Forward Focus

It is becoming “table stakes” for a retirement plan adviser to offer not just 3(21) fiduciary services, but 3(38) fiduciary services as well, says Brian Hanna, senior retirement plan consultant at Everhart Advisors in Dublin, Ohio.

Sponsors he encounters doing a search increasingly look for an adviser willing to take on 3(38)-level discretion as an investment manager, Hanna says. “If you are a 3(21) fiduciary only, you really do need to look at why you are unable to take on the 3(38) role, and resolve that,” he says. “I think that if you don’t resolve that, you may lose opportunities. You will have a competitive disadvantage, even in the near term.”

Just 25% of sponsors questioned for the 2018 PLANSPONSOR Defined Contribution (DC) Survey utilize a 3(38) fiduciary adviser, but that is up from 16.6% in 2016 as interest has grown.

It took years for sponsors to see hiring a 3(21) fiduciary adviser as a best practice, says Brad Arends, co-founder and CEO of the advisory firm intellicents inc., in Albert Lea, Minnesota. “There are a lot of plan sponsors who are now looking at a 3(38) as a way to reduce their own fiduciary responsibility,” he says. “I think it’s going to be a growing part of our practice­—I know it is.”

A Way to Free Up Resources

Defined benefit (DB) plan sponsors have long utilized 3(38) advisers to have discretion over those plans’ complex investment decisions, but the idea increasingly interests defined contribution plan sponsors, says Phil Edwards, a principal at Curcio Webb, in Princeton, New Jersey, and an employee benefits adviser whose specialties include helping sponsors with searches. “On the DC side, the interest stems from the resource constraints that employers have in working on their plan,” he says. “Everybody is acting on more and more demands, with fewer and fewer resources.”

Pension Advisors, in Cleveland, offers 3(38) investment manager services at both the plan and participant levels and sees it as the wave of the future for sponsors. These services appeal to employers that realize they lack the internal expertise or the time to make prudent plan investment decisions, says David Krasnow, president and CEO. “People are saying, ‘I don’t know how much I don’t know. They realize that if they hire a 3(38) investment manager, they are removed from the ongoing investment-decision process, which not only decreases their fiduciary liability, but frees up their time to focus on their business.”

Plante Moran Financial Advisors has offered plan-level 3(38) services for about 10 years. “We have some clients that really don’t want the fiduciary responsibility of making those investment decisions,” says Susan Shoemaker, partner and qualified plan practice leader at the practice, in Southfield, Michigan. “They are saying to us, ‘Make the decision, and let us know why you’re making the decision, and that will work.’” Sponsors of smaller plans especially feel drawn to outsourcing that responsibility, she adds.

If an adviser takes the time to clearly explain to sponsors the difference in how much fiduciary responsibility they retain with a 3(38) adviser versus with a 3(21) adviser, “they’re going to pick a 3(38) service 98% of the time,” says Dick Friedman, a managing director at investment manager IRON Financial LLC in Northbrook, Illinois. “When push comes to shove, they want to run their business. They don’t want to be the investment manager of their 401(k) plan.”

But advisory firms keen to sign new clients sometimes have overstated the legal benefits of hiring a 3(38), Hanna says. “For a long time, it felt like the 3(38) service was oversold by certain institutions or independent advisers, under the guise of telling sponsors, ‘We’re going to take all of your fiduciary responsibility away,’” he says. “What is accurate is to say: ‘We’re going to take away your fiduciary liability related specifically to investment selection and monitoring. You still will have the fiduciary responsibility for other aspects of the plan.’” This includes the fiduciary responsibility of selecting and monitoring the 3(38) adviser.

Plan advisers increasingly see 3(38) investment management as one of their key growth opportunities, Edwards says. “That’s where the money is. And this is where the plan sponsor market is moving.” The market for traditional plan advisory work has consolidated considerably, he says. “There are fewer new DC plans being created, and advisers basically are competing for the same number of plans. So they are trading market share.”

IRON Financial is seeing substantial growth in its partnerships, as a 3(38) investment manager, with plan advisers at other firms who prefer not to focus on investments. “Ten years ago, being a plan adviser was all about picking funds. Now the narrative has shifted dramatically, and it’s more focused on participant outcomes,” Friedman says.

“For these advisers, their value proposition has shifted,” he continues. “These advisers are saying to sponsors, ‘Let me get your plan design set up for the 21^st century. We’re also going to hire a 3(38) fiduciary at the plan level that will take the investment liability off your shoulders. And I’m going to help you monitor the 3(38) fiduciary, to make sure they do what they say they’re going to do.’”

Service-Model Implications

Intellicents gives sponsors flexibility to choose the fiduciary service model they want at both the plan and participant levels, Arends says. Most basically, the advisory firm can be a plan-level 3(21) or 3(38) fiduciary and not offer any employee education or fiduciary advice. Or it can be a plan-level 3(21) or 3(38) fiduciary and also do employee education that stops short of the advice line. Or it can do plan-level 3(21) or 3(38) work, as well as participant education and one-on-one meetings in which it gives 3(21) fiduciary investment advice or takes investment discretion over risk-based models or custom target-date funds (TDFs) as a 3(38).

Taking on the investment-manager role does change an adviser’s service model somewhat. “In some sense, offering a 3(38) service is a little easier,” Shoemaker says. “Our fund lineup becomes more manageable, because we are not incorporating ‘legacy’ funds [such as a plan’s longtime sub-par performers] when we’re a 3(38). We also don’t have to wait for a plan committee to make a decision on a fund replacement, which can take a long time, because they’re busy.”

When it shifts from a 3(21) model to a 3(38) model with a plan, Plante Moran then spends less time at committee meetings covering a plan’s investments. “We may have historically spent a half-hour talking about investments, and now that can be cut down to 10 or 15 minutes,” Shoemaker says. “But we do provide them with all the same backup reporting, so they have the due diligence they need.”

