Participant Directed Investments Through Brokerage Windows: The Last Frontier or a Trap for the Unwary?
By Ivelisse Berio LeBeau and Stephen Wilkes
What should fiduciaries of participant-directed plans consider in deciding whether to allow participants to direct their own investments using arrangements loosely referred to as “brokerage windows”? The realm of ERISA plan investments through these arrangements remains largely uncharted territory. Fiduciaries operate under the broad understanding that ERISA Section 404(a) fiduciary duties of prudence and loyalty apply, but with little guidance on how.
The revised Investment Duties regulation that went into effect in January 2021 has brought renewed attention to how the fiduciary duties of prudence and loyalty guide and restrict investment decision making for ERISA plan assets. The Biden Administration is reviewing the new regulation, which had been promoted as a means to limit benefit plan investments in ESG vehicles. The final rule, however, had formalized informal guidance issued across political administrations for all investment decisions by all ERISA plan fiduciaries. These principles are not dependent on the final form of the revised regulation and remain relevant to ERISA investment decision making.
Investment Self-Direction in 401(k) Plans
Understanding the role of brokerage windows requires first understanding participant investment direction generally. ERISA Section 404(c) recognizes that individual account plans may permit participants to “exercise control over the assets” in their accounts and direct their own investments. If participants exercise such control, “as determined under [DOL] regulations,” then plan fiduciaries are not liable for investment losses stemming from the self-directed investment choices.
A 404(c) plan typically gives participants the opportunity to invest some or all of the assets in their accounts in a broad range of “designated investment alternatives” (DIAs), defined in the 404(c) rules as “a specific investment identified by a plan fiduciary as an available investment alternative under the plan.” Plan fiduciaries exercise fiduciary discretion in selecting DIAs. If the requirements in the 404(c) regulation are met, then plan fiduciaries are not responsible for losses resulting from participants’ investment choices.
Brokerage Windows, Self-Directed Brokerage Accounts, or Similar Arrangements
The use of brokerage windows to allow participant-directed investment choices is an invention without regulatory form. The 404(c) rules do not refer to or describe brokerage windows. Neither does ERISA. The DOL indirectly recognized brokerage windows in 2012 when its expanded definition of “designated investment alternative” for use in the Section 408(b)(2) participant disclosure regulation specifically excluded “‘brokerage windows,’ ‘self-directed brokerage accounts,’ or similar plan arrangements that enable participants and beneficiaries to select investments beyond those designated by the plan.” The participant disclosure rules also set forth the only regulation that directly applies to brokerage windows, requiring fiduciaries to disclose certain fee and expense information about brokerage window options available under a plan.
Subsequent DOL guidance explained that brokerage window-type arrangements are not prohibited, that they are not designated investment alternatives because they do not identify available investment funds, and that fiduciaries of plans that offer such options are bound by ERISA Section 404(a) fiduciary duties of prudence and loyalty in connection with such offerings. No additional DOL guidance has been issued, despite a 2014 Request for Information seeking to understand when, how, and why some participant-directed individual account plans allow participants to use brokerage windows in addition to or in place of investment options selected by plan fiduciaries.
Brokerage window arrangements thus exist in a regulatory void, defined by what they are not rather than what they are. Their common factor is that fiduciaries have not designated investments accessed through them. Implementing or retaining brokerage windows in ERISA plans remains, however, a fiduciary function subject to the ERISA Section 404(a) fiduciary duties of loyalty and prudence. The factual circumstances in which these arrangements exist—the when and how and why they are implemented or retained—can vary widely, creating different fiduciary challenges.
Fiduciary Duty of Loyalty in Implementing or Retaining Brokerage Windows
In particular, how does a plan fiduciary exercise the fiduciary duty of loyalty when implementing or retaining a brokerage window option? While the choice to offer a brokerage window could be considered a sponsor decision, implementing and monitoring the option is necessarily a fiduciary function to be discharged solely in the interest of plan participants for the exclusive purpose of providing benefits and defraying reasonable expenses.
Fiduciaries might start with examining their motivations for evaluating a brokerage window option. Are they seeking to give plan participants broader investment choices? Are they responding to participant demands or complaints about available investment vehicles? Are they seeking to limit their own fiduciary responsibility under the 404(c) rules?
The revised Investment Duties regulation spotlights the fiduciary duty of loyalty in evaluating investment options, requiring exclusive consideration of an investment’s risk/reward characteristics. While the key characteristic of a brokerage window is that fiduciaries have not evaluated or designated investment options available through the window, the underlying principle that the fiduciary duty of loyalty requires focus on financial interests presumably does apply where fiduciaries are evaluating whether and how to allow plan participants to make investment choices outside of the investment alternatives that they have vetted and designated.
Each benefit plan has distinct characteristics. Would it be consistent with the fiduciary duty of loyalty to offer a brokerage window option without considering demographic information about a plan’s participants, such as their educational backgrounds, the size of participant accounts, the age of the population? In light of plan population data, could the fiduciary duty of loyalty require that fiduciaries impose restrictions on how plan participants may use a brokerage window, such as limiting the types of non-designated investments available, or the percentage of plan accounts that can be directed outside of DIAs? Could the circumstance instead lead a fiduciary to determine that participants’ interests would be best served by giving them unfettered discretion to evaluate and select the investment options that best fit their individual retirement savings needs?
