The Sides of Fiduciaries

Is there room for two fiduciary advisers serving the same retirement plan? Maybe so. Although it might sound counterintuitive, some plan sponsors are choosing to hire both a 3(38) and a 3(21) fiduciary adviser that are separate entities, says Gary Allen, a principal at Prudent Investor Advisors LLC in Folsom, California. His own company serves plans as both a 3(21)(A)(i) fiduciary adviser and a 3(38) investment manager.

“The primary driver of growth has been the emergence of recordkeeping platforms selecting a 3(38) partner to provide outsourced, discretionary fiduciary services. Most of the major platforms now offer some kind of 3(38) service,” Allen says. “The second main reason is the competition between fiduciary and nonfiduciary advisers. Brokers and insurance agents may use a separate 3(38) to provide fiduciary services, while [they] remain a nonfiduciary to the plan. This is a growing trend among various entities: not wanting to be a fiduciary while still providing services that clients ask for. Otherwise, they are shut out if a plan sponsor desires or requires a fiduciary relationship.”

As retirement plan regulations continue to tighten, more small-plan sponsors in particular like the idea of working with a 3(38) adviser who takes full discretion with investments, says Mike Possley, managing director at Wilshire Associates in Chicago. It is generally a small plan’s existing 3(21) or nonfiduciary adviser who refers a sponsor to Wilshire, whose Wilshire Funds Management arm partners with recordkeepers, offering its 3(38) and 3(21) services as part of the recordkeeper’s package.

“More and more, we’re running into situations where an adviser does not have that expertise, and his business model is not set up to work as a 3(38),” Possley says. “We are seeing with more and more plans—certainly under $5 million, and up to $10 million, in assets—that they have an adviser associated with the plan who doesn’t want to take on that responsibility.”

But even after a 3(38) comes on board, the original adviser still has a key role with the plan. In fact, the alliance frees the adviser up to concentrate more on other client services. “These plan advisers are interested in working more directly, hands-on, with the plan sponsor,” Possley says. “And they’re helping with the plan in other ways, such as participant education.”

The Beginning of a Trend?

The demand for a 3(38) adviser “is really just emerging in the DC market,” says Scott Brooks, Oaks, Pennsylvania-based managing director of the defined contribution (DC) business in SEI’s Institutional Group, a provider of 3(38) services. “If you were to look at the overall DC market in terms of the penetration of 3(38), it’s probably south of 10%.” Sponsors’ use of a 3(21) fiduciary—defining that broadly to include advisers, traditional investment consultants and recordkeepers serving in that function—is “fairly high,” he says.

Brooks sees two key reasons that more sponsors now choose to work with 3(38) fiduciaries. First, there has been a striking rise in the number of defined contribution participant lawsuits, as well as increased attention from regulators and legislators on the results these plans achieve for participants. Second, more sponsors are coming to realize that decisions to change investment options “should be left in the hands of professional money managers, versus well-meaning committee members who may not have the expertise to make these decisions prudently and in a timely manner,” he says.

“Plan sponsors are very similar to plan participants,” Allen says. “Most participants want someone else to take care of their investments. This same mentality of wanting someone else—a subject expert—to handle the task of the investment process for a retirement plan is present in many plan sponsors, as well. The majority of plan sponsors are still not aware that a sponsor can legally delegate certain fiduciary functions to a qualified third party. However, that message is slowly percolating. Fiduciary outsourcing will become mainstream in the not-too-distant future.”

Additionally, in this cost-conscious era, sponsors concerned about 3(38) fees may find the service less expensive than they might have thought. “The cost spreads between 3(21) and 3(38) services have narrowed dramatically; the sensitivity around fiduciary risk has increased; and a 3(38) manager seems to be a better value now than perhaps a few years ago,” says Matthew Eickman, an attorney and director of Employee Retirement Income Security Act (ERISA) services at Lawing Financials Inc. in Overland Park, Kansas. Eickman, whose firm offers both services, attributes the fee dynamics largely to heightened competition, as more advisory firms build up the systems and processes needed to fulfill the 3(38) role.

Still, it is not yet the norm for a plan to work with two fiduciary advisory firms, sources say. “I would not say it’s more common to work with both a 3(38) and a 3(21),” says Susan Stiles, president of Stiles Financial Services Inc. in Edina, Minnesota. Her firm does both types of work, but primarily 3(21) service. “Plan sponsors are enticed by the prospect of alleviating all their fiduciary liability, but, as they learn more about the application of 3(38), they learn that it is impossible to completely absolve from all liability [as sponsors],” she says. And utilizing both a 3(38) fiduciary and 3(21) fiduciary “can be more costly as well,” she says. “I think that, in most cases, once a plan sponsor is properly versed, it leans toward a strong 3(21) adviser alignment.”

Not all advisers will feel enthusiastic about a second advisory firm serving one of their plans, Possley acknowledges. “For many RIAs [registered investment advisers] and other advisory firms, this is their specialty,” he says of serving as a 3(38). “They would never want Wilshire or another advisory firm to come in and act as a 3(38), because that’s their value proposition. But there are other advisers who see that a sponsor can hire us as a 3(38) and the adviser still has a very central role delivering services to that plan. We actually embrace the idea of a second adviser whose role is to have the primary relationship with the plan sponsor.”

Value Propositions

When a plan does work with two fiduciary advisory firms, each has a distinct value proposition to offer a plan sponsor.