The move also means that advisers can shift the focus to outcomes. For instance, devoting less time to investments in committee meetings means Plante Moran can spend more time talking about other important issues such as participant demographics, plan design, communication strategies and operations. “We can look more at the overall success of the plan and how to make it the best it can be under that plan’s circumstances,” Shoemaker says. “Most of the time, we don’t reduce the number of meetings with a sponsor. It’s just the content of those meetings that changes somewhat.”

Advisers who act as a 3(38) investment manager do not have to “get into the weeds” when doing investment reviews in committee meetings, Krasnow says. “We go through the funds on the watch list, but we spend more time and effort on employee education and plan design and metrics,” he says. “Now, instead of always being a plan’s investment adviser in those meetings, we’re more balanced as a specialized retirement plan adviser in a consulting role.”

In those meetings, Pension Advisors can speak more about trends in a plan’s key analytics such as average contributions and participation. And it can talk with the committee about targeted education campaigns, for instance one aimed at increasing participation or deferrals up to the match. When a committee is freed up from making investment decisions in its meetings, Krasnow says, “it’s one less thing they have to worry about, so they can focus more on the overall health of the plan.”

Hiring an adviser for 3(38) work can increase the advisory fee. Asked how he explains that to sponsors, Arends says, “Do we have an upcharge for serving as a 3(38)? We do, but it’s not like it’s double,” he says. “We’re assuming a higher level of risk, and we have to pay for that extra risk in our E&O [errors and omissions insurance] to do that. I think sponsors understand risk—I mean, they’re businesspeople. They say, ‘OK, is the value there for that upcharge?’” For sponsors especially concerned about fees, his firm has developed an all-passive-fund lineup it can use for a core investment menu or to create custom target-date funds or risk-based funds.

Everhart Advisors decided, for several reasons, to charge the same fee for its 3(38) and 3(21) services, Hanna says. “Complete independence is one of our key differentiators, and we want to be independent when we guide our clients through the 3(38) vs. 3(21) decision,” he says. “And we view our liability as being the same: We are on the hook fully as a fiduciary, either way.”

The Communications Dynamic

“It’s actually more efficient for us to function as a 3(38) adviser vs. a 3(21) adviser,” Hanna continues. “Instead of having to educate a committee through an investment decision it has to make, we as a 3(38) adviser can simply make that decision. It’s a far more streamlined approach for an adviser.”

Being a 3(38) investment manager, vs. a 3(21) investment adviser, changes the communication dynamic between an adviser and sponsor. To get the reduced fiduciary liability that comes with having a 3(38) adviser who assumes discretion, Hanna says, a sponsor has to stay out of investment decisions. “The committee is giving up a significant amount of control to obtain that limitation in liability,” he says. “If all they’re going to do is rubber-stamp our decisions, I suggest that they might want to take advantage of the additional protection they can get from hiring us as a 3(38). But if they want to continue to participate in conversations about investments being selected or removed, then hiring us as a 3(21) is the only option.”

Sometimes sponsors who have hired a 3(38) investment manager feel surprised that the adviser really does make all of the investment decisions, Shoemaker says. “The plan sponsor’s challenge is that, when they first hire you, they struggle with giving up that decision-making authority,” she says. “In those cases, we always tell them, ‘If you start acting like we’re a 3(21) fiduciary, we’re going to be viewed [legally] as a 3(21), not a 3(38),’” she says. New clients sometimes hire Plante Moran as a 3(21) adviser initially, because they want the experience of going through all of the investment details with the advisory team. “A year or two later, they have gotten comfortable with our processes,” she says, “and then they may move to our 3(38) service.”

No one formula works for the ongoing dynamic between a sponsor and a 3(38) investment manager, Edwards says, but a sponsor always has a fiduciary responsibility for monitoring the 3(38) manager it chose. “The only way a plan sponsor can shed its fiduciary responsibility is to no longer be a plan sponsor,” he says. “A plan sponsor can delegate what work it wants to, but the sponsor has to continue to monitor what the adviser is doing and whether it is adding value for the fee.”

The biggest challenge for a 3(38) investment manager comes in the adviser deciding how much to communicate with the client about investments, Krasnow says. “These clients have kind of handed everything over to us to make investment decisions. Yes, we’re getting the keys to the castle, but it’s a balancing act on how much we keep them [apprized],” he says. “We still want them to understand what we did, and why we did it.”

IRON Financial serves as a 3(38) fiduciary on over 3,000 plans, and each sponsor gets plan-specific reporting on a quarterly basis, Friedman says. “We put that report in a layman’s format,” he says. “But behind that is as much empirical data as they want to see.”

Each of IRON Financial’s quarterly investment reports includes a performance review of the plan’s funds, a narrative on what is happening with each watch-list fund, and a “fiduciary scorecard” visual for the plan’s investment menu. The scorecard includes color-coding that communicates each fund’s status in an easy-to-understand way. If the 3(38) adviser changed the share class of an investment, for example, that fund’s name appears in orange. If it made a fund change, that appears in red on the scorecard. “At the end of the day, if you’re a plan sponsor, quantitative analysis is not your cup of tea,” Friedman says.
 
Intellicents provides written quarterly investment reviews as a 3(38) and still goes out and delivers those reviews every quarter in meetings, Arends says. “We encourage the committees to oversee the process on a quarterly basis,” he says. He stresses the importance of a 3(38) adviser providing written, thorough due-diligence reports on investment changes.

“You have to take detailed minutes on why and how you’re making decisions such as fund changes and share them with your 3(38) clients,” Arends says. “You can’t just print out the Morningstar report for that fund. You have to be able to show that you know what you’re doing.”

Art by Uijung Kim