Don’t Let 3(38) Fiduciary Confusion Entangle Your Plan

Plan sponsors must take as much time as necessary to understand what it means to hire a 3(38) discretionary investment manager; setting clear goals and expectations is critical.

According to Curcio Web Chief Compliance Officer and Consultant Elliot Raff, it doesn’t happen very often that a plan sponsor decides to go down the 3(38) investment outsourcing route and totally misunderstands what they are signing up for in terms of handing over fund menu discretion.

“However, there are occasionally some misunderstandings about the nitty-gritty details, which can be unsettling for plan sponsors,” says Raff, whose firm acts as a matchmaker between fiduciary investment advisers and retirement plan sponsors.

Besides consulting with plan sponsors, a big part of Curcio Web’s business involves tracking the work of retirement plan advisers and other entities that provide Employee Retirement Income Security Act (ERISA) Section 3(38) outsourced fiduciary investment management services. Raff says providers in this space are constantly reevaluating their service models, and so plan sponsors may benefit from conducting a review of potential services providers. 

Phil Edwards, principal of Curcio Webb, explains that many of his firm’s clients are investigating 3(38) service providers because they lack internal expertise or sufficient time to allow staff to do the hard work of retirement plan investment monitoring.

“The biggest issue we hear about from our plan sponsor clients is the resource issue,” Raff agrees. “They need to free up time to allow staff to focus on the business.”

When it comes to helping plan sponsors make the most of 3(38) relationships, Raff and Edwards say setting goals and expectations up front is of paramount importance.

“One of our first questions for plan sponsors considering hiring an outsourced investment fiduciary is, what is the objective here?” Raff says. “What ideal outcomes are we managing to? This is important for defined contribution plans, but it is especially important for pension plans that are bringing in an outsourced chief investment officer. For example, when you have a pension plan sponsor that is leveraged and has constrained cash flows, they simply can’t afford to have a big bump in required contributions due to a downturn in the market. This is the sort of thing that should be articulated at the start of a 3(38) relationship.”

Raff and Edwards say plan sponsors must take as much time as necessary to understand these issues. Some questions to explore ahead of a 3(38) review process include the following: What functions does the sponsor want to hold onto? What functions is the company comfortable handing over? And what functions does the sponsor really want to get rid of?

“This is the line of questions that should drive and define a well-documented delegation of duties,” Raff adds. “You need to start thinking about the specifics at the earliest stage of the process. I think some companies may be thinking about jumping on the outsourcing bandwagon without really understanding why or what it means.  They hear about outsourcing as a way to reduce their liability and the amount of time they spend on the plan. But we know it’s much more than that.”

“We should clarify that these are not questions that plan sponsors are going to be able to just answer right off the bat if they have not thought about this sort of thing before,” Edwards says. “For plan sponsors just starting out, the RFP process itself can be a part of the learning curve. By the time you will have reviewed all the responding firms, you can get a good foundation for deciding what you want.”

Joe Connell, partner, retirement plan services, at Sikich Financial (and a former winner of a PLANSPONSOR Plan Adviser of the Year designation), says in his many years serving plan sponsors in this capacity, he has not had a lot of experience with clients regretting going down the 3(38) route. He credits this to the fact that he and his clients make it a priority to establish clear ground rules at the outset of the relationship.

Giving up investment selection and monitoring

Plan sponsors need to carefully consider the level of outsourcing they are comfortable with. Some plan sponsors just won’t feel comfortable giving over full investment menu discretion to an outside adviser, and that’s okay. These plans may be a better fit for 3(21) service, wherein the investment process is much more collaborative and discretion remains with the sponsor.

In Connell’s experience, even when a plan sponsor brings on an outside discretionary fiduciary under ERISA Section 3(38), the client is not necessarily trying to remove themselves entirely from all plan-related decisions. Instead the move is more about getting the right expertise in place for the challenging task of investment selection and monitoring, by the same token freeing up time for the plan sponsor to worry about other things.

Scott Matheson, managing director, defined contribution practice leader at CAPTRUST, says plan sponsor demand for 3(38) services continues to grow at a strong pace. According to Matheson, nearly all of the RFPs the firm filled out last year asked about 3(38) capabilities, and many of those asked for 3(38) pricing, even if the intent of the plan sponsor issuing the RFP was the hiring of a 3(21) adviser.

“To the extent we see friction points with plan sponsors accepting a 3(38) engagement, it tends to come during the transition period as plan sponsor employees and/or committee members are settling into their newly evolved roles,” Matheson says. “Much of this, however, can be reduced or avoided by proper expectation setting and by advisers ensuring a good fit for plan sponsors before transitioning them to a 3(38) service model.”

Matheson agrees that plan sponsors that are very interested in the investment selection and monitoring process are likely not good fits to transition to a 3(38) approach and, as such, would likely experience more friction during a transition period. 

Monitoring the 3(38) investment manager

When they engage us as a 3(38) investment manager, clients often ask how they should monitor us,” Matheson observes. “We have a unique perspective in answering this question because, in the course of business, we evaluate and monitor the investment managers whose products are present in our clients’ investment lineups. In fact, we have a dedicated team doing this every day, and the rigor we apply to that process influences how we suggest that you monitor a plan-level investment manager.”

Matheson shares a long list of questions plan sponsors should consider:

  • Has the investment manager acknowledged in writing that it is acting as a plan fiduciary? 
  • Is the investment manager adhering to the plan’s investment policy statement (IPS)?
  • Is the investment manager selecting plan investment options consistent with the plan’s IPS?
  • Is the investment manager monitoring (and replacing, if needed) investment options consistent with the plan’s IPS?
  • Does the investment manager report performance compared to each strategy’s objective, appropriate benchmarks, and peer groups?
  • Does the investment manager provide adequate rationale and documentation for investment changes made?
  • Does the investment manager work with your provider to execute fund changes on your behalf?

Matheson also suggests that plan sponsors, after bringing in a 3(38) provider, periodically ask the investment manager questions about its organization, perhaps annually, to ensure the firm has not changed in a significant way that could impact its ability to fulfill its duties.

When conducting these annual reviews, Matheson says the following questions are relevant:

  • Have there been any changes to the management or ownership of the firm?
  • Have there been any organizational changes to the firm that may impact plan management?
  • Has there been a change to the firm’s status under the Investment Advisers Act of 1940? 
  • Has the firm been the subject of an investigation by any regulatory or government agency?
  • Has the firm been routinely examined by regulators or independent auditors? 
  • Has the firm been the subject of any litigation (settled, pending, or threatened)?
  • Have there been any material changes to the firm’s fidelity bond or errors and omissions insurance?
  • Have there been any changes to the firm’s written fiduciary status related to the plan?
  • Have there been any changes to the firm’s roles and responsibilities related to the plan?
  • Has the firm disclosed all sources of compensation?
  • Does the firm have any conflicts of interest with any of the plan’s investment managers or other providers?
  • What are the investment manager’s 3(38) assets under advisement? 
  • What is the total number of plans for which the investment manager acts as 3(38)?