W. Scott Simon
Two kinds of qualified retirement plans provided for under the Employee Retirement Income Security Act (ERISA) are “participant-directed” plans and “trustee-directed” plans. An example of a participant- directed plan is a 401(k) plan, which is a defined contribution (DC) plan in which a plan participant (and the employer/plan sponsor if it so chooses) can make certain legally determined “contributions” to the participant’s plan account.
A trustee-directed plan, in contrast, can be either a DC plan or a defined benefit (DB) plan in which the sponsor of a DB plan is legally required to make certain actuarially determined contributions to the plan on behalf of a plan participant that will generate certain actuarially determined “benefits” to be paid to the participants in retirement. (Please note that this month’s column will discuss a qualified retirement plan that’s “trustee-directed”–and not a “directed trustee”–which is a whole different kettle of fish.)
Two questions posed to me recently raise some issues that advisors may wish to ponder as they are sitting around digesting their Thanksgiving dinner. First, in a trustee-directed DB plan where an advisor works with a plan sponsor on the pooled account, is the advisor an ERISA section 3(38) Investment Manager? (Such “work” would include creating and supplying an Investment Policy Statement, documenting the investment review process, and managing the portfolio in which the plan’s pooled assets are invested.) Second, is a plan sponsor and/or its advisor better off or worse off for choosing to stay with a trustee-directed plan instead of a participant-directed plan? (Let’s assume that the investments in both kinds of plan are the same.)
Recapping an ERISA Section 3(38) Investment Manager
ERISA section 3(38) provides that only a bank, a registered investment advisor, or an insurance company can become an “Investment Manager,” at which point it then also becomes an ERISA section 405(d)(1) “Independent Fiduciary.” A 3(38) has the sole responsibility (and liability) to select, monitor, and replace the investments in a qualified retirement plan.
When ERISA was first put on the books in 1974, the world of retirement plans was quite different from today. Most retirement plans were DB plans. A DB plan then (as now) held assets collectively in a “pooled account,” which was composed of a single portfolio invested on behalf all participants in the plan. The drafters of ERISA knew that the typical sponsor of a qualified retirement plan, including those at large companies, had little expertise in running a plan. That’s why they allowed plan sponsors to delegate some of their duties, with such delegations being subject to certain carefully defined safeguards. In the 3(38) sphere, for example, these safeguards include the requirement that the sponsor determine its initial delegation to the 3(38) to be prudent and the ongoing monitoring requirement that the sponsor determine its initial delegation continues to be prudent.
One cluster of these delegable duties involves plan investments. Under the ERISA statutory scheme, every plan sponsor has the inherent duty to select, monitor, and replace the investments in a qualified retirement plan whether they’re the pooled assets that are invested in the single portfolio of a trustee- directed pooled account in a DB plan, or the discrete investment options in a participant-directed DC plan.
A plan document, when properly drafted, provides for the appointment of an ERISA 3(38) Investment Manager. However, the actual process of appointing an ERISA 3(38) is rarely explained or provided for in detail in the plan document. It’s even rarer when a 3(38) is actually explicitly identified by name in a plan document. Nonetheless, there must be authorization to appoint a 3(38) in the plan document. Failing that authorization to appoint in the plan document, 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.
Far, far better for the legal protection of the sponsor when appointing a 3(38) directly 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 an advisor in which the advisor acknowledges (in blood) that it will be the plan’s 3(38) fiduciary.
When a plan sponsor creates a retirement plan committee and delegates to it the authority to hire and fire 3(38) Investment Managers of its own volition, the sponsor has effectively created a legal “short circuit” that cuts it off from the legal responsibility (and liability) that the sponsor otherwise inherently assumes for selecting, monitoring, and replacing the plan’s investments. In doing so, the sponsor obtains additional legal protection: Creating a retirement plan committee as described means that it’s the sole investment duty of the committee–not the plan sponsor–to ensure that the committee’s initial selection of the 3(38) was prudent and to ensure on an ongoing (i.e., monitoring) basis that retention of the 3(38) continues to be prudent. In sum, the plan sponsor in this situation is legally off the hook for any duties (and liabilities) involving the selection, monitoring, and replacement of plan investments, as well as for any duties (and liabilities) associated with monitoring the 3(38) itself.
Trustee-Directed Defined Benefit Plans
Now, back to the first question: In a trustee-directed DB plan where an advisor works with a plan sponsor on the pooled account, is the advisor an ERISA section 3(38) Investment Manager? Note that this “work” would include creating an Investment Policy Statement, documenting the investment review process, and managing the portfolio in which the plan’s pooled assets are invested.
