Personal Brokerage Accounts in 401(k) Plans

[Guest MPretlow]

I have a client that is interested in choosing a provider that offers personal brokerage accounts in their 401(k) plan. Can anyone share any experiences with this type of 401(k) specifically with regard to the fiduciary liability.

[k man]

Some people think that self directed brokerage is the ultimate 404© compliance since participants have seemingly infinite investment choices and access to their accounts anytime. Thus fiduciaries would have an added level of protection when offering this vehicle.

[Alan Simpson]

As a TPA that allows plans to have self-directed accounts I would like to point out a few things. If the plan participants are required to use a specific broker the Plan Administrative Committee/Trustees are still retaining some fiduciary liability since they are requiring the participant to use a specific broker, not the broker of the participant's choice. While generally this may not really matter, it could if you have a participant with a large account balance and a down market. The participant could then be upset with the investment advice from the broker and possibly go against the company because the participant was "forced" to use a specific broker.

If the company really wants to lessen its fiduciary liability they should review a number of brokers and allow the participants to pick and choose from those brokers as well as offering a few mutual funds (maybe 6 or 7) for those that do not wish to have a brokerage account. When a participant indicates that they would like to use a broker that is not on the "approved broker" list, some due diligence shold be performed to determine whether that broker could be added to the "approved" list.

Be aware, that self directed account need to be watched carefully to avoid any possible prohibited transactions, that the broker is aware of the approved investments according to the plan document/investment policy, and that recordkeeping fees for the plan will more than likely increase due to the extra time to reconcile multiple accounts.

Historically, it seems that the participants with large account balances are interested in the brokerage account while the smaller account balances are more likely to use a select group of mutual funds, if offered.

[Kirk Maldonado]

Be careful about unrelated business taxable income from certain investments.

[k man]

Alan's post assumes that there will be a broker making recommendations. I don't think this is the way they are set up these days. I think the trend today is to offer self directed brokerage as an investment "option" in addition to several mutual funds and the firm offering directed brokerage will try not to take a fiduciary position.

[Jon Chambers]

Actually, I think Alan's post goes to one of the primary concerns with brokerage accounts--that not all securities are available through all brokerage firms. For example, if you want a Merrill Lynch mutual fund, you generally have to buy that fund from a Merrill Lynch broker through a Merrill Lynch account. If as a plan sponsor, if you don't offer Merrill Lynch brokerage accounts, you haven't made those funds available, thus you have constrained employees' choices (of course, similar availability arguments could be made for any brokerage firm). I've been at conferences where DOL representatives indicate that where you constrain choice in any manner, you impose due diligence review requirements for all funds made available. I don't necessarily agree with this argument, but I see their point.

Let me make a different point. With brokerage accounts, your Investment Policy Statement (IPS) is crucial. It should define what fund selection and review responsibilities the sponsor is retaining, and what is passed to the participant and brokerage firm. To many plans' IPS are silent on this issue.

I have a paper on our firm's web site that addressed brokerage accounts in more detail. You may want to check out www.schultzcollins.com.

Hope this helps,

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Jon C. Chambers

Principal

Schultz Collins Lawson Chambers, Inc.

(415) 291-3004

[Dave Baker]

Personal brokerage accounts are the subject of an article on the 401Kafe.com web site this week -- http://www.401kafe.com/commentary/feature/feature.html

[MoJo]

Not to raise new issues - but I think an argument could be made that a self directed brokerage account could never be 404© compliant. 404© requires that participants be given sufficient information to make "informed" investment elections. By offering the world, you are essentially committing to educating participants to be investment professionals in the general sense -rather than retirement asset allocators, as you would with a limited number of investment options in the plan.

[k man]

Fred Reish also has an article out concerning directed brokerage and 404©. His contention is that plan fiduciaries can get 404© protection on these accounts so long as the plan meets certain 404© requirements.

To obtain protection he says that the plan must offer a broad range of investment alternatives. To meet this requirement, the Regs say the plan must provide at least three diversified investment alternatives. These are called the "core investments." Second, the plan must give participants the opportunity to excercise control. This is done byu giving participants the opportunity to change their investments frequently and by providing prescribed information to participants.

[This message has been edited by k man (edited 05-10-2000).]

