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Pros and Cons of 401(k) Brokerage Options

Jeff Brown

A key shortcoming of many 401(k) plans: You're stuck with the investment options picked by your employer, usually a string of mutual funds. Wouldn't it be better if you could invest in anything you want, like you can in an individual retirement account?

In fact, for many 401(k) participants, this is possible. The "brokerage window," "brokerage option," or "self-directed 401(k)" allows participants to buy individual stocks or just about any exchange-traded fund or mutual fund they like, though high-risk moves like options trading and borrowing on margin are usually barred.

But with freedom comes risk.

"My experience has indicated that the self-directed option has gained in popularity since the bull market that started in March of 2009," says Marc Lowlicht, CEO of Opes Private Wealth Management in East Hampton, New York. "I believe a big part of this is the overconfidence generated by one of the longest bull markets in history and the ongoing focus of the ease of do-it-yourself investing, which always peaks out during the height of bull runs."

Once found almost exclusively in 401(k) plans for professionals such as doctors and lawyers, the brokerage option is now more common.

"According to our 2015 Trends & Experience in DC (defined contribution) Plans report, 40 percent of companies offer a self-directed brokerage window," says Rob Austin, director of retirement research at Aon Hewitt, a risk management and consulting firm. "This is up from 16 percent back in 2005."

[See: 9 Food-Focused ETFs to Feed Your Portfolio.]

But not many employees use this option, he adds.

"Employee usage is relatively small, with only about 3 percent of participants having money in a self-directed brokerage window when it is available," Austin says. "However, the self-directed brokerage window tends to attract investors with large balances in the plan -- average total balance is roughly $250,000."

As in the past, the brokerage window is more likely to be found in firms with highly educated, professional employees, which is why many experts argue it has not gone mainstream.

"The more educated the participants are regarding their plan and its features, the more likely they are to take advantage of the brokerage option," says Josh Sailar, investment advisor at Miracle Mile Advisors, an investment advisory firm headquartered in Los Angeles. "It is more popular among smaller, specialty practices like law, medical and consulting services. ... The self-directed option is a very useful tool when integrated into holistic asset management."

So, if you do have this option, what should you keep in mind?

First, you need to know what you're doing.

The key benefit is the ability to choose investments that fit your situation exactly, rather than having to rely on those the boss picks for the average employee. You could bet on real estate with a real estate investment trust, or buy an ETF that holds commodities like gold. Or you could buy an individual stock that you think can do better than the market return produced by index funds so often found in choices presented by employers.

And you could fine tune to address changes in the market or your situation. The brokerage option is the other end of the spectrum from another option that has become more common in recent years, the target-date funds for hands-off investors.

But experts warn that too much tinkering is hazardous to your financial health. After all, 401(k)s are for long-term retirement savings. Over long periods, even professionals find it's nearly impossible to beat the market performance delivered by a low-fee index fund. Betting on narrow sectors or individual stocks could blow up in your face.

"If you really hate somebody, give them a brokerage account and tell them to Google 'investment ideas,'" says Nathan Fisher, 401k solutions managing director at Fisher Investments in Camas, Washington.

Aside from the dangers of active trading, investors are wise to study other plan features:

Costs. Experts warn that participants should watch out for charges such as trading commissions and account-maintenance fees. If you have a professional manage the account, you may pay a percentage of the assets under management even if the investments do poorly.

[See: 8 Times When You Should Sell a Stock.]

"Fees and commissions are always a concern in a 401(k)," says David Reid, CEO of EaseCentral, a benefits consulting firm in San Francisco. "You need to look at your participant fee disclosure. This is a legal document you will be issued and should detail all the fees passed through the 401(k) program to the end participant. They are numerous. Purchase fees and loaded equities (stock with sales commissions) will be an additional concern in a brokerage-enabled plan. "

Keeping abreast of things. Mutual funds in 401(k)s have professional managers to buy and sell individual holdings, or keep the fund in line with an underlying index. With a brokerage window you're out there on your own unless you hire a pro to manage things. This can be too much for many small investors, which is why the fund industry is so huge.

Keith Clark, a partner at DWC ERISA Consultants, a plan administrator and professor at the University of Minnesota Carlson School of Management, says that "those that invest in the stocks should be reviewing frequently -- as much as daily, even if they are using stop and limit orders."

What benchmark will you use to measure your success? How long will you stick with a disappointing holding? When will you cash in a winner? How well will you evaluate corporate financial statements, the economy and state of the financial markets? What is Plan B if things go wrong?

If you don't know, maybe this option is not for you.

Hire a pro. Many employees who use brokerage options hire an advisor to manage the account or advise on investment moves, experts say. This includes integrating the 401(k) to the client's other investments.

"Having the advice of a professional often helps separate emotional decision-making from rational decision-making during difficult markets, a factor that is often overlooked by the do-it-your-self investor," Lowlicht says.

While a handful of employers offer only the brokerage option, Clark says, it's more common to find it alongside a typical list of funds and target-date funds, so you probably won't be forced down this risky path.

If you have the time and skill to research holdings like individual stocks, have a long-term plan and can keep abreast of things, or just want to dabble while keeping most of your account in funds and target-date accounts, the brokerage option could be for you. If you'd rather spend weekends at your kid's soccer games, sticking with funds and target-date investing might be the wisest choice.

Keep in mind that even professional asset managers who focus on investing all day every day have a hard time matching the performance you can get in an index fund mirroring the broad market, says Dory Wiley, president & CEO of Dallas-based Commerce Street Holdings, an investment banking firm.

[See: 9 Under-the-Radar Ways to Buy Financial Stocks.]

"If 90 percent of professional active managers underperform indices and passive choices, what can we expect from amateurs?" Wiley says.



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