July 24, 2017—In this final blog in our Fiduciary Sudoku series, our goal is to help you, the employer, understand ERISA Section 3(38) well enough so that you can properly evaluate, hire, and monitor retirement plan vendors who offer “3(38)” services. As discussed in our Introduction, “Fiduciary Sudoku – Comprehending ERISA 3(16), 3(21) & 3(38),” vendors who service retirement plans will use the term “3(38)” to describe their service offering. But what is a 3(38) service? Will it make your life easier? Does it alleviate your fiduciary responsibility? Are there levels of 3(38) service?
In short, yes, if you hire a vendor to provide 3(38) service for your company retirement plan you will reduce your responsibility for selecting and monitoring plan investments and associated potential fiduciary liability. To what degree, however, depends on the level of 3(38) support your vendor is offering to provide.
What is a 3(38) Fiduciary?
If you have read the prior three blogs in this series you understand that it is actually ERISA Section 3(21) that defines retirement plan fiduciaries. So, when your vendor suggests that they are a 3(16), 3(21) or 3(38) “fiduciary,” technically they are saying that they are offering a service to the plan under either 3(21)(A)(i), (ii), or (iii). For our new readers, let’s review:
- Defines a party who has discretion regarding plan investment options. This is a plan sponsor employee, a committee of employees, and/or an outside investment manager who accepts all or part of this role in writing.
- Defines a fiduciary financial advisor who provides advice to the part (i) fiduciary to help them select and monitor their investments, and who is paid a fee by the plan for this service.
- Defines a party who has the ultimate decision-making role regarding plan administrative issues. This role is performed by the plan sponsor (employees) unless an outside firm, marketed as a “3(16),” is hired to perform part or all of this role in lieu of the plan sponsor.
A 3(38) is an outside investment manager who will take on some or all of the role for plan investment selection and monitoring under part (i) of ERISA 3(21)(A). As this is the case, why do plan vendors refer to their service as 3(38) instead of 3(21)? It is because ERISA Section 3(38) defines the term “investment manager”:
- a non-employee fiduciary with the power to manage, buy and sell plan investments.
- permitted firm type: Registered Investment Advisor (RIA), a Bank, or an Insurance Company. Note that brokerage firms (Merrill, Ameriprise, Fidelity, etc.) are not allowed to perform the role of a 3(21)(A)(i) per 3(38)(B).
- has acknowledged their fiduciary role in writing.
Discretion versus Advice
Why doesn’t ERISA allow a brokerage firm to function as a 3(38) to a retirement plan? It’s because a brokerage firm is not paid by the plan (and its participants). Instead, the brokerage firm is paid by the investments it sells to the plan. It’s at this point we want to have a clear understanding of the term “discretion” and “advice.” Someone with “discretion” has the ultimate authority to choose the investments. It would not make sense to allow a firm who is paid by the investments in the plan to be the ultimate decision maker on what investments will be available in the plan. This would be a prohibited transaction and plan fiduciaries are responsible for avoiding prohibited transactions.
On the other hand, an RIA, Bank, and Insurance Company can earn their compensation in the form of service fees billed directly to the Plan (and, therefore the plan participants). When the advisor’s compensation is coming from the plan, and not from the investment products, the advisor is able to be objective and conflict-free. Practically speaking, it’s rare to see a Bank or Insurance Company offer to serve as a 3(38) to a small 401(k) plan. Generally, the end game for the Bank or Insurance Company is to sell their very own proprietary mutual funds or annuities to the plan. Of course, if they do so they immediately create a prohibited transaction. And therefore, they no longer qualify to serve as a fiduciary under ERISA 3(21)(A)(i) even though they still qualify under 3(38). In a nutshell, you should only expect an RIA to service as a 3(38) in the small plan market.
To be clear, any financial institution may provide investment advice to a plan sponsor under 3(21)(A)(ii). This is what is marketed as a 3(21) service. These advisors are not exercising any investment discretion. They are simply making investment recommendations to the plan sponsor. The employee(s) of the plan sponsor, such as the Trustee or the Investment Committee, are the ultimate decision makers under 3(21)(A)(i), not the 3(21) financial advisor. A 3(21)(A)(ii) may be paid directly by the plan or indirectly by the plan investment options. A typical indirect payment method is where the 3(21) suggests that the plan trustee add mutual fund XYZ to the fund lineup. As participants invest in this fund, the XYZ fund manager will pay a fee to the 3(21). This may sound conflicted but remember that it’s the plan sponsor employees who, at the end of the day, selected the investment. Not the 3(21).
Because a 3(38) replaces the plan sponsor in the role of investment manager, the 3(38) is the one on the hook if the DOL or Court decides to be critical of the quality or cost of the plan funds. ERISA Section 405(c)(1) effectively allows a plan sponsor, or a named fiduciary such as the Plan Trustee or the Plan Administrator, to delegate their responsibility to a third party. 405(c)(2) basically states that if the delegation is handled properly then the plan sponsor employees “shall not be liable for an act or omission of such person in carrying out such responsibility.” Hiring an expert to perform your role will reduce your potential liability and, very likely, improve the operation of your plan.