[Jon Chambers]

With regard to MoJo's comment regarding "informed" investment elections, the 404©regs set different standards for "designated" investment alternatives, and merely available options. Consensus of opinion in the community is that an investment structure that provides 404© required information for the designated alternatives, and general information relating to the brokerage account should receive 404© protection. This is one of the primary arguments for NOT having a brokerage account only structure. K Man's summary of Fred Reish's article makes the point that brokerage accounts work best in combination with a group of designated alternatives.

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Jon C. Chambers

Principal

Schultz Collins Lawson Chambers, Inc.

(415) 291-3004

[KJohnson]

I have read the Reish article and hope that is a correct interpretation because a number of employers are demanding a PBA option. However, I am still not completely convinced that the the distinction between "designated investment alternatives and other "administratively feasible" investment alternatives is that clearly set forth in the reg. It would seem that someone could argue that any investment available under the Plan would be a designated investment alternative. The following language is from the preamble to the 404© regs where it appears that DOL is stating that the information requirement applies to "each investment alternative available under the plan":

"First, the Department has concluded that the obligation of an ERISA section 404© plan fiduciary to disclose information should not be limited to information conerning those investment alternatives intedned to satisfy the 'broad range' requirement of the regulation, but rather should extend to information concerning the plan itself and each investment alternative made available under the plan. The Department can find no reasonable basis for distinguishing between information concering investment alternatives which are intended to satisfy the "broad range" requirement and information concering any other investment alternattive made available under a plan in terms of value to participants and beneficiaries in evaluatiing thier investment options and making informed investment decisions"

Does anyone know if DOL has formally or informally "bought off" on the distinction between designated investments and other "administratively feasible" investments?

[k man]

The KJohnson post scares me in that it seems to imply that the education process extends to the complete plan and all possible investments. Futher, that plan sponsors might have to expressly caution against participants buying risky stocks in a directed brokerage account at the expense of maintaining some acceptable asset allocation model.

[MoJo]

Not that I agree with the DOL preamble, but it is precisely the point that KJohnson is raising that I intended to address in my prior post. The brokerage option does seem to be the wave of the future (current) but one must question whether, given the transactional nature of the 404© protection, such a feature is consistent with the spirit of the regs. I've yet to see a brokerage option that is "seemless" with the core options in the plan (usually a day or two lag in transfers, etc.), and have never seen a platform that can effectively guard against plan or ERISA prohibited investments (i.e. how does one prohibit the purchase of employer securities in a brokerage account, when employer securities are not authorized in a plan (as I read the requirements - plan authorization and restriction are required under ERISA) and worse yet, what about 16b implications?). The problem here, is that 404© protection is only afforded where the plan sponsor prudently selects the investment options. Is a brokerage window an option, and if so, is allowing it considered "prudent" with no parameters around it or restrictions on investments within it?

[This message has been edited by MoJo (edited 05-11-2000).]

[Jon Chambers]

Again, I believe I agree with the last couple of posts. My observations are as follows:

1) There's no sponsor responsibility for prudent selection of alternatives where there is no selection of alternatives (i.e., where participant can open brokerage account with any broker/dealer).

2) I've heard DOL opine at conferences that where any constraints apply (e.g., all brokerage accts must be with Schwab) that the sponsor then has responsibility for determining that all alternatives offered through the acct are prudent. Obviously, this is a practical impossibility.

3) We have many clients with brokerage accts, generally with a designated broker/dealer. In the real world, we deal with the fiduciary issues by:

a) having a prudently selected group of core fund options available

b) having the investment policy expressly indicate that the core fund options are the plan's primary investment vehicles, and that participants who choose to invest outside the core funds do so at their own cost and own risk

c) charging participants for the incremental costs of the brokerage accts, reinforcing (B) above

d) adopting some reasonably prudent constraints on investments in the brokerage accts to demonstrate some minimal level of fiduciary oversight (e.g., no investing in core funds, no muni bonds, no company stock, etc.)

e) developing procedures for demonstrating the prudence of the sponsor's selection of the designated broker/dealer

Will this be enough to get 404© protection? We don't know, but it seems reasonable to us.

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Jon C. Chambers

Principal

Schultz Collins Lawson Chambers, Inc.

