What are the considerations in offering a self directed 401(k ...

Plan Sponsor Education Series

What are the considerations in offering a self-directed 401(k) account?

Self-Directed 401(k) Account Basics

What is a self-directed 401(k) account?

A self-directed 401(k) is a brokerage account that provides a broad range of investment alternatives to experienced investors who prefer to do their own trading.

Participants typically open a self-directed account with a brokerage firm through the employer's plan and trade at their own discretion, making their own investment choices. The primary benefit of a self-directed account is the participant's access to a far wider range of investments than one typically finds in a pre-selected portfolio.

Can restrictions be made on which investments participants can hold?

Most plans limit the types of investments available to investors. Some plans allow individual stocks and bonds; others limit the participant to mutual funds. Participants generally are not permitted to buy municipal bonds, commodities, derivatives, options, or futures. Buying on margin and selling short are also restricted.

Key Point

Self-directed 401(k) accounts provide greater investment alternatives to experienced investors who prefer to do their own trading. The primary benefit is the participant's access to a far wider range of investments than one might typically find in a managed model portfolio.

Plans also may limit how much a participant may invest. For example, a plan may limit participants to investing only a specific percentage or monthly dollar amount of their total plan assets.

Does offering self-directed accounts require more disclosures or result in greater liability?

Self-directed brokerage accounts typically result in greater liability for plan sponsors and fiduciaries.

Under the Employee Retirement Income Security Act (ERISA), plan fiduciaries must act prudently in selecting and monitoring investments offered to participants. As a result, plan fiduciaries could end up in breach of their fiduciary duty if participants lack the required investment sophistication, education, and know-how to make sound investment decisions.

Even among participants who consider themselves to be savvy investors, a large percentage often purchase funds that are inferior to those offered by their plan.

This can be a tricky balancing act for plans wishing to offer self-directed accounts to entice and retain their highly paid executives, who typically are the driving force for offering these accounts in the first place. ERISA and the IRS forbid plans from discriminating when it comes to self-directed accounts. If a plan offers a self-directed account, it must be made available to all participants, not just the experienced investors.

What fees are involved in self-directed accounts?

A self-directed arrangement with a brokerage firm may increase a plan's record-keeping and audit fees, as well as a plan's overall expense. Participants typically pay all or most of the investment management, trading, and administrative fees.

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What are the advantages of offering this type of account?

The main advantage for participants is the abundance of investment options for the experienced investor, particularly in plans offering a limited choice of mutual funds.

For plan sponsors, self-directed accounts allow the company to limit the number of mutual funds it might otherwise have to offer. The more mutual funds a plan offers, the greater the expense and administrative hassles. Self-directed accounts are also a good way to attract and retain highly paid executives.

Take Action

While self-directed accounts increase the investment options for experienced investors, they are not without risks. For employers that offer self-directed accounts, employee education should be a top priority. It is important that employees understand both the advantages and disadvantages before opening this type of account.

What are the disadvantages?

Self-directed accounts are not without risks. Many participants find themselves overwhelmed by the vast array of investment alternatives. Ultimately, the participant may end up buying only a very limited number of investments that can increase the portfolio's risk level.

Overconfidence, which leads to overtrading, has been cited as a major reason for poor success rates. Participants who have an inflated sense of their investment prowess tend to trade more, which statistically lowers their returns. Frequent trading also drives up transaction fees.

In addition, as attractive as self-directed accounts may initially seem, surveys show that only about 6 percent of employees take advantage of this feature in plans that offer it.

It's not surprising that many employers refuse to offer self-directed accounts given the growing concern that employees ? experienced investors and novices alike ? may make poor investment choices and sue. For employers that do offer self-directed accounts, education should be a top priority. Employees need to understand the risks before opening this type of account.

Additional considerations need to be made to ensure, as plan sponsors, you understand the 408(b)2 disclosure requirements and the participant 404(a)5 fee disclosure requirements and are able to demonstrate that you're meeting them both. It's highly recommended that you consult an ERISA attorney to verify compliance with these regulations if you do offer self-directed accounts.

Disclaimers:

This fact sheet was developed by Financial Service Standards, a division of fi360, Inc. and is part of The 401k Service SolutionTM set of tools. The 401k Service Solution is a trademark of Financial Service Standards. The information on this fact sheet is provided for educational purposes and was developed based on current legislation. Because regulations regarding this subject change, check with your ERISA attorney for the most current facts.

? 2005-2013 Financial Service Standards, a division of fi360, Inc. Abele Office Park, 10 Emerson Lane, Suite 801 Bridgeville, PA 15017 All rights reserved.

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