Demystifying self-directed brokerage accounts and non-traditional (specialty) assets in retirement plans

Self-directed brokerage accounts in retirement plans are gaining momentum due to the additional flexibility they offer retirement plan participants in gaining access to additional investment options outside of normal core offerings. These accounts can be set up with a variety of different parameters and structured based on the needs and desires of the plan sponsor. In conjunction with other benefits, offering these types of accounts can be part of a competitive benefits package that may help employers attract and retain talent at the highest level of the organization. In certain situations, offering non-traditional assets through self-directed brokerage accounts can further meet the specific objectives of a targeted group within the organization.

What is a self-directed brokerage account?

Brokerage accounts are a type of account that allow participants to trade securities, such as mutual funds, exchange traded funds, and stocks. Self-directed brokerage accounts within a retirement plan allow participants access to other investments outside of a retirement plan’s core investment lineup. In general, most core investment lineups are made up of mutual funds that cover different asset classes, such as cash equivalent, fixed income, large cap growth, large cap value, foreign large growth, and target date funds. While these self-directed brokerage accounts can be held through different financial institutions outside of the plan, the rules of the plan still apply as they are still considered a plan asset. In addition, depending on the flexibility the plan sponsor would like to allow, participants can generally work with their advisor or brokerage firm of choice.

Self-directed brokerage accounts in plans and participant utilization

While brokerage accounts are not as popular as target date funds, with 95% of all plans offering target date funds and only 20% offering a self-directed brokerage account, for plans that added funds in the year 2021, the addition of a self-directed brokerage window was the most common action, taken by 21% of survey respondents. It is also worth noting that plans with 5,000 or more participants are almost twice as likely to offer a self-directed brokerage account option as plans with fewer than 5,000 participants. In plans where this option is provided, utilization is about 1%, generally by participants with higher incomes and higher account balances.^1,2

Self-directed brokerage accounts as a potential diversification option

Section 404(c) of ERISA, generally provides that, if a retirement plan permits a participant or beneficiary to exercise control over assets in their account and the participant or beneficiary does in fact exercise control, then no other person who is otherwise a fiduciary shall be liable for any loss that results from the exercise by the participant or beneficiary of such control. In addition, this section of ERISA points to offering a broad range of investments, with various degrees of risk and return that are diversified, that in aggregate enable the participant or beneficiary to achieve a portfolio with aggregate risk and return characteristics, and, when combined with other investments, tend to minimize, through diversification, the overall risk of the participant’s or beneficiary’s portfolio.³ Offering a self-directed brokerage account allows those participants that may be interested in further diversifying their portfolio access to investment options not otherwise available through the core investment lineup of the plan. Some examples of these options are environmental, social, and corporate governance (ESG) investments and Shariah-compliant investments.

Self-directed brokerage accounts as a competitive benefit

Given the current competitive environment in which employers participate, each and every benefit offered plays a role in attracting new talent and retaining existing talent, and could be the difference in meeting those objectives. Depending on the goals and objectives of the organization, offering a self-directed brokerage account may help attract talent at the highest levels of the organization due to the particular demographic that tends to utilize this option.

Self-directed brokerage accounts and risk

Some items to consider tied to this option is the recent activity in Meme stocks and cryptocurrency, and the changing landscape of Environmental, Social, and Governance (ESG) in the investment decision process. If the Department of Labor (DOL) were to reach the decision to impart exigent fiduciary oversight of individual securities purchased by the plan participant through a brokerage account, a claim could be made by the DOL that the plan sponsor committed fiduciary impropriety by allowing the participant to purchase such securities through this medium.

In particular, cryptocurrency has been an area of focus of the DOL recently. It has been very vocal about warning plan sponsors to “exercise extreme care” before including cryptocurrency assets and crypto-related products as investment options in retirement plans. The DOL’s concerns arise from what it perceives as a speculative, highly volatile, and difficult to evaluate investment option. In addition, due to the structure of cryptocurrencies, the risk of fraud, theft, and loss are generally higher than those associated with more traditional investments participants may be accustomed to.⁴ The release also illustrates the agency’s discomfort with self-directed brokerage accounts and a potential shift in whether plan fiduciaries may have responsibility for investment choices participants make through brokerage accounts.