(415) 291-3004

[MoJo]

I agree Jon, that the approach you have is probably the most prudent, but yet the DOL has been inconsistent on the issue. Obviously, the use solely of brokerage accounts would be a problem in the DOL's view (as the plan fiduciaries are not exercising tehir responsibility to "select" appropriate investment funds. But then, by "actively selecting" a brokerage option, would not the fiduciary be advocating that as an appropriate vehicle for the investment of plan assets? Keep in mind, that restrictions on the use of a brokerage account to some only would be prohibited as a discriminatory benefit, right and feature. Hence - the mere allowance of the accounts must mean that the fiduciary has determined that it is more appropriate than not, for the "plan and all of its participants." Its a classic catch 22. The DOL needs to clarify formally, or a legislative change needs to occur. Couple this with the recent trend towards providing advice, and the whole scenario becomes ridiculous (i.e. if participants need advice, why are giving them more and faster ways with which to demonstrate their lack of understanding of the investment process?) Can't be all things to all people. Maybe its time go back to professionally managed assets. Stats indicate they consistently outperform participant directed....

[BeckyMiller]

Another consideration with such individual brokerage accounts, realize that all of this activity must be consolidated somewhere, somehow for the plan's financial statements. A plan with fewer than 100 participants has somewhat less financial disclosure than a large plan with ERISA schedule and an audit, but the assembly task can still be complicated.

The recent changes in the Form 5500 series and the new financial disclosure standard for audited plans has reduced the amount of detail for participant directed accounts, but the cumulative activity must still be reported. Where one brokerage house is used, this summary may be provided by the brokerage house. Where multiple brokerage houses are used, the plan sponsor must be prepared for the additional cost of doing this.

I am not making any recommendations, I am just advising that there is more to consider. We audit a couple of large professional services plans (doctors, lawyers, etc.) that authorize full investment discretion through the participant's broker of choice. One plan has 2 fulltime clerks responsible for tracking this activity for the plan's reporting. The others pay someone else to do it. In the case of one plan covering roughly 400 participants, the additional cost to assemble this information was $60,000. This cost was incurred when we still had to track reportable transactions for self-directed plans. It might be less now, but it will still be substantial.

[Guest tschenk]

Could the participant directed features also raise issues of suitability? Consider an example where a participant guts his account with a portfolio of high risk tech stocks or overtrades. While ERISA doesn't directly address something like this, could one imagine a case like this coming before the courts? Where there is little or no case law to rely on, is it not logical for the courts to look for parallels in the securities industry? While some culpability may be found for the broker of record, what about the plan sponsor - acting as a fiduciary? In that capacity, should the plan sponsor be looking over the shoulder of the participants and monitoring their activity? Isn't that what a fiduciary should be doing???

Also, keep in mind the trend in the courts to often side with the plaintiff's as victims in product liability litigation. Could self-directed accounts be like turning a kid loose at a gun store? It is not too difficult to extrapolate into the future where the emotional impact of a generation of baby boomers who have done dumb things with their retirement savings and investing will point their fingers at the evil corporation (read- deep pockets). I'm sure there are a few politically ambitious attorney generals who will take up the cause of this demographic group in the future, too (not to mention plaintiff lawyers.)

I apologize for the editorial, but while self-directed accounts are fine options for some participants, there are many more who will find a sizable account balance too great of a temptation not to succumb to the hype of the financial media and hurt themselves with investment decisions that are inconsistent with prudent, long-term investing. Plan sponsors should just say no to this popular trend. A little common sense may be in order. Yes MoJo, it is time to bring back professionally managed assets. From the inception of 401(k) plans, it was crazy to assume that ANY participant could and would acquire the skills and disciplines to manage a retirement portfolio that may have to carry them for a quarter century or more of retirement. Corporations used to hire teams of actuaries, consultants and money managers to do this stuff! Allowing self-directed accounts - while fine in pure theory - may turn out to be the worst business decision an investment committe could ever make. It's not as if they don't have enough liability already, just give your workers the tools to emulate the actors on the get rich quick E-Trade commercials.

[Guest bflynn]

This market is hot right now and as an investment advisor I see potential for fee based advisement through brokerage accounts.

I believe that if the plan sponsor would invite the broker in to the company and cover or split the cost of a consultation they could cover themselves from any potential future litigation.

[Kirk Maldonado]

While I don't discount the possibility that somebody will lose a lot of money in a scenario similar to that TShenk posits, I don't think that there is any realistic risk of liability to the fiduciaries.

