W. Scott Simon
The phrase “3(38) vs. 3(21)” is often bandied about in the investment advisory profession. Its use is usually meant to delineate the difference between a discretionary investment fiduciary decision-maker (pursuant to section 3(21)(A)(i) of the Employee Retirement Income Security Act of 1974 (ERISA)) and a non-discretionary investment fiduciary advice-giver (pursuant to ERISA section 3(21)(A)(ii)).
Discretion is the lynchpin that separates the two kinds of fiduciaries; the former has it and the latter doesn’t. This seemingly small distinction can often mean a world of difference in retirement plans with respect to legally protecting plan fiduciaries as well as providing low-cost and well-diversified investment options to plan participants (and their beneficiaries).
But what if instead of “3(38) vs. 3(21),” a discretionary investment fiduciary decision- maker teams up with a non-discretionary investment fiduciary advice-giver? That is, instead of a 3(38) vs. 3(21) face-off, what about a “3(38) and 3(21)” team?
In the 3(38) and 3(21) team scenario, the former protects plan fiduciaries and provides plan participants with a menu of prudent investment options. The latter can provide plan participants with legally meaningful and objective investment advice.
The following memorandum is an example that explores the benefits of a 3(38) and 3(21) team versus a Big Insurance Company/Big Brokerage Firm/Big Consulting Firm team as they vie for the hand of a 401(k) plan.
The COOL team is composed of 1) COOL: a registered investment advisory firm and a non-discretionary ERISA fiduciary and 2) Prudent Investor Advisors: a registered investment advisory firm and a discretionary ERISA fiduciary. The Big Brokerage Firm team is comprised of 1) a Big Brokerage Firm (not any kind of fiduciary), 2) a Big Insurance Company (not any kind of fiduciary), and 3) a Big Consulting Firm (a non-discretionary ERISA fiduciary). The retirement plan is the XYZ 401(k) Plan, a relatively small plan that has been serviced by the Big Brokerage Firm team for a number of years.
To: Fiduciaries of the XYZ 401(k) Plan From: W. Scott Simon, J.D., CFP®, AIFA®
Subject: The Anatomy of a No-Brainer Decision Date: April 3, 2014
I have been asked by COOL to draft a brief memorandum for your review as you go about deciding which team of service providers to retain for your 401(k) plan. I am a principal with Prudent Investor Advisors, which, as you know, is part of the team assembled by COOL.
The Issue of Risk
Fiduciaries of retirement plans governed by the Employee Retirement Income Security Act (ERISA), such as your own 401(k) plan, have a lot of fiduciary duties they must carry out on behalf of their plan participants (and their beneficiaries). Among the most critical of these duties is to select, monitor, and (if necessary) replace the investment options offered by a plan.
In finalizing ERISA in 1974, Congress knew that sponsors of retirement plans such as you are not experts in plan investment options. It therefore provided a way for fiduciaries such as you to legally transfer your fiduciary investment responsibility (and associated liability) to another entity that would then assume same as an investment manager pursuant to ERISA section 3(38). The end result is that the 3(38) investment manager assumes sole fiduciary responsibility (and associated liability) for selecting, monitoring, and replacing a plan’s investment options. This is a significant off-loading of fiduciary duty and liability from the shoulders of any plan sponsor.
A plan sponsor such as you needs to make sure that its decision to retain a 3(38) investment manager is prudent a) initially (demonstrated by the due diligence process you are now conducting) and b) on an ongoing basis (demonstrated periodically through completion of a checklist of duties listed in the written contract between you and the 3(38) investment manager; among other things, this releases you from endless hours of poring over reams of statements and investment returns every quarter).
ERISA Fiduciaries: Discretionary or Non-Discretionary
The ERISA statutory scheme generally allows only three kinds of fiduciaries:
- A fiduciary that exercises any discretionary authority or control in the management of the plan or disposition of the plan’s assets (i.e., a “discretionary decision-maker” under ERISA section 3(21)(A)(i)).
- A fiduciary that can or does render investment advice for a fee (i.e., a “non- discretionary advice-giver” under ERISA section 3(21)(A)(ii)).
- The third kind of fiduciary is irrelevant to the discussion at hand because it is an administrative fiduciary, not an investment fiduciary.
With the foregoing statutory scheme in mind, the various players involved here can be sorted out according to whether or not they are ERISA fiduciaries and, if they are, what kind:
- Prudent Investor Advisors is an ERISA discretionary decision-maker (3(21)(A)(i) and 3(38)).
- COOL is an ERISA non-discretionary advice-giver (3(21)(A)(ii)).
