Through the 'Window'

Asset-allocation funds—be they target-date, balanced or target-risk—that offer ready-made diversification and professional portfolio management have attracted a growing proportion of the deferrals into U.S. defined contribution (DC) plans. Vanguard reports that, within its client base, target-date funds (TDFs) claimed 57% of new contributions last year, up from 16% in 2009.

Yet, for a small contingent of employees determined to chart their own investment course, TDFs hold less appeal. These independent-minded investors prefer to allocate their capital through a brokerage window offered in their plan alongside the conventional fund menu.

Notwithstanding the growth of TDFs, brokerage windows have become more widely available: The 2019 Defined Contribution Trends Survey from consultant Callan found that 50% of DC plans offered a brokerage window feature last year, up from 15% in 2009. “It’s not uncommon for a vocal group of participants to clamor for a gold fund or an ESG [environmental, social and governance] option, and it’s a way for employers to say, ‘We hear you. Through the brokerage window you can get whatever you want,’ while keeping the number of options in the plan at a reasonable number,” says James Veneruso, a senior vice president at Callan, in Summit, New Jersey.

The idea of a brokerage window is straightforward enough. Plan sponsors adopt one, using whatever brokerage provider is available through their plan’s recordkeeper, and offer it to participants as an investment election. Some sponsors fence off the amount a participant may devote to the brokerage option, or the sorts of investments allowed.

“Within our plans, 22% of sponsors allow only mutual funds through the brokerage window, but the remainder let people buy any security,” notes Martha King, managing director of Vanguard’s institutional investor group, in Valley Forge, Pennsylvania, and author of the firm’s annual “How America Saves” report. Not only allowing brokerage window investors to trade on their own, some plans let them engage outside investmentmanagers for custom portfolio management.

“There’s typically a group of participants who can’t live without a certain fund or, less often, things such as direct real estate, or timber and logging vehicles,” says Julie Stapel, a partner in the Chicago office of law firm Morgan Lewis & Bockius LLP. “Or a sponsor might acquire a business, and the 401(k) plan along with it. The sponsor can’t keep adding to the fund lineup, so it says, ‘That fund from your prior plan won’t be on the main lineup, but you can have it through the brokerage window.’”

A brokerage window is more apt to be found at larger plans. In a special report on the feature’s use in DC plans, Vanguard noted the median age of brokerage participants to be 52 years vs. 45 years overall and the median account balance to be $250,000 vs. $26,000.

“The people who self-select into the brokerage window are those who feel more confident in making investment decisions, and we see higher utilization among lawyers, engineers and airline pilots,” says Veneruso.
Several observers also cited the popularity of brokerage options at medical practices.

“The trend toward simpler 401(k) menus is great for many people, but there are many reasons a 50-year-old might want to own a long bond or emerging markets equity fund, which may not be available to them in a shrinking core menu,” says Nathan Voris, managing director at Schwab Retirement Plan Services Inc. in Richfield, Ohio.

A look at the big DC picture, though, reveals that brokerage options appear in just trace amounts. King says that, while 29% of all participants are offered a brokerage window, just 1% actually use it. Even in the plans sponsored by investment management firms, where participants’ investment acumen would arguably be highest, a recent Callan study showed allocation of assets to brokerage windows to be just 3%.

Schwab and Vanguard both report that the most popular holdings of individual stocks these days are top tech names such as Apple, Amazon, Facebook and Google—names that are already present in a big way in index funds. Also popular are Standard & Poor’s (S&P) 500 index funds and exchange-traded funds (ETFs).

For some participants, a brokerage window could be a step backward: “It’s heartbreaking to see a participant who owns a fund through a brokerage window and is paying retail fees, when it’s available through the 401(k) plan at an institutional fee,” Stapel says.

One important, distinctive feature of brokerage windows is they permit use of an outside adviser. Schwab regularly reports on brokerage window activity, and about 20% of users engage a third-party portfolio manager. “For advisers working with individuals, it’s a great opportunity,” Voris says. “They can look at the participant’s outside holdings and fine-tune his overall asset allocation.”

Plan advisers follow sponsors’ instructions to add a brokerage window to their plan but do not seem happy about it. “They have to be offered to all the employees—not just the most engaged or educated or highest-income who can handle the most risk,” says Brian Hanna, a partner in Dublin, Ohio, firm Everhart Advisors, a finalist for 2018 PLANSPONSOR Retirement Plan Adviser of the Year in the Mega Team category. “If professional money managers have difficulty outperforming benchmarks over long periods, can we expect the individual participant to do any better?” He prefers to identify what options participants are looking for and work with a plan’s committee to add them to the lineup.

Brokerage options may be like gym memberships: undertaken with initial enthusiasm but insufficient follow-up. “People buy investments and hold onto them and don’t want to sell when they should,” says John Ludwig, founder and president of LHD Retirement, in Indianapolis. “They think it should be a day-traded account, and then they don’t, and it goes back and forth.”

“My personal view is that I discourage brokerage windows, but there are some groups that are adamant about it,” says Chad Larsen, founder and CEO of MRP, retirement plan specialists in Denver. “My experience has been that very few folks have the time, sophistication and investment knowledge to make good long-term portfolio decisions over and over. In picking individual stocks, people’s emotions can get the best of them, and things will end poorly.” Still, Larsen adds, “if a sponsor is bound and determined, we put it in. I’m not going to die on my sword for a brokerage window.”

Even though investing through brokerage windows may add risks and costs for participants, sponsors have relatively few fiduciary obligations. “Brokerage windows occupy a regulatory no-man’s land,” Stapel says. “ERISA [Employee Retirement Income Security Act] does not recognize brokerage windows as part of the official designated alternatives; there aren’t the same resources or capacity to look at the 10s of thousands of investments that might be available.” Sponsors do have the latitude, though, to exclude trading in single stocks, bonds or ETFs, as well as company stock, and to limit participants’ choices to mutual funds.

As to the absence of regulation, Stapel says, “Instead, we have interpreted the Department of Labor [DOL]’s view that sponsors need to exercise diligence in selecting the brokerage provider.” That means a thorough review of the fees to be charged and the quality of execution of transactions. —John Keefe

Art by Mark Wang