Clear Ground Rules Essential With 3(38) Fiduciary Clients

Experts share strategies for helping advisers taking on 3(38) fiduciary clients understand how they can set up the right processes and procedures—up front—for dealing with client concerns and questions about the investment menu.

Art by Linda Liu

Phil Edwards is principal of Curcio Webb, a firm that helps both defined contribution (DC) and defined benefit (DB) plan sponsors identify the most appropriate service providers for outsourced 3(38) fiduciary investment management.

Besides consulting with plan sponsors, Edwards explains, a big part of this business involves working with the retirement plan advisers and other entities that provide Employee Retirement Income Security Act (ERISA) Section 3(38) outsourced fiduciary investment management services. Edwards says providers in this space are constantly reevaluating their service models to promote client outcomes and improve their own returns from a business growth and efficiency perspective.

According to Curcio Web Chief Compliance Officer and Consultant Elliot Raff, it doesn’t happen very often that a plan sponsor client decides to go down the 3(38) investment outsourcing route and totally misunderstands what they are signing up for in terms of handing over fund menu discretion. However, there are occasionally some misunderstandings about the nitty-gritty details, which can be unsettling for clients and the adviser alike. As such, Raff highly recommends advisers moving into the 3(38) area put strong processes and procedures in place—up front—for dealing with client concerns and questions about their investment menus.

In their experience as 3(38) matchmakers, Edwards and Raff say there are two basic things advisers must do at the outset of this type of a relationship to prevent misunderstandings and even potential compliance lapses. The first and simper of the two agenda items is describing in sufficient and written detail all the specific duties and responsibilities being taken on by the 3(38) provider—as well as detailing in the same specific manner which responsibilities will remain with the plan sponsor client.

“We make sure to work with our clients to go way down into the weeds and create a very clear understanding of who is responsible for what decisions and on what timeframes,” Edwards says. “That clarity is critical. Of course, sometimes it’s going to be an evolving situation, especially with very large plans that may decide to almost do a trial period, where they delegate increasing portions of the responsibility to the 3(38) provider over time as confidence increases. This type of thing should also be clarified.”

The second and more subtle agenda item is to ask clients, what is the objective of the retirement plan and how will outsourcing the investment management support that goal?

“The adviser and the client must be able to answer the question of to what goals they are managing and how 3(38) service will be beneficial,” Edwards says. “This is important for DC plans but especially for DB plans that are bringing in an outsourced chief investment officer (OCIO). DC plans have a more straightforward and open-ended objective of growing participant accounts, while DB plans have much more variability in terms of time horizons and goals.”

Beyond these two points, Raff emphasizes the importance of making sure plan sponsor clients know the retirement plan committee must remain highly active even when a 3(38) manager is brought onboard.

“Plan sponsors must take as much time as necessary to understand these issues,” Raff says. “Advisers can help guide them by asking, what are the functions you want to hold onto? What functions are you comfortable handing over? And what functions do you really want to get rid of? Advisers and sponsors need to start dealing with these questions at the earliest stage of the outsourcing process.”

While Raff and Edwards say they have broadly had success finding appropriate fits between plan sponsors and providers of 3(38) services, some jobs require more up-front legwork than others.

“We occasionally see companies that may be thinking about jumping on the bandwagon without really understanding why or what it means to give over discretion to a 3(38) provider,” Edwards says. “They hear about outsourcing as a way to reduce their fiduciary liability and the amount of time they spend on the plan. We have to teach them that 3(38) outsourcing is much more involved than that.”

Edwards points out that, surprisingly, there is no strong correlation between plan size and the sponsor’s quality of understanding of the plan’s goals and objectives.

“We’ve met several multi-billion dollar plans where there has not been a well-defined goal,” Edwards says. “It’s not like the committee didn’t have the expertise to think about this stuff, they just haven’t had the time. And then we have much smaller plans that we meet that have clearly been able to spend a whole lot of time thinking about this—and so they are much better prepared to get started.”

Joe Connell, partner, retirement plan services, at Sikich Financial (and a former winner of a PLANSPONSOR Plan Adviser of the Year designation), says he has not had much experience with clients being confused about what 3(38) relationships entail—even though he has been offering 3(38) services for years.

“I have not had any issues with any client or participant asking for a fund we would not feel comfortable using,” Connell says. “You must set expectations up front and be very clear about the role of a 3(38) adviser and how this role does change the decisionmaking and fund evaluation process for the plan sponsor.”