Nondiscrimination standards require that investment options be offered equally to all participants in a plan. A fiduciary responding to participant requests for greater investment flexibility, for example, may recognize that suitability for a subgroup of plan participants—the ones asking for more options—does not necessarily mean that a brokerage window would be suitable for the entire plan population, and thus might not be an appropriate alternative.
The one DOL rule that applies to brokerage windows in participant-directed plans is that fiduciaries must disclose to participants certain information about related fees and expenses. Does the fiduciary duty of loyalty to defray plan expenses require fiduciaries to evaluate the nature of costs that may be incurred in connection with individual investment choices? For example, could fiduciaries limit brokerage windows to no-commission platforms without investigating whether and how such platforms generate indirect compensation? Would that depend on the financial expertise of a plan’s participant population? Or does the nature of investments made through a brokerage window shift responsibility for understanding and assessing investment costs to participants who use this option?
Fiduciary Duty of Prudence in Implementing or Retaining Brokerage Windows
Fiduciaries must also act prudently in deciding whether and how to implement or retain brokerage windows. The revised Investment Duties safe harbor regulation counsels fiduciaries to give “appropriate consideration” to relevant facts and circumstances, including considering a plan’s investment design and comparing options with reasonably available alternatives with similar risk/return features. Fiduciaries implementing or retaining brokerage windows exercise their fiduciary duty of prudence when they evaluate the type of services needed, the quality of the services provided, associated fees and expenses, and how the services will coordinate with an existing plan structure.
In selecting or monitoring brokerage platforms fiduciaries will likely consider the nature of the investment services themselves, such as the speed and accuracy of effectuating transactions, the timing of notifications, and the availability of investment choices on a brokerage platform. Fiduciaries may need to engage a consultant to evaluate platform services and expenses if they do not have expertise in this area.
Fiduciaries should be cognizant of fee and expense disclosure requirements, comparing fees and expenses between similar service providers and inquiring whether they can provide required disclosure information.
Selecting a brokerage platform may pose unique challenges given related recordkeeping needs. Investments directed through brokerage windows remain plan assets, and plan recordkeepers remain responsible for maintaining necessary records and information. What comes first, selecting a brokerage platform or considering logistical needs for maintaining records about investments made on the brokerage platform? How does a fiduciary compare and evaluate options for brokerage platforms if such choices are limited by recordkeeping needs? Should the feasibility of managing brokerage windows be a consideration in comparing and evaluating recordkeepers and recordkeeping fees?
Fiduciaries should also consider the relationship between a plan’s platform for designated investment alternatives and a plan’s platform hosting a brokerage window. For example, if plan rules place limits on investment options through brokerage windows, such as limiting the percentage of participant accounts that can be invested outside of designated investment alternatives, then procedures would need to be in place to enforce such restrictions.
Ongoing monitoring and evaluating services supporting brokerage windows may also require considering the interplay between recordkeeping, designated investment platform, and brokerage platform services.
Section 404(c) Compliance
Fiduciaries interested in offering a brokerage window option and also complying with ERISA Section 404(c) should select designated investment alternatives in addition to the brokerage window. The DOL has specifically excluded brokerage windows from the definition of designated investment alternatives; the DOL has explained that brokerage windows are not acceptable substitutes for designated investment options and cannot be used as a workaround to avoid participant fee disclosures. Under current guidance, the safe way to comply with Section 404(c) rules while offering a brokerage window is to offer designated investment alternatives as well, which the DOL has indirectly suggested is acceptable.
Fiduciaries should, however, make sure that there is a clear distinction between designated investment alternatives in a 404(c) plan and investment options available through a brokerage window. Brokerage windows and similar arrangements are defined by not being designated investment alternatives; if investments accessed through a brokerage arrangement look more like a menu of designated investment alternatives, however, then they may be treated as such and be subject to the same fiduciary responsibilities, whether or not a plan’s design so labels them. Factors such as the number and types of investment options available through a brokerage window, and rules or restrictions on using the window, may transform an intended brokerage window option into an offering of designated investment alternatives, potentially exposing vulnerability if fiduciaries had not evaluated the options in compliance with fiduciary responsibilities.
There is also no guidance on whether a brokerage window arrangement could be designed to satisfy 404(c) rules as an alternative to designated investment alternatives, not a substitute. The statutory language refers to DOL rules to establish how participants are deemed to exercise control over their plan account investments, and the 404(c) rules have been understood to require fiduciaries to designate investment alternatives. Whether such is the exclusive method for complying with 404(c) rules has yet to be explored.
Fiduciary evaluation of brokerage window arrangements is subject to the same broad fiduciary standards governing all ERISA fiduciary decisions. The DOL’s lack of formal guidance is buffered by its recognition that brokerage windows are not prohibited; fiduciaries can explore how such arrangements might enhance opportunities for their plans within the bounds of their fiduciary responsibility. Fiduciaries can also avoid brokerage windows altogether and rest on established standards to designate investment alternatives and benefit from Section 404(c) protection.
Fiduciaries should also be aware that there are few reported court cases addressing fiduciary duties and brokerage windows. Does the lack of court action indicate low litigation risk or unmeasured litigation risk? Is the scarcity because few plans offer these options; because brokerage window investing is still fairly new; because of difficulties in establishing loss causation? ERISA jurisprudence does not yet offer answers to these questions, and fiduciaries may wish to consider this uncertainty in evaluating their risk tolerance.