Taking on Discretion

Art by Jing Wei

As plan sponsors feel more concerned about meeting all of their fiduciary responsibilities, they will increasingly turn to advisers and others who can assume 3(38) fiduciary status, believes Melissa Cowan, executive director at Morgan Stanley in New York City.

Offering 3(38) services means taking on an investment-management role and having fiduciary discretion in making decisions about plan investments. “Upmarket, among larger plans, they are probably hearing about it from their ERISA [Employee Retirement Income Security Act] attorneys, who are saying, ‘Why not do this? It’s going to reduce your risk,’” Cowan says. “At the smaller end of the market, plan sponsors are juggling so many things. They may not understand the 3(38) role off the bat, but when it’s explained to them that it will reduce their risk and take a lot of the work off their shoulders, they understand.”

Considerable opportunities exist in both markets, as well as in between, because the vast majority of plans do not yet work with a 3(38) adviser, according to the 2017 PLANSPONSOR Defined Contribution (DC) Survey. Just 17.9% utilize one—most typically plans in the $10 million to $20 million asset range (22.0%) and in the $5 million to $10 million plan market (21.1%). Plans with less than $1 million in assets use 3(38) advisers least often (10.9%).

Advisers working in the micro- and small-plan segments of the defined contribution market oftentimes work only with a handful of employer-sponsored retirement plans, with the bulk of their business in traditional wealth management, says Jessica Sclafani, director, retirement at researcher Cerulli Associates in Boston. “Cerulli does not anticipate these advisers will rush to offer themselves as an ERISA 3(38) investment manager co-fiduciary. Most of their plan sponsor clients aren’t even aware of what a 3(38) fiduciary is, and, furthermore, some [advisers] may not be permitted to act as an ERISA 3(38) fiduciary by their broker/dealer [B/D],” she says.

Some plan advisers who want to offer 3(38) services are affiliated with firms that have these capabilities in-house. “If you’re talking about mid-tier advisory firms such as Lockton or CAPTRUST, they already have the capacity to do the 3(38) work from the home office,” Sclafani says. Wirehouses also have the home-office resources to do investment management, she says, pointing to Morgan Stanley’s recent efforts to centralize small-plan 3(38) services. Having that work centralized reduces the risk for the plan sponsor client, she says, because the many individual advisory practices are not left to their own devices to fulfill the fiduciary responsibilities.Some advisers who want to offer 3(38) services will not have the resources within their practice or an affiliation that provides them with those resources. They may turn to a third-party outsourcing provider. “I think where there is the most potential is the segment of advisers we call ‘dabblers,’ who typically have a handful of plans as clients,” Sclafani says. “There, we could see a growing interest in outsourcing the 3(38) fiduciary relationship to a ‘shadow fiduciary’ outsourcing provider. The outsourced fiduciary service then allows the advisers to be more efficient and scale their business.”

Centralizing Small-Market Work

Some members of Morgan Stanley’s specialist plan adviser group have been serving as a 3(38) adviser to midsize and large plans for years, Cowan says. “Specialists are allowed to take discretion for investments on their own, with oversight from the home office, and we have allowed them to do that for some time,” she says.

In 2017, Morgan Stanley, partnering with Ascensus, introduced ClearFit, a 3(38) discretionary manager targeting plans with $10 million or less in assets. It has centralized the investment selection and monitoring work, rather than each advisory practice taking on those tasks.

Morgan Stanley’s Graystone Consulting group does the investment legwork for ClearFit. “We have a home-office team dedicated to manager selection and oversight,” says Jeff McConnell, chief investment officer (CIO) at Graystone in New York City. “We put the CITs [collective investment trusts] together at the home office, and the investment fees are typically lower than if a single smaller plan sponsor went into the market by itself. We’re also looking at how the investments fit together: We design a glide path for the target-date funds [TDFs], for example.”

Advisers still have an investment-related role, McConnell says. “The advisers don’t have to do the work of the quarterly investment reviews themselves—we have the horsepower at the home office to do that work for them,” he says. “But they can talk through the results with the sponsor.”

ClearFit also frees advisers up to spend more time working with small-plan sponsors on plan features and participant education, Cowan says. “It really allows the advisers to refocus with their clients on actionable items that drive better participant outcomes, such as participation rates, deferral rates and financial wellness,” she adds.

