Shielding Yourself
Christopher Venuti is senior vice president and institutional consulting director for Graystone Consulting, a business of Morgan Stanley, in Los Angeles. His team consults on about $5.5 billion in assets, with an average plan size of around $100 million. According to Graystone leadership, a big part of the recent growth and client retention success of the firm has involved delivering discretionary investment management services as a 3(38) fiduciary.
Roughly 60% of the advisory group’s book of business is now serviced under 3(38) arrangements, Venuti observes, and just about three-quarters of all new plans brought on in recent years utilize the service. “It is a topic that’s really important right now among our existing clients and prospects,” Venuti says.
Regulatory and litigation pressures—as well as organic client demand—have forced most advisers serious about having a future in the Employee Retirement Income Security Act (ERISA)-governed retirement planning industry to take on the somewhat less rigorous 3(21) fiduciary role. The 3(21) arrangement involves requirements to offer best-interest advice to plan sponsor clients but still leaves them with the final decision; 3(38) services mean the adviser is in control, offering discretionary investment management services.
Against this backdrop, Venuti says, offering “the next level of fiduciary service” as a 3(38) investment manager can be a natural and powerful differentiator in the eyes of clients, who now commonly see 3(21) advisers.
“Clients are very attracted to the notion of gaining additional fiduciary protection however they can,” he adds, “and the 3(38) investment management service can offer just that.”
Sizing the 3(38) Marketplace
The latest PLANADVISER Practice Benchmarking
Survey (PLANADVISER, November–December 2016) showed a large increase in
advisers serving as fiduciaries, of any type, to plan sponsors and plan
participants. There was a jump in the percentage of advisers acting as a 3(38)
to plans—from 56% up to 60%—and as a 3(21)—from 90% up to 92%.
Jonathan Blaze, head of the defined contribution investment only (DCIO) specialist team at New York Life/MainStay Investments, Jersey City, New Jersey, agrees that more attention is clearly being paid to 3(38) service opportunities. He says many clients would benefit from competitively priced 3(38) service, but it is not right for everyone.
“Given the current regulation and litigation pressure, it is hard to argue that 3(38) service is not emerging as the next extra layer that you, as an adviser, can either provide for your clients or source for your clients,” Blaze says. “When we look at 3(38) and talk about it with clients, we feel it is important to label it as 3(38) fiduciary investment management. It is not really advising anymore. It is going potentially far beyond the 3(21) advisory service.”
Because of the extra risk involved, any advisers currently offering or considering 3(38) services should be working closely with ERISA counsel to maintain pristine recordkeeping and other process controls.
“If you are going to expand into offering or sourcing 3(38) service, then trusted ERISA counsel is absolutely essential,” Venuti says. “Not only does this help us really understand our offering and what protections it is delivering to the client—we’ve also found that our counsel is then a tremendous advocate when we go in front of clients and talk about the additional fiduciary protection we can offer via 3(38).”
The experts stress it is key for clients to understand that they maintain their fiduciary duty to monitor the 3(38) service provider. In other words, even full-fledged 3(38) service does not remove all liability from the plan sponsor client.
“There is still a duty on the part of the plan sponsor to monitor for prudence and adherence to process,” warns Jonathon Schultheiss, retirement plan adviser and partner with Gate City Advisors, out of Greensboro, North Carolina. “We will sometimes see clients who think about it but ultimately decide they do not want to go down the 3(38) route because they don’t want to hand over discretion. We sometimes come across CIOs [chief investment officers] or CFOs [chief financial officers] who raise an eyebrow at the idea that the adviser would take on that role.”
Such clients believe the adviser should simply advise, and the final investment decisions should be made by the sponsor, Schultheiss says, “and that is fine for those clients.”
Other clients will hesitate because there is also pricing to think about, the experts note. In general, the cost will be greater for 3(38) services because the adviser is taking on more work and more risk.
No Single Favored Approach
Blaze observes that there is diversity in how advisers and
providers are structuring and delivering 3(38) services.
