Understanding 3(38) Investment Manager Services

shutterstock_260251187_blog.pngIn recent requests for proposal (RFPs) that we have responded to for prospective clients, I have noticed an increase in the number of plan sponsors asking us about 3(38) investment manager services to their plan. In many cases, the questions appear to be boilerplate language included from an RFP template, but in certain instances, we are seeing plan sponsors specifically seeking to delegate investment authority to a firm that will contractually agree to serve the plan as a 3(38) investment manager.

Given the increased interest level I thought it would be helpful to give a quick overview of what that means, the benefits and drawbacks of a 3(38) investment manager, and what we are seeing from clients.

In a 3(38) role, the plan sponsor delegates to an investment advisor the discretionary authority to select the investment managers available within the plan. In a 3(21) role, the investment advisor will still serve as a fiduciary for the investment advice provided, but the plan sponsor's fiduciary committee would maintain the ultimate decision-making responsibility with respect to the investment options available within the plan.

The primary benefit of the 3(38) scenario is the plan sponsor's ability to delegate explicit fiduciary responsibility and decision-making to a qualified, prudent expert. While potentially beneficial in some scenarios, there are drawbacks. 

First, plan sponsors still maintain a fiduciary responsibility to oversee the vendors to their plan. In this case, while they have delegated investment decisions, they still need to implement a due diligence process to evaluate the quality of the work  the 3(38) fiduciary is providing to the plan. In practice, there is less consensus as to what prudent oversight of a 3(38) fiduciary consists of, and may create risks for the plan sponsor if they are not diligent in their oversight.

Second, most firms willing to serve as a 3(38) fiduciary will only accept that responsibility in scenarios where they can implement their investment decisions. In 403(b) plans, often the majority, if not all, of the plan assets are held in individually-owned insurance contracts. When individually-owned insurance contracts are used within the plan, the insurance company will not take investment direction from the plan sponsor or its delegate (the 3(38) provider). Because the 3(38) fiduciary cannot implement their investment choices within the individual contracts, they are unwilling to accept fiduciary responsibility for the assets invested in those contracts. As a result, the plan sponsor will still maintain fiduciary responsibility for a large portion of the plan.

Lastly, choosing a 3(38) investment fiduciary removes any flexibility the plan sponsor has in making decisions regarding the plan. Initially, there is likely to be a higher volume of turnover within the investment menu as the 3(38) fiduciary implements their preferred set of investment options. On an ongoing basis, there is less ability for the plan sponsor to add unique investment options if they do not meet the standards of the 3(38) fiduciary.

Selecting a 3(21) fiduciary advisor provides the plan sponsor with the advice of a qualified, prudent expert while still retaining control over the investment menu. In this scenario, the plan sponsor retains fiduciary responsibility for the investment decisions within the plan. While they are not able to delegate away all of their responsibility, as mentioned previously, in either scenario they are not able to eliminate all of their fiduciary responsibility. 

The primary benefit of the 3(21) model relative to the 3(38) model is the flexibility it affords the plan sponsor. This manifests itself in a few different areas. First, the investment menu can typically be more tailored to the needs of the individual plan. Examples of this include the use of an all-index based menu, the selection of certain socially responsible investment options, or the inclusion of specific asset classes. Second, the flexibility manifests itself in the timing of investment decisions. For example, the plan sponsor may decide it is willing to wait a few months to make an investment change within the plan because many participants are off campus for summer break or they are receiving a lot of communication regarding the health plan.

At Multnomah Group, we have the ability to serve our clients as a fiduciary either under ERISA Section 3(21) or 3(38), depending on the preference of our clients. While we see more inquiries about 3(38) investment management services, when faced with a loss of control, the majority of clients select the 3(21) model.

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