Practice Management May 1, 2023

Why More Advisers Are Assuming 3(38) Role, Responsibility

The fiduciary model that puts plan investment decisions in advisers’ hands offers expertise and streamlining, industry experts say.
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Art by Lars Leetaru


The Employee Retirement Income Security Act Section 3(38) fiduciary designation can often mean more work for an adviser, since it assigns decision-making responsibility. It also means a conversation with a plan sponsor that likely leads to a higher fee. Even so, the industry is trending toward more advisers seeking, and taking on, the role of the 3(38) in order to manage what is increasingly complex, and important, investment strategies.

“I would tell you that we do see a trend,” says Kathleen Kelly, managing partner at Compass, which is involved in both the 3(21)—in which advisers guide on investments, but leave decisions to the plan sponsors—and 3(38) capacity.

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“Traditionally, we have thought more about 3(38) for our smaller clients, those that may have less sophistication, experience, expertise and internal resources to support decisionmaking. But in fact, we’ve seen some of our largest clients transition from 3(21) to 3(38).”

Part of the shift to 3(38)s has come amid a volatile and uncertain investment market in recent years, ranging from the COVID-19 pandemic to inflation to interest rate hikes. According to PLANADVISER’s most recent Adviser Value Survey, about 15% of DC plan sponsors had 3(38) fiduciaries, about 31% had 3(21) fiduciaries and a startling 24% were unsure of which type of adviser they had. While that puts 3(38) at the lower end of the spectrum, there is often potential to shift a client to that relationship with time, Kelly says.

A plan sponsor might first hire an adviser as a 3(21), Kelly says, but once the client becomes comfortable with the firm’s internal processes, philosophy of menu construction and monitoring, they then feel confident changing to a 3(38).

Brandon Budd, a consultant at Intellicents, agrees that clients will often consider switching to a 3(38) setup. He used the example of a client his firm had worked with for many years as a 3(21). During one of their catch-ups, Budd’s team mentioned the option of the 3(38) and shift in fiduciary duties that it would bring, among other benefits.

Budd recalls the client saying, “We take all the recommendations that you already make, we’ve hired you to outsource this and we trust you with these responsibilities We absolutely want to move into that role where you’re saying we have more protection and more liability off of our shoulders.”

Budd thinks the more that advisers have that conversation with plan sponsors, the more employers will move to the 3(38) capacity. He says Intellicents can fulfill both roles but has had more engagement on the 3(38) recently.

3(38) vs 3(21)

Kelly suggests that an advantage of being a 3(38) is that an employer does not have to be involved in a process with which they aren’t comfortable.

“They’re busy running a company, and chances are, they don’t have any expertise in investment management or investments in general,” she says. “It just makes more sense for them to outsource that decision.”

In addition, in a 3(38) role, advisers can streamline the process and make changes more quickly, says Jim Sampson, director of retirement advisory services at Hilb Group Retirement Services. As a result, employees are invested in underperforming funds for less time.

Another advantage of the 3(38) scope is that the firm accepts the full fiduciary status, which is what Budd has seen as what many employers and plan sponsors want.

“Most times when we have the conversations between 3(21) and 3(38), most employers and plan sponsors out there are trying to limit their liability as much as possible,” he says. “That’s why I think we have seen so many more go the 3(38) route than the 3(21).”

However, for employers who want full decisionmaking power, a 3(38) adviser does not offer that oversight for the employer.

“If they want to have control over the process, that doesn’t work with a 3(38),” he says. “Occasionally, clients will express their kind of fear of letting go. But they get over it pretty quick once they realize how easy the process is.”

On the other hand, the 3(21) offers employers a level of control that company leadership might prefer. For example, if an employer has an investment committee that is fully involved in researching funds and making decisions, then a 3(21) could be a preferable option.

“I spoke with a group late last year,” Budd says. “They’re in the investment business. They decided to go with somebody who was going to be a 3(21), because they wanted to maintain control of the analysis, the research—all that kind of stuff.”