This is where you must be careful. Not all 3(38) services are created equal. On one end of the spectrum the 3(38) service may simply approve funds for the plan sponsor’s selection. For example, the 3(38) may identify 3 approved U.S. large cap growth funds to select from. The plan sponsor then goes in and selects 1, 2, or 3 of the funds to include in the plan’s fund lineup. The challenge here is that as the 3(38) replaces approved funds the sponsor must follow suit. I’ve witnessed sponsor fund lineups where half of the funds in the fund lineup long ago fell off of the 3(38)’s approved list. I would suggest that a plan sponsor who signs up for this level of 3(38) service risks raising their liability if they hold unapproved funds. How would you explain a fund in the lineup that your 3(38), say 2 years ago, decided no longer met the monitoring criteria?
A step up in service is where the 3(38) maintains up to 4 different fund lineups and the plan sponsor selects which line up is right for their plan demographics. If the funds change, the 3(38) will change them for the plan sponsor. But, still, the sponsor did make the fiduciary decision of which line up was right for their plan. This will require the sponsor’s prudence and documentation of the decision.
You’ll recall that I explained earlier that a brokerage firm cannot serve as a 3(38), and that an insurance or bank will rarely do so. In response to client demand, these firms are establishing relationships with RIAs who in turn provide these lower levels of 3(38) “lite” service. While inexpensive, and in some cases free, you do get what you pay for.
In our opinion, if you are seeking a 3(38) service, don’t cut corners. Hire a 3(38) who is willing to service as your plan’s Fiduciary Investment Manager (FIM). The FIM will make all investment related decisions for your plan, and therefore you have successfully delegated 100% of the investment responsibility for plan investments to a third party.
A FIM will craft your plan’s Investment Policy Statement (IPS). However, a 3(38) “lite” service frequently will not provide the plan with an IPS.
Lastly, some 3(38)s are willing to create & monitor model “asset allocation” portfolios for plan participants. The 3(38) will review the asset class allocation, investments, and rebalance the models as necessary. We suggest that model portfolios go a long way to improving most participant’s expected investment return.
Monitor your 3(38)
Yep, a plan sponsor can never delegate away 100% of responsibility. At the end of the day the sponsor needs to monitor the 3(38). However, monitoring is not difficult. The process can be done annually and may include a) ensuring that your provider still qualifies under 3(38), b) hasn’t changed their investment philosophy or the responsible professionals, and c) that the investments which the 3(38) selected are not substantially underperforming their benchmark. If you think this is a lot of work, just consider what a sponsor who has retained the decision-making responsibility for investments must do. This would include more frequent meetings (quarterly are recommended) to review all plan investments, and document that all continue to meet the IPS monitoring criteria. If not, what do you do about it? Keep, replace, watchlist? Why?
Which is better? 3(21) financial advisor, or 3(38) Investment Manager?
Of course, that depends. If the plan sponsor wants to be able to decide which investments to make available in their plan with advice from an objective financial advisor, then 3(21) is the route to take. However, if the plan sponsor does not possess the time and expertise to perform the fiduciary investment role “prudently,” then they are much better off delegating this role to an expert who will sign on, in writing, as accepting such delegation.
From an investment performance perspective, I’d argue that you should expect better performance from a 3(38) lineup than from a 3(21) lineup. Not because the 3(38) manager is better than the 3(21) advisor, but because (a) to be candid, the sponsor (who is rarely an investment expert) can veto the 3(21) advisor’s recommendation and make their own investment decisions. And (b), a 3(38) manager can be more efficient due to their total discretion. They do not have to call an Investment Committee meeting to pitch their new fund recommendation. The 3(38) just adds the fund to the lineup. Also, in my experience, a 3(38) advisor should have far fewer investments to keep an eye on. The 3(21) may end up with hundreds of funds to track as they fall prey to the whims of the plan sponsor’s pet funds.
From a time perspective, a plan sponsor who has hired a 3(21) should be monitoring plan investments quarterly, and documenting their decisions and process to hold or replace funds. The plan sponsor who has hired a 3(38) does have to monitor the manager as discussed above, but they can do so annually, and reviewing the advisor’s adherence to the Investment Policy Statement is a much quicker task than reviewing all the funds in a fund lineup.
From a liability perspective, it’s very clear that a 3(38) Investment Manager offers the highest level of protection against the Department of Labor and the courts because the 3(38) becomes the plan fiduciary totally responsible for the investment decisions. The best the 3(21) can offer is a co-fiduciary relationship where they offer to go down with the ship.
Note that I’ve been careful to reference 3(38) here as an Investment Manager. Remember that 3(38) “lite” service offerings are not the final plan investment decision makers.
I hope that you, the retirement plan sponsor, are now a better consumer of the different types, and service levels, of third party fiduciaries available for hire. Step one is always to identify what you, as a plan sponsor, want to be responsible for, and what you don’t. Step two is to identify the service providers who will take on what you don’t want to do. The result can be meaningfully less liability for the plan sponsor, and meaningfully improved results for the plan participants.