During the depths of the 2008 financial crisis, when it justifiably felt as if our entire financial system was on the verge of imploding, I was working as a licensed broker at Charles Schwab (NYSE:SCHW). This was at a time when it seemed like major financial institutions were going broke or being swallowed whole by peers every other week.
As such, I fielded my fair share of frantic phone calls from clients who were downright terrified of losing their retirement accounts and life savings. Among the more frequent queries was this: "Is my account safe and insured?"
At the heart of that question lies the single biggest misconception that investors have regarding their brokerage and bank accounts. Let's set the record straight about how these two account types are fundamentally different.
One of these ...
With bank accounts, consumers are very well aware that banks immediately take their funds and use those dollars to make loans to other people and businesses, subject to regulatory reserve requirements, among other things. After all, that's the business that banks are in.
That loan is exactly what puts your money at risk in a bank account, which is why the FDIC exists in the first place. Consumers know that their money isn't actually sitting in an account somewhere -- it's being loaned out. In the event that those loans go bad and the bank becomes insolvent, the FDIC steps in to cover losses up to $250,000 per individual.
This perception is precisely what leads investors to wonder whether their brokerage accounts are also at risk when times are tough. It's simply how we're accustomed to thinking about our financial accounts. Everyone knows what a "run on the bank" is.
... is not like the other
In contrast, brokerage accounts are entirely different. Client brokerage accounts are segregated from firm assets as required by federal law. Your broker isn't taking your idle cash and lending it out to others and technically putting it at risk. In the case of brokerage accounts, your money truly is sitting in a separate account with your name on it.
However, there have been rare instances when brokers aren't playing by the rules, such as MF Global's collapse a few years ago. This is where the Securities Investor Protection Corporation, or SIPC, comes into play. The SIPC covers losses of up to $500,000, including up to $250,000 for cash claims.
To be clear, this doesn't cover investment losses -- only you can save yourself from losing a fortune on that hot penny stock tip your college roommate's mother-in-law heard about from her plumber. Market fluctuations are never covered; only missing assets are eligible if they haven't been properly segregated. The most common types of eligible securities would be cash, stocks, and bonds, while alternative investment classes such as futures contracts, annuity contracts, currencies, and limited partnerships, among others, don't qualify. Occasionally, though, other efforts can claw back assets even in those categories. For instance, with MF Global, SIPC President Stephen Harbeck noted that it was able to make arrangements that would be likely to "allow for the return of 100 percent of allowed securities customers claims [and] will also result in significant distributions to be made to commodities customers" whose investments weren't eligible for SIPC protection.
I used to tell clients that there are multiple lines of defense for their assets. The first and foremost is the segregation requirement, which is the fundamental foundation of account safety. If a brokerage firm is properly segregating client assets and in compliance with federal regulation, there's nothing to worry about even if the brokerage goes under. Only if the broker fails and the firm has been misappropriating funds in excess of SIPC coverage are you at risk.
Simply put: A firm must have been stealing an awful lot of money from you. We're talking about Madoff and MF Global type scenarios here. This is why 99% of eligible investors in SIPC cases have been made completely whole over the past 42 years. That's why you never hear of a "run on the brokerage."
Many brokers even purchase excess insurance beyond the SIPC's limits, even though it's extremely unlikely for those limits to be hit in the first place. For example, Schwab, TD AMERITRADE (NASDAQ:AMTD), E*TRADE (NASDAQ:ETFC), and Fidelity all offer excess coverage from Lloyd's of London and London Insurers. Schwab, AMERITRADE, and E*TRADE offer aggregate protection up to $150 million per customer, including SIPC limits, while Fidelity has no dollar limit on the coverage of securities.
If you ever win the lottery, don't stick it in your checking account; put it in a brokerage account. Even if you're not investing it, those dollars can sit idle in safety.
Fool contributor Evan Niu, CFA, has no position in any stocks mentioned. The Motley Fool recommends TD AMERITRADE. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.