However, he notes that in his experience, it is very rare that a client has the expertise and desire to take on the responsibility, and almost all of his clients have chosen to hire Intellicents in a 3(38) capacity.

Ultimately, Kelly does not believe the 3(21) versus 3(38) discussion should be viewed through the lens of advantages and disadvantages, but as which offering best suits an employer.

“It really just boils down to what is the right fit for the client,” Kelly says “What are their needs? What are their preferences? Then how do we best align our services and deliverables to what they’re seeking to achieve?”

Future-Looking

Sampson says the trend of employers preferring 3(38) designations has grown over the last five years. He attributes the change to a major shift toward the registered investment adviser model from the broker/dealer model towards the registered investment adviser model. The RIA is inherently a fiduciary model, he notes, whereas the broker/dealer model tends to be non-fiduciary.

“I think that’s where the trend is coming from,” he says. “Expert advisers who are in the RIA model, and who are experts at 401(k) plans, determined that not only are they qualified and allowed to be a 3(38), but it also just makes sense.”

He believes there are many people who might want to explore a 3(38) model, but their back office has certain restrictions in place or they simply outsource the work.

Budd also expects that brokers—individuals not acting in any fiduciary capacity—are likely to decline.

“Just from a standpoint of a sound business decision, [a client] shouldn’t be working with an adviser that’s taking on some level of liability and risk, whether that’s 3(21) or 3(38),” says Budd. “I think that will continue to accelerate, to make sure that you’re working with an expert and a specialist in this space to do what’s right for you and for your company.”

The Markets May 1, 2023

CITs May Be the New Mutual Funds of DC Plans: Have They Earned It?

Low-fee collective investment trusts, already popular among large plan sponsors, may be moving down-market to smaller plans.
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Art by Lars Leetaru


Collective investment trusts have taken the defined contribution investment world by storm in the past decade.

The pooled investment vehicles, which are held by a bank or trust, have overtaken mutual funds as the most prevalent investment vehicle in defined contribution savings plans, according to consultancy Callan’s most recent DC Index. In addition, analysts at Morningstar say CITs are poised to become the most used target-date-fund strategy in 2024, a potentially watershed moment for the “set-it-and-forget” retirement savings tool.

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CITs, known for taking more paperwork and setup for a plan sponsor than adding a mutual fund to a plan lineup, appear to be making up for that friction by offering lowering fees. But what kind of savings does a CIT really provide when compared with mutual funds, previously the most popular investment vehicle in retirement plans due to their diversity and ease of use?

Using a CIT can save, on average, 15 basis points, or 0.15%, due to lower administration, marketing and management fees, says Toby Cromwell, senior director for CIT funds product management and development at Broadridge Financial Solutions.

“Historically, one of the selling the points of a CIT is that you have a lot less shareholder noise and, with that, lower fees,” Cromwell says. “There is a lot more asset movement in a mutual fund, whereas a CIT is much more sticky, with money staying invested there for a longer period of time once it’s invested.”

When comparing a fee of 50 bps (0.50%) to one of 35 bps (0.35%) on $100,000 over 20 years, the savings do not look like much. For example, assuming an 8% annual growth rate, a participant is pocketing about $700 more by choosing a CIT. But multiply that potential savings by thousands of participants in a plan, as well as the raft of excessive fee lawsuits going after plan committee and adviser choices, and the CIT becomes a compelling option for plan sponsors, says Megan Pacholok, a senior manager research analyst at Morningstar Research Services.

“A larger plan sponsor can negotiate their fees, and that larger base can bring a lower cost than mutual funds,” Pacholok says. “As they weigh in the excessive fee lawsuits around more expensive TDF options, CITs are a compelling option.”

Those lawsuits often include plaintiff allegations that a plan sponsor or fiduciary adviser stuck to one mutual-fund-backed TDF without exploring lower-fee options.

Steven McKay, head of global defined contribution investment only and institutional management at Putnam Investment, says demand for CITs has grown in part due to that fee pressure. But there is also “tremendous growth” due in part to increased transparency and the ability to benchmark CIT options against each other.

