A funny thing happened on the way to financial independence.
When the 401(k) plan appeared on corporate benefit statements in the 1980s, workers rejoiced. They no longer had to depend on the kindness of strangers when it came to investing their retirement savings. Finally, they had control.
But “control” turned out to be a double-edged sword.
With great control comes great responsibility. And that means more work than many employees wanted. As 401(k) investment choices proliferated, plan participants responded in a way you’d expect. They froze like deer in the headlights.
Then came TDFs like a knight in shining armor.
But that sheen had a smudge on it. Small enough not to matter to some. Big enough to cause concern among others. Hence, the birth of the self-directed account. It’s the ultimate in freedom and self-reliance. It stands as the true testament to independence.
“401(k)s are ‘self-directed,’ but most 401(k) plan participants use mutual funds managed by a portfolio manager who directs the day-to-day investments inside the mutual fund,” says Todd Scorzafava, Principal/Partner with Eagle Rock Wealth Management in East Hanover, New Jersey. “These funds are comprised of various sectors, categories, risk levels. There are also funds typically known as Target Date Funds or ‘TDFs’ which are mutual funds that are designed for persons planning on retiring in a certain year or ‘target date.’ A target date fund is a very well diversified type of fund that adjusts its holdings over time. As the target date gets closer, the fund reduces its risk to account for less time until the target arrives and the money is needed. The further the target date, the riskier the fund, as the money has the opportunity to grow for longer. Some 401(k) plans allow for a brokerage window where a participant can truly be self-directed and buy almost any publicly traded investment, whether it be a stock, bond, ETF or mutual fund.”
The twist with TDFs, however, is that they come with layers of mutual funds. This, in turn, means layers of fees. If you’re fee-conscious, that can make you want to look at a self-directed option.
“For an investor who has the time and knowledge base, a self-directed 401(k) is the option that offers the lowest fees and the most flexibility,” says Michael Fischer, Director, Wealth Advisor at Round Table Wealth Management in New York City. “You can invest directly in the funds or asset classes you’d like and build your portfolio to suit your own needs.”
The main attraction of self-directed accounts is the virtually unlimited potential when it comes to investments. You can pick almost any available stock or bond, as well as investment product (although this will increase the costs to you). This allows you to concentrate on what matters most to you.
“Self-directed accounts allow the investor to personally choose what type of investments and strategies to use,” says Brian Stivers, Investment Advisor and Founder of Stivers Financial Services in Knoxville, Tennessee. “Self-directed accounts can quickly move from one investment strategy to another, should the investor need change. They also focus more directly on risk management versus growth management and aren’t tied to a specific investment criteria and timeline.”
Of course, the downside to such a large range of options is that you’re getting into the investment management business, if only for your own account. That can mean learning more than you’ve ever learned in the past. This may save you cost in terms of dollars, but it adds cost in terms of time.
“You now must become the expert in managing your own 401(k),” says Matthew Grishman, Principal, Wealth Advisor at Gebhardt Group, Inc. in Roseville, California. “If you already have a full-time job, managing your 401(k) can take a great deal of time away from what you are very good at (your job), which is also the primary source you use to create most of your wealth. Learning how to invest your own 401(k) is like learning to speak a foreign language. It takes time, lots of practice, and often comes with painful (and often costly) mistakes.”
“Learning about investment options, determining the appropriate allocations, and researching markets can be a daunting task for investors who don’t come from an investment background,” says Fischer. “Others simply don’t have an interest or desire to manage investments themselves and would prefer a ‘set it and forget it’ type of approach. A self-directed account will take significantly more commitment to ensure you’re properly allocated for your retirement goals than using a target date fund.”
But the rewards of this investment of time and energy can produce a level of satisfaction not possible if you were to just pick from the standard 401(k) menu. “An investor with the time and skill can personalize their asset allocation in a way that expresses their own risk preferences and market views instead of accepting the TDF investment manager’s approach,” says Bill Ryan, Partner at NEPC, Head of Defined Contribution Solutions in Chicago.
This is not to say there aren’t any dangers to doing it yourself. In fact, during the early to midpart of your career, your excitement might be enough to carry you through all the work you have to do to maintain your account. In fact, because you can afford to emphasize only one objective (growth), it may lull you into thinking managing your own money is easy.
The challenge comes in later years when you may grow weary of the work and only wish to retire in comfort.
“Self-directed accounts require the investor to make their own decision about what to buy and sell,” says Stivers. “Self-directed accounts rely on the investor to monitor the account and make necessary changes as they get closer to retirement.”
Any slip-up, even a small moment when you’re not paying attention for whatever reason (a family emergency, a vacation, or just oversleeping) can expose you to a loss you didn’t expect. A self-directed account is not a one-time decision. It never ends.
“It’s highly unlikely that the self-directed investor will make investment decisions over the long-term that result in better investment performance than would have been achieved in the professionally managed TDF,” says Paul Swanson, Vice President, Retirement at Cuna Mutual Group in Madison, Wisconsin.
Which way you choose to invest your retirement assets is up to you. There’s no right or wrong answer. Remember this: any choice you make will have consequences. You must be comfortable with those consequences.
Don’t forget, there may be other choices in your 401(k) plan. If that’s the case, be sure to check out these articles: