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3(21) Versus 3(38) ERISA Investment Fiduciaries — Decoding the Numbers

Posted By NIPA Headquarters, Tuesday, September 3, 2013

By Kimberly Shaw Elliott, Attorney at Law

This is the first in a series of three briefs concerning investment advice and fiduciary responsibility.

What is the difference between a 3(21) and a 3(38) investment fiduciary? This question is being asked with increasing frequency, and the answer provides a host of planning opportunities for both the plan sponsor and the producer providing investment services to the plan. Despite the popularity of the question, many remain confused about the distinctions relating to these important numbers.

Executive Summary
A 3(21) investment fiduciary is a paid professional who provides investment recommendations to the plan sponsor/trustee. The plan sponsor/trustee retains ultimate decision-making authority for the investments and may accept or reject the recommendations. Both share the fiduciary responsibility. By properly appointing a monitoring an authorized 3(38) investment manager, a plan sponsor/trustee is relieved of all fiduciary responsibility for the investment decisions made by the investment professional.

Analysis
Decoding 3(21) versus 3(38) fiduciaries is found in the section numbers of the law itself. The Employee Retirement Income Security Act of 1974 ("ERISA”) is the major law governing the operation of employee benefit plans. Section 3 of ERISA contains the definitions of the terms used in the act. The 21st definition (ERISA Section 3(21)) is the definition of fiduciary. A fiduciary is:
1. Anyone who makes decisions about managing the plan or its investments, such as selecting the investment choices for participants or hiring persons who provide services to the plan;
2. Anyone who makes decisions about administering the plan, such as determining eligibility of participants, providing benefits statements and ruling on benefits claims, or
3. Anyone who is paid to provide investment advice to a plan.

Typically, the plan sponsor/trustee makes the first category of decisions, while the plan administrator makes the second category of decisions. To meet the third category, one must provide investment advice, which currently  includes recommendations to invest in, purchase or sell securities:

  • On a regular basis to the plan
  • Pursuant to a mutual agreement, arrangement or understanding, written or otherwise
  • That the services will serve as a primary basis for investment decisions
  • Individualized to the needs of the plan
  • For a fee

Fiduciaries bear a high level of responsibility. A fiduciary has the duty to:

  • Operate the plan only in the interest of participants and beneficiaries, for the sole purpose of providing benefits and paying plan expenses
  • Act "prudently,” meaning how a professional would perform under similar circumstances
  • Diversify the plan's investments in order to minimize the risk of large losses
  • Follow the terms of plan documents written to govern the plan
  • Avoid conflicts of interest with the plan

Anyone who is a fiduciary is a 3(21) fiduciary because that is simply the number of the section in ERISA that contains the overall definition. This includes the plan sponsor, trustee, plan administrator and investment fiduciary.

 

An investment fiduciary is a paid service provider that gives investment recommendations but does not necessarily have discretionary authority to make the actual investment decisions. Instead, the 3(21) investment fiduciary typically provides suggestions to the plan sponsor, who is free to accept or reject those recommendations and who must then execute the investment decisions for the plan. The plan sponsor and the 3(21) investment fiduciary, therefore, share fiduciary responsibility.

The 38th definition in the act (ERISA Section 3(38)) is the definition of investment manager. An investment manager is special type of fiduciary, one who has been specifically appointed to have full discretionary authority and control to make the actual investment decisions. The manager may select, monitor, remove and replace the investment options offered under the plan. Only certain types of financial institutions may be appointed as a 3(38) investment manager. The 3(38) must be a registered investment adviser, bank or insurance company and must acknowledge its fiduciary status in writing. It is important that service agreements be carefully drafted to provide for both the appointment of a 3(38) and for the acknowledgement of fiduciary status.

 

Once properly appointed, the 3(38) investment manager has full fiduciary responsibility for its investment decisions, subject to the terms of the plan documents and its investment policy statement. The plan sponsor and all other plan fiduciaries are relieved of all fiduciary responsibility for the investment decisions made by the investment manager. The plan sponsor does have a continuing responsibility to monitor whether the investment manager is actually performing the services but need not second guess its investment decisions.

This shifting of fiduciary responsibility is the key distinction — and core advantage — of using a 3(38) investment manager. In the face of ever-increasing litigation and heightened regulatory scrutiny, many plan sponsors want this extra layer of protection, especially if they are not comfortable making the plan’s investment decisions themselves.

Next month, we will examine the various accountabilities associated with three different models to deliver investments to retirement plans so that plan sponsors may better select whether they wish to work with a non-fiduciary registered representative, a 3(21) investment fiduciary or a 3(38) investment manager.

 

Kim Shaw Elliott is a partner at Roberts Elliott, LLP, specializing in retirement investment law. She helps clients integrate the complex rules founded in ERISA/employee benefits, securities law, broker dealer regulation, insurance and tax into actionable advice. Contact her at (618) 223-1479 or kelliott@roberts-elliott.com.

For more content from NIPA, join an elite community of retirement industry TPA business owners at the 2018 Business Management Conference (2018BMC), January 13-15 in Scottsdale, Arizona. Learn more and register today!

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Choosing the Right Type of Investment Assistance

Posted By NIPA Headquarters, Tuesday, September 3, 2013

By Kimberly Shaw Elliott, Attorney at Law

(Last month, we examined the question of who is a 3(21) versus a 3(38) investment fiduciary. In this installment, we look at the three traditional models for how investments are delivered to retirement plans and when it is preferable for a plan sponsor to use each type. Next month, we will consider what due diligence measures can be followed in making that selection.)

Plan sponsors often need help selecting the investment options for a plan so they may wish to engage professional assistance. Choosing what type of help may seem like a confusing task. A TPA may bring extra value to a relationship by educating a plan sponsor about what types of guidance are available and what impact each type may have on the sponsor’s own fiduciary liability. 
There are three traditional models for delivering investments options to retirement plans: registered representatives, investment advisers and investment managers. Each arrangement offers a different level of service and protection to plan fiduciaries and different compensation rules apply to each model.

Registered Representative
A registered representative of a broker dealer provides investment education that assists the plan sponsor in making the investment choices for the plan. The plan sponsor retains full discretionary authority to select the plan investments and uses information gained from the registered representative to guide his or her own decisions. Since no investment advice is given and no investment authority is granted, the registered representative is not a plan fiduciary and is not held to a fiduciary standard of care. He or she is not bound to avoid conflicts of interest.

Since a registered representative is not a fiduciary, he or she may receive commissions and other charges assessed against each transaction, whether a buy or a sell. These commissions may vary, based upon the investment choices actually made. Revenue sharing is permissible and is a means to compensate the registered representative for continuing to service an account after the original commissions have been earned.

Investment Adviser
An investment adviser representative (IAR) delivers services on behalf of a registered investment adviser. As we learned last month, an IAR gives investment advice and is a fiduciary as defined in Section 3(21) of ERISA and under the Investment Advisers Act. When using a 3(21) investment adviser, the plan sponsor retains investment authority but uses the recommendations made by the adviser when selecting the investments. The plan sponsor and the adviser, therefore, share the fiduciary responsibility with the sponsor.

An investment adviser receives an annualized fee, based upon the value of the assets in the program. This level fee is payable each period, regardless of the number of transactions actually processed. Because advisers give investment advice, they are fiduciaries to the plans. As such, their compensation cannot vary with the investments selected because it would be considered a conflict of interest to use a fiduciary position to influence one’s own compensation. The conflict is removed if the compensation remains level, regardless of what investment is selected.

Investment Manager
Finally, sponsors might also select an investment adviser and grant that adviser discretionary authority to make the plan investments him or herself. If the plan sponsor properly appoints and monitors the activity of an investment manager, as defined in Section 3(38) of ERISA, the sponsor can be relieved of fiduciary responsibility for the investment choices made by the manager. The properly appointed investment manager bears the fiduciary responsibility alone.

Since a 3(38) investment manager exercises investment discretion, it is a fiduciary and follows the same level compensation scheme as a 3(21) investment adviser, described above.

How to Choose?
A plan sponsor, in considering what type of assistance to seek, must assess his or her own comfort level and skills and select the distribution model that best fits his or her own needs.

  • Registered Representative: Choose this delivery method if the sponsor is confident about making all the investment decisions, with the help of information from a professional, and having sole responsibility for those decisions.
  • Investment Adviser: This is a good choice for the sponsor who wants to retain the decision-making authority but needs some guidance and specific investment recommendations. The sponsor may want someone else to bear part of the investment responsibility. He or she must be prepared to pay a fee every year, regardless of how the investments perform.
  • Investment Manager: This option provides the most protection to the plan sponsor because it also involves the most relinquishment of control. This is not for the do-it-yourselfer. 

Here is a summary of the attributes of each model:

 

Kim Shaw Elliott is a partner at Roberts Elliott, LLP, specializing in retirement investment law. She helps clients integrate the complex rules founded in ERISA/employee benefits, securities law, broker dealer regulation, insurance and tax into actionable advice. Contact her at (618) 223-1479 or kelliott@roberts-elliott.com.

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