How 3(38) Advising Profits Clients

Art by Andrew Haener

There are plenty of important life tasks that few people choose to take on themselves, home renovations and auto repair being two. While it might be admirable to step up and assume responsibility for these missions that are so critical to one’s enterprise, most people lack the requisite knowledge, skills or tools, and turn to experts.

So it is with defined contribution (DC) plan sponsors, which have been increasingly handing off the crucial processes and duties of selecting and monitoring their plan’s investments to their adviser and/or other consultants in so-called 3(38) arrangements. According to the 2020 PLANSPONSOR Defined Contribution Survey, at least 40% of respondents—all plan sponsors—use a 3(38) adviser, though 29% were unsure whether their adviser served in 3(21) or 3(38) capacity.

“DC sponsors see their plans are increasingly important for workers’ retirement readiness,” says Michele Brennan, U.S. DC solutions leader at Willis Towers Watson in Chicago. “They realize the investments have to work harder and smarter.”
“The whole premise of the Employee Retirement Income Security Act [ERISA] is to put participants on track to a successful retirement,” says Nate Palmer, a managing director at Wilshire Associates, in Santa Monica, California. “If a sponsor doesn’t have investment expertise in-house, he should engage experts to create appropriate solutions.”

Defining Responsibilities

“3(38)” refers to that section of ERISA that defines an investment manager—a party that has been granted full discretion by the sponsor over selecting, monitoring and replacing the investment options in a plan. In contrast, 3(21) advisers give advice and recommendations to sponsor clients on their investments but do not take full responsibility; formal decisions and fiduciary risk are left to the sponsor.

To be clear, through a 3(38) manager, sponsors can never fully give up all fiduciary liability on investments. While they are not responsible for the funds themselves, they do retain an obligation to oversee the manager. Sponsors of all sizes need to address the fiduciary responsibility in their investment choices. “Your corner dry cleaner has the same ERISA liability as a Fortune 100 company,” cautions Michael Annin, senior managing director at Mesirow Financial in Chicago. “There aren’t separate rules for the micro-plan market, and you can still have a participant lawsuit.” Thus, providers have developed a new sub-industry of 3(38) services, and 3(38) capabilities have evolved for plans and advisers of all sizes.

The benefits to plan sponsors of engaging their adviser on a full-discretion 3(38) basis are many and extend beyond just fiduciary obligations. “While handing over the liability on investment selection and monitoring is a big part of the decision for some sponsors, for many others it’s a workload issue,” says Jeff Gratton, chief marketing officer at Sageview Advisors in Santa Monica, California.

“For smaller employers, the only involvement they want is to see that the contributions are transferred and notices go out on time,” says Jim Sampson, director of Hilb Group Retirement Services, in Cranston, Rhode Island. “They do want to improve participant outcomes, however.”

Clients are relieved of performing due diligence on each fund in their plan, explains Todd Kading, a co-founder and president of Leafhouse, a 3(38) advisory firm in Austin, Texas. “Our staff spends thousands of hours a year on [such] reports.”

Delegating the investment side lets sponsors focus on key compliance and administrative issues—plan design, participant communication, financial wellness—“all the things that are just as important in helping people,” Gratton says.

And it is not just plan sponsors that can outsource the investment monitoring function. Advisers without the requisite DC investment skills or scale in-house can outsource by engaging their own 3(38) adviser—third-party firms such as Wilshire Associates, Mesirow Fiduciary Solutions, Morningstar and Leafhouse Financial—each of which approaches the business a bit differently.

Compensation for Adviser Risk

Whether the benefits of a 3(38) arrangement entail additional fees to the plan depends on the adviser. The investment work is essentially the same under a 3(21) agreement or a 3(38). “Some would say advisers should charge extra for the additional liability you’re taking on,” Sampson says. “We generally don’t charge extra for 3(38). We use the same investment policy statement [IPS] and the same criteria in grading funds, and we explain it all to the committee the same way.”

What differs is the adviser’s increased liability. “There is clearly more liability for us, so there’s some extra cost to the client,” Gratton says. “That’s not significant, though, and it’s rare that a sponsor would look at the extra cost of a 3(38) as a negative—that isn’t what’s going to determine whether they engage us. It’s more about relinquishing control over the investments to an outside adviser.

“Rather than a question of putting in extra hours for the client,” he continues, “it comes down to an additional insurance liability and being sure we are compensated for that.” He reckons that Sageview charges an average of 15% higher fees under 3(38) programs.

