It's a well-established, if discouraging, fact that professional fund managers routinely underperform the market. According to Morningstar, 79 percent of large-cap fund managers underperformed the S&P 500 stock index last year.
Could you, the average investor, do better? Many 401(k) plans allow you to try.
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What's known as a "brokerage window" allows 401(k) participants to invest some portion of their contributions outside of the dozen or so mutual funds in the typical 401(k) menu. The feature is sometimes referred to as a "self-directed" 401(k) or "self-directed brokerage account." Your employer (the plan "sponsor") decides whether your plan offers a brokerage window, and what proportion of your contributions you can invest through it. Your employer can also determine the range of investments permissible through a brokerage window. Some might restrict you to mutual funds, while others might permit a broader range of choices.
The rise of more flexible 401(k) investing options started as participants began demanding more control over their retirement accounts during the bull market of the 1990s. The number of sponsors adopting the feature continues to rise despite--or perhaps because of--the market swoons of the past four years. A survey by consulting firm Aon Hewitt shows that 29 percent of plans offered a self-directed feature last year, up from 18 percent in 2008. The bigger the plan, the more likely the option: Of the plans on Vanguard's platform, 23 percent of those with 5,000 or more participants offer a brokerage window, compared with 11 percent of Vanguard-serviced plans overall.
That doesn't mean your typical investor is eager to get behind the steering wheel. While 23 percent of Vanguard's 401(k) participants are offered a brokerage option, only 1 percent use it, the firm says. Fidelity says 38 percent of its participants have a brokerage window, but that only 2.4 percent use it.
Schwab--one of the biggest servicers of self-directed 401(k) brokerage accounts--says the small percentage of its 401(k) clients with brokerage accounts (3.4% of the total) invest 80% of their 401(k) assets through them, and have the rest in their plan's core offering. As of March 31, Schwab says, 54 percent of these self-directed assets were invested in equities, 39 percent in mutual funds, and 7.6 percent in fixed-income assets.
The biggest single equity holding was Apple (AAPL), accounting for 8 percent of equity assets in Schwab's self-directed accounts, followed by the SPDR Gold Trust (GLD), an exchange-traded fund. The most popular mutual funds were the Schwab S&P 500 Index fund (SWPPX), which accounted for 1.8 percent of mutual-fund assets, followed by PIMCO's Total Return bond fund (PTTRX).
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Older investors are more likely than younger workers to use the option. About half of Schwab's self-directed 401(k) investors are 50 and older, compared with about a quarter who are in the 20-to-39 demographic. Men are more likely to self-direct than women (8 percent vs. 3.6 percent), according to Aon Hewitt.
Federal rules require that plans which offer a brokerage-window option offer it to all in the plan, not just executives. But that doesn't mean self-direction is appropriate for everyone. The concept was developed, after all, with more sophisticated investors in mind, and it long predates the rise of the 401(k).
"It was a standard plan design, especially for law firms, historically," says David Wray, president of the Plan Sponsor Council of America, a nonprofit that represents companies offering 401(k) and profit-sharing plans. Even today, he says, "the people who use [brokerage windows] are typically highly paid--not your typical 401(k) participant going into a target-date fund."
Indeed, utilization of the brokerage option tends to rise along with income: Among people making $100,000 or more, some 10 percent used them in 2010, says Aon Hewitt, and their total 401(k) balance averaged $200,000, about three times the average 401(k) balance.
A common objection to self-directed 401(k) accounts is that the average investor isn't equipped to make sound choices. Performance data are hard to come by, but a 2005 survey reported by the Journal of Pension Benefits suggested that almost half of plan participants don't feel competent to invest on their own and prefer to rely on a professional. Even sophisticated participants, the study showed, were reluctant to use self-directed accounts.
Perhaps with good reason. The same article, citing a survey of self-directed accounts maintained by Lexington, Ky.,-based Unified Trust, and using 2002-03 data, showed that 76 percent of their account returns underperformed the S&P and 72 percent underperformed the core-fund model for their respective plans, by an average of 4.7 percentage points after fees. Unified Trust CEO Gregory Kasten, who authored the report, says the underpeformance rate has been fairly consistent since then, averaging 3 percent to 5 percent below plan performance.
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"Everything we looked at years ago continues to be true," says Mr. Kasten. "There will be some isolated pockets of success, but there are many more failures."
Schwab suggests that the self-directed option is best for people who are "comfortable making their own investment decisions" and who "can dedicate more time to managing their own investments"--not the exactly the profile of your average 401(k) participant. It's up to each brokerage whether it offers advice on self-directed accounts (Schwab doesn't). If not, your plan may allow you to hire your own adviser. In fact, that's one of the things you should probably do if you're not a professional fund manager and you're determined to use a brokerage window.
Other things include minimizing transaction costs by buying no-load funds and ETFs, which generally have lower expense ratios than mutual funds. And minimize trading. Numerous studies document the tendency of people to exaggerate their own investing competence, and to overtrade as a result. (Men tend to trade more than women, and to suffer more as a consequence). A broker would invite trouble for "churning" your account--that is, trading excessively to rack up commissions. Most people tend to be their own worst broker.
"It's human nature that they have a lot of emotional overlay," says Kasten, "so they will tend to be buying at market tops and selling at market bottoms."
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