Creating a Superior ERISA 3(38) Appointment Framework

Contributor Scott Simon provides a blueprint for the best way to legally protect a plan sponsor when appointing a 3(38).

W. Scott Simon

There are myriad products in the marketplace that service providers to 401(k) plans–say, insurance companies–offer to plan sponsors. These products include so-called “fiduciary warranty” services, “indemnification and hold harmless” services, “fiduciary support” services, and “third-party fiduciary” services.

The marketing materials for these services claim that the insurance company itself will take on fiduciary responsibility pursuant to section 3(21) of the Employee Retirement Income Security Act of 1974, or ERISA. Other such services include the insurance company providing a 401(k) plan with a Registered Investment Advisor that will be an ERISA §3(38) investment manager–that is, one acting as a third-party fiduciary–to select, monitor, and (if necessary) replace the investment options on the investment menu of a 401(k) plan. I’ve never seen a case where an insurance company (or, for that matter, a brokerage firm or mutual fund company) itself provides 3(38) services; that’s why, in previous columns, I’ve referred to these entities in such situations as “scaredy cats.”

As a general proposition, the materials marketing these services not only can be misleading, but they can also harm a plan sponsor that gets sucked in by such marketing sweet talk by inducing detrimental reliance on its part. (“Detrimental reliance” is a legal term that means, in effect, that I relied on your word, which hurts me because it was a material lie.)

Let’s ignore marketing materials and turn to the contracts that govern what services will actually be delivered to a plan sponsor (on behalf of the participants and their beneficiaries in the plan). A careful examination of such a contract reveals that the sponsor must do everything right–note all the conditions imposed on the sponsor in these contracts before an insurance company will provide coverage as, say, an ERISA 3(21) fiduciary.

But if a plan sponsor does everything legally and correctly, then it doesn’t need coverage by the insurance company. That’s why an insurance company can give such services away for free or sell them to a sponsor for a small amount of money. The insurance company will very likely never be required to perform on behalf of the plan sponsor. Heads the insurance company wins, tails the sponsor loses. Such are the shenanigans that go on in a nonfiduciary investment milieu.

A particularly egregious example of an indemnification and hold harmless service peddled to sponsors of 401(k) plans is one that claims to provide the same level of fiduciary protection as that provided by an ERISA section 3(38) investment manager.

One such service offered by a large and well-known insurance company–I’ll call it Big Insurance Co.–claiming to provide the same protections for a plan sponsor as an ERISA section 3(38) investment manager is absolutely false–despite its marketing materials saying the contrary.

Relevant text from Big Insurance Co.’s indemnification agreement reads:

“The Plan Fiduciary remains responsible for discharging its fiduciary duties with the care, skill, prudence, and diligence as required by ERISA with respect to: (i) the selection of the Group Contract and its investment options; (ii) monitoring the investment options available to the Plan through the Group Contract; and (iii) determining that such investment options continue to be prudent investment options for the Plan’s participants and beneficiaries.”

Note that the preceding text references the Plan Fiduciary (the plan sponsor, usually) as retaining fiduciary responsibility for selecting and monitoring a plan’s investment options and for determining that they continue to be prudent. In fact, the whole point of retaining a 3(38) investment manager is to rid a plan sponsor of such responsibilities (and any associated liabilities). On the face of it, then, this particular indemnification agreement is nonsensical–especially when the marketing materials referring to it promise the opposite benefits–that is, those provided by a 3(38) fiduciary.

Other text from this same indemnification agreement states: “A breach by the Plan Fiduciary of the prudence or diversification requirements under subparagraphs (B) and (C) of section 404(a)(1) of ERISA in its selection and monitoring of the investment options provided through the [Big Insurance Co.] Separate Account under the Group Contract funding the Plan …”

Note that the preceding text fails to include coverage for ERISA section 404(a)(1)(A), which is the duty of loyalty. The breach of that duty–the most fundamental duty in the law of trusts–is always pleaded in lawsuits. So there is no coverage for that crucial fiduciary duty. That omission, alone, makes this agreement less than satisfactory.

The assertion that an indemnification agreement like that offered by Big Insurance Co. provides more protection than a 3(38) investment manager is nonsensical. That comparison, on its face, is not one of apples to oranges, but rather one of apples to the Easter Bunny.

Sponsors of 401(k) plans that wish to reduce their fiduciary duties and liabilities for investment decision-making need not fool around with deceptive fiduciary warranties and the like, which ultimately can financially harm participants in 401(k) plans.

Instead, they can go for the real deal and appoint a 3(38) investment manager. But plan sponsors should do so in a way that provides maximum fiduciary protection for them. There must be authorization in the plan document to make such an appointment. Failing that authorization, the board of directors of the plan sponsor must pass a resolution providing for authorization to appoint before delegation to any 3(38) can take place.

The best way to legally protect a plan sponsor when appointing a 3(38) would be for it to appoint, say, a retirement plan committee and provide that one of the committee’s powers would be to conduct searches for, and retentions of, a 3(38) investment manager. Upon completion of a successful search, the committee–not the sponsor–would then enter into a written agreement with, say, an RIA in which the RIA acknowledges that it will be the plan’s 3(38) fiduciary.

A plan sponsor that creates a retirement plan committee and delegates to it the sole authority to hire and fire 3(38) investment managers has effectively created a legal “short circuit” that cuts it off from the legal responsibility (and liability) that the sponsor otherwise inherently assumes under ERISA for selecting, monitoring, and replacing a plan’s investment options.

In doing so, the sponsor obtains additional legal protections: Creating a retirement plan committee as described means that it’s the sole investment duty of the committee–not the plan sponsor–to ensure not only that the committee’s initial selection of the 3(38) was prudent but also to ensure on an ongoing (that is, a monitoring) basis that retention of the 3(38) continues to be prudent.

In sum, the plan sponsor in this kind of framework is legally off the hook for any duties (and liabilities) involving the selection, monitoring and replacement of plan investment options, as well as for any duties (and liabilities) associated with monitoring the 3(38) itself. That all resides with the retirement plan committee. As can be seen, then, appointing a 3(38) can be even more valuable to plan sponsors when done with more (legal) imagination.

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.

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