In the case of a trustee-directed DB plan with a single portfolio invested in a pooled account, it’s very likely that the advisor working with the plan sponsor would be a 3(38) Investment Manager given the preponderance of this model in such situations. (In situations where this isn’t the case, the plan’s 403(a) Trustee ordinarily would be responsible–and liable–for the plan’s investments.) This answer is bolstered by the reference in the question that the advisor is “managing the portfolio” of the pooled account for the DB plan. Another such reference–“documenting the investment review process”–might also be construed as being 3(38) in nature because it could encompass the duty to monitor investments.
Trustee-Directed Defined Contribution Plans
A trustee-directed DC plan is, in essence, a managed account. I co-authored an article in the Journal of Pension Benefits in which we deemed such a plan to be a “non-participant-directed 401(k) plan.” This kind of plan is decidedly not a rerun of pre-ERISA days when most retirement plans were in a single pooled account with a single asset allocation for the benefit of all participants and invested by a plan’s 403(a) Trustee or delegated outside the plan to a 3(38) Investment Manager. Instead, in a non- participant-directed 401(k) plan, the 403(a) or 3(38) invests and manages individual accounts for plan participants with prudent asset allocations reflective of participants’ differing risk tolerances and investment time horizons.
A trustee-directed DC plan offers a number of benefits. For plan participants, there are two primary benefits. First, participants are no longer required to struggle with figuring out how to invest prudently in their 401(k) plan. Second, the odds are much better that a participant invested in a model portfolio composed of low-cost and deeply and broadly diversified (passively managed) funds will, over time, have generated greater investment wealth than one invested in high-cost and poorly diversified (actively managed) funds. Lowering costs helps keep more money in the pockets of plan participants just as lowering risk (and thereby reducing “variance drain”) helps keep more money in their pockets. Any investor’s investment behavior is sound when it’s focused on factors over which it has control–costs and risk–but it’s unsound when it’s focused on factors over which it has absolutely no control–the entirely random variable of achieving (or even predicting) some return.
For plan fiduciaries, there are two primary benefits with a trustee-directed DC plan. First, they’re no longer responsible (or liable) for the selection, monitoring, and replacement of plan investments if those burdens have been properly delegated to a 3(38). Second, plan fiduciaries no longer need to comply with the myriad rules of ERISA section 404(c). Compliance would be unnecessary because in a trustee- directed DC plan, participants aren’t allowed to direct the investment of their individual accounts (i.e., the participant “control” requirement of 404(c) becomes moot).
By the way, many trustee-directed DC plans continue to maintain a balance forward valuation system. In some circumstances, a better approach for such plans is to maintain a daily valuation system with segregated accounts. This type of system avoids a number of problems including those related to valuation. Note that participants are not allowed to make changes in their plan investments even in the presence of segregated accounts in trustee-directed DC plans.
Participant-Directed Defined Contribution Plans
An example of a participant-directed DC plan, as noted, is a 401(k) plan in which a plan participant (and its employer/plan sponsor if it so chooses) can make certain legally determined contributions to the participant’s plan account.
Now, back to the second question: Is a plan sponsor and/or its advisor better off or worse off for choosing to stay with a trustee-directed plan instead of a participant-directed plan? (Please assume that the investments in both kinds of plan are the same.)
A sponsor and its advisor are, in my opinion, generally better off with a trustee-directed DC plan. A trustee-directed DC plan eliminates the single most destructive element from the retirement plan equation: participant investment discretion. The DALBAR studies over the last 20-odd years show consistently that the great bulk of underperformance suffered by the average plan participant investor can be attributed to his or her poor investment decisions, many of which involve that time-honored technique of buying high and selling low. Eliminating the participant from the 401(k) plan equation has the potential of eliminating much of the underperformance identified by the DALBAR studies.
Most of the often unintentionally self-destructive participant investment behavior cannot be changed by any kind or amount of investment education provided by whatever source. Participants–often for very good reasons–are just not interested, nor will they ever become interested, in becoming junior financial analysts. The vast majority of participants are looking for simple solutions, and advisors should provide them.
My opinion is conditioned on the assumption that an advisor–whether or not it takes on discretionary 3(38) duties–provides model portfolios of transparent, low-cost, and broadly and deeply diversified investment options, and is working with a plan sponsor that can appreciate such an approach and supports it with great vigor. Indeed, the rest of the underperformance identified by the DALBAR studies can be eliminated largely by providing such plan investment options.
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™. The author’s views expressed in this article do not necessarily reflect the views of Morningstar.