LPL Financial also has centralized 3(38) investment management for the small-plan market. With its Small Market Solution service, started in 2016, LPL Research takes on the investment responsibilities. “We are finding the most traction with plans under $5 million in assets,” says Bill Beardsley, senior vice president, retirement plan consulting with LPL, in Chicago. “In the under $5 million plan space, traditionally that is more of a wealth adviser-driven marketplace, because the advisers are working with business owners who also want the advisers to handle their company’s retirement plan. Many of those advisers want to leverage LPL’s capabilities and research in a centrally managed solution.” As of mid-February, 267 plans utilized Small Market Solution.

“LPL Research is selecting and monitoring the investments,” Beardsley says. He adds that the investment managers chosen agree to treat Small Market Solution assets as a single asset base for fee purposes, which brings fee efficiencies. In centralizing small-market 3(38) work, LPL wants to provide a “turnkey solution” for advisers, he says. “It frees advisers up to grow their business, to spend more time with clients, and to do more of what sponsors hire them for—provide coaching and assistance in growing their 401(k) plans,” he says.

Meanwhile, retirement specialist advisers at LPL have long been doing larger-market 3(38) work. LPL has 1,650 such advisers in its Retirement Plan Consulting (RPC) program who serve as a 3(21) fiduciary, and some also handle 3(38) work, Beardsley says. “Specialist advisers are leveraging our research capabilities and our technology,” he says, but the advisers take on discretion and do the investment selection. “These advisers already have built up a specialty in investment management and a capability in that space,” he adds.

The Outsourcing Option

Some advisers see outsourcing 3(38) work to a third-party provider as their best option. “Especially with all the heightened attention on fiduciary responsibilities and need for these investments to be actively monitored, if you are not doing 100 plans or more, and plan work isn’t your core business, advisers tend to outsource that function,” says Babu Sivadasan, group president of Envestnet Retirement Solutions in Chicago; the firm’s Fiduciary Advantage service takes on 3(38) outsourcing. “Those advisers would rather rely on an established, large fiduciary team,” he says.

Envestnet does business with some of the nation’s largest registered investment advisers (RIAs), Sivadasan says, but those professionals generally serve as the 3(38) fiduciary and simply adopt Envestnet’s technology, such as compliance software. Smaller advisory firms sometimes outsource a part of their book of plan business to Envestnet for 3(38) services, while keeping larger-plan 3(38) work themselves. “That’s where we get a lot of traction,” he says. “We’re playing in the small- to midsize-plan marketplace.”

When it handles the investment management role, Envestnet takes on 3(38) status in a contract with the sponsor, and the sponsor pays for its services. “The adviser is the 3(21) fiduciary who initially recommends an investment lineup,” Sivadasan says. Envestnet evaluates that lineup, and “ as long as all the recommended investments pass our screening process, we are comfortable managing the lineup from there. Then we monitor the investments, and, if we take any actions on [them], we communicate that to the sponsor through the adviser.”

Mesirow Financial takes on 3(38) outsourcing, as well, and finds that advisers have differing motivations depending on their market niche. Mesirow’s 3(38) Fiduciary Partnership services appeal most often to generalist advisers who understand how risky it could be for them to tackle that work themselves, says the firm’s senior managing director, Michael Annin, also in Chicago. “I think that a generalist adviser working with a small plan, without some sort of fiduciary backup, is even more dangerous than before the new fiduciary rules. So they either have to rely on something that their firm provides or something that a company like us provides,” he says.

Specialist advisers turn to Mesirow more often because they want to outsource the 3(38) work for their smaller plan clients, Annin says.

Mesirow has very limited interaction with plan sponsors when it assumes the 3(38) role, Annin says. “We are the 3(38) fiduciary, so we’re responsible for selecting and monitoring the investment lineup, and we have discretion on investments,” he says. “But there is still a big role for the adviser to play, helping the plan sponsor decide on the appropriate investment lineup for their plan population.”

Currently, almost all of Mesirow’s 3(38) work for plans originates through recordkeepers, Annin says. But he thinks his firm may soon start to establish outsourcing relationships with broker/dealers. “Many broker/dealers are trying to launch their own fiduciary services,” he says. “They’re finding that these programs are more difficult to administer than they initially thought. So broker/dealers are trying to sort this out, and there are a lot of conversations going on right now.”