Over the past couple of years, the retirement industry has been increasingly promoting the concept of the ERISA 3(38) fiduciary and how this is much better than hiring a firm that will “only” be an ERISA 3(21) fiduciary. While many more firms are starting to get into the 3(38) game, my firm Greenspring Advisors have accepted 3(38) appointments since 2007, and I wrote about the concept extensively in my book Fixing the 401(k): What Fiduciaries Must Know (and Do) to Help Employees Retire Successfully, published in 2008. In fact, to my knowledge, we were one of the first registered investment advisors (RIAs) to serve as such for defined contribution plans. Currently, about 20% of our corporate retirement plan clients utilize us in this capacity.
So, given the marketing push for the 3(38) movement within the industry and our significant, real-world experience as a 3(38) fiduciary, you probably think I would tell you this is a “no brainer,” right? Actually, the answer is not necessarily. In fact, the 3(21) vs. 3(38) decision is actually just a minor decision point when it comes to choosing the right advisor for your retirement plan. Furthermore, the benefits of a 3(38) fiduciary are often heavily oversold by the retirement industry. A 3(21) vs. 3(38) engagement only describes an advisor’s legal relationship with your plan and, in most cases, actually has no real bearing on the capabilities of the advisor. Even more concerning, many RIA firms are promoting the 3(38) model that actually have very little experience as an ERISA fiduciary for corporate retirement plans. So let me explain my rationale a little further.
Let me begin by explaining the difference between an ERISA 3(21) and ERISA 3(38) fiduciary. The Employee Retirement Income Security Act of 1974 (ERISA) is broken down into different sections. ERISA Section 3(21) defines the role of fiduciary and specifically states that:
a person is a fiduciary with respect to a plan to the extent (i) he exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets (ii) he renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so, or (iii) he has any discretionary authority or discretionary responsibility in the administration of such plan.
This is where the concept of an ERISA 3(21) advisor comes from: specifically, part (ii) of that definition. Advisory firms that acknowledge fiduciary status are usually doing so as an ERISA 3(21)(ii) fiduciary that renders investment advice for a fee. To be clear, the vast majority of investment professionals working in the retirement industry have historically done so in a non-fiduciary capacity and avoid providing “investment advice” at all costs to avoid fiduciary status. When push came to shove, these investment professionals (or, probably more accurately, their firms) would claim that they only provided “education” (even though there was a strong likelihood advice was actually provided) and therefore made the argument they were not fiduciaries with respect to a plan. They did so to avoid potential risk and liability.
So back to this idea of an ERISA 3(21)(ii) fiduciary—you will notice a difference in the 3 types of fiduciaries listed above. In the ERISA 3(21) definition, a person who is a (i) and/or a (iii) has what’s known as “discretionary” authority with respect to a plan, whereas a (ii) does not have any discretion. The word “discretion” in ERISA is important because it empowers the fiduciary to make decisions and that is where the proverbial “buck stops” from a standpoint of legal responsibility. So basically the two pathways to acquiring fiduciary status are either by having discretion or providing advice, and the former has the greater legal responsibility (and liability). In some instances, fiduciaries can legally delegate certain functions to other parties and be relieved of direct legal responsibility for any decisions made by that third party so long as they were prudently appointed and monitored. In the context of ERISA, unless you stop being a fiduciary, you cannot ever eliminate fiduciary liability entirely (more on that later) but you can delegate and fall back to a position of monitoring.
Because an ERISA 3(21)(ii) advisor doesn’t have discretion, the scope of his or her responsibility with respect to investments is to provide advice or recommendations to those fiduciaries who do exercise discretionary authority and who must then decide whether or not to act on that advice. In the real world, this usually means that an advisor provides recommendations to a retirement plan committee who decides whether to act on those recommendations. In that scenario, the advisor fulfills its legal responsibility so long as the recommendations were “prudent” and the retirement committee retains the full liability for any decisions that are made based on those recommendations.
As if this isn’t confusing enough, ERISA carves out a different type of fiduciary known as an “Investment Manager” (remember that ERISA goes all the way back to 1974, when companies sponsored defined benefit pension plans and before 401(k) plans or other similar defined contribution plans even existed).
You are probably thinking this is any financial advisor because their job is to “manage investments,” right? If only it were that easy. ERISA Section 3(38) defines an “Investment Manager” as any fiduciary (other than a trustee or named fiduciary) that fulfills three requirements:
The role of “Investment Manager” provides that plan fiduciaries can legally appoint and delegate the authority for making investment decisions to “professional” fiduciaries as long as the firm that is appointed fulfills the requirements above, and the decision to delegate was prudent. However, remember, a current fiduciary cannot eliminate fiduciary liability entirely and always needs to monitor any responsibilities that are delegated to third parties. In the real world, this usually means that a retirement plan committee appoints an ERISA 3(38) fiduciary and delegates the selection, monitoring, and replacement of investments (if necessary) to that firm, effectively giving up discretion (or control) for any decisions and falling back to a monitoring role. This also means that, while the committee may provide input about the investments in the plan, they have given up the final decision-making authority. If the committee wants an investment to be in the plan and the 3(38) does not agree to it, the committee will need to essentially fire the 3(38) and take back the discretion (and direct liability) for the investment decisions.
So let me summarize the distinction between the two roles. An ERISA 3(21)(ii) fiduciary makes investment recommendations to plan fiduciaries (e.g., committee members) who either approve or reject them while an ERISA 3(38) Investment Manager has the authority to make investment decisions without the approval of other plan fiduciaries.
