W. Scott Simon
Sometimes when the sponsor of a retirement plan such as a 401(k) plan issues a request for proposal, it may include a requirement for proposers to provide the services of an investment manager pursuant to section 3(38) of the Employee Retirement Income Security Act of 1974, as amended (ERISA). A 3(38) investment manager accepts delegation from a plan sponsor to select, manage, and, if necessary, replace all (or some) of the investment options on a plan menu.
A proposer that responds to such an RFP can either provide the requested 3(38) services directly itself or it can indirectly provide such services by outsourcing them to a Big Third Party 3(38). In either case, ERISA section 3(38) mandates that the investment manager be (1) a registered investment advisor (that is, an “adviser” under the Investment Advisers Act of 1940, as amended), (2) a bank, or (3) an insurance company. A 3(38) must also acknowledge in writing that it’s a fiduciary with respect to the retirement plan in question.
In my view, there’s a significant difference in value between the direct and indirect provision of 3(38) services. A 3(38) that provides its services directly is free from the influence of an entity with the power to highly restrict the available universe of investment options from which an outsourced 3(38) must assemble a plan’s investment menu.
Who is responsible for such restrictions? In these RFP situations, it’s often insurance companies or stockbrokers. For example, say that an insurance company answers an RFP calling for a 3(38) investment manager. It will not provide those services itself but will instead turn to a Big Third Party 3(38) to provide them.
The insurance company requires a certain amount of revenue from a plan’s investment options to help pay for its services to the plan. So it provides the Big Third Party 3(38) with a restricted menu of options including, say, mutual funds and/or exchange-traded funds from which the 3(38) must select. That selection is usually made with a wink and a nod, because the 3(38) pretty well knows the magic revenue number required by the insurance company. After all, Big Third Party 3(38)s have well-established relationships with insurance companies which reward them with business. Insurance companies do not rain manna from heaven on Big Third Party 3(38)s because they are uncooperative.
Here’s how this setup appears to a plan sponsor in the contract that it enters into with one Big Third Party 3(38) that was kind enough to draft it:
“The [Fiduciary of the 401(k) Plan] acknowledges that [Big Third Party 3(38)’s] Services are subject to any limitations or changes in the investment universe generally made available to plans by the [insurance company’s] Recordkeeper, including, without limitation, any generally applicable investment option requirements, including any proprietary fund requirements. The [Fiduciary of the 401(k) Plan] further acknowledges and agrees that [Big Third Party 3(38)’s] Services may be subject to additional limitations imposed at the direction of the Plan’s financial professional.”
The preceding language means, in effect, that the Big Third Party 3(38) (legally, not only a fiduciary pursuant to ERISA section 3(21)(A)(ii) but also a discretionary fiduciary pursuant to ERISA section 3(21)(A)(i)) is subject to the whims of the insurance company’s record-keeper (a nonfiduciary).
I have said a number of times in this column over the years that, in the retirement plan marketplace, the inmates are running the asylum whenever non-fiduciaries control the activities of fiduciaries, such as in the 3(38) outsourcing milieu. Lest anyone forget what’s at stake in such situations, we are reminded by standard “including any proprietary fund requirements” language.
The preceding language comes through clearly enough but it’s even plainer in other language in this Big Third Party 3(38)-drafted contract:
“As [Fiduciary of the 401(k) Plan], you…further agree and acknowledge that our [i.e., Big Third Party 3(38)] determination of the Plan’s investment lineup will be subject to any limitations or changes in the investment option universe generally made available to plans by the [insurance company] Recordkeeper, including any proprietary fund requirements (such as the requirement that a certain percentage of investment options must be sponsored by the Recordkeeper [such as, say, a stable value fund from which the insurance company derives lots and lots of revenue]), regardless of whether the Recordkeeper has waived or modified such requirements for the Plan and that without such limitations our selection and monitoring of the Investment Option Menu would not necessarily be the same.”
In other words, as fiduciaries, we (i.e., Big Third Party 3(38)) are “subject to” the (financial) needs of the nonfiduciary record-keeper including any “proprietary fund requirements”– but we swear that if we weren’t straight-jacketed by this requirement, we might even be able to provide you (i.e., fiduciary of the 401(k) Plan) with a prudent menu of plan investment options.
Here’s some more contractual language detailing the limitations of the investment universe controlled by a nonfiduciary record-keeper:
“You [i.e., Fiduciary of the 401(k) Plan] acknowledge that the investment universe available to the Plan may be limited by service arrangements of the [insurance company] Recordkeeper and/or your Plan’s financial professional may change from time to time as a result of actions by investment providers or other parties (including the Recordkeeper) that are not within our control.”
In the preceding paragraphs, it sounds as if the Big Third Party 3(38) is helpless. In fact, it is pretty helpless, because the insurance company in this instance defines the parameters of the relatively small universe of investment options available to the 3(38) from which it must select a plan’s investment menu. To me, all this language points clearly to a blatant conflict of interest.
Speaking of conflicts of interest, here’s how the Big Third Party 3(38)-drafted contract treats them:
“We may also have relationships with investment managers, brokers, banks, custodians, insurance companies or other financial professionals that provide one or more investment options that may be included in the investment universe available to the Plan. As a result, a potential conflict may arise between the Plan’s interests and our interest in providing other services or in maintaining other relationships. Due to these potential conflicts, we may have an incentive to provide certain investment advice or to recommend certain securities or products over others that may also be suitable for the Plan.”
Note this key sentence in the preceding paragraph:
“Due to these potential conflicts, we may have an incentive to provide certain investment advice or to recommend certain securities or products over others that may also be suitable for Plan.”
In last month’s column, I cited the basic duty required of fiduciaries found in the common law of trusts: placing their clients’ interests ahead of their own. When there’s an “incentive” involved like that just described, the word “suitable” is cited rather than the ERISA fiduciary standard even though this is a contract involving ERISA fiduciaries and a fiduciary (a discretionary fiduciary, moreover, that should be making decisions) is being controlled by a nonfiduciary, then, as they say, something must be rotten in Denmark. And that, folks, is why I concluded in last month’s column that you just cannot fit a square peg in a round hole. You just cannot serve two masters.
“[Big Third Party 3(38)], using its own proprietary evaluation methodology, reviews the investment options your [insurance] Recordkeeper makes available to your Plan and provides a selection of investment options … which you [i.e., fiduciary of the 401(k) Plan] select for your Plan.”
In my view, the phrase in the preceding paragraph, “which you select for your Plan,” negates any fiduciary protection for a plan sponsor relying on the Big Third Party 3(38) that drafted this contract. In situations where a plan sponsor delegates sole responsibility and liability for selecting, monitoring and replacing the investment options on a plan’s investment menu to a 3(38), there should not be any language stating that it’s the sponsor that “selects” the investment options. That’s just crazy, and is a fundamental misreading of the law of ERISA. In fact, when a sponsor appoints a 3(38) to select a plan’s investment options, it does so precisely because it doesn’t want the responsibility and liability for making such selections.
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.