How 3(38) Fiduciary Status May Benefit Your Practice
“Fiduciary”—it’s a ubiquitous term, heard often in retirement conferences and broadly used in client value propositions.

Many advisors have spent the past few years focusing on what kind of fiduciary they want to be. With enactment of the Department of Labor’s (DOL) Fiduciary Rule, which took effect in June  2017, it seemed that most advisors settled upon the role of becoming an Employee Retirement Security Act of 1974 (ERISA) Section 3(21) fiduciary. That is, until last month.

In mid-March, a 2-1 decision by the Fifth U.S. Circuit Court of Appeals vacated the DOL’s Fiduciary Rule. The court’s ruling effectively throws out the expanded definition of fiduciary advice, the related prohibited transaction exemptions, and the Best Interest Contract Exemption (known as the BIC exemption). There’s also the expectation that the U.S. Securities and Exchange Commission (SEC) will propose its own rule.

That leaves us asking two questions: Where are we now and where are we going?

ERISA provides two different models for delivering fiduciary investment support—ERISA 3(21) investment advisors and ERISA 3(38) investment managers. While becoming an ERISA 3(21) fiduciary seems to be the popular choice for many advisors, I think it is important for advisors to explore the ERISA 3(38) option.

3 Reasons to Become a 3(38) Fiduciary

ERISA 3(38) investment managers take on full discretionary responsibility for managing the plan’s investments. While ERISA 3(38) investment managers take on more fiduciary risk, I believe the relative risk, given the potential upswing in reward and business opportunities, makes exploring this option worthwhile for the seasoned retirement advisor. Here are three reasons why:

1.The value proposition of a 3(38) is a differentiation. Many seasoned retirement plan financial advisors have years of experience as 3(21) fiduciaries, long before the DOL proposed its fiduciary advice rule.  These 3(21) fiduciaries enjoyed a competitive advantage over non-fiduciary advisors.  I believe that becoming a 3(38) fiduciary now offers differentiation from 3(21) advisors. As noted above, ERISA 3(38) investment managers take on full discretionary responsibility for a plan’s investments, and that is an integral part of their value proposition.

Take, for example, a plan sponsor who is looking to be relieved of investment fiduciary responsibility. Unfortunately, many plan sponsors don’t understand the difference between 3(21) and 3(38) fiduciary services. Plan sponsors working with a 3(21) advisor might mistakenly believe that they have transferred their investment fiduciary responsibility to their 3(21) advisor, but that is far from reality. 3(21) advisors serve as co-fiduciaries to the plan—meaning that they only recommend investments based on specific due diligence and benchmarking processes.  The plan sponsor still makes the ultimate decision on the plan’s investments. As a result, the plan sponsor – even if working with a 3(21) advisor – is still very much an investment fiduciary to the plan and retains exposure and risk as an investment fiduciary.

A 3(38) investment manager, on the other hand, takes on full responsibility for the selection and monitoring of a plan’s investments. Plan sponsors can rely on the 3(38) fiduciary for their investment expertise. And let’s face it, many plan sponsors are not investment experts.

By assuming full investment fiduciary risk and responsibility, a 3(38) investment manager effectively eliminates the plan sponsor from the equation. Sponsors are not responsible for the 3(38) advisor’s investment decisions or actions. What plan sponsors are responsible for is choosing and monitoring their 3(38) advisor—and they should monitor their 3(38) investment manager as diligently as they monitor other partners, such as their record keeper.

Other steps plan sponsors can take to monitor their 3(38) investment manager include:

  • Holding periodic meetings to review investment performance and fees against benchmarks and Investment Policy Statement criteria;
  • Discussing investment-manager firm changes or changes in investment philosophy;
  • Reviewing compensation and disclosure of all sources;
  • Reviewing industry trends and any regulatory changes; and
  • Ensuring that the investment manager is maintaining the required fiduciary bond (ERISA Fidelity Bond).

2. You can readily scale your business. 3(38) investment managers can develop their own processes and methodologies for plan investment lineups and model portfolios. They can even develop custom target date funds. These processes and models can easily be replicated across existing books of business and adapted for prospects. Being a 3(38) investment manager allows for more flexibility in the mid-size market, where plan sponsors don’t necessarily have investment committees. (Larger plans generally have investment committees staffed by personnel with investment backgrounds who expect to be involved in the ongoing monitoring and selection of the funds available in their plan.) Being a 3(38) investment manager also clears the way into other lines of business, such a wealth management.

3. Becoming a 3(38) investment manager helps you justify your fees. With margins compressing, you might be wondering if it is truly a race to the bottom. For many plan sponsors who would like to limit their investment fiduciary liability, a 3(38) investment manager’s ability to take on investment discretion may be worth the price. Also consider that in the mid-size plan market, the 3(38) investment manager effectively plays the role of the entire investment committee. The work, investment expertise, and assumed risk that are shared by many in larger plans, now fall entirely and squarely on the 3(38) investment manager’s shoulders. This alone offers value to a plan sponsor.

The role of the fiduciary advisor continues to evolve.  I believe that ERISA-experienced professional retirement plan advisors now have a great opportunity to consider the marketplace differentiation, status, and potential business rewards offered by taking on the role of 3(38) investment managers.