Considering New Uses for SDBAs

Self-directed brokerage accounts could be the answer for meeting participants’ ESG investing desires and maybe guaranteed lifetime income needs.

Retirement plan participants are demanding environmental, social and governance (ESG) investment opportunities, and, recently, the Federal Thrift Savings Plan (TSP) announced it will make ESG funds available in a new mutual fund brokerage window for the plan.

In addition, some investment consultants say private equity can improve participants’ outcomes, and there is a clear need for guaranteed retirement income options for participants. However, no clear regulatory guidance on how to include ESG factors in investment selection for retirement plans has been given; the Department of Labor (DOL) has sanctioned the use of private equity only in asset allocation funds, such as target-date funds (TDFs), for defined contribution (DC) plans. And despite provisions of the Setting Every Community Up for Retirement Enhancement (SECURE) Act to encourage the adoption of in-plan retirement income products, plan sponsors are still hesitant to add them to their fund lineup.

Could self-directed brokerage accounts (SDBAs) or managed accounts be the answer for meeting participants’ specific investment wants and needs?

Robyn Credico, managing director, retirement at Willis Towers Watson, notes that managed accounts typically use the core funds in the DC plan and determine risk and asset allocation based on these funds. If ESG-investment-type options are not part of the plan fund lineup, then it is unlikely that the managed account provider will use them.

Martin Schmidt, a retirement plan adviser at the Institutional Retirement Income Council (IRIC), concurs that most managed account providers use funds already on the plan’s investment menu; however, he says, some managed account providers are creating a sleeve of funds for which participants can receive advice. Yet, even if managed accounts offer the opportunity to use these types of investments, will the selection methodology of the provider pick them? Schmidt queries. “Some select the cheapest funds for the participant’s goal,” he explains. “If private equity and lifetime income are more expensive than other options, they may be bypassed.” Additional fees could be charged for advising on funds not on the plan’s investment lineup.

SDBAs can offer ESG investments via particular stock or funds, says Credico, and investment advice offered through managed accounts may cover options in the SDBA. However, the plan sponsor typically may not pick and choose which funds and stocks the SDBA makes available; in situations where sponsors do so, as plan fiduciaries, they will have to monitor all of those funds and stocks.

SDBAs Might Be a Better Solution

SDBAs would definitely be a vehicle in which plan sponsors could offer those types of investments, Schmidt says. Currently about half of sponsors make SDBAs available, he says, adding that very few participants use them. Exceptions are high-wage earners in professional service firm plans or airline pilots in plans for pilots. Still, Schmidt says, historically the message has been, “Go to an SDBA to get the investment you want.”

“I’m having more conversations with clients where ESG is front and center,” Schmidt says. “That’s becoming, or will start to become, the norm.” He doesn’t see plan sponsors clamoring to offer private equity in their investment lineups, though. “SDBAs can offer them, but the problem will be getting participants to use it,” he says.

As for retirement income products, Schmidt says SDBAs could reduce some of the fiduciary risk for plan sponsors, depending on how their plan is structured.

Gregory Kasten, founder and CEO of Unified Trust Co., says SDBAs could include different types of ESG investments, and participants would be able to select from a wide array.

Kasten warns, however, that Unified Trust’s extensive studies of SDBAs have found it is generally true that a participant in an SDBA—about 70% of the time—will underperform the rest of participants in that particular retirement plan. He says a variety of factors contribute to this, but most studies have found that the largest single holding in SDBAs is cash. “SDBAs do not take advantage of other income preservation options such as stable value funds,” Kasten says. “SDBAs link to money market funds or cash accounts to facilitate transactions, and right now cash is getting a 0% rate of return. I’ve seen people move money to an SDBA and put it in cash for over a year, foregoing earnings.” For this reason, he says, he’s always viewed SDBAs with skepticism.

Private equity investments can produce good returns, and SDBAs could offer private equity, Kasten says. However, participants’ understanding of private equity could be a problem. This vehicle has primarily been used by defined benefit (DB) plans to seek higher returns, he says, but studies are mixed as to whether private equity net of fees really generates that much in returns.

“Even a sophisticated investor could be making some large bets, which sometimes work out and sometimes don’t,” Kasten says. “In my own experience, returns can be higher, but so can costs, and the investments are too complex for the typical DC plan participant to understand how they work. I would find it hard to believe that even a plan participant who would consider himself somewhat sophisticated would understand private equity.”

SDBAs could also offer retirement income products, Kasten says. But the problem with buying fixed annuities is that, right now, they probably yield less than a stable value fund, he says. “Also, the participant would have to annuitize [the investment] and irrevocably convert it to lifetime income, and studies show few participants are willing to do this. They don’t want to give up control.”

According to Kasten, the one plausible thing that could work to provide retirement income for participants is to buy a no-load or low-fee variable annuity with a guaranteed minimum withdrawal benefit (GMWB) within the SDBA. As with private equity investments, though, it’s uncertain whether participants will understand how the investment works.

Offering participants access to an adviser along with the SDBA could help them understand and choose appropriate options, he says.

Additionally, participants don’t have to put all of their money into an SDBA, , Schmidt points out, and in many cases, sponsors put a limit on the amount of saving participants can allocate to it.

Plan Sponsors’ Fiduciary Duties

“One of the beauties of SDBAs from a plan sponsor perspective, is there is no increasing fiduciary responsibility from offering them,” Schmidt says. “However, if a plan sponsor selects and limits the offerings within the brokerage window, then it will have the fiduciary burden of selection and monitoring of funds.” He says plan sponsors need to do due diligence to determine if an SDBA is an appropriate investment vehicle for their plan.

In deciding whether to provide an SDBA option, “the sponsor needs to determine whether the participant population has the type of knowledge to understand how to use [it] and the investments within it,” Kasten says. “If an SDBA is offered, sponsors want to monitor whether participants are properly diversified.”

Plan sponsors also must do their fiduciary due diligence when selecting an SDBA provider. The sponsor must evaluate what services the SDBA custodian supplies and whether fees are reasonable, Kasten says. “The sponsor would also want the SDBA to be ERISA [Employee Retirement Income Security Act] Section 404(c)-protected and want to go through  the things it needs to do to ensure that,” he adds.

“Out of the three investment types, ESG will be easiest to offer through an SDBA,” Schmidt concludes. “It’s an easy way to solve for participant demand, and, with the increase in interest, I think SDBAs will have more assets flow into these types of investments.”