It appears, according to recent survey data, that self-directed brokerage accounts are being rediscovered by a whole new generation of 401(k) participants.

Schwab, for example, reports a 12% increase in new brokerage accounts opened in 2008. Similarly, Hewitt Associates reveals in its survey, "Trends and Experience in 401(k) Plans for 2009," that self-directed brokerage accounts have grown 44% since 2007 and now are offered by 26% of plan sponsors.

Let's start with the basics. A self-directed brokerage account is an individual brokerage account that is part of a 401(k) plan that can allow a participant to invest in any stock, bond, mutual fund or alternative investment - e.g., REITs, ETF, hedge fund or any restriction thereof. It allows 401(k) participants to go beyond the standard menu.

What's the appeal to plan participants? The usual drivers include one or more of the following factors:

First, fund menus in many plans have gotten smaller with target-maturity funds for those employees who want a "one and done" investment choice. Some employers provide self-directed brokerage accounts for participants who are more sophisticated investors.

Second, account balances are, in fact, getting larger and belong to participants who have their own advisers for personal funds. Many of these participants believe they - or their personal advisers - can do a better job.

Now, is it the right thing to do? It is, after all, a fiduciary decision with respect to the inclusion of self-directed brokerage accounts in a 401(k) plan. There is a wide spectrum of opinion in the industry on whether plan sponsors should permit this investment option.

Some of the negative opinions have been expressed in highly emotional terms - for example, allowing self-directed brokerage accounts is the same as letting the inmates run the asylum.

Making the decision a nonemotional one means considering such matters as participants' investment sophistication, the effectiveness of the investment education program, the availability of investment advice, control over cost and administration, etc.

In some cases, the decision may be driven by executives with large account balances who - using the term that made Chicago politics famous - have "clout."

Three considerations

If you do decide to go ahead with a self-directed brokerage account option, there are three areas to consider in structuring this investment option to avoid unintended consequences.

1. Administrative parameters. Establishing and administering SDBAs should be subject to several restrictions:

* Don't permit the participant to open an investment account without the approval of the trustees.

* The account should be opened in the name of the trustees for the benefit of the participant, and the participant shall deposit no funds in the account without the approval of the trustees.

* Use one custodian account for all brokerage accounts, which should be electronically linked to a master plan account to facilitate consolidated reporting.

* The trustees should receive regular statements from the investment custodian.

* The cost of the self-directed brokerage account should be borne by the participant involved.

2. Investment restrictions. Procedures should be put in place so that a participant cannot make investment decisions that would:

* Not be in accordance with the documents and instruments governing the plan.

* Jeopardize the plan's qualified status.

* Result in a prohibited transaction.

* Result in unrelated business income.

* Cause a loan or distribution to be made from the plan.

* Invest in any property, the fair market value of which cannot be readily determined on a recognized market or otherwise requires an appraisal.

* Invest in tangible personal property characterized by the Internal Revenue Service as collectibles, other than U.S. Government- or state-issued gold and silver coins.

* Cause the plan to not be in compliance with state or federal securities laws and regulations.

The cost of unwinding any transaction listed above should be charged to the participant's account.

3. Qualifying plan assets. If your 401(k) plan is a small plan (one with fewer than 100 participants), you want it to be exempt from the general requirements under Title I of ERISA that a retirement plan be audited each year by an independent qualified public accountant as part of the plan's annual report Form 5500. To take advantage of this exemption, however, at least 95% of a small plan's assets must be "qualifying plan assets," which include:

* Any asset held by certain regulated financial institutions.

* Shares issued by an investment company registered under the Investment Company Act of 1940, e.g., mutual fund shares.

* Investment and annuity contracts issued by any insurance company qualified to do business under the laws of a state.

* Any assets in the individual account of a participant or beneficiary over which the participant or beneficiary has the opportunity to exercise control and with respect to which the participant or beneficiary is furnished, at least annually, a statement from a regulated financial institution describing the plan assets held or issued by the institution and the amount of such assets.

* Qualifying employer securities, as defined in ERISA, section 407(d)(5).

* Participant loans meeting the requirements of ERISA, section 408(b)(1), whether or not they have been deemed distributed.

To the extent that a participant's self-directed brokerage account causes the plan to have less than 95% of its assets in qualifying plan assets, then the participant should be responsible for the cost of meeting the audit waiver requirements, i.e., the cost of obtaining bonding in accordance with Department of Labor Regulations.

Communicating to employees

And how should these matters be communicated to employees? A written investment procedure should be provided to each participant and any outside investment adviser that a participant uses.

Self-directed brokerage accounts, if properly structured and administered, have the potential to help participants have a more favorable retirement outcome. But before you take the plunge, think it through very carefully and discuss it with all of your advisers.

Contributing Editor Jerry Kalish is president of National Benefit Services, Inc., a Chicago-based retirement consulting and administrative firm. He also publishes The Retirement Plan Blog, Follow EBN on: Twitter | Facebook | LinkedIn | Podcasts

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