Brokerage Window: An Overview

Brokerage Window – aka self-directed brokerage account (SDBA) or self directed 401(k) – is a 401(k) plan feature that offers participants flexibility to invest in opportunities not available through the plan’s core line-up. A SDBA is a brokerage account that is part of the 401(k) plan that provides participants access to a broad array of mutual funds, hedge funds and ETFs, stocks, bonds and in some cases, specialized investments like REITs or precious metals. They can also be designed to exclude certain investments (to dissuade frequent / speculative trading or for other reasons), while maintaining their key function of providing participants a broad range of investment opportunities. Some 401(k) plans limit the percentage of your 401(k) assets that can be invested through the brokerage option. These accounts usually have appeal for higher-paid executives and professional groups like attorneys, doctors, architects and engineers.

If you have enough good choices within your plan, staying within the options in the plan is usually cheap, convenient and makes the decision simple than deciding on investment products all by yourself.

The demand for more control over 401(k) plans started during the bull market of 1990s. Since the employees are responsible for their retirement and onus is on them to explore their plan options to take maximum advantage of their favorable provisions, it is only fair to give them freedom to pick their own investment options. A survey by Aon Hewitt shows that 29 percent of plans offered a self-directed feature in 2011, up from 18 percent in 2007. Only 1 percent of Vanguard’s 401(k) participants and 2.4 percent of Fidelity’s participants choose to use brokerage window option. Even though only a small percentage exercise this option, not all assets are moved to the self-directed brokerage account. Only 3.4 percent of Schwab’s 401(k) clients with self-directed brokerage accounts, invest 80% of their 401(k) assets through brokerage window and have the rest in their plan’s core offering.

Here are a few dos & don’ts to help you take maximum advantage of your SDBA:

Consider the fees

Self-directed brokerage accounts (SDBA) may charge you

  • setup / enrollment and termination fees

  • fixed ongoing monthly / quarterly / annual fee

  • ongoing administration fees

  • commissions / transaction fees for each trade

  • distribution fees

With brokerage accounts, you pay retail instead of institutional costs. Often, there are no transaction fees for buying and selling standard fund offerings within your plan. However, you may have to pay a commission on purchase and sale of investments through window. Transaction costs depend on the number and size of transactions. For an older worker with higher income and larger retirement balance, the brokerage window may be cost effective. A young worker contributing money in small increments frequently will have to pay high transaction costs. If not managed well, buying / selling / re-balancing your investments through brokerage window can prove very expensive.

For example, if you are contributing 6% to get a 3% employer match, at $50,000 annual salary, that’s $375/month total 401(k) contributions. With a monthly trade ($20 per trade) plus account maintenance costs ($120 / year), you lose 8% of your contribution in fees ($30 total fees for $375 monthly contribution). On the other hand, a single annual trade on max 401(k) contributions is about 0.8% ($20 per trade + $120 annual fees for $17500 annual contribution excluding employer’s contribution).

Although SDBA is not a designated investment alternative, it is still subjected to the fee disclosure regulations. Your monthly brokerage statements or quarterly fee disclosure statement should be your first reference for all fees associated with your SDBA.

Spend time on research & analysis

Brokerage window is a good option for those who are comfortable making their own investment decisions and can dedicate more time & energy to manage their own investments. Investing in stock market needs time for research, patience and a good financial knowledge. If you are investment savvy, enjoy doing research & analysis, then you can use SDBA to enhance your returns. And make sure this extra effort is worth it.

Pick the right investments

Take a long term approach to building your retirement nest egg rather than trying to pick stocks in an attempt to “beat” the market in the short term. Attempting to time the market often results in buying at market tops and selling at market bottoms. It is very difficult for inexperienced investors to not succumb to their greed and fear emotions.

With self-directed brokerage accounts, it makes sense to choose investments that either help reduce your expense ratio or offer diversification that isn’t available in your regular 401(k) plan menu. Compare expense ratios of similar asset classes within the regular plan menu before choosing funds in your brokerage account. Taking the above mentioned fees into account, explore no-load or low cost funds & ETFs to lower expenses and emerging market / international funds for diversification. If such an option is available, you should invest in individual stocks only if you have sound financial knowledge and follow the trends of the chosen stocks’ market sector. In essense, brokerage window should enable you to actually implement a better portfolio than you otherwise could with your regular plan menu.

Avoid day trading

In the recent past, brokerage windows (and IRAs) have been blamed for workers day trading with their retirement accounts. Remember you are investing for retirement and this is a long term endeavor. Its not advisable to do frequent / short-term trades, check your account balance daily or become obsessive about your returns.

Bottom line

If default choices are not good, then use brokerage window to customize your investments to suit your individual needs and goals. Brokerage window is an important supplement to your 401(k) plan that can help achieve your goals of low cost and diversification.

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