The Risk of 3(38) Fiduciary ‘Flexibility’

If you invite flexibility into your 3(38) services, you should understand the risks

401k fiduciary, 3(38), DOLHere's how to dial it back.

There are many reasons that a plan sponsor and/or a plan advisor would look to engage an investment manager under section 3(38) of ERISA.

The two most compelling reasons are:

  • Prudence: A prudent 3(38) offers the most comprehensive outsourcing of the investment liability available to a plan sponsor under ERISA. Some will argue that the plan sponsor is never off the hook—that they are required to monitor the 3(38) investment manager.

This is true and should be part of the vetting process when a 3(38) investment manager is engaged. However, most plan sponsors engage a 3(38) investment manager because they do not have the required expertise.

As such, a good 3(38) investment manager should provide the plan sponsor, and the plan advisor, with the necessary deliverables to make monitoring of that fiduciary a matter of periodic although definitely not pro forma protocol.

If it’s hard to monitor your 3(38) investment manager, it may be time to look for a new one. The Department of Labor details this in the “Meeting Your Fiduciary Responsibilities Resource Guide:”

A fiduciary can also hire a service provider or providers to handle fiduciary functions, setting up the agreement so that the person or entity then assumes liability for those functions

selected. If an employer appoints an investment manager that is a bank, insurance company, or registered investment advisor, the employer is responsible for the selection of the

manager but is not liable for the individual investment decisions of that manager. However, an employer is required to monitor the manager periodically to assure that it is handling the

plan’s investments prudently and in accordance with the appointment. 

  • Process: ERISA 3(38) investment managers have a duty of loyalty to the plan participant…..yes, the plan participant.

While a prudent process does not necessarily ensure successful investment outcomes, the prudent process that your 3(38) employs can be critical to the ultimate success, or lack thereof, in the participant’ ability to accumulate the necessary assets to retire. Process not only is the single best protection for liability, it also has the ability to affect the success of the funds in your plan.

  • Does your 3(38) investment manager choose funds that are top quartile? If not, why not?
  • How low do they allow them to go? The third or fourth quartile in performance?
  • How does this add value?

This leads me to the genesis of this article, the introduction of “flexibility” into the offering of ERISA 3(38) investment manager services. Or as we like to call it, “the bleeding of 3(21) into 3(38).”

It’s highly unlikely that the draftspersons of ERISA had flexible investment managers in mind when they drafted ERISA Section 3(38), and provided a significant exclusion from fiduciary liability for the named fiduciary who properly appoints and monitors the activities of a 3(38) investment manager.

Everybody likes simplicity. When given a choice, most of us would take the path of least resistance. But when you do that under ERISA, you do so at your own peril. Although the content of this article deals with 3(38) investment manager services, the same narrative can be applicable across other industry product offerings today, such as:

  • You will hear some people (especially salespeople) say that plan sponsors get the same, if not better, protection from a platform level 3(21) fiduciary service as they do the platform level 3(38) fiduciary service. Simply not true; it’s not even close and probably fake news.
  • All 3(16) fiduciary services are the same. Again, simply not true. Not even close. There is a vast difference in the firm’s offering 3(16) services and those that will serve as the 3(16) Plan Administrator. Furthermore, there is a difference in the few firms that will serve as the Plan Administrator.

The trend in 3(38) investment manager offerings today is to offer “flexibility.” In some circumstances, the plan sponsor and/or advisor can suggest to the ERISA 3(38) that certain funds be offered or favorite legacy funds be retained.

The reasoning or narrative being used is “as long as the funds you suggest meet our criteria, we will take discretion over those funds, and add them to the plan under our 3(38) umbrella and at our liability.”

The other most prevalent form of flexibility is where the engaged 3(38) investment manager takes discretion over an incumbent line-up. There is no mapping of current investments into the funds that the ERISA 3(38) investment manager has defined as prudent for other clients on the same recordkeeping platform or custodian.

The “flexible” 3(38) investment manager simply takes over the existing fund lineup or makes little change as a result of client or advisor influence.

Below are reasons why plan sponsors and plan advisors should be concerned with both of these scenarios. First, let’s start with the definition of a “fiduciary,” as defined by ERISA:

Definition of a fiduciary

The Employee Retirement Income Security Act of 1974, as amended (“ERISA”) includes a code of conduct for individuals known as fiduciaries.

The primary purpose of identifying fiduciaries is to determine who has responsibility and liability for each aspect of plan administration and management. Under ERISA § 3(21), a fiduciary includes any person who:

  1. Exercises discretionary authority or control with respect to the management of a plan,
  2. Exercises any authority or control respecting management or disposition of plan assets,
  3. Has discretionary authority or responsibility in the administration of the plan, or
  4. Provides investment advice for a direct or indirect fee with respect to money or property of the plan. 29 C.F.R. 2510.3-21(c).

The bottom line is that anyone who has “authority, control, or discretion” over the plan or plan assets will be deemed to do so as a fiduciary. The law is also clear that a person can become a fiduciary in one of two ways: a person can either be named as a fiduciary in the plan documents, or be a functional or de facto fiduciary, so a plan sponsor cannot simply point to a plan document to avoid being treated as an ERISA fiduciary.

