Why Individually Directed Accounts Are A Dumb Idea
By Matthew D. Hutcheson, an independent fiduciary and a nationally recognized authority on qualified plans and fiduciary responsibility. He is a Certified Pension Consultant and an Accredited Investment Fiduciary Auditor™. He may be contacted at matt@erisa-fiduciary.com.
Individually directed accounts (IDAs) are an extremely popular concept in the 401(k) and investment industry right now. While hundreds of plan sponsors have already added this feature to their plans and many more are considering it, many retirement plan professionals think they are generally a bad idea.
I am one of those professionals. I jokingly (yet somewhat seriously) tell my clients that IDA spelled backwards is ADI, or “A Dumb Idea.”
An individually directed account is a brokerage account established for the benefit of plan participants that enables them to use pre-tax retirement plan funds to buy and sell shares of mutual funds, individual stocks, bonds or other securities within their plans. They are sold to plan fiduciaries, and then to certain participants, as the way of the future.
In fact, I have heard sales pitches claim an IDAs can protect fiduciaries even more than a traditional 404(c) plan can because it removes almost all restrictions on investment options.
This could not be further from the truth. Some think the more investment options or strategies that are offered, the less fiduciary liability. This is a myth. The fact is, more investment options create greater fiduciary responsibilities to educate, communicate and evaluate retirement plan investment options.
Overlooked issues
Don’t get me wrong, I have personal investment accounts where I enjoy the freedom to buy and sell securities as I see fit. However, these accounts are not ERISA accounts — an important difference. The fiduciary responsibility that accompanies ERISA retirement plans is quite frightening. I suppose it is more frightening because of the lack of understanding of the responsibility, rather than the responsibility itself.
ERISA plans must be operated in accordance with the “exclusive benefit rule.” The exclusive benefit rule states that an ERISA plan must be operated for the exclusive benefit of its participants and their beneficiaries.
What? Beneficiaries? Many fiduciaries ask themselves, “Why do I need to think about beneficiaries? Surely no one cares more about their beneficiaries than the participant, so what makes the government think I, as the trustee, need to monitor or intervene on their behalf?”
It is true that stocks have historically outperformed other traditional investments. The problem is, when an individual has too many choices, the emotional element is introduced and a buying and selling frenzy can occur. Those participants who are not emotional or frenzied investors, but instead only “rearrange” their account from time to time, can also greatly reduce their potential for solid long-term growth.
Simply stated, those who choose an asset allocation strategy and then stick to it generally outperform those who frequently move assets around.
What does this mean? It is my opinion that the majority of future lawsuits relating to retirement plan investment failures will be by beneficiaries rather than plan participants.
My prediction
While no one can know for sure what the future holds, I do have some very strong opinions. A hypothetical scenario might look like this:
Let’s say that in 2002 a small group of highly paid professionals convince their employer to give them IDAs within their retirement plan because they are “expert” investors. They claim that because their account balances are much higher than the other participants, and also because they are fairly proficient in investing, they would be much better off by choosing their own investments outside of the “core” mutual funds offered by the plan.
They reassure the trustee and other fiduciaries that they are “big boys/girls” and that the fiduciaries need not worry about them. They are fully educated about the risks associated with this type of investing. Feeling reassured, the fiduciaries allow a select group to adopt IDAs, not knowing that 20 or 30 years from now one participant’s beneficiary will be holding the plan responsible for an account’s investment performance.
Thirty years later, one of these participants has died, but the beneficiary of the account is in relatively good health. A caring child begins to assist the beneficiary with financial matters and determines that the retirement account will be depleted in less than five years, while the beneficiary expects to live for another 10 at least!
"How can this be? My spouse said we would have more money because of the IDA! What happened?" (In reality there could be more money in the IDA, but I would not count on it.)
The beneficiary, now frightened because of the financial uncertainty, begins to question whether the fiduciaries operated the ERISA plan for his or her exclusive benefit. A jury could well determine that the answer is no. In fact, it could be argued that it was operated for the exclusive benefit of some highly compensated employees rather than all participants and beneficiaries. This is what fiduciaries need to fear.
Understanding the limits
As a retirement plan consultant, I believe I am very knowledgeable about investments, but not nearly as knowledgeable as a professional fund manager. In my personal ERISA plan, I have selected a sound asset allocation strategy and I leave it alone. It is absurd to think I can outperform professional fund managers. If I as a professional retirement plan consultant know my limitations, it is astonishing to me that individuals who are not retirement plan experts think they can do better.
There are other frequently overlooked issues that can cause other problems. Specifically, many plans only offer IDAs to highly compensated employees (HCEs). This clearly violates the benefits, rights and features rule under IRC § 401(a)(4). If an IDA is offered to highly compensated employees, an IDA also needs to be made available to non-highly compensated employees on a relatively equivalent basis. This could open up a communications and educational nightmare.
Most fiduciaries do not understand their duties, or they understand them but don’t have time to fulfill them completely. I personally think it is unwise to add another layer of complexity and exposure until the basics are mastered.
May I suggest a starting point that is good for both big and small, rich and poor, HCE and non-HCE, formally educated or not:
The starting point is a fundamental financial education strategy that will help the participants in their daily lives and ensure the plan is there for the exclusive benefit of both the participants and their beneficiaries. Notwithstanding the fact that some highly educated investors might find this insulting to their intelligence, there are much larger fiduciary issues at hand that must take precedent over the vocal minorities.
The starting point is found in another acronym, “IT WILL DO.” It is what needs to be taught to and mastered by plan participants as a whole before branching out into schemes that have not been proven – and maybe should not be. Participants must understand the principles of interest, time, wage replacement, inflation, life expectancy, lifestyle, debt, and objectives defined in terms of their retirement plans.
Seem obvious? Of course it does. Do participants get it? I don’t believe so. This is why so many are in financial peril now. Take care of “It Will Do” now, and chances are fiduciaries will be able to rest easy in the future.
Don’t complicate your lives because of the pleadings of a small “elect” group of your workers. You say you are not worried because your investment professional has “taken care of all of that stuff.” Are you sure about that?
Need More Information?
Matt would be glad to discuss this issue with you further. You may email him at matt@erisa-fiduiary.com.
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