We’ve all experienced it – anyone who’s ever advised a 401(k) plan. There’s always one employee who knows it all. He’s the guy (and, yes, I’m not being sexist, but it usually is a guy) who thinks he could school Warren Buffet. He is, after all, the only person who believes some obscure fund with only $100,000 in assets is about to explode. It usually does, except not “explode” as in “ever higher growth,” but “explode” as in “blow up.”

Many times, a 401(k) plan sponsor will create a special “self-directed brokerage account” to appease these employees (who may, in fact, be owners or high level executives of the firm). These plan sponsors may be under the impression that giving these employees free range both solves the problem of their vociferousness and leaves the plan sponsor off the hook in terms of liability. 

Nothing may be further from the truth, as revealed in “Is the Fiduciary Liability of Self-Directed Brokerage Options Too Great for 401(k) Plan Sponsors?” (FiduciaryNews.com, June 11, 2013). 

Consider this: At what point is a fiduciary liable for enabling bad behavior? Most believe 404(c) fully absolves the plan sponsor of any fiduciary liability because it’s the employee’s responsibility to pick the investments. But what if one of the three “materially different” investment options includes a fund that always loses money because it treats every shareholder who invests more than $2,000 from their 401(k) every year to an all-expense paid trip to the Caribbean in February. Every employee will flock to that fund. It’s a losing fund, but it essentially bribes shareholders to stay in and contribute more. The only thing it guarantees is that no shareholder will ever reach their retirement goal. 

Are 401(k) plan sponsors safe only because it’s the employee’s choice to invest in this fund? Or is the 401(k) plan sponsor guilty of offering a poor choice to employees? There’s a good chance it’s the latter because, in this case, the plan sponsor either failed to conduct proper due diligence or ignored the due diligence it did conduct. Either way, this is a bad thing and exposes the plan sponsor to a certain level of fiduciary liability. 

We must therefore conclude 404(c) alone does not protect 401(k) plan sponsors. Offering an inappropriate choice is just as damning as any other breach of fiduciary duty. 

How does a self-directed brokerage option fit in this scheme? Aside from the enormous additional fiduciary liability exposure from purely a compliance reporting standpoint (this is outlined in the above referenced article), the plan sponsor faces the undaunted prospect of a naïve employee using a self-directed option to pick a wholly inappropriate fund – one never even vetted by the plan sponsor. The plan sponsor may claim ignorance, but it cannot claim a lack of responsibility. It’s like a bartender giving care keys to a drunk patron. That’s the kind of faux pas that lands the bartender in jail as an accessory to what ensuing damage results for the drunk driving. 

In this case, the plan sponsor is giving the employee the keys to a vehicle the employee might not be able to drive. Said another way, the plan sponsor may just be giving employees enough rope to hang themselves by. 

Does this mean brokerage windows should be outlawed? Some advisors make that exact case saying, to the effect, “if you want to manage your own account, do it in your taxable account.” But what if the plan sponsor and the loud-mouthed employee is one in the same person? What if the only user of the self-directed brokerage option is also the trustee of the plan? 

Clearly, the circumstances must be examined to see if this is appropriate – and it just might be. In the case of extremely small plans – one participant who happens to be a doctor or lawyer or some other kind of highly paid virtually self-employed professional – a self-directed option might be OK. The only thing – an ERISA attorney might suggest this individual set up an SEP-IRA instead of a 401(k). The compliance reporting burden is a lot less in the IRA.