In a litigation context, whether a person is a fiduciary is a mixed question of law and fact. ERISA litigation seems to also include influence as evidence of authority or control, although not surprisingly, the case law in this area is mixed. There are a series of decisions in the Seventh Circuit indicating that authority or control for purposes of determining an ERISA fiduciary connotes actual decision-making power rather than mere influence over the decision of others.

Other cases, however, such as the decision of the Fifth Circuit in Reich v. Lancaster recognize that while not all influential advisors are fiduciaries, in certain circumstances an advisor’s influence may be so great as to render that advisor a fiduciary.

So, the question becomes, “Has a plan sponsor that ‘suggests’ certain funds be offered or retained exerted sufficient influence over the investment manager so that he or she has not simply played a role in the decision-making process, but actually exercised authority?”

The same and the robably stronger case can be made for an advisor, who may already be a fiduciary by providing investment advice for a fee that suggests certain funds be offered or retained in the plan. The recently enacted Conflict of Interest Regulation (new fiduciary rule) explicitly states that the receipt of a fee for recommendation of an investment to a plan fiduciary is a fiduciary act, although the regulations indicate that whether a suggestion amounts to a recommendation depends upon the content, context, and presentation.

For example, if a plan sponsor or investment manager inquires of an investment manager whether it would be possible to continue retention of some or all of the existing investment line-up, it is unclear if that inquiry in and of itself would constitute a recommendation. The questions that begs answering is why would you want to take that chance?

So, let me suggest a few scenarios.

The Department of Labor randomly audits your plan. You might be the plan sponsor, or you might be the plan advisor. They are questioning the investment structure and they notice that your 3(38) investment advisor has a set plan lineup. Those funds may or may not be in your line-up. They begin to question why the other funds are in the plan and who recommended these funds? You say that you “suggested” to your 3(38) investment advisor that these funds be added. You say it was the 3(38) investment advisor’s final decision to include them or not, you simply suggested them.  Do you think that the DOL is going to look at that scenario and come with the conclusion that you are not a fiduciary?

The risk is even greater for the investment advisor than for the plan sponsor, since the basis for being a fiduciary is authority or control with respect to management of plan assets, and there is no clear line as to when influence with respect to an investment decision constitutes authority or control with respect to that decision.

Take the same circumstances in a litigation event. Can you envision a scenario where the plaintiff’s attorneys and ultimately the courts are going to excuse you as a non-fiduciary? The next time you get the opportunity to chat with an ERISA attorney, run either scenario by him or her.

Ask them if the 3(38) investment advisor allows the plan advisor or plan sponsor to suggest or influence the funds in the plan lineup, will make you a fiduciary? I think unquestionably they will answer that there is a risk that either the plan sponsor or the plan advisor would be treated as a fiduciary under ERISA, with the plan advisor having the greater risk.

Our contention is that flexibility (or influence over the decision) inherently comes with potential liability when dealing with ERISA investment management and oversight. If it is flexibility that you are looking for, why not engage a 3(21) platform fiduciary?

At the end of the day it probably offers similar protection as a 3(38) solution where you are allowed to suggest fund options, and you get to have a say beyond merely making a proposal or having some other involvement in the selection of the included funds in all asset classes. Also, the extent of the plan sponsor’s fiduciary liability in the “flexible” 3(38) investment manager circumstance is unclear.

The decision by the investment manager to accept the funds initially, and certainly the decision to retain the funds thereafter, would be acts or omissions of an investment manager for which the appointing plan sponsor would have no liability. The risk, however, is that the plan sponsor’s initial suggestion/recommendation is a separate fiduciary activity for which the plan sponsor could be liable and not covered by the appointment of the investment manager.

IRON Financial is of the opinion that a plan sponsor engages a 3(38) investment manager to outsource the investment liability as comprehensively as possible. We believe the 3(38) investment manager process should be a pure process. A 3(38) investment manager can and should demand better than average performance.

Why not demand top quartile performance? This may cause you to replace a few more funds over time and it is worth it. After all, aren’t participants better served? We also believe a 3(38) investment manager should only include proprietary products when they meet the same high standards that all other funds are required to meet. 3(38) is discretion, 3(21) is advice. Flexibility blends the two. If it is flexibility that you seek, then use 3(21) services and keep it simple.

The next time a 3(38) investment manager says to you “we want you to consult with us on the funds for your plan. As long as the funds meet our screening, we will be the 3(38) investment manager over the funds”, or “sure you can keep all of the funds you have today, as long as the funds meet our screening, we will be the 3(38) investment manager over the funds”, you have decide what level of fiduciary protection are you seeking. Are you willing to run the risk of be pulled back in as a fiduciary?

As the plan advisor, will your broker dealer approve of a scenario that potentially pulls you back in as a fiduciary? Do you understand the potential liability of doing so? Remember, this concept is new and marketing makes it sound good. Just because the DOL or the courts haven’t determined that this approach is flawed as of yet, doesn’t mean they won’t, it may just be they haven’t gotten there yet. Proceed with caution.

Richard (Dick) Friedman is managing director of business development, corporate retirement solutions with IRON Financial.

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