Another topic of contemplation is the inclusion of Environmental, Social, and Governance (ESG) in the investment decision process or the inclusion of what may be deemed an ESG investment. Historically, the messaging from the DOL around this topic to plan fiduciaries has been that as long as these type of investments have “an expected rate of return at least commensurate to rates of return of available alternative investments” and if the ESG investment met other factors, such as diversification and the investment policy of the plan, then a plan fiduciary would not be prevented from including ESG type investments or products.⁵

Previous guidance and communication from the DOL around this topic has been perceived by some as confusing and somewhat cryptic, but it is important to recognize that both the DOL and the Securities and Exchange Commission (SEC) have proposed rules that would expand or, include prospectively, the definition of investment advice to incorporate principles of ESG.

The DOL’s rule seeks to amend the language of “Investment duties” to “Investment prudence duties”, and include additional language around “projected returns and funding objectives that may often require an evaluation of the economic effects of climate change and other ESG factors on the particular investment or investment course of action.” Another objective the proposed language intends to accomplish is to counteract the negative perception of the use of climate change and other ESG factors in investment decisions caused by the 2020 Rules. In other words, to clarify that a fiduciary's duty of prudence may “require an evaluation of the effect of climate change and/or government policy changes to address climate change on investments' risks and returns”.⁵

In its proposal, the SEC has three main objectives. First, they seek to create “accuracy, reliability and comparability among the various ESG asset management practices” and offerings. Second, to require disclosure of material information to investors so they may make well informed decisions, and third, the proposal seeks to align investor expectations with manager practices through such disclosure; the ultimate goal is for the rule to provide investors with transparency as to how ESG factors are being utilized by funds and advisers in investment decisions and remain “neutral as to the benefits or risks of ESG investing”.⁶

With these considerations in mind and with the understanding that this option must be offered to all plan participants, in general, this option tends to be utilized by more experienced investors with larger account balances or with higher incomes. Furthermore, plan sponsors have the ability to determine the overall structure of these types of accounts. For example, the percentage of a participant’s account that could be invested in this option can be limited to 50%. Furthermore, certain securities and types of investments can be omitted and/or restricted from access within the self-directed brokerage account.

Unique requirements of non-traditional assets in retirement plans

Self-directed brokerage accounts can be utilized to access non-traditional assets through a retirement plan. Offering these non-traditional investments comes with additional administrative challenges due to the additional complexity of these investments. The ability to offer this option requires a flexible platform that allows custom programming and enough technological expertise to adapt to the needs of each individual plan sponsor and the individual needs of the participant. Some of the factors that should be examined in the record-keeping and administration areas when considering access to these alternative investments are:

• Ability to work with various asset companies and brokerage firms to meet the specific needs of both plan sponsor and participant.
• Reconciliation process between record-keeper, trust company, and asset companies.
• Processes in place to complete tasks such as the purchase of a new asset, capital calls, participant account reconciliation.
• Reporting for both the Plan Sponsor and auditor.
• Well trained benefits call center staff ready to assist participants with non-traditional assets related questions.

¹ Vanguard. How America Saves 2021, 20th edition.

² Callan Institute. 2022 Defined Contribution Trends Survey.

³ GovInfo. 29 CFR § 2550.404c-1 - ERISA section 404(c) plans. Retrieved August 22, 2022, from https://www.govinfo.gov/app/details/CFR-2016-title29-vol9/CFR-2016-title29-vol9-sec2550-404c-1/summary.

⁴ Compliance Assistance Release No. 2022-01. Retrieved October 27, 2022, from https://www.dol.gov/agencies/ebsa/employers-and-advisers/plan-administration-and-compliance/compliance-assistance-releases/2022-01.

⁵ Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights. A Proposed Rule by the Employee Benefits Security Administration on 10/14/2021. Retrieved October 27, 2022 from Federal Register :: Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights.

⁶ Statement on Proposed Rule Requiring Enhanced Disclosure by Certain Investment Advisers and Investment Companies on ESG Investment Practices. Retrieved October 27, 2022 from https://www.sec.gov/news/statement/crenshaw-statement-esg-investment-practices-052522.