Stuck in a Stinky 401(k)? Open the (Brokerage) Window

Note: This article is part of Morningstar's January 2014 401(k) Week special report.

Unhappy with your employer's 401(k) plan? Perhaps the fund selection is too limited, expense ratios are too high, or you just wish you could invest in stocks and ETFs as well as funds? The answer to these problems may, in fact, be right under your nose if your employer's plan includes a brokerage window option.

A brokerage window in a 401(k) plan--sometimes also referred to as a self-directed 401(k)--basically functions as a brokerage account embedded within the plan. 401(k) plans typically offer participants a menu of perhaps 10-20 mutual funds from which to choose, but the brokerage window offers a way for participants to invest in a much broader selection of investments that may include stocks and ETFs along with mutual funds.

Only about 17% of 401(k) plans offer a brokerage window option, according to a 2012 survey by the Plan Sponsor Council of America. Those that do typically require that the participant set aside assets in the plan's money market account for use in the brokerage window, with a minimum amount sometimes required. Rules about how brokerage accounts are used and what can be held in them vary by plan. For example, some plans allow participants to buy only mutual funds through the brokerage window, while others also allow for the trading of stocks and ETFs.

Brokerage windows have not been without controversy, however, and in the coming months the Department of Labor plans to review policies that govern these accounts. According to its upcoming regulatory agenda, the department will consider "whether, and to what extent, regulatory guidance on fiduciary requirements and regulatory safeguards for such arrangements are appropriate."

Using a brokerage window isn't for everyone. If your plan offers a good selection of funds with reasonable expenses and low administrative costs, there may be no reason to even consider a brokerage window. But for those investors who think it may be right for them, here are some dos and don'ts to consider.

Do open a brokerage window for the right reasons.
When does a brokerage window make sense? If your 401(k) plan offers a menu of funds that doesn't meet your investment needs or is unnecessarily pricey. For example, many 401(k) plans offer one measly foreign stock fund; small-cap and fixed-income exposure may be similarly limited. Investors who want to diversify--say, by also investing in a dedicated emerging-markets fund, a high-yield bond fund, a real estate fund, or a small-value fund--while retaining the tax advantages of a 401(k) may need to go outside the plan's fund lineup via the brokerage window. Likewise, investors who favor index funds may find their 401(k) lineup wanting. Being able to invest in a wide variety of index funds and ETFs through the brokerage window can be a real plus for these investors.

Don't open the window just to dabble.
Investing in stocks or ETFs as part of your 401(k) may sound enticing, but look before you leap. A well-designed 401(k) plan will provide the right mix of equity, fixed-income, and other funds--possibly including target-date funds--to suit the majority of the company's employees. Opening a brokerage window on top of that simply because you want to dabble in stocks or ETFs, too, may be courting trouble if it will lead you down the road to temptation--namely, trying to time the market with stock picks, investing in trendy but unproven ETFs, and other bad investor behavior. The brokerage window should help solve problems with your 401(k), not create new ones.

Don't trade frequently.
One major downside to using a brokerage window is that each transaction may very well require paying a commission, which can make buying stocks, funds, or ETFs for your 401(k) an expensive proposition if you contribute assets on a per-paycheck basis. For an investor contributing on a biweekly basis to a 401(k) brokerage window account that charges $20 per trade, that would mean paying an extra $520 in fees each year.

To avoid paying these high transaction costs the investor might decide to make contributions only periodically, but this invites market-timing, which could hurt performance. Contributing regularly with each paycheck represents a form of dollar-cost averaging--buying more shares when prices are low and fewer when they are high--not to mention getting your money into the market sooner than with the stockpiling approach. For those who wish to contribute to their 401(k) investments on a per-paycheck basis, investing in mutual funds--either those offered within the 401(k) or commission-free funds available through the brokerage window--tends to be much more cost-effective than investing in stocks or ETFs that require paying a commission each time.

Do check investing costs.
In addition to commissions on the purchase or sale of funds, stocks, and ETFs, a brokerage window within a 401(k) plan may charge participants an annual fee. Fees and commissions paid to invest through the brokerage window act as a drag on 401(k) performance and may result in a smaller nest egg than might be achieved by sticking with the funds available within the 401(k). They also may defeat the purpose of using the brokerage window to circumvent a lousy plan with high costs. In addition, the 401(k)'s fund lineup may include institutional share classes of funds that cost less than comparable funds available through the brokerage window as well as no-load versions of funds that would normally charge a load.

Don't forget the IRA.
An alternative to paying the fees and commissions of a brokerage window may simply be to redirect some of the money you would normally put into a 401(k) into an IRA (taking care to invest at least as much in the plan as it takes to get the company match). After all, any investment available through a 401(k) brokerage window is likely available outside the plan for use in an IRA as well. For tax purposes, the adjusted gross income limits to contribute to a traditional (tax-deductible) IRA for taxpayers who also take part in a workplace retirement plan are $70,000 for singles and $116,000 for those who are married filing jointly (assuming the IRA holder is also the one in the employer-sponsored plan). For those wishing to contribute to a Roth IRA, in which contributions are not tax-deductible but growth and distributions are tax-free, income limits are $129,000 for singles and $191,000 for those who are married and filing jointly.

Do look at your retirement savings holistically.
It may be tempting, while using a brokerage window, to think of the money as separate from your other 401(k) holdings. But it's all there to do the same job: provide for your retirement. Asset allocation is crucial, so make sure that any holdings you have in your brokerage window complement those elsewhere in your 401(k) and in any IRA you might have, and avoid duplicating holdings. Also, beware of taking on excess risk by owning individual stocks or equity ETFs in your brokerage account if you already have adequate equity exposure in the rest of your 401(k) and an IRA.

The bottom line for investors considering using a brokerage window in their employer's 401(k) plan is this: Given the added costs of using this option, make sure it's worth your while before moving ahead. Is it the only way to accomplish your retirement investing goals? Are you willing to spend the extra time and effort to manage this portion of your retirement portfolio? Will you honestly be able to resist trading too much or chasing hot performers? If the answer to any of these questions is "no," then perhaps this is a window you'd best keep closed.