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Are ETFs and Self-Directed Brokerage Accounts Available in 403(b) Plans?

This article originally ran on January 26, 2015.

By Diane D. Capone

The answer to the question posed in the title is "maybe," but let’s take a look at how these type of accounts might work in a 403(b) plan and specific challenges that they bring.

Section 403(b) plans are permitted to invest in two specific type products/investments — either a (b)(1) annuity, such as a fixed or variable annuity; or a (b)(7) custodial account of a regulated investment company (mutual fund), such as an index fund, stock fund, bond fund, money market fund, etc. That’s it — no individual stocks, bonds, derivatives, alternative investments, etc. If a participant wants to invest in stocks or bonds it must be done indirectly through a 403(b)(7) mutual fund. 
Of course, to every rule there is always an exception and it is no different here. A 403(b)(9) retirement income account, which is a defined contribution plan of a church or convention or association of churches, are permitted to include investments other than annuities and custodial accounts. Also, church plans are more likely to have a trust similar to a 401(k) qualified plan that permits various types of investments, including stocks, bonds, mutual funds, annuities, exchange-traded funds (ETFs), self-directed brokerage accounts (SDBAs) and others. 
There has been a lot of discussion recently in the qualified plan arena regarding the use of ETFs and SDBAs in 401(k) participant-directed plans. Both are certainly available for use in 401(k) plans if the plan fiduciary has done due diligence together with their investment advisor and have decided that they are appropriate investments to be used in their plan and made available to plan participants. Qualified plans such as a 401(k) do not have investment restrictions that are spelled out in the Internal Revenue Code or ERISA. The investments permitted in the plan are selected by the plan fiduciary and may include ETFs, SDBAs, mutual funds, stocks, bonds, annuities, etc.
So why are these types of investments rarely, if ever, seen in 403(b) plans? ETFs and SDBAs present specific challenges whether the 403(b) plan is a public school employer plan or a plan of a 501(c)(3) non-profit organization which is either covered by ERISA or not. The plan fiduciary will need to verify that the product platform offering these investments complies with all the requirements of Section 403(b) of the Internal Revenue Code (ICR) in addition to meeting the Section 403(b)(7) regulated investment company criterion for ETFs.
Let’s take a look at ETFs and Self-Directed Brokerage Accounts and the challenges that they present to the 403(b) plan sponsor.
The SEC defines ETFs as a type of exchange-traded investment product that must register with the SEC under the 1940 Act as either an open-end investment company (generally known as “funds”) or a unit investment trust. An SEC Investor Bulletin issued in August 2012 provides information and education on this type of investment. ETFs are not always set up to comply with the Regulated Investment Company provision of IRC Section 851(a). If they do meet this criterion they may be offered in a 403(b)(7). The expenses in ETFs are usually much lower, but because they are sold individually, they have higher transaction costs related to purchases and sales. These higher transaction costs may make it more expensive to actually administer for the 403(b) plan sponsor. 
As we know, there is increasing awareness of fees and expenses in all types of retirement plans and the high costs to administer the ETFs in a 403(b) plan have resulted in very little interest by plan sponsors. If the ETF is not a registered investment company complying with IRC Section 851(a), it is not an eligible 403(b) investment; it is a misconception that all ETFs are eligible.  Also, ETFs are continuously valued throughout the day unlike mutual funds which are valued daily. Most plan recordkeeping platforms are designed for daily-valued investments, which presents another challenge. 
SDBAs have also been in the news lately. Specifically, the Department of Labor has been reviewing these types of accounts to identify whether or not they are suitable to be offered in retirement plans and has issued an RFI asking for input regarding the pros and cons of these types of investment options. So how would they work in a 403(b)? If offered by the plan sponsor, a participant could use the SDBA to go outside the specific annuity and mutual fund options offered in their plan and purchase any other annuity or mutual fund that they decided fit their specific investment criteria. These SDBA investments must meet the requirements and provisions set forth in IRC Sections 403(b)(1) and 403(b)(7), in addition to their status as an annuity or mutual fund. 
There have been some plans that have permitted SDBAs to be offered, only to find that participants were purchasing stocks, bonds and other ineligible investments. It is important for the platform and the plan sponsor to have restrictions in place to avoid these types of occurrences. Some plan sponsors have also utilized the SDBA as an option for their 403(b) plan so that investors would have access to ETFs. Again, as indicated above, it is important to verify that they meet the requirements under Section 403(b)(7).
Both ETFs and SDBAs may be of interest to the 403(b) plan sponsor, but it is important that the product provider or recordkeeper have safeguards in place to ensure that it makes only products legally permitted available to plan participants.
Diane D. Capone, TGPC is a member of the NTSA Communications Committee and Sr. Retirement Compliance Consultant for Lincoln Investment Planning, Inc. Registered Investment Advisor, Broker/Dealer, Member FINRA/SIPC
Please note that this article is for general informational purposes only and is not intended to be taken as legal advice or a recommended course of action in any given situation. Readers should consult their own legal advisor before taking any actions suggested in this article. 01/15.