- Big Insurance Company is not an ERISA (or any other kind of) fiduciary.
- Big Brokerage Firm is not an ERISA (or any other kind of) fiduciary.
- Big Consulting Firm is an ERISA non-discretionary advice-giver (3(21)(A)(ii)).
Based on the foregoing, it is now easier to understand the amount of fiduciary protection provided to plan fiduciaries such as you in descending order of protection:
- Prudent Investor Advisors: ERISA discretionary fiduciary decision-maker.
- COOL and Big Consulting Firm: ERISA non-discretionary fiduciary advice-giver.
- Big Insurance Company and Big Brokerage Firm: No fiduciary protection is provided at all since neither entity is an ERISA (or any other kind of)
Since neither Big Insurance Company nor Big Brokerage Firm is an ERISA fiduciary, it is clear legally that they are both non-players in your 401(k) plan as far as providing you, as plan fiduciaries (or by extension your plan participants and their beneficiaries), with any fiduciary protection. As such, neither Big Insurance Company nor Big Brokerage Firm has any duty to offer low-cost investment options and/or well- diversified ones. There is no legal (or non-legal) penalty that they will suffer for maximizing their own revenue at the expense of plan participants (including any plan fiduciaries who participate in your 401(k) plan).
Both COOL and Big Consulting Firm are non-discretionary advice-givers, so is there any real difference between them? Yes. COOL can (legally) and will (in fact) offer independent investment advice to your plan participants (in accordance with the “best interests” fiduciary standard of the Investment Advisers Act of 1940). In sharp contrast, Big Consulting Firm (or Big Insurance Company or Big Brokerage Firm, for that matter) has chosen not to offer any kind of investment advice to your plan participants for various legal and business reasons.
If you, as fiduciaries of your 401(k) plan, wish to transfer your fiduciary responsibility (and associated liability) for 1) selecting, monitoring, and (if necessary) replacing the investment options in your plan and for 2) the default investment options offered in the plan, then the only legal way to achieve those goals is with the COOL team. If you wish to provide your participants with independent, objective investment advice, then this team is your only option since these goals cannot be accomplished by any member of the Big Brokerage Firm/Big Insurance Company/Big Consulting Firm team.
Even if you do not wish to achieve any of the foregoing goals, it would still make sense for you to retain the COOL team. Why? Significantly lower costs.
The Issue of Costs
Big Brokerage Firm uses the example of a portfolio with a 60/40 ratio of stocks to bonds and says that its cost is about X basis points (100 basis points = 1.00%). The 60/40 model portfolio offered by Prudent Investor Advisors, in contrast, costs about Y basis points–or a fraction of the cost of the portfolio offered by Big Brokerage Firm.
Big Brokerage Firm contends that it has the ability to offer low-cost index funds. Indeed it can. But if it were to do that, it would have to boost its revenue requirements elsewhere among your plan’s investment options by including on the menu, for example, a Big Insurance Company stable value fund and proprietary funds. If you were to insist that Big Insurance Company not include a stable value fund or any of its own funds, and not be paid any 12(b)-1 or Sub T/A fees–that is, be only a record- keeper and be paid only for such–that might well produce an apoplectic reaction on the other end of the line.
In addition to being far lower in costs, any model portfolio offered by Prudent Investor Advisors is broadly diversified (across all the asset classes in a portfolio) and deeply diversified (within each asset class in a portfolio) to reduce risk and enhance return.
Each portfolio holds thousands of securities from many countries around the globe and includes all major asset classes. Broad diversification of a portfolio can limit the harmful effects of decreases in portfolio value and generate enhanced returns. While everyone likes big returns, it is far more important to avoid the risks to portfolio values posed by large losses (in accordance with ERISA section 404(a)). Big Insurance Company would not offer your plan participants anything close to the diversification found in the portfolios offered by the COOL team.
If, as fiduciaries of your 401(k) plan, you wish to 1) transfer the significant (and personal) fiduciary responsibilities and liabilities you owe to your plan participants (and their beneficiaries) that have been discussed in this memorandum to an ERISA section 3(38) investment manager, 2) provide your participants with legally meaningful and independent investment advice, and 3) provide low-cost, and broadly and deeply diversified investment options to your plan participants, then your decision is an easy one: retain the COOL team. The team assembled by the Big Brokerage Firm cannot legally provide you with what the COOL team can, nor will it actually provide it, because, given its business model, it chooses not to.
If, however, the foregoing tangible (legally and actual) benefits brought to you by the COOL team are not important to you, then your decision is an easy one as well: retain the Big Brokerage Firm team.
In either case, your decision is a no-brainer.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.