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Hit or Miss

Self-directed brokerage accounts have drawn raves from some, doubt from others.
Meg Glinska, CFO Magazine
December 1, 2000

Southwest Airlines Co. CEO Herb Kelleher is renowned for his iconoclastic approach to management: He's been known to ask prospective pilots to drop their pants during job interviews, to test their sense of humor. But his company takes employee relations very seriously. In fact, the airline's employees are viewed as its "first customers." So when the company's pilots heard about some high-flying stocks and wanted a piece of the action, they got it.

In July, the Southwest Airlines Pilots' Retirement Savings Plan began offering its participants the Schwab Personal Choice Retirement Account, a self-directed brokerage (SDB) account, as a new investment choice. Now pilots can invest a portion of their 401(k) plan account balance in individual stocks and bonds as well as in more than 1,900 mutual funds. "We ran surveys, and that's what most people wanted," says Richard Doherty, director of member benefits for the Southwest Airlines Pilots' Association, the retirement savings plan's administrator. "They weren't satisfied with the 10 core funds we had." So far, 550 of about 3,500 Southwest pilots have taken advantage of the brokerage option, and Doherty expects that 25 percent of the pilot workforce will sign up by year's end.

In large part because today's business environment is marked by a wide-ranging skills shortage--the "war on talent," in managementspeak hyperbole--a growing number of companies are willing to listen when employees ask for an SDB option as part of their 401(k) accounts. According to a study conducted earlier this year by Cerulli Associates Inc., a Boston-based financial research and consulting firm, 14 percent of the 250 companies surveyed offer an SDB option, up from 8 percent in 1999 and 5 percent in 1998. Another 9 percent of respondents said they were planning to add the feature this year.

The growing interest in SDB accounts reflects a philosophical shift away from what's viewed as corporate paternalism; in essence, the same impulse that led to the creation of 401(k)s to begin with reaches a new level with SDB accounts. For more than a decade, companies have been abandoning defined-benefit plans in favor of defined-contribution plans, which require participating employees to make their own investment decisions. Arguably, when an employer transfers the responsibility for retirement saving to its employees, it is duty-bound to provide them with an optimal range of choices. "Self-directed brokerage is the next logical progression in the empowerment of participants," says Walt Bettinger, president of the Retirement Plan Services Enterprise division at Charles Schwab & Co. "It offers them broader choice. If we ask participants to be responsible for their investments, it's only fair to give them all the necessary tools to do so."

But not everyone favors the trend toward unlimited investment choice and unmitigated individual responsibility for retirement savings. Christopher Hobbs, CFO at Xuma Inc., a San Francisco­based E-business infrastructure and managed services provider, advises against including an SDB option in 401(k) plans. "We've looked at that issue," he says, "and I specifically declined it for the simple reason that, philosophically, you shouldn't day-trade your retirement account. This is retirement money, and it should be managed professionally." Hobbs explains that Xuma employees can achieve potentially high returns within the company 401(k) menu, which includes a wide array of mutual funds. "If they want to be aggressive, we offer a solid selection of emerging-growth funds," he says. "Besides, our employees are young folks, and I don't want them looking at tickers all day."

The most common business rationale for introducing a brokerage option--to attract and retain good employees--doesn't fly with Hobbs, either. "In a start-up market, no employee is going to leave over a 401(k). It's a sweetener, not a hook. I don't know of anyone in our sector who's left anyplace or accepted a job offer because of the investment options available to [him or her]." Hobbs believes that what really attracts talent to Xuma is the fact that his company is doing "exciting things," not that it offers access to exciting stocks through an SDB account.

Hobbs has the allure of a cutting-edge company on his side, of course. Yet many experts agree with him. They caution that with more investment choices come some potential pitfalls: the risk of day-trading retirement money and the risk of inappropriate investment selection by employees faced with too many options. Another area of concern is the employer's fiduciary responsibility to select and monitor appropriate investments for the plan. The lack of Department of Labor (DoL) guidance and Employee Retirement Income Security Act (ERISA) case law regarding the maintenance of SDB accounts makes many plan sponsors nervous about offering them.

But the case for prudence is often in conflict with the desire to please employees. "Plan sponsors are generally reacting to a very vocal minority who are the highest-paid employees," says Michael McCarthy, a Hewitt Associates 401(k) consultant. "Self-directed brokerage is definitely something they are demanding, but for the plan sponsors, there's a steep learning curve." Experts recommend that companies look at their employee population and determine for whom SDB accounts might be appropriate and how they would fit with the overall menu of choices available.


What's Old Is New Again

While SDB accounts have only recently begun to attract the attention of CFOs, they aren't new. During the 1990s, a few large companies offered them as part of their 401(k) menu, and their genesis goes back even further. "They had been the primary options for small professional firms, such as law firms and accounting firms," says Ruth Hughes-Guden, a principal with Morgan Stanley Dean Witter Investment Management. When Ted Benna, president of the 401(k) Association, in Bellefonte, Pennsylvania, designed the first defined-contribution retirement savings plans for professional firms in the late 1960s, he structured them as SDB accounts. "They were totally self-directed," he says. "All the money in the plan was controlled by the participant."

SDB accounts are usually structured as a "window" through which a plan participant can buy and sell stocks, bonds, and mutual funds not included on the list of core funds traditionally offered by a plan sponsor. "It can be a mutual fund window, which can be as small as 10 or as large as 150 funds," says Joseph LoRusso, president of Fidelity Institutional Retirement Services Co., in Marlborough, Massachusetts, "or it can be a full-blown self-directed brokerage window" offering access to virtually any stock, bond, or fund.

