3(38), 3(21), 3(16): Do 401k Advisors Really Know the Difference?

When it comes to their fiduciary duty, they’d better. With April’s implementation of the fiduciary rule breathing down their necks, these three numbers mean big success—or complete disaster. Troy Tisue, Ary Rosenbaum and other high-profile experts clue us in.

ERISA confusion reigns in the 401k space.ERISA confusion reigns in the 401k space.

(From Issue 4, 2016)

“WELL, GOOD LUCK WITH THAT,” Troy Tisue good-naturedly laughs when told we’re attempting to gauge advisor awareness and understanding of the ERISA hieroglyphs.

Far from condescending or dismissive, Tisue, president of 401(k)-provider Tag Resources, understands the confusion they cause. The 2016 fiduciary rule frenzy put 3(38), 3(21) and 3(16) on the front burner. What are they? Which are you? What’s covered (and what is not) by each?

All critically important questions that, if answered incorrectly, can get 401(k) advisors sanctioned—or worse, sued.

“When something goes wrong, the courts will immediately look to identify the fiduciary,” says Pete Swisher, senior vice president and national sales director with Pentegra Retirement Services. “They’re going to find out who’s responsible, and that’s who they’ll hang it on.”

Swisher relates the scary, yet unsurprising, anecdote of a well-versed and experienced 401(k) advisor who repeatedly transposed the numbers, referring to them as 3(31) and 3(28).

“Do advisors know about these ERISA sections? No, but they are getting there,” he states. “Ten years ago I was giving a talk at a conference and asked the audience members to raise their hand if they’d heard of 3(38); nothing, crickets. But more people raise their hands now.”

Here’s a little indication of what’s on the line, courtesy of high-profile ERISA attorney Ary Rosenbaum.

“I believe there will eventually be a Bernie Madoff of the 3(38) space,” he says. “You’ll always have somebody that tries to take advantage—it’s just a matter of time before it happens. The question becomes what kind of measures you have in place to prevent it, or to ensure the damage is limited.”

If sequential ordering is any guide, 3(38) would offer the most protection, while 3(16) the least. If only; true to government form, regulatory caveats exist that make little sense and add to the stress advisors already suffer.

“3(38) has been around a long time, and most advisors should have an idea of what that is,” Tisue explains. “More flexibility exists with 3(16) and what can be included, but it also means the opportunity to get torched is huge.”

And 3(21)?” he cryptically adds. “That’s another term for ‘co-defendant.’”

Tisue reveals why in his description of each, and saves his ire over 3(21) for last:

ERISA Section 3(38)

Pretty straightforward; Section 3(38) names investment managers who have discretionary authority as fiduciaries. The firm must be structured as an RIA, bank or insurance company, and it must specifically acknowledge its fiduciary status.

“The fiduciary responsibility is delegated to the investment manager, who ultimately has full discretion,” Tisue says. “They have the credentials and expertise, which is why you hired them, so ideally you’ll leave them alone to do it.”

ERISA Section 3(16)

Not so straightforward: the Wagner Law Group defines a 3(16) fiduciary as an administrator with ERISA reporting and disclosure duties. It does not refer to traditional third-party administrators providing non-fiduciary services.

The challenge (or maybe opportunity) is that 3(16) services are incredibly broad.

“In an ideal world, it would be the same definition as a 3(38), except instead of the word investments you would replace it with the words regulatory and administration,” Tisue notes. “In reality, the fine print must not only be read, but carefully studied, because it could include anything.”

“Anything” could mean acting as essentially a surrogate employer in the plan description on one hand, to simply sending notices as a TPA on the other, and everything in between. Which is fine, but the plan sponsor has to know what they’re getting and what they are not.

“Less than 1 percent of advisors engage in 3(16) services,” adds ERISA attorney Jason Roberts, CEO of Pension Resource Institute. “The challenge is that no two 3(16) descriptions are the same. They are a creature of the contract and specifically what that contract states.”

ERISA Section 3(21)

A 3(21) fiduciary includes anyone who provides investment advice for a fee. From Wagner:

“Advice relates to advisability of investing. Either the advisor has investment discretion, or non-discretionary advice is provided as follows: on a regular basis; under a mutual agreement or understanding that advice will serve as the primary basis for decisions, and; advice will be individualized to needs of plan.”

Tisue calls 3(21) a “tough one,” especially with the new fiduciary rules and making investment decisions on investments.