Could you imagine a participant going into court, "Can you believe what those fiduciaries of the plan did? They invested my money exactly how I told them to! Can you imagine anything so outrageous in your life? I think that you should make them personally liable for doing exactly what I told them to do."

I find it almost inconceivable that a court or jury would find for somebody who made that argument.

[Guest tschenk]

I was a broker for 22 years with a major Wall Street firm. It was their policy each month to circulate in each branch and to each broker (initials required for acknowledgement) a summary of all recent court and arbitration rulings that were handed down regarding compliance violations of one sort or another. The obvious purpose was twofold: to scare any undiscovered wrongdoers straight and to put the good brokers on notice as to how often the courts rule on absolutely absurd complaints - so document everything. In response to Kirk Maldanado's comment, if you think that scenario is absurd, call a compliance counsel at ANY brokerage firm and you'll be told farfetched it really is. Or call an attorney who specializs in trust law and ask him to recall cases of fiduciary violations that most of us could never conceive of. Securities laws have had a long head start in developing case law while ERISA is not only new, but it involves a process (saving for retirement) that takes years to unfold. Under ERISA, not only can the participant bring suit, but even their beneficiary! How many heirs will claim that mom or dad made "uninformed" decisions in their self-directed account over the years?

My observations of working with indinidual investors over the years were quantified in two recent studies: Individual Decision-Making and Investor Welfare by Michael Brennan and Walter Torous of UCLA (1-99) and Naive Diversification Strategies in Defined Contribution Savings Plans by Shlomo Benartzi (UCLA) and Richard Thaler (U- Chicago) 1-99. In short, when it comes to people's money and investing, people are their own worst enemy. It's also noteworthy to add Dalbar's study of investor returns at a brokerage firm from 1984(?) to 1997: individuals averaged about 7% while a passive S&P made 17%, People tend to cut profits short and let losses run and time the markets and they are influenced greatly by the media and peers. If the participants requesting the self-directd option feel that they can outdo the broad market by their own trading, just remind them that 75-80% of active money managers with all their information technologies and staffs can't beat the market.

When a prudent plan sponsor reads any of these studies, one must ask if self-directed accounts are going to hurt more people than they will help? Or, rather, is this going to produce more problems in the long run than it will solve? Remember, this is America and no one is responsible for their own actions, it's usually the fault of whomever has the $. :~)

[This message has been edited by tschenk (edited 06-01-2000).]

[Jon Chambers]

With regards to bflynn's comments:

I agree that there is a significant opportunity for providing advice on individual brokerage accounts. A qualified advisor has the ability to play an important role when the advice is not constrained by a brief menu of fund choices. For various fiduciary reasons that I won't go into here, it's preferable that the advisor be a "QPAM" (qualified professional asset manager--check the regs) However, companies that "invite in" advisors, and/or pay a portion of the cost become co-fiduciaries responsible for the advisor's recommendations. In my experience, companies rarely want to take on that liability.

With regards to tschenk's comments:

I don't believe that a suitability determination is required, or should even be attempted. The whole purpose of self-direction is to take the employer out of the investment decision-making process. An employer that made suitability based recommendations would lose the 404© protection, and would probably violate securities laws, because they would be providing advice without any background or licensing in investments.

With regards to MoJo's comments:

I believe that the regs are pretty clear that 404© protection extends to brokerage accounts, and that the information requirement does not extend to providing data on every potential alternative. In numerous areas, the regs refer to brokerage accounts, and how they comply, but they also set up numerous potential hurdles that need to be considered. The whole process is tricky, but if handled properly, with prudent selection of the brokerage provider, reasonable trading restrictions, and an appropriately structured Investment Policy Statement, the potential fiduciary liability issues are manageable.

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Jon C. Chambers

Principal

Schultz Collins Lawson Chambers, Inc.

(415) 291-3004

[MoJo]

Well, that raises the question considered in previous posts - can you comply with 404© with a brokerage account option? Absent 404© compliance, ERISA is clear that the fiduciary is liable, *even* in participant directed accounts.

[Guest tschenk]

Jon-

I understand your comments on suitability but I'm speaking more to where does fiduciary oversight enter the picture. If a plan sponsor sees an employee trade his 401(k) account into oblivion, should he say something, or just figure he's covered under 404© and overlook it? Also, since plan sponsors are held to a higher standard than a mere mortal, should they not be aware that offering a feature like a brokerage window (based upon several studies of individual investor returns) could subject them to at least some criticism in litigation?

