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| > Investing > Fiduciary Focus |
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| Fiduciary Focus: Risk of Self-Directed Brokerage Accounts in 401(k)s |
| by
W. Scott Simon
| 01-05-06 |
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Those of you that are investment advisors to fiduciaries of 401(k) plans are probably familiar with what is referred to as a "self-directed brokerage account" (SDBA). A SDBA is also know as a "individually directed account," "personal brokerage account," "self-directed option," "self-directed brokerage option," "self-directed brokerage window," and "self-directed investment account."
Fiduciaries of 401(k) plans have the authority under the Employee Retirement Income Security Act (ERISA, the comprehensive federal law that governs the implementation and operation of 401(k) plans) to add a SDBA option to their plans. This option allows every participant in a self-directed 401(k) plan to open an individual brokerage account. Although a plan participant's SDBA is a separately designated account, it is still part of the participant's overall 401(k) account.
Although long permitted by ERISA law, SDBAs were not particularly popular until the bull market of the 1990s came along. Professional groups particularly seized on this seldom-used option. Suddenly, attorneys, doctors, engineers, architects, and accountants discovered that they could day-trade inside their own 401(k) retirement accounts. (While it's probable that many among these groups made some quick money through day-trading in their SDBAs on the way up, it is equally probable that they lost just as much, or more, money on the way back down. That's another story, though, not appropriate for telling in polite company.)
In a SDBA, a participant in a 401(k) plan has the ability to invest in virtually anything--apart from certain investments specifically forbidden by ERISA, such as options, futures, commodities, derivatives, and even municipal bonds. Nor can a participant in a SDBA sell short or margin his or her 401(k) account. In general, such participants cannot employ an investment strategy that will result in losing more than the total value of their account (i.e., a leveraging strategy).
Brokerage firms (and other vendors), of course, have been all too happy to peddle the SDBA option to fiduciaries of the 401(k) plans for these professional groups. Part of their sales pitch to fiduciaries is that they will incur less liability by offering a greater number of investment options to plan participants. The general counsel of a large brokerage house adds that a SDBA option enables fiduciaries to give plan participants more choices without the expense of due diligence, management, and recordkeeping for multiple funds.
So there you have it: The SDBA option is good for plan participants because they get to invest in virtually anything under the sun, it is good for plan fiduciaries because they get to reduce their liability and save money, and it is good for brokerage firms because they get to make more money. That sure seems like a win-win-win situation. Things, unfortunately, are a bit more complicated than that.
Not so, of course, for brokerage firms. Their win is simple and secure because they most assuredly get to make more money since a SDBA allows them additional distribution channels.
What about the win for participants in SDBAs? Well, I have seen the SDBA accounts of far too many attorneys, doctors, and other professionals who not only have not won but have lost horribly--during one of the greatest bull markets on record.
And what about the win for fiduciaries of 401(k) plans that offer the SDBA option? Brokers contend that a SDBA option is good for plan fiduciaries because they incur less liability. That, in a nutshell, is simply false. Here's why.
When fiduciaries of 401(k) plans offer a SDBA option, a plan participant can establish a SDBA with his or her favorite broker either on a standalone basis or through a plan's master custodian.
Fiduciaries of 401(k) plans that offer a SDBA option are asking for trouble if they allow plan participants to establish a SDBA with their favorite brokers on a standalone basis, apart from a plan's master custodian. ERISA charges investment fiduciaries of 401(k) plans with the duty to make sure that their participants make prudent asset-allocation decisions for their plan accounts. How is it at all possible for plan fiduciaries to live up to that duty--not to mention the equally critical duty of monitoring such asset allocations to ensure that they remain prudent--if the fiduciaries don't have any idea what SDBA participants have invested in?
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| W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing. Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals. For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. |
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