investment-oriented | PLANADVISER March/April 2017

Window Guard

How to help limit the potential risks of brokerage windows

By Judy Ward | March/April 2017
Art by Jon Han

Self-directed brokerage windows (SDBWs) are commonly a large-plan element. According to the 2016 PLANSPONSOR Defined Contribution (DC) Survey: Plan Benchmarking, only 18.7% of plans of all sizes have a brokerage window. However, while just 7.7% of plans with less than $1 million make them available, nearly half, 49.6%, of plans with more than $1 billion do so—despite some concerns that participants may imprudently invest their money. Advisers serving the upper end of the market should be familiar with this option—and how to limit the risks for both sponsors and participants.

Eric Droblyen, president and CEO of Employee Fiduciary, a third-party administrator (TPA) in Mobile, Alabama, recommends to his sponsor clients that their plans have no brokerage window option. “I just don’t like giving participants too much rope to hang themselves,” he says of the risk that they will invest unwisely. And he sees growing concern about brokerage windows among federal regulators such as the U.S. Department of Labor (DOL). “I don’t like the regulatory trend line here,” he says. “And, given that trend line, there’s potential for participant litigation. Why take the risk?”

But in reality, Droblyen recognizes, sometimes a company’s top executives push for a SDBW option in their 401(k) plan, and that frequently explains why it gets added. “In many cases, it is the owners or the primary plan decisionmakers who want it,” he says.

Here are several ways by which plans with brokerage windows can reduce the potential risks:

• Limit investment options. “We’ve seen plan sponsors put up guardrails on what individual participants can invest in,” says adviser Cliff Dunteman, vice president and investment consultant at Francis Investment Counsel in Brookfield, Wisconsin. “Some plans allow participants to only invest in publicly traded, no-load mutual funds in the brokerage window.”

Tara Hessert, president of Dynamic Pension Services, Inc. (DPS), a TPA firm in Dayton, Ohio, says her plan clients that utilize brokerage windows mostly limit the investment universe to mutual funds and individual stocks. A law firm client also allows access to options, but that firm has in-house financial-services professionals manage the partners’ money. Outside that type of scenario, she does not recommend making such complex investment options accessible.

• Prohibit access to company stock. After participant lawsuits arose, in recent years, over companies offering their own stock as an investment option in their 401(k), many plans eliminated such stock from their core menu. Some have made the same choice for company stock in their brokerage window. “There is less fiduciary protection on employer stock as an investment option, and that opens up a whole other class of potential difficulties for sponsors,” says attorney Andrew Oringer, a partner at law firm Dechert LLP in New York City.

Oringer generally sees sponsors that are concerned about access to employer stock within their brokerage window simply prohibit it altogether, rather than establishing limits for participants on what percentage of their account they may invest in it through the brokerage window.

• Require an indemnification agreement. DPS plan clients with a brokerage window require that participants who want to use it must sign an indemnification agreement beforehand, a one-page document put together for the firm by an Employee Retirement Income Security Act (ERISA) attorney. “It spells out that the participant confirms he understands the risks and the fees associated with a self-directed brokerage account,” Hessert says. “It also says the participant understands that the investments available in the brokerage window have not been reviewed by the sponsor or plan trustees and that it is solely [his] responsibility to review those investments. And it says [he] understands that we highly encourage participants to work with an adviser in using the brokerage window, and that the participant confirms he understands how to pick an adviser.”

• Provide appropriate education. Francis Investment Counsel recommends requiring participants who want to invest in a plan’s brokerage window to both sign an indemnification letter and attend a three-hour education session, which the advisory firm conducts for its plan clients. “If a sponsor is going to allow participants to invest in individual stocks, it’s important to educate those participants on the risks of investing in individual stocks,” Dunteman says.

Regulations do not require sponsors with a brokerage window to offer participant education about it, Oringer says. “You generally wouldn’t want to try to give these participants advice on the specific investments available under a brokerage window,” he notes. “But you can give them more general information about things such as appropriate asset allocations with the overall portfolio.”

• Separate brokerage window fees from other investment fees, and make them explicit. Sometimes Francis Investment Counsel takes on new clients that are offering a brokerage window but their service agreements include SDBW fees in the overall recordkeeping fee, not listed explicitly. “The issue with that is the participants invested in the target-date funds [TDFs] or other core funds are effectively subsidizing the administrative fee for participants invested in the self-directed brokerage window,” Dunteman says. SDBW-investing participants tend to have more trading commissions and may incur mutual fund load fees. “Plan sponsors need to be careful that the participants using the brokerage window are the ones paying all the fees associated with the brokerage window,” he adds.

• Implement a SDBW allocation limit or a liquidity requirement. Sponsors can set a limit on what percentage of their portfolio participants may invest in the brokerage window. “Those limitations are pretty rare, but, for plans that have a limit, usually it’s between 50% and 80% that a participant may invest in a self-directed brokerage account,” Droblyen says.

Sponsors also can impose a liquidity minimum for participants 100% invested in a SDBW, he says. That helps ensure all participants pay their share of plan administrative fees. “One of the risks as a fiduciary is, how do you allocate administrative fees equitably? Typically, some of the largest account balances in a plan may be the ones in the brokerage window,” he says, adding that those investments frequently are less liquid than the core menu. “With the core funds, it is much easier to pull money out for the administrative fee. So some sponsors will say something like, ‘We need your SDBW to maintain a $1,000 money market balance, so we can deduct plan administrative fees,’” he says.

• Re-evaluate regularly. Sponsors should look at participants’ brokerage-window transactions at least annually, Dunteman recommends. “So, for instance, if a sponsor limits participants to using only no-load mutual funds in the brokerage window, the sponsor should look at every transaction to make sure there were no violations of that policy,” he says. “Plan participants, unfortunately, can do a lot of harm to themselves in a very short time.”

Key Takeaways:

  • Advisers should ensure plan sponsor clients are aware about the DOL’s heightened unease over brokerage windows and explain the pros and cons of such an option.
  • Sponsors can mitigate risks associated with brokerage windows by limiting investments to just mutual funds and excluding company stock, providing education and separating the higher fees that participants pay for this option from other plan fees.