Something that’s important to note is that, regardless of whether you hire an advisor in a 3(21) or 3(38) capacity, the advice and process should really be the same. I’ve seen a number of firms promoting 3(38) services that make it seem like they do something totally different than if they were only a 3(21) fiduciary or that 3(38) services are somehow superior. But why would you want to hire someone that takes a different approach when the risk is on them (i.e. advisor as 3(38) fiduciary) versus when the risk is on you (i.e. advisor as 3(21) fiduciary)? At Greenspring Advisors, our process and recommendations are exactly the same regardless of whether our engagement is for 3(21) or for 3(38) services because good fiduciary process is good fiduciary process regardless of who has the final decision-making authority. And that’s the simple difference—who has the power to decide which has certain implications on your overall experience as a client. It certainly means giving up some measure of control for the investments in your plan. Some clients are happy to do this, but others will have a real problem it.
Based on the above, it seems like a retirement plan committee that wants to minimize fiduciary liability for investment decisions would ALWAYS want to hire a retirement plan advisor and appoint them as an ERISA 3(38) fiduciary, right? Like many things in life, the answer is a bit more nuanced.
I’ve heard numerous advisors describe 3(38) services as if they were “magical fiduciary fairy dust” that you simply sprinkle on your plan and all your problems go away. And many plan sponsors fall prey to this thinking because they assume that they can just hand over the keys and walk away. That couldn’t be further from the truth, especially if there isn’t a prudent process in place to evaluate and monitor the performance of the 3(38) advisor. Remember, whenever fiduciary duties are delegated, a monitoring requirement is always established. Retirement committees need to be just as engaged as ever so that they understand the process of the 3(38), what decisions are being made, and the rationale for those decisions. Otherwise, how can they prudently judge the performance of the 3(38)?
Personally, I think the industry heavily oversells the idea that it significantly reduces risk. Make no mistake, in the unlikely event of litigation related to poor investment performance, everybody is getting sued. If a 3(38) has been appointed by a plan sponsor, that decision is going to be scrutinized as to whether it was prudent. Not to mention, the industry tries to use scare tactics about the probability of potential risk of litigation as justification for hiring a 3(38) advisor. But let me point out a few things which might not be evident at first glance.
First, it’s certainly possible a company will be sued by its employees for fiduciary breach, but it’s unlikely, especially for smaller plans. Historically, ERISA litigation has been confined to the realm of very large plans and there’s a simple reason—incentives for plaintiffs’ attorneys. ERISA litigation is time-consuming (think years that approach decades) and it’s expensive. The largest settlement to date has been the Lockheed Martin case where the company agreed to pay its participants $62 million to settle the case. Court records showed the plaintiffs’ attorney made roughly $20 million (about 30%)—a pretty good payday indeed and making it economically attractive for the law firm. That lawsuit was originally filed in 2006, and it wasn’t settled until 2015. Also, the Lockheed plan had approximately $28 billion so the total settlement only represented about .22% of total plan assets. Since there are no punitive damages under ERISA, smaller plans typically don’t represent a great target market for fiduciary breach claims from the standpoint of plaintiffs’ attorneys. For instance, a settlement representing .22% of plan assets for a $50 million plan is only $110,000. Is an attorney going to be willing to receive 30% or $33k for potentially nine years of litigation? Unlikely.
Look, that’s not to say smaller plans can’t be sued, and, in 2016 and 2017, there were examples of a $25 million plan (Bernaola v. Checksmart Financial), a $9 million plan (Damberg v. Lamettry’s Collision Inc. which was voluntarily dismissed by the plaintiffs) and even a $1.1 million plan (Schmitt v. Nationwide Life Insurance Co.) being sued. But, to date, these types of lawsuits have been the rare exception.
My point is that some advisors like to play the fear card in ways that overstate the risk and make litigation seem far more probable than it actually is, especially in the small market. And, to be clear, most defined contribution plans in the U.S. are in the small market. In February 2018, the DOL released its Private Pension Plan Bulletin which evaluated data from 2015 Form 5500 Annual Reports. According to the data, there were 648,252 defined contributions in 2015, and 610,495 (or 94%) had less than $10 million in plan assets.
Finally, there’s the cost issue when considering a 3(38) advisor. Most firms charge more for 3(38) services because of the assumption they are taking more risk. In many cases, these fees can be 20-25% higher than 3(21) services. Is the benefit worth the additional cost? Only you can decide.
So in light of all this, the fundamental question remains: should you hire an ERISA 3(38) advisor for your plan? It really depends on whether you want to retain the control to select the investments for your plan or outsource that control. Here’s the thing—the vast majority of firms that specialize in retirement plan consulting can be either a 3(21) or 3(38), so the best course of action in my opinion is to choose the best advisor for your plan and then decide how to engage them. Here's 6 qualities you should look for:
In my opinion, hiring the right retirement plan advisor is the single most important decision you make when it comes to shaping the financial future of your employees and their families over the next 10, 20, or 30 years. That’s because the right advisor is going to provide the advocacy, insight, and leadership to engineer, optimize, and drive your plan forward in a way that gives your people the highest probability of retirement success. Moreover, while all service providers make valuable contributions, I believe there is none more important or more impactful than the leadership of a capable, effective fiduciary advisor.
If you’d like to learn more about how my firm helps companies drive successful retirement outcomes for their employees and minimize risk for their retirement committee members, please read about our consulting services.