A 3(38) adviser can stress its ability to relieve a sponsor of much of the fiduciary burden. “A 3(38) has to demonstrate that it has the expertise to select a prudent lineup of investments and to monitor that lineup over time, making any changes that are necessary,” says Managing Director Scott Pritchard, whose advisory firm, Capital Directions LLC in Asheville, North Carolina, also does 3(38) fiduciary work. “Taking the discretion for investment selection off the shoulders of the plan sponsor significantly reduces [its] fiduciary liability.”

The real differentiator for a strong 3(38) is a robust investment due-diligence process, Pritchard says. “Many nonfiduciary advisers simply make their recommendations based on what their mutual fund wholesaler tells them. In essence, they’re just rubber-stamping what the salesman told them,” he says. “But someone who is taking on the discretion for building a 401(k) lineup has to have the expertise, and take the time, to actually do the research to build a lineup that’s truly in participants’ best interests.”

Because a 3(38) has discretion on investment decisions, “we oversee that lineup, and we are on the hook if anything were to happen,” Possley says. “There’s a lot of value to a sponsor in working with an adviser who is willing to say [that]. Many of these people are business owners who are a fiduciary to that plan [by default], and they just don’t have that expertise or the time.”

A 3(38) adviser is entrusted with the duty to select, monitor and, if necessary, replace the plan’s investment options, Allen says. “Normally, this is the duty of the plan sponsor. A 3(21)(A)(ii) nondiscretionary fiduciary cannot take on this task. Only a 3(38) investment manager under ERISA accomplishes that.”

Plans that choose to also work with a 3(21) fiduciary often do so because the sponsor feels it lacks the expertise to adequately monitor the 3(38)’s work. “The plan sponsor has a fiduciary responsibility to oversee the 3(38) adviser it hires,” Possley says. “We’ve seen 3(21) advisers helping with that.”

But according to Allen, “One of the biggest misconceptions” regarding fiduciary advisers is that a 3(38) can come in and replace the duties of a 3(21). “The 3(21) is an advice-giver, while a 3(38) is a plan decisionmaker,” he says. “There is no overlap between the two types of services being offered. The 3(38) doesn’t replace the 3(21) at all.”

In addition to monitoring the 3(38) adviser, a 3(21) adviser has numerous ways to add value, Allen says. A 3(21) can offer fiduciary services as it gives investment advice to participants; it can also benefit participants by educating them on issues such as retirement readiness. Further, an advisory firm providing 3(21) services to a plan can deliver a host of nonfiduciary services, he says. That advisory firm can provide education and assistance to the plan committee, such as helping it determine the plan’s objectives and assisting with plan design.

The 3(21) adviser can help the sponsor with its duty to manage vendor relationships, including reviewing fees and services received, as well as aiding with vendor searches and transitions.

Still, a sponsor working with two fiduciary advisory firms must be able to justify the cost. “I believe that monitoring the 3(38) manager would be the best justification for also engaging a 3(21) adviser,” Eickman says. If Lawing Financial served as a 3(21) on a plan that also utilizes a 3(38) manager, “our chief value proposition would be to tighten up the analytics and processes of the 3(38) manager,” he says.

“With respect to defined contribution plans, I see a valuable role for a 3(21) adviser only if the 3(38) manager [fails to] apply objective criteria in a predictable way.” If the 3(38) has consistent and transparent processes, he says, the sponsor itself likely has the ability to monitor the 3(38).

But Eickman offers a potential solution to sponsor concerns about defined contribution plan participants paying for a 3(38) adviser and for a 3(21) adviser to monitor the 3(38). “If the plan sponsor chooses to pay a second party from the company’s assets—and not plan assets—we don’t have the same DOL [Department of Labor] and ERISA concerns about whether that expense is reasonable and necessary,” Eickman says of the 3(21) advisory firm. “That is, if the plan sponsor wants to pay a 3(21) to help with its residual duties to monitor the 3(38) manager, that might make sense. Of course, the sponsor would then need to monitor the 3(21) adviser.”

What It Takes to Be a 3(38)

While sponsor interest is growing, not every adviser has the resources or expertise to serve as a 3(38) fiduciary. Prudent Investor Advisors’ Gary Allen shares his thoughts on the basic requirements for offering 3(38) services:

1. “You have to be a subject expert on ERISA [the Employee Retirement Income Security Act],” Allen says. “Our experience is that most [advisory] firms are not. They simply do not understand the legal environment of offering 3(38) services; they don’t understand the nuances and the practical implications of ERISA interacting with investments; and they don’t understand that they have become a decisionmaker on the plan—and all that implies.”
2. “Many advisers who offer 3(38) services are competent with investments, but they struggle with ERISA, DOL [Department of Labor] and IRS [Internal Revenue Service] requirements,” Allen says. “For example, they often stumble on simple things such as the investment policy statement [IPS] and who should be responsible for it. They struggle to document and explain their investment process to the plan sponsor, and they often fail to do enough to document their investment process.”
3. The previous issue “is a prelude to the real issue: Most advisory firms do not have a separate, documented investment process for their ERISA engagements,” Allen says. “If a firm does not have a separate investment process in writing that is documented, repeatable and scalable, then it will fail to meet its requirements under ERISA.”
4. “To be a great 3(38), you have to have knowledge of how all retirement plan players operate and interact: the plan sponsor, the participants and all vendors that can touch the plan,” Allen says. “Most advisers have rudimentary knowledge at best. Without this knowledge, a 3(38) is flying somewhat blind and doing a disservice to the plan sponsor and certainly the participants.”
5. Finally, “It’s a mistake for any firm to offer 3(38) services if it will not dedicate the proper amount of resources and time to do it right. A part-time 3(38) service is subject to failure,” Allen says. “One cannot be offering wealth-advisory services in the morning and 3(38) services in the afternoon. Either you are in this business or you are not.”