“We live in a world of benchmarking options against the competition or against the best,” McKay says. “It’s very important to the fiduciary advisers or the plan sponsors to have access  to benchmarking to compare options.”

The broadening uptake of CITs has created a somewhat virtuous cycle, McKay notes, as increased use has mostly done away with minimum asset requirements for CITs, which further broadens both the demand and case for innovation.

“We’ll continue to look at growing our CIT suite and strategy as client demand continues to grow,” he says. 

Moving Down Market

While large plans have started the CIT trend, the ease of use and increased transparency of the investment offerings are making them more compelling for mid-market and even smaller plans as well, says Julie Wimer, director of client service and product at Great Gray Trust Company, the new company formed from Wilmington Trust NA’s former CIT division, which was purchased by private equity firm Madison Dearborn Partners LLC.

“We are starting to see more plans in the small and midsize market take advantage of CITs,” Wimer says. “From a fiduciary standpoint, they are tasked with the overall prudence of the investment lineup, and part of that is to not only look at investment strategy, but also the fees as well.”

Great Gray, which can act as the trust on its CIT offerings, looks to make CITs an easier-to-use option for plan sponsors with a digital onboarding process. In the past, that onboarding could be onerous, as the sponsor had to sign a participation or adoption agreement to invest in a CIT.

“We need to make sure we are only putting qualified money into the CIT—the second that you put in a plan that is not eligible, it won’t work,” Wimer says.

Another stumbling block for CITs had been transparency of the investments. Unlike mutual funds, which are publicly listed, CITs were often off the radar and only visible to the advisers, plan sponsors and participants.

The former Wilmington Trust division, now Great Gray, has worked to improve that transparency in the hopes of increasing market uptake. In 2019, the trust announced a partnership with the Nasdaq Fund Network to show searchable tickers for CITs—giving them six letters instead of the five usually used for mutual funds.

“That myth that was out there that it’s so hard to add a CIT to plan has gone away, and it has become more sensible in that small and mid-market,” Wimer says. “That is why we are starting to see growth there, and I would expect to see more growth in that area going forward.”

McKay of Putnam notes that the firm offers both in-house trust services for CITs as well as use of third parties depending on client need.

“This is important because we work with a lot of plan service providers and a lot of large intermediaries and aggregators,” he says. “Sometimes they want to have access to Putnam CITs, but while working with other trust companies.”

Advising the Advisers

Cromwell of Broadridge says he has seen more interest in CITs among smaller-and midsize plans. But he has also been in discussion with sub-advisers who manage funds that want to add CITs to their investment mix. Cromwell says subadvisers have the experience creating target-date funds, large-cap funds and mixed-income funds, and they see the CIT as a way to provide the same investments with lower fees.

“With the CITs, you’re going to see roughly whatever performance that manufacturer or investment manager can put up without those trustee fees or expenses,” he says. “Performance is key, because you get better outcomes for participants because of lower expenses and the compounding of accounts over long periods of time.”

Cromwell notes that the regulatory burden on CITs, once they are set up, is often less onerous than that shouldered by mutual funds, which are overseen by the SEC. CITs, instead, are overseen by state regulators and the Department of the Treasury’s Office of the Comptroller of the Currency because the investment vehicle sits within a trust or bank.

That said, plan sponsors and advisers should understand that CIT disclosures should have the same rigor as any other DC investment.

“We view disclosure as basically the same as the mutual fund in terms of fees for the plan sponsor and participant,” he says. “We need to make sure that we are catering to ERISA and the DOL, because by the the nature of the CIT, it can only be ERISA plans that use it.”

Like many trends in the retirement space, it has taken years for the CIT to take hold, and it is only recently that smaller plans have gotten access to the investment vehicle thanks to advances in technology and practices that have lowered the plan asset threshold for entrance, Cromwell says.

“Now you are seeing a democratization for the DC plan,” Cromwell says of CIT use. “I don’t think just because you work for a large plan, you should get a much bigger deal than someone with a smaller plan. That democratization is key and already starting to happen in the CIT space.”

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