The Cons and Cons of a Self-Directed 401K

The “self-directed 401K buzz” is building once again. This time, in response to a dismal market and high 401K fees.

Traditionally, 401K’s offer a limited selection of mutual funds and other investments and not the total universe of available investments in various markets. This is done in order to contain administrative expenses as well as potential investment mistakes made by plan participants who may be prompted to invest differently under a plan sponsored by their employer.

A self-directed option allows a participant (depending on the plan’s rules) to invest a portion or more of their 401K savings into a wider universe of choices — including stocks — often in exchange for a transaction fee.

As an advisor, I feel this is a bad idea. It’s synonymous to our not being satisfied with the quality of vegetables at our neighborhood grocer and starting our own farm. While we may be successful the first few months — in particular, during nice weather — we may not have the time nor experience to know how to farm during a snowstorm or heatwave.

My point being rather than take on this responsibility myself 24/7, I would not only demand that the grocer provide me with better vegetables but I would also learn enough about farming so that I would know whether the grocer was doing a good job just by looking at the vegetables.

Rather than provide a self-directed option and a pat on the back for good luck, employers (also known as the plan sponsor) should not only provide a lower fee investment menu in the 401K, but they should also provide participants with the option to invest in model portfolios managed by an independent advisor (e.g., an RIA). Add to that better engagement by employees with portfolio reviews and education, and the self-directed option may appear less attractive.

401Ks were originally just an executive perk and a means for lowering an executive’s taxable income. They were not originally intended to be a key part of employees’ retirement savings. As a result, the management of these plans desperately needs to evolve. Because while a few employees may make good farmers, the majority should not be forced to get their hands dirty as a second (and in some cases, third) job.

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