Why More Advisers Are Assuming 3(38) Role, Responsibility

Art by Lars Leetaru

The Employee Retirement Income Security Act Section 3(38) fiduciary designation can often mean more work for an adviser, since it assigns decision-making responsibility. It also means a conversation with a plan sponsor that likely leads to a higher fee. Even so, the industry is trending toward more advisers seeking, and taking on, the role of the 3(38) in order to manage what is increasingly complex, and important, investment strategies.

“I would tell you that we do see a trend,” says Kathleen Kelly, managing partner at Compass, which is involved in both the 3(21)—in which advisers guide on investments, but leave decisions to the plan sponsors—and 3(38) capacity.

“Traditionally, we have thought more about 3(38) for our smaller clients, those that may have less sophistication, experience, expertise and internal resources to support decisionmaking. But in fact, we’ve seen some of our largest clients transition from 3(21) to 3(38).”

Part of the shift to 3(38)s has come amid a volatile and uncertain investment market in recent years, ranging from the COVID-19 pandemic to inflation to interest rate hikes. According to PLANADVISER’s most recent Adviser Value Survey, about 15% of DC plan sponsors had 3(38) fiduciaries, about 31% had 3(21) fiduciaries and a startling 24% were unsure of which type of adviser they had. While that puts 3(38) at the lower end of the spectrum, there is often potential to shift a client to that relationship with time, Kelly says.

A plan sponsor might first hire an adviser as a 3(21), Kelly says, but once the client becomes comfortable with the firm’s internal processes, philosophy of menu construction and monitoring, they then feel confident changing to a 3(38).

Brandon Budd, a consultant at Intellicents, agrees that clients will often consider switching to a 3(38) setup. He used the example of a client his firm had worked with for many years as a 3(21). During one of their catch-ups, Budd’s team mentioned the option of the 3(38) and shift in fiduciary duties that it would bring, among other benefits.

Budd recalls the client saying, “We take all the recommendations that you already make, we’ve hired you to outsource this and we trust you with these responsibilities We absolutely want to move into that role where you’re saying we have more protection and more liability off of our shoulders.”

Budd thinks the more that advisers have that conversation with plan sponsors, the more employers will move to the 3(38) capacity. He says Intellicents can fulfill both roles but has had more engagement on the 3(38) recently.

3(38) vs 3(21)

Kelly suggests that an advantage of being a 3(38) is that an employer does not have to be involved in a process with which they aren’t comfortable.

“They’re busy running a company, and chances are, they don’t have any expertise in investment management or investments in general,” she says. “It just makes more sense for them to outsource that decision.”

In addition, in a 3(38) role, advisers can streamline the process and make changes more quickly, says Jim Sampson, director of retirement advisory services at Hilb Group Retirement Services. As a result, employees are invested in underperforming funds for less time.

Another advantage of the 3(38) scope is that the firm accepts the full fiduciary status, which is what Budd has seen as what many employers and plan sponsors want.

“Most times when we have the conversations between 3(21) and 3(38), most employers and plan sponsors out there are trying to limit their liability as much as possible,” he says. “That’s why I think we have seen so many more go the 3(38) route than the 3(21).”

However, for employers who want full decisionmaking power, a 3(38) adviser does not offer that oversight for the employer.

“If they want to have control over the process, that doesn’t work with a 3(38),” he says. “Occasionally, clients will express their kind of fear of letting go. But they get over it pretty quick once they realize how easy the process is.”

On the other hand, the 3(21) offers employers a level of control that company leadership might prefer. For example, if an employer has an investment committee that is fully involved in researching funds and making decisions, then a 3(21) could be a preferable option.

“I spoke with a group late last year,” Budd says. “They’re in the investment business. They decided to go with somebody who was going to be a 3(21), because they wanted to maintain control of the analysis, the research—all that kind of stuff.”

However, he notes that in his experience, it is very rare that a client has the expertise and desire to take on the responsibility, and almost all of his clients have chosen to hire Intellicents in a 3(38) capacity.

Ultimately, Kelly does not believe the 3(21) versus 3(38) discussion should be viewed through the lens of advantages and disadvantages, but as which offering best suits an employer.

“It really just boils down to what is the right fit for the client,” Kelly says “What are their needs? What are their preferences? Then how do we best align our services and deliverables to what they’re seeking to achieve?”

Future-Looking

Sampson says the trend of employers preferring 3(38) designations has grown over the last five years. He attributes the change to a major shift toward the registered investment adviser model from the broker/dealer model towards the registered investment adviser model. The RIA is inherently a fiduciary model, he notes, whereas the broker/dealer model tends to be non-fiduciary.

“I think that’s where the trend is coming from,” he says. “Expert advisers who are in the RIA model, and who are experts at 401(k) plans, determined that not only are they qualified and allowed to be a 3(38), but it also just makes sense.”

He believes there are many people who might want to explore a 3(38) model, but their back office has certain restrictions in place or they simply outsource the work.

Budd also expects that brokers—individuals not acting in any fiduciary capacity—are likely to decline.

“Just from a standpoint of a sound business decision, [a client] shouldn’t be working with an adviser that’s taking on some level of liability and risk, whether that’s 3(21) or 3(38),” says Budd. “I think that will continue to accelerate, to make sure that you’re working with an expert and a specialist in this space to do what’s right for you and for your company.”