“Quite simply, investment advisors are now accountable, where before they didn’t necessarily have to be. They could react by stepping up and really helping people, since they’re now fiduciaries anyway. The other possibility is they will look at the risk tied to the new responsibilities and say, ‘I’m not going there. I’ll never talk to a participant again.’”

To keep it nice and confusing, a plan sponsor might think they’ve outsourced the fiduciary responsibility to a 3(21), but the only thing they’ve done is share in the decision-making process, and the aforementioned legal exposure if anything goes wrong.

“So, surprise! Non-discretionary advice means they’re still liable, and too many sponsors and advisors who partner with 3(21) don’t understand that.”

Ultimately, 3(16), is “newer and therefore easier to play with,” meaning easier to manipulate if the service agreement isn’t exact. While the definition of a 3(38) is established and plan sponsors generally know what to expect and the services provided, it’s a “wild assumption with 3(16), and definitely a wild assumption with 3(21).”

So, which one is “right” for advisors and plan sponsors?

It depends on how far they’re willing to go in the responsibilities they’ll accept, and those they wish to outsource. 3(38) is obviously ideal, but not always cost effective for smaller plans. Larger plans might not even want it, Roberts says, because they’ll continue to demand a seat at the table, and a voice in the retirement decisions for their employees.

Questions over what 3(38), in particular, covers are answered in the following passage, which is helpfully included in every plan advisory agreement Roberts and Pension Resource Institute draft for the RIAs with whom they work. It’s wonky, but stick with it:

With respect to any Discretionary Fiduciary Services, Section 402(c)(3) of ERISA allows Sponsor to delegate responsibility for selecting, monitoring and replacing plan assets to an “investment manager” that meets the requirements of Section 3(38) of ERISA.   Section 405(d)(1) of ERISA provides that if an investment manager is properly appointed, then “no trustee shall be liable for the acts or omissions of such investment manager or managers, or be under an obligation to invest or otherwise manage any asset of the plan which is subject to the management of such investment manager.” [Emphasis ours]

Yes, it means the sponsor and advisor can outsource their fiduciary responsibility to a 3(38), but there’s a catch (government again), and resides in the wording of “…if an investment manager is properly appointed.” Plan sponsors still have to approve the 3(38) investment manager, and properly document the due diligence involved in doing so.

“Investment committees are relieved of fiduciary responsibilities,” says Roger Levy, CEO of Cambridge Fiduciary Services. “Does it mean the plan sponsor is completely off the hook? No! They have additional responsibilities of properly examining and vetting the manager.”

There is always a litigation risk, whether or not a plan sponsor or advisor is a fiduciary, he warns. Levy should know, having been invited to file a Supreme Court amicus brief in its landmark Tibble vs. Edison decision involving fiduciary duty.

“They can act as a 3(21) and mitigate it further under 3(38). Investment committees are then relieved of additional responsibilities, but they must still by properly examine and vet the 3(38) manager.”

One point repeatedly made is that plan sponsors (with the exception of some larger plans) don’t want to be in the fiduciary business.

“Healthcare is consuming more of the plans sponsor’s and HR department’s time,” Roberts says. “If they hire a 3(38), they don’t have to sit there and listen to conversations about Sharpe Ratios and other technical aspects of managing the plan, and it frees time for other tasks.”

And one solution for advisors to limit their legal exposure is to partner up.

“It’s unwise for smaller broker-dealers to exit the retirement plan space, so they can partner with RIAs to have the latter take on the fiduciary services,” Rosenbaum says. “Larger broker-dealers need a structure that allows them to remain in the retirement plan space, but with limited fiduciary exposure. That would mean designating certain advisors with retirement plan exposure to also serve in a fiduciary capacity.”

Or, they could partner with a firm that specializes in offering packaged fiduciary services like Tag.

“This approach makes life easier for the 401(k) advisor because then it’s on us,” Tisue concludes. “It’s not a time for the predicted 150,000 advisors to leave the industry because of the fiduciary rule. That’s 150,000 advisors that could sit with people face-to-face and motivate them to save for retirement. We can help.”

1 Comment on "3(38), 3(21), 3(16): Do 401k Advisors Really Know the Difference?"

  1. FYI there is no “Share Article” button for LinkedIn! Either way, great breakdown of the “Fiduciary Threes.”

    Something I’ve noticed lately with some of the FinTech disruption in the 401(k) space is the manipulation of the 3(16) Fiduciary. The marketing and simplification that Silicon Valley is known for is being used to attract these small business 401(k) plans (start ups and less than $3mm).

    They are turning out to be no better than the “typical big 401(k) provider” they claim to save participants from, by talking in half-truths.

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