While most trends in the DC world start at the largest plans and migrate down-market, delegating investment responsibility had its roots in smaller plans and worked its way up. “At smaller companies, the people administering the plan wear multiple hats, and an outsourced investment model made the plan more effective,” observes Brennan. “But with the growing complexity and importance of DC plans, larger plan sponsors also are finding the benefit of focusing on strategy and allowing the experts to implement the investments.” In its 2020 survey of DC plan sponsors—predominantly on the large end—Willis Towers Watson found that 15% of plans had adopted 3(38) structures, up from 6% in 2017.

The Ultimate Beneficiaries

Participants see benefits from 3(38) services, as well. One may be lower fees on plan investments. Kading says Leafhouse’s reviews of plan menus, besides finding underperforming funds, often turn up inefficiencies. “We might not change the fund, but we would change the share class.

“With our scale, we also have the ability to realize lower fees at the fund level,” he adds. “We may change a fund from an R6 share class to a collective investment trust [CIT] where we’ve negotiated a lower fee.”

Ultimately, participants can experience greater peace of mind, knowing that an expert is making the decisions regarding the investments and no committee member has undue influence, Gratton says. “To make up a hypothetical case, a committee member might have a passion for a fund investing in gold or a niche sector that’s not suitable. They should always be acting in the best interest of participants, but selecting prudent investments is what advisers do all day, which should reassure participants.”

A Question of Value

Many advisers perform investment selection and monitoring within the firm. Others see greater value in hiring an arm’s-length adviser.

“I can’t understand why an adviser who specializes in retirement plans would go to a third party,” says Sampson. “There are already too many cooks in the kitchen in servicing 401(k) plans—third-party administrators [TPAs], the adviser, the recordkeeper, and within each there are multiple individuals who touch a plan.

“Keeping our investment selection in-house makes us more efficient,” he argues. Doing so lets the firm scale down to one lineup per recordkeeper. “The reality is that many of the third-party 3(38) services provide advisers with a list of funds, and the adviser still has to pick from that list. There’s value to add by keeping the process internal.”

A change in perception is taking place, says Kading. Where many advisers were taught that “their biggest value added was in picking funds, … over the years they’ve started to realize there are many other factors more important to participants’ outcomes: education, plan design and [providing] consulting to the employer on its plan and business.”

Adviser firm size can govern the choice. “If a sponsor is looking to hire a firm such as ours to act as a 3(38) adviser, it would be keenly interested in our research capabilities and experience in selecting managers,” says Ryan Gardner, managing partner at DiMeo Schneider & Associates, in Windsor, Connecticut. “We have dozens of people involved in asset-class research, and there is an advisory committee whose job it is to help our consultants develop the best menus in that 3(38) capacity.”

Many candidates for third-party 3(38) services are advisers whose practice is predominantly in wealth management, plus having a few retirement plan clients. “Unless advisers really specialize in the DC space, they should be leery of taking on the fiduciary liability of a do-it-yourself 3(38) arrangement and consider a third-party service,” recommends Annin. He points to the investments in DC plans that can be foreign to wealth management, such as target-date funds (TDFs) and stable value accounts.

Annin also notes that third-party services provide ongoing monitoring for funds and share classes, as well as for changes in the broader marketplace. “Are you moving your clients into less expensive and more efficient products over time? That’s what the outsourced 3(38) adviser service is supposed to be doing.”

Another setting for third-party 3(38) services is among advisers practicing within broker/dealers (B/Ds), whose firms do not wish to take on the fiduciary risk internally. “That helps the adviser provide the service but not serve as the fiduciary,” says Palmer. He contends that by reducing the allocation of in-house resources, third-party providers enable more rapid growth of advisers’ franchises.

Direct to Participants

Besides providing 3(38) services to plan sponsors, advisers also work at the participant level, primarily through managed accounts. According to Willis Towers Watson’s 2020 plan sponsor survey, over half of plans offer managed accounts, across the size range—although Vanguard research, reporting similar availability, found that participant uptake across its recordkeeping universe is in only single digits.

With managed accounts, 3(38) services are an essential element and are rendered to the participant directly. Both Wilshire Associates and Leafhouse have a 3(38) hand in these services for several recordkeeping platforms.

Complexity Calls for Risk Management

Consultants and providers expect a growing market for 3(38) services: Complexity of the markets and regulations moves only in one direction, expanding the need for expert services. “Increasingly, we see annuities in DC plans, and they can be especially challenging in the due diligence process,” Annin says. Another source of growth is the looming availability of pooled employer plans (PEPs), which will require the same investment diligence as any other DC plan, and with which smaller employers will likely need help.

“Managing a plan can mean many things, and we think the sponsor has the opportunity to reimagine what its role is,” says Brennan. “Does it want to be running a plan, or choosing the investments? How much sole responsibility does it want to take on? Or does it want to partner with experts to help determine and implement the plan’s needs?”