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It's a frustrating scenario. Your
friends cashed in on the bull market last year, while your retirement money was stuck in a
limited number of stodgy mutual funds offered by your 401(k) plan.
If this describes you, take heart! Freedom is
coming in the form of self-directed 401(k) investment options. But that liberty also
brings increased responsibility to invest your nest egg wisely.
When it comes to her money, Nancy Crosby, a 48-year-old
information systems specialist, is a control freak. That's why she's aggravated with her
employer's current retirement plan—it doesn't give her enough discretion.
If she had the reins, she believes she could generate
better returns than the investment options offered through her plan. "In 1999, I had
a 93% return (in my personal portfolio)," she bragged.
Retirement plan participants with this itch to run the show
may soon get the control they want with something called a brokerage window or
self-directed 401(k). Unfortunately, Crosby doesn't expect her employer, a state
university, to offer this option at all.
This option lets the participant invest in almost any
mutual fund, stock, or bond. About 10% of employers in 1998 offered brokerage windows,
says the Profit Sharing/401(k) Council of America, up from none in 1993.
One watchdog group raises big concerns about self-directed
401(k)s. Crosby's startling return came from her dabbles in last year's soaring tech
stocks, a "fluke" of playing an explosive market. The Pension Right Center's big
questions: (1) When, not if, the market levels out or spirals downward, will self-directed
401(k) investors have diversified their retirement portfolio enough to protect their
retirement money? (2) Who's liable for the losses?
Increased Cost
Brokerage windows aren't cheap. Typically, investors pay an
annual administrative fee, plus all transaction fees. The annual administrative fee can
run up to $100 a year, said Ted Benna, president of The 401(k) Association and creator of
the first 401(k) retirement plan.
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For more on plan fees, read the 401Kafe's
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Charles Schwab & Co., Inc., one of the largest
providers of brokerage-window options, charges commissions according to its regular fee
plan, said Lance Berg, a company spokesman.
Increased Responsibility
With the increased freedom offered by self-directed 401(k)s
comes the additional responsibility to invest wisely.
A traditional 401(k) plan offers the worker some legal
protection. Employers are required to select investment options in the best interests of
their employees, according to the Employee Retirement Income Security Act (ERISA). If you
lost money in a particular fund due to the fund manger's incompetence, your employer might
be liable for failing to prudently choose a fund.
With a self-directed 401(k), you may be solely responsible
for any losses. That's a concern raised by workers at the Pension Rights Center, a
non-profit public-interest group representing retirement-plan participants' rights. Karen
Friedman, director of the Pension Fairness Project, is concerned about where the fiduciary
responsibility for self-directed 401(k)s ultimately rests. She holds that 401(k) plans are
employer sponsored and the employer should maintain some responsibility.
Benna recommends to his employer clients that they ask
workers choosing a self-directed 401(k) to read and sign disclosure documents saying
they're assuming full responsibility for their investment choices.
"I believe with that the employer washes their hands
of the liability," he said.
The liability arguments may be economically, not legally
motivated.
For this reason, plans may not advertise self-directed
401(k)s heavily to their participants, says Trisha Brambley, president of Resources For
Retirement Plans, Inc.
"The (plan) vendor doesn't make a lot of money (with)
that option" because often another firm provides the brokerage services, she
explains.
There have been few lawsuits to resolve these liability
issues.
Why Self-directed?
Still, self-directed 401(k) plans may be the best way to go
for some companies—striking a balance between employee control and employer
liability.
David Fisser, 52, is a pilot with Southwest Airlines. He's
also a member of the union's 401(k)-plan investment committee. The latter responsibility
can be almost as stressful as the former; especially when fellow pilots, many of whom are
active investors, suggest that the plan include their favorite fund.
Fisser would love to accommodate them, but it's not
realistic. If the union added all their suggestions, its investment offering would balloon
to 30 to 40 funds, thereby driving up the cost of, and time involved in, monitoring all of
the funds.
Fisser has a solution. In early July, the union—the
Southwest Airlines Pilot Association (SWAPA)—will roll out a new brokerage-window
investment choice. The pilots, should they choose the brokerage window, would be wholly
responsible for the funds they chose. For Fisser, it's a way to keep "my headaches
down," he said.
May Have Some Limits
Due to the lack of precedent on their liability with
self-directed 401(k)s, some employers place limits on self-directed 401(k)s. While some
say this defeats the self-directed nature of the investment option, "it's appropriate
for an employer to think about these kinds of restrictions," Benna said.
SWAPA plans to let pilots invest 25% of their core holdings
in the self-directed 401(k). The rationale is that the limit will prevent pilots from
losing their retirement nest eggs in one shot, should their investment choices turn out to
be poor ones.
Other plans may limit the investment choices to only mutual
funds or only stocks.
The SWAPA plan will offer individual equities, bonds,
mutual funds, and some exchange-traded equity options, Fisser said.
Know Thy Investments
If you choose a brokerage window, you will need to do more
investment homework than if you choose from a limited number of funds. You may need to
develop your own asset allocation strategy.
You will have to resist the urge, often fueled by free
advice from friends and coworkers, to put all your money in a single stock, advocates
certified financial planner, Kim Dignum, of Fort Worth, Texas. "If you have no
diversification, you are betting on one horse," she said.
In other words, you'll need to properly diversify.
Equities and mutual funds tend to be the most popular
choices among self-directed 401(k) users. The chart below shows how Charles Schwab &
Co., Inc.'s brokerage-window clients have invested their money.
"If you're the type of 401(k) participant who can't
decide how to invest among five funds, this probably isn't an appropriate investment
choice for you," Benna said.
Brokerage windows tend to be used by investors like Crosby
who read magazines and newspapers, and track stock-price performance to investigate their
investments. Indeed, only about 5% of employees who are offered brokerage-window
investment choices actually use them, Benna added.
Fisser expects 20% of pilots to use SWAPA's brokerage
window. But, he notes that pilots often have more time and money to manage their accounts
than people in other professions.
Most of the folks pushing employers to offer brokerage
windows are "higher paid people," Brambley said.
If you are not up for the homework, you could always hire a
financial planner to help you make your choices. Schwab, for instance, offers a
planner-referral service through its brokerage window, enabling its investors to get
recommendations from an independent financial planner for a fee.
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