Self-Directed Brokerage Windows in 401k Plans: Empowering Participants, Protecting Sponsors

by Gary Jenkins

Gary E. Jenkins is the general counsel for CitiStreet, the global benefits provide that is a joint venture of Citigroup and State Street Corp. He has written numerous articles drawn from his expertise as an attorney in the insurance, securities, banking and retirement services industries.

Opening Windows for 401k Plans

Sponsors of 401k plans are turning to self-directed brokerage windows to meet the demands of sophisticated investors for more choices and greater control. What many plan sponsors do not realize is that a self-directed brokerage option also can help them meet their fiduciary requirements under the federal Employee Retirement Income Security Act (ERISA).

Self-directed brokerage windows make 401k plans more like individual retirement accounts, enabling plan participants to buy and sell stocks, bonds and other securities through a broker, usually with an additional fee and commissions.

These features offer far more investment choices and diversification than the typical 401k plan can reasonably make available. For plan sponsors, this enables them to give their participants more choices without the expense of due diligence, management and recordkeeping for multiple funds.

Plan sponsors recognize these benefits, and have responded accordingly: Although no 401k plans offered self-directed brokerage windows in 1993, 10 percent did within five years. More sponsors may offer these accounts once they understand the ERISA advantages.

Section 404(c)'s Safe Harbor Provision

ERISA mandates significant fiduciary requirements for 401k plan sponsors in order to protect employees who depend on these plans for their retirement. However, ERISA Section 404(c) offers plan sponsors a "safe harbor" from their fiduciary responsibilities in cases where the

participant has decision-making power over her account's investments. Section 404(c) relieves plan sponsors from liability for any loss that is a "direct and necessary" result of a participant's exercise of her control.

In order for Section 404(c)'s safe harbor provision to take effect, plans must meet certain procedural and substantive requirements. Procedurally, the plan must make certain required disclosures to participants.

Substantively, the plan must offer a range of investment options. Generally, a plan must offer a minimum of three investment options, each of which must be diversified and have materially different risk and return characteristics.

While most plan core offerings address the investment needs of most participants, a brokerage window goes beyond this to ensure that all participants will be able to create a portfolio that is appropriate for all levels of risk and return.

Ensuring that a plan qualifies for safe harbor under Section 404(c) could be important in declining markets, especially if disgruntled investors search for scapegoats.

Disclosure

As most plan sponsors know, an essential aspect of Section 404(c) compliance is fulfilling its disclosure requirements. The primary disclosure requirements relate to providing a participant with the information needed to make an informed decision in exercising control over her account.

Section 404(c) imposes a series of disclosure requirements on both designated and non-designated investment alternatives. A brokerage account offering a universe of mutual funds or other securities would be categorized as a non-designated investment alternative under a 401k plan, and have to provide the following information to plan participants:

• A general description of the brokerage account, including the investment alternatives available;
• An explanation of the circumstances under which participants may give investment instructions in the brokerage account;
• A description of the transaction fees and expenses of the brokerage account;
• The name, address and phone number of the person responsible for providing disclosures which are required to be provided upon request;
• The distribution of a prospectus to participants in connection with their initial investment in a mutual fund or other registered security;
• A description of proxy voting materials if proxy voting is passed through to participants for the investment; and,
• Prospectuses, financial statements, reports and other materials relating to mutual funds offered under the brokerage account, provided upon request.

When properly identified as a non-designated investment vehicle, compliance with Section 404(c)'s disclosure requirements can be accomplished efficiently, and, in some ways, with fewer burdens than for the designated investment vehicles options of the plan's core investment lineup.

Additional Sponsor Steps

Sponsors can increase their protection against liability by taking additional steps.

Properly educating plan participants who wish to use brokerage accounts, through literature, enrollment meetings and consultations, also can communicate financial hazards and help screen out those whose risk profiles or lack of market knowledge makes them unsuitable for self-directed investing.

As an added measure of protection, plan sponsors also may consider requiring participants who want to invest through brokerage accounts to read and sign documents indicating that they understand the risks of this approach and assume responsibility for their decisions. These documents should clearly outline the responsibilities of each party in the investment process, and make it clear that the plan sponsor is not providing investment advice.

Some plan sponsors want to reduce risk for their participants, but sometimes this can be a two-edged sword: Sponsors may prevent participants from suffering losses that could lead to lawsuits; however, sponsors may be considered to be exercising fiduciary responsibility any time they make decisions on behalf of their plan's participants.

If a sponsor recognizes the risk of liability, then several actions can be considered. The brokerage window can be designed to exclude exotic investments, such as futures, options and covered calls. Sponsors may establish minimum balances, or limit the share of a participant's 401k account that can be invested through the brokerage window. Restricting investments in limited partnerships through brokerage windows can not only protect participants but also help sponsors avoid technical tax and administrative issues associated with these partnerships.

Conclusion

Sponsors need not fear the loss of Section 404(c) fiduciary relief by offering a brokerage window. While a finding that a plan complies with Section 404(c) is a factual determination, the availability of a self-directed brokerage window would benefit most plan sponsors should the compliance of their 401k plans ever be questioned.

Although a brokerage window does not bulletproof a plan against the threat of Section 404(c) noncompliance, in appropriate circumstances it adds fiduciary insurance that, combined with its other benefits, makes it well worth considering.