“You have some advisers who act now as a 3(21) or a 3(38) through their respective registered investment advisory firms, and there are advisers who will utilize a partnership with a recordkeeping platform that has hired its own preferred 3(38) manager to screen and evaluate funds for their client to select from,” he says. “And there are third-party firms that stand alone, for example Envestnet.”
Blaze goes on to warn that “anyone can hang the shingle out and say you’re a 3(21) or 3(38), but what is behind that? It’s all about scale, resources and process.”
Questions along these lines the experts have seen from sponsors include: Will you commit it to writing that you are formally a 3(38) manager, and what is the full scope of the relationship in terms of regular services? What kind of indemnification is going to be put into place between the 3(38) manager and the plan sponsor? What happens if there is a breach? Is there fiduciary liability coverage that can be relied upon? What is the cost?
“The environment today is so much about cost, as we all know,” Schultheiss observes. “It will be a tougher sell for small plans. However, it is a non-settlor expense, so the plan sponsor can utilize plan assets to pay for [it], if [the sponsor] feels it is important but not necessarily in the employer’s own budget right now.”
Misconceptions About 3(38) Services
It should be made absolutely clear that clients understand a
3(38) does not seek to guarantee excess returns. “You might not think you would
have to even cover this, but one of the things [a] 3(38) is not, clients must
understand, is some type of guarantee of better performance,” Venuti says.
“We’ve had clients that have been thinking about signing on for 3(38) service,
and they will come to us all excited and make the comment that, ‘Now that we
have a 3(38) manager, we are going to beat the market!’
“We are guaranteeing that we are going to follow a prudent process, follow the investment policy statement [IPS] and protect the client in that way,” Venuti says.
He shares another interesting anecdote: “We had thought originally that our most sophisticated clients would be the ones who would be most hesitant to relinquish control to us as a 3(38), such as the law firms and professional investment practices we have as clients. We thought there is no way they would go for 3(38), given their internal expertise.”
In fact, they were the first ones to sign up for it because they “most clearly saw the value in getting so much more help managing fiduciary liability for really only an incremental increase in cost.”
“Another great anecdote I like to share,” Venuti says, “is that we had one client who asked us to go back and do a review of the service we provided to it as a 3(21) fiduciary adviser and compare its decisions made with advice [against] what we would have done had we instead been granted discretion as a 3(38) manager during that time.”
The firm ran the reporting, and the analysis showed there would actually have been no difference in the decisions made; the same funds would have been changed and the same investment decisions would have been made.
“It’s kind of remarkable, but the client still decided to go for the full 3(38) service even after seeing this eye-opening reporting,” Venuti says. “[The client] really saw the value in having greater fiduciary protection, and it was eager to see our advice implemented even faster, with the 3(38) discretion. There would no longer be a lag of a quarter or two, the time it took the committee to consider advice it was almost certainly going to take anyway. The plan saw real value in this.”
3(38) Opportunities
A flash poll taken among PLANADVISER readers at the most
recent PLANADVISER National Conference, last September, garnered a variety of
responses about how advisers view 3(38) opportunities as an opportunity. Some
advisers suggested they “always discuss 3(38) as a basic part of their value
proposition and client service approach,” while others “can discuss it and
provide it but don’t do it often.” Still others say they “rely on trusted third
parties to provide this type of investment management service for them.”
Responses to the admittedly unscientific poll were roughly evenly split among
these outlooks.
Important to note, there were also advisers who argued it is not really the “true retirement plan adviser’s role” to become the discretionary investment manager for client plan assets—or even to play a direct role in sourcing that type of service from a third party. Advisers should offer advice, this group argued, leaving clients to maintain the real discretion.
The upshot, perhaps, is that staff and leadership
personality, and general business philosophy, play a big role in whether the
3(38) service makes sense in a given situation, for a given client or within a
given firm. —JM
KEY TAKEAWAYS
- As more advisers decide to offer only 3(21) fiduciary
services, this has allowed those who offer 3(38) services to stand out.
- Certain plan sponsor clients may like the added fiduciary protection of a 3(38), while others prefer to retain decisionmaking.
- Advisers need to explain to sponsors that just because they have hired a 3(38), they still have fiduciary responsibilities and need to monitor the 3(38) adviser.