I also understand your response to MoJo. I know that this issue is not black and white, but I'm interested in the difference between legal theory and the real world.

If a corporate client of yours (who had "typical" due diligence procedures) asked your OPINION if they would be better off offering a brokerage window to their plan or should they forget it, what you recommend - as a practical answer? Yes or No?

[KJohnson]

I tuned back into this thread and went back and re-read both the reg and the preamble. There are clearly information requirements applicable to PBAs, but I think Jon is right that at least the preamble gives you some comfort with PBAs that the information/disclosure requirements are more general.

For example according to the preamble a "general statement" advising participants of the availabiiity of [PBAs] would seem to satisfy the requirement that particpants be informed of the investment alternatives under the plan. Apparently there is no requirement of "risk and return" disclosure or investment objectives. (Of course any such requirement would be a practical impossibility).

As far as fees and expenses, the preamble indicates that the only disclosure required for a PBA is "whether, or to what extent transaction fees and expenses incurred in connection with the purchase or sale of interests [through the PBA] will be charged against the account of a beneficiary." There is no requirement of disclosure for the investments "internal" fees and expenses.

Of course the prospectus requirement would be applicable to any investment made through the PBA.

Therefore, you clearly cannot ignore the information/disclosure requirements applicable to PBAs, but DOL does appear to give some practical leeway.

[MoJo]

I think the fundamental issue is: Is it a 'prudent" exercise of fiduciary responsibility to offer a PBA in a qualified retirement plan" when clearly the statistics (and practice) indicates that the average participant is incapable of manageing even among limited choices, let alone unlimited ones.

I hate to be paternalistic, but we're heading for a crisis when a bunch of boomers realize they can't retire at the lifestyle they have become accustomed to. And whether you believe it justified or not, there will be lawsuits - and considering the trend in scruitinizing investment offerings (New York Life appears to be the next defendant), the lawsuits may have some potential. The courts will likely treat PBAs as another option, and if it wasn't appropriate for the majority of the participants (despite the disclosure, etc.) then it may be ruled imprudent.

Maybe not what was intended under the 404© regs, but probably closer to reality.

In any event, any time any of my clients is hauled into court, they've lost, whether they prevail on the merits or not.

[Jon Chambers]

OK, it seems that people want opinions. So here I go:

Do I think PBA's are a good idea? No. They take a participant's opportunity to invest in an institutional manner, and convert it back to a retail account.

Do I think PBA's are popular and here to stay? Yes. There is a vocal minority of participants who want this level of control, and believe it is appropriate for their own accounts. We typically see 5% - 10% of participants opening PBA's. In my opinion, offering a PBA is preferable to confusing the core menu with dozens of excess funds requested by vocal participants.

Do I think the fiduciary issues surrounding PBA's are manageable. Yes. I'm not in the camp that believes PBA's absolve the sponsor of responsibility. This is an oversimplification. I'm not in the camp that believes PBA's bring on huge potential liability. This requires an interpretation of the 404© regs that I believe will be unlikely. And my sense of the "new" litigation (SBC, First Union, et al) is that it's targeted at perceived fiduciary abuses, not at a lack of paternalism. So I'm not too worried about litigation IF the PBA's are managed appropriately.

Do I recommend PBA's for clients? It depends on the individual clients' circumstances. For some companies, PBA's are an important enhancement to the plan. For others, they are an enormous pain. Our objective is merely to see that they are designed and administered properly, in the context of the plan's overall investment program.

Do I recommend that the sponsor perform a "suitability overview"? No. Although I think this would be a good idea, and would help the participant, it's my contention that conducting a review exposes the sponsor to MORE liability than not conducting the review.

Finally, I agree with MoJo that managed accounts are more likely to be successful over the long run than PBA's. But that doesn't mean that participants share my belief. Optimistic participants think they've found the next Cisco, and want to concentrate their investments to take advantage of their insight. Maybe they are correct (but probably not). In today's environment, I don't believe we need to stop them from trying (although we may want to dissuade them, by carefully explaining the risks that they are choosing to take).

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Jon C. Chambers

Principal

Schultz Collins Lawson Chambers, Inc.

(415) 291-3004