Pros and Cons of Self-Directed 401Ks & IRAs

Pros and Cons of Self-Directed 401Ks & IRAs

By: Financial Planning Association

 

An increasing number of 401(k) and other types of qualified retirement plans are giving plan participants the option of opening a self-directed brokerage account within the plan. While this option offers participants a much broader universe of investment options, it is not without its risks, caution many financial planners and other investment experts.

Traditionally, employer-sponsored retirement plans have offered participants a varied but limited menu of mutual funds, ranging from a handful to 20 or more, and perhaps access to company stock. But some participants began pushing for more choices, especially with the explosion of online trading and the long bull market, so more employers have begun offering the option of self-directed brokerage accounts. The participant opens up an account with a brokerage firm of their choosing through the plan, which offers up a much wider universe of investment selections, sometimes including individual stocks and bonds.

 

Despite the market skid since the spring of 2000, the push for self-directed accounts continues to grow. In a survey earlier this year by Hewitt Associates, nearly 20 percent of employers offer self-directed accounts, another 5 percent will be offering them soon and another 30 percent are considering adding them.

 

How exactly do self-directed accounts work, and are they a good idea for both employer and employees? To begin with, self-directed accounts aren't usually as wide open as you might think. Most impose some limits on the participants. For example, participants might be able to invest only a portion of their retirement plan assets -- say 20 percent or a maximum monthly dollar amount -- in the self-directed option. The plan may limit investments to mutual funds. Others may allow individual stocks and bonds, but not municipal bonds, commodities, derivatives or buying on margin.

 

The main advantage of self-directed accounts is the increase in investment options, especially beneficial if the current plan offers a poor menu of mutual funds or the funds are performing poorly. Self-directing participants can then find better-performing funds or buy individual securities.

 

But this new flexibility comes with some risks and expenses, warn financial planners. First, is added investment responsibility on the part of the participant. Choosing from a large number of funds can be overwhelming, or the investor may end up buying only an individual stock or two that dramatically boosts the portfolio's level of risk.

It's also more tempting to trade frequently through such accounts, reacting to the ups and downs of the market.

 

Research shows that most workers using a plan's mutual fund menu tend to trade very little. That's why planners often say only more sophisticated investors willing to do their homework, including a careful review of their overall investment portfolio, should consider a self-directed option. In fact, according to the Profit Sharing/401(k) Council of America, less than five percent of employees take advantage of the self-directed option when it's made available.

Furthermore, self-directed accounts add to participants' cost. There typically is an administrative fee and there are transaction fees, though online trading may help keep these down. Usually these fees must be paid for by the participant.

 

Employers have mixed feelings about offering such plans. On the one hand, self-directed accounts help employers keep down the number of mutual funds they might otherwise be pressured to offer. More mutual funds mean more expenses and administrative headaches. Self-directed accounts are especially appealing to higher-paid executives, and by offering them, employers improve their ability to recruit and retain those executives.

 

On the other hand, surveys show that many employers refuse to offer self-directed brokerage accounts because they are concerned that employees will make poor investment choices -- and possibly sue the employer as a result. (Numerous studies have shown that plan participants already make poor investment choices with the limited fund menus.) How liable an employer may be with self-directed options is open to debate, but at a minimum, agree many experts, employers have to be very forceful in educating their employees about the risks.