The More the Merrier?

Such choice is desirable for some, overwhelming for others. Despite an aggressive push for investor education in the past few years, studies reveal that large numbers of 401 (k) participants remain in the dark when it comes to investment fundamentals. Money magazine and The Vanguard Group recently conducted a 20-question poll to test the personal-finance expertise of 1,501 investors. Most flunked. The average respondent got only 37 percent correct.

Even investment-savvy participants, experts point out, may fall down on SDB accounts. For example, few are asking about costs, and they sometimes end up paying large fees and commissions when they could have come out ahead by sticking with the investment option in the core funds group.

Ironically, only a small number of those with access to SDB accounts actually use them. Today, SDB accounts garner a mere 3 percent of plan assets at firms that offer them, according to Hughes-Guden. "In most 401(k) plans, many people don't do much once they make their initial investment decisions, but there's always a select, sophisticated group of people who want to trade," she says.

The dollar volume may be low, but there is still an all-or-nothing element to consider. According to Richard Koski, principal with Buck Consultants Inc., a benefits and compensation consultancy in Secaucus, New Jersey, those employees who do participate in SDBs not only tend to be among the highest paid at a firm, but also keep substantial balances in them. That raises the specter of employees with a lot at stake reaching retirement age in less than optimal fiscal health: Will they look to blame the employer who threw a ton of choices at them but then left them to flounder?

To avoid that dire possibility, a tiered investment approach for 401(k) plans comes in handy. "You have the basic tiers, like lifestyle funds, for people who are uncomfortable making asset-allocation decisions, and a set of 8 to 10 core options," says Hughes-Guden. "And for those who want more, the third tier could be a self-directed brokerage option." That way, says Hewitt's McCarthy, "participants can choose to stick with the core investments and still make good choices without being overwhelmed."

Increased Plan Complexity

While one can certainly argue that an SDB account provides the ultimate in asset allocation, thereby helping plan sponsors cover one fiduciary flank, it also increases a plan's complexity, especially on the reporting side. Both the DoL and the Internal Revenue Service require plan sponsors to file a 5500 form on an annual basis, an administrative burden made worse by SDB accounts. "The form has to summarize all of the contributions, distributions, dividends, and interest," says Schwab's Bettinger. "An SDB feature adds a level of complexity to that reporting."

More complexity usually means higher costs, and in the case of SDB accounts, that cost is shouldered by those participants who choose to go into the brokerage window. Typically, participants have to pay transaction costs as well as an account fee, which ranges from $50 to $150 and covers reporting expenses. "If they buy individual stocks and bonds, they'll have commission costs," says Bettinger. A less expensive option is a mutual fund window, which, according to Fidelity's LoRusso, can be set up at a marginal cost, since providing access to a large pool of funds is not much more difficult than offering a core group of 5 or 10.

Fiduciary and Legal Issues

Southwest's Doherty admits to having had some trepidation about fiduciary responsibility and the risk of future lawsuits. "We did meet with the company, because the company is the plan fiduciary; we met with our board of directors; and [we met with] both the company's and our ERISA attorneys," he says. But there seemed to be no intermediate solution, and the pilots were adamant. "They aren't short on opinions," says Doherty. "No matter what you do, you can't find 10 funds everyone likes, so ultimately the need to provide more options outweighed our fiduciary and legal concerns."


Unfortunately, there seems to be no clear guidance from, or interpretation of, ERISA about how the brokerage window fits in. "It's uncharted territory, from a legal-challenge standpoint, and that's why a lot of plan sponsors haven't instituted SDBs yet," says Thomas Rossi, a consultant in the New York office of Watson Wyatt Worldwide. "Without significant regulatory guidance, you have to make sure you've documented your every step."

Undoubtedly, plan sponsors are in a difficult position. "You're damned if you do it, and you're damned if you don't," says Buck Consultants's Koski. By giving participants access to virtually any mutual fund and publicly traded security available, the brokerage option helps plan sponsors as fiduciaries by not limiting participants to only a few investment options, which means that participants can't say, "You didn't provide the right kinds of securities to choose from," says Hughes-Guden.

Containing Liability?

There are steps companies can take that may prove invaluable. First, provide plan participants with as much information and disclosure as possible, says Rossi. "Plan sponsors have to make sure they've communicated the risk associated with investing in a brokerage account. They have to demonstrate that they've educated their people."

Companies can also try to mitigate risk by limiting the amount of money that participants can invest through a brokerage window, as well as by restricting the type of investments that can be used. For example, Southwest's pilots can't trade on margin or invest in futures, commodities, precious metals, currencies, or Southwest stock. In addition, says Doherty, "They can move only 25 percent of their 401(k) out of core mutual funds into the brokerage window." While there is no limit on trades, Southwest pilots will be watched closely. "We're going to be able to monitor activity," says Doherty. "If people are excessively trading, we'll be notified, and we'll get hold of the individuals to make sure they know what they're doing."

With those policies in place, Doherty believes that an SDB option makes a lot of sense for the pilot workforce. "Most of our pilots are college-educated, well-informed investors and risk-takers," he says. But they aren't reckless: The Southwest Airlines Pilots' Association started an education process six months before offering the SDB option. So the company with the clever tag line "You are now free to move about the country" has employees who are free to move about the investment universe. Doherty is confident that they've done their homework and aren't flying blind.

Meg Glinska is a Boston-based freelance writer.




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