The 401(k) Self-Directed Brokerage Window
May 01, 2023Are you a hands-on investor seeking investments beyond your 401(k) plan’s core list of investment choices? If so, you may have a self-directed brokerage account (SDBA) option in your retirement plan.
Who typically uses a self-directed brokerage account in a 401(k) plan?
SDBAs are intended for experienced investors who are comfortable making their own investment decisions. This option is generally popular among savers with larger retirement plan balances or who work with an outside financial advisor. For example, Schwab recently reported that the average account balance of those using this option is just over $273,000. Compare this to Fidelity’s reported average balance of all 401(k) participants, which is just under $104,000.
What does a self-directed brokerage account offer?
The main benefit is that SDBAs give you more flexibility regarding the investment options available. Wider access can be a refreshing alternative if you are generally unhappy with the currently available investment options.
For example, let’s say your 401(k) plan doesn’t include target-date or asset allocation funds. With the SDBA, you can add those funds to your retirement portfolio. This can be appealing if you’re trying to access asset classes not represented in your core portfolio. Examples include emerging market stocks, international small cap, and value or growth-oriented funds. SDBAs can even help you diversify with alternative asset classes such as real estate and commodities.
Beware of the paralysis of too many choices
But as behavioral finance studies on the paradox of choice have shown us, too many options can hinder participation. This is true for 401(k) plans as well. Choosing the right investments for your goals, risk tolerance, and time horizon also requires discipline. Most investors lack a written game plan or investment policy statement. As a result, many individual investors are prone to the “behavior gap” and underperform the actual funds they own due to mistakes related to emotional decision-making and market timing.
Self-directed brokerage accounts are designed for advanced investors who know how to research and manage their investments. Bankrate warns investors that the additional choices commonly associated with self-directed accounts do not lead to better outcomes for most investors. In order to follow a disciplined investment plan, focus on things within your control, such as asset allocation, contribution rates, minimizing costs, and asset location (i.e., pre-tax vs. Roth 401(k)).
Pay attention to the fees
It’s important to note that while SDBAs offer greater investment flexibility, they may also come with higher fees. These fees can include transaction fees, account maintenance fees, and trading commissions. So, carefully consider the costs and benefits of an SDBA and your investment objectives and risk tolerance before opening one.
Minimizing your overall investment costs is one thing you have some control over as an investor. So, it’s equally important to understand all fees and expenses as it is to know your core 401(k) plan expenses.
Some 401(k) plans charge an annual maintenance fee for using the mutual fund or brokerage window. It is also necessary to identify if there are any commissions and transaction costs associated with trades made through SDBA accounts. You can check your plan’s fee disclosure to better understand the actual costs related to your 401(k) plan.
Check mutual fund expenses
In some cases, you may also see increased mutual fund expenses when you go outside your core investment options. This is because most funds available in the SDBA are retail share classes. Retail share classes tend to be much more expensive than the institutional funds many large retirement plans provide access to. On the other hand, if your 401(k) plan has expensive mutual funds, the self-directed brokerage account is a potential remedy.
How does its performance compare?
Finally, it is important to note that there is a reason self-directed brokerage accounts are underutilized. The average investor is often better served by simplifying their investments as much as possible. That is why it is important to establish benchmarks to track your performance.
Self-directed brokerage accounts give you an opportunity to try to outperform or diversify your plan’s core options. But if you choose to take the self-direct route and find that your investment performance consistently lags behind the core investment portfolio, you may need to take a simpler approach to your retirement savings plan.