by Ginger Applegarth
If you have been less than impressed with the investment options in your 401(k) plan, there may be some hope. And if you have been using poor returns as an excuse for not contributing to your 401(k) plan, figuring you can do better elsewhere, please stop making excuses. Instead, get out the plan booklet your company gave you and check for the term “self-directed brokerage option.” If you have it, your investment horizon has just opened up.
Traditionally, an employer chooses the menu of investment options available to workers who elect to participate in the 401(k) plan. Under federal pension law, your employer has to put your interests first in selecting the investment options available to you. That also means that the company can be held liable if, for example, the mutual fund you bought for your 401(k) plan is mismanaged. (Sorry: You may be thinking you have recourse to sue because your 401(k) money disappeared during the long bear market, but poor investment performance alone doesn’t count.)
Meanwhile, many workers have seen a lot of stocks take off in the rally of 2003, and they want the same chances to succeed with their 401(k) money. With the self-directed brokerage option, employers can offer more investment flexibility without the added liability.
Here’s how it works. Your employer decides to let you move a dollar amount, or a percentage of your contributions, into a brokerage account. The company also sets broad guidelines for the kinds of investments you can buy — some employers only allow mutual funds, others only allow stocks, etc. After that, you’re on your own. If you can put the first $4,000 of your annual 401(k) contributions into a self-directed brokerage account, and your employer allows you to buy stocks, you may well decide to bet all of it on one or two stocks, or buy smaller amounts of 10 different stocks. It’s your choice. That’s a real advantage if you are a great stock picker, or if your other investment options in the plan stink.
There are drawbacks
But, as you can imagine, there are some major downsides as well.
Additional costs. Most brokerage firms charge an administrative fee of as much as $100 a year just to use the self-directed brokerage option. Transaction charges usually apply as well — each time you buy or sell. Those can really add up, especially in relation to the amount of money involved.
The temptation to day-trade. I sometimes tell my clients that we all need to be protected from our own worst instincts. If you are a gambler by nature, and are constantly changing the investments in your regular accounts, the self-directed brokerage option may simply be too much temptation.
You lose the right to sue. Your employer will likely ask you to sign a statement stating that you understand you are taking full investment responsibility for any losses, so you lose the right to sue your employer that 401(k) plans traditionally afford.
More work involved. It will take more work to monitor your investments. You may decide you simply do not want the responsibility of following these investments on your own.
Retirement is definitely a long-term goal, and study after study shows that the “buy and hold” approach is the way to go. That may be a little easier to accept now that the market has started going up again.
Take a careful look
If you think this is an option you want to consider, here’s what to do.
First, take a cold, hard, long-term look at the investment performance of your existing 401(k) plan options. Forget short-term losses. Check out the three-, five- and 10-year performance numbers of the funds in the plan. (You can check them in the Mutual Funds section on MSN Money.) If you don’t see anything to your liking, consider the self-directed brokerage option.
Check with your plan administrator and see if a self-directed plan is available. If so, get a fee schedule in writing — both the annual fee and all transaction charges. Estimate how much you would be trading during the year, so that you can estimate your annual fee. Find out exactly how much you can set aside in this brokerage account, and compare your annual fees to the total. If the fees are too high, stop right there. If not, then move on to checking out what you can invest in, and decide whether having that flexibility is worth the cost.
Finally, if you are one of those folks who last looked at your 401(k) plan statement two years ago, don’t delude yourself into thinking you’re going to pay close attention to investments that you must manage on your own.
The reality is, most of us just don’t pay much attention and are happy leaving our 401(k) money where it is now. And, for most of us, that makes sense. But if your current 401(k) plan options leave much to be desired, the administrative fees are not very high and you are a sophisticated investor who will pay attention, the self-directed brokerage option may be for you.