Do 3(38)s Assume More Risk?

Kimberly Shaw Elliott

Serving as a 3(38) investment adviser has become a mainstay for many talented financial professionals. Others are still troubled by the additional responsibility imposed by 3(38) status, compared with acting as a 3(21), and go no further than offering advice to sponsors. In reality, the assumption of primary fiduciary duty for plan investments is unlikely to result in increased actual liability.

The Basics

What the industry calls a 3(38) relates to the first prong of the Employee Retirement Income Security Act Section 3(21)—i.e., one who manages the plan investments. This investment manager is a special type of plan fiduciary, as defined in ERISA Section 3(38). An investment manager 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. It’s 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) has full fiduciary responsibility for the plan’s investment decisions, subject to the plan documents and investment policy statement. The sponsor and other fiduciaries are relieved of all fiduciary responsibility for the investment decisions the manager makes. The sponsor must still monitor whether the manager is performing the services but need not second-guess the 3(38)’s 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 sponsors want this extra layer of protection, especially if they’re uncomfortable making the plan’s investment decisions themselves.

Ultimate Authority

The 3(38) is a trained, licensed and presumably highly skilled investment professional. A firm’s chief compliance officer may require more experience and credentials to allow an adviser to act as a 3(38). This adviser has many resources available to study investment performance and maintains sophisticated tools to monitor investments available to a plan. The 3(38) manager also has established relationships with fund providers to surveil potential investments. The manager’s services are often benchmarked against industry peers’.

The plan sponsor, or other fiduciary responsible to manage the investments, is engaged in another business and may or may not have investment experience or current investment knowledge. Despite this, the plan fiduciary has ultimate authority to “pull the trigger” and choose the plan’s investments. The 3(