes, there are generally fees for using the self-directed account.  Using the core account is not free either.  It’s a hotly debated matter but understand that the 401(k) is not a freebie.  With the core account likely consisting of 5-20 mutual funds, the fees are embedded in the mutual funds performance (or lack thereof) and are not entirely transparent.  While reading the prospectus might help you understand certain costs, mutual fund trading fees are difficult (arguably impossible) to discern because they can vary greatly from time to time and from fund to fund.  For instance, if you’re looking at the small company stock fund or the emerging markets stock fund, undisclosed trading expenses could be much more than what you’d think (a whopping 3-5% per year).  So, when someone discourages you from using the self-directed brokerage account because of expenses, understand that there are always two sides to every argument.

A 2015 study conducted by Empower Retirement and its subsidiary Advised Assets Group[2] suggests that participants who are using a managed account in their 401(k) retirement account are outperforming by nearly two percentage points over the five year period ending March 31, 2015.  Managed accounts being available through the self-directed brokerage account. 

Finally, understand that your financial advisor may have the ability to help you manage your account only if it is allocated to the self-managed account.  While many financial advisors may offer tips or advice on which funds to use in your core plan, in all likelihood, their compliance and supervision departments would prohibit them from doing so.  Why?  Legal liability.  Offering advice without any official contractual agreement (including a fee) probably voids their errors and omissions coverage should things go awry.   It is an unfortunate aspect of modern living that handshakes and goodwill are not acceptable methods of doing business.  By using the self-directed brokerage account, your advisor may be able to be added to the account for oversight.  Yes, they will be compensated for this but consider this question.  When was the last time you got something for free that was worth having?  Also consider that the average investor underperforms drastically when they invest.  Dalbar recently revealed that the average investor underperformed the stock market by 74% over the 20-year period ending 2015.  Said differently, the stock market produced a return of 8.19% while the average investor produced a return of 2.11%.  That’s more than a 6% difference.  Now, the unanswerable question, unless you have a crystal ball, is whether or not with your advisor’s help, you will earn more than the added cost above and beyond what you would get by doing it ALL BY YOURSELF.  Think about it.

[1] Allocating dollars to a self-directed brokerage account does not constitute a withdrawal.  Withdrawals from 401(k) plans may be taxable and may incur additional penalties if taken before age 59 ½

[2] A registered investment advisor.

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