Connell adds that the adviser should be mindful of whether a client is a good fit for 3(38) services. Some plan sponsors just won’t feel comfortable giving over discretion to an outside adviser, and that’s okay. These plans may be a better fit for 3(21) service, wherein the investment process is much more collaborative and discretion remains with the sponsor.

“The plan sponsors we assume 3(38) services for are looking to remove that decisionmaking from the committee level and looking to us to provide the expertise on fund decisions,” Connell explains. “So, they are very supportive of us saying ‘No,’ when we have to, to a fund addition that would not meet our investment policy statement criteria.”

In Connell’s experience, when a plan sponsor brings on an outside discretionary fiduciary under ERISA Section 3(38), the client is not necessarily trying to remove themselves entirely from all plan-related decisions. Instead the move is more about getting the right expertise in place for the challenging task of investment selection and monitoring, by the same token freeing up time for the plan sponsor to worry about other things.

“They are just looking to use our expertise in this specific area and allow themselves more time to focus on other plan related decisions and discussions,” Connell says. “They will be spending more time on plan design, participant services, education programs and other initiatives focused on their employees.”

Scott Matheson, managing director, defined contribution practice leader at CAPTRUST, echoes many of these points and says his firm continues to see tremendous growth in the demand for 3(38) services.

“In fact, nearly all of the adviser RFPs we filled out last year asked about 3(38) capabilities,” he says, “and many of those asked for 3(38) pricing, even if the intent of the plan sponsor issuing the RFP was the hire a 3(21) adviser. We have continued to invest in our resources and infrastructure to support the growth in our 3(38) business.”

To the question of friction points when hiring a 3(38), Matheson has a few additional thoughts.

“To the extent we see friction points with plan sponsors accepting a 3(38) engagement, it tends to come during the transition period as plan sponsor employees and/or committee members are settling into their newly evolved roles,” Matheson says. “Much of this, however, can be reduced or avoided by proper expectation setting and by advisers ensuring a good fit for plan sponsors before transitioning them to a 3(38) service model.”

Matheson agrees that plan sponsors that are very interested in the investment selection and monitoring process are likely not good fits to transition to a 3(38) approach and, as such, would likely experience more friction during a transition period. 

“We also find that 3(38) service models continue to vary considerably across the adviser community, with many advisers still accepting 3(38) assignments yet continuing to run investment decisions by plan sponsors before finalizing,” Matheson adds. “This is not much, if at all, different from how they were operating as 3(21) advisory fiduciary. The industry lack of a standardized service model/offering only adds to the potential for friction during transitions to 3(38) because expectations were often set during the adviser search/proposal phase of transitioning to 3(38).”

According to Matheson, part of the fuel behind the growth in 3(38) service can be tied back to the Great Recession of 2008 and 2009. He says the financial crisis forced many of CAPTRUST’s clients to reduce the headcount in their finance and human resources departments, and while the economy has improved significantly since that time, U.S. employers have not broadly added back the positions. Many companies, Matheson says, have fewer staff working on retirement plan administration as a result.

“Faced with financial market volatility, rising interest rates, regulatory scrutiny, and rising plan-related litigation activity, plan sponsors are looking for help managing their plans,” he says. “In some cases, they are turning to their plan advisers, asking them to do more on their behalf [as a 3(38) fiduciary].”

Matheson says it is important for retirement plan sponsors to understand that ERISA Section 3(38) does not define “investment advisers with discretion,” nor does it say “here’s a way to transfer more risk to your investment adviser.”

“Rather, it defines investment managers as distinct fiduciaries contracted with full discretionary authority over plan investments and making plan investment decisions,” he says. “An appropriately contracted and executed 3(38) arrangement frees the plan sponsor from the time involved in selecting and monitoring plan investment options and the liability associated with these decisions. As explained in ERISA Section 405(d), the plan sponsor and/or trustees of the plan are not liable for acts or omissions of the 3(38) investment manager, and are under no obligation to invest or otherwise manage any asset of the plan which is subject to the management of that investment manager.”

Plan fiduciaries must still monitor the work of the 3(38) manager to ensure plan participants and assets are being managed in a best-interest capacity, but that workload can be significantly lighter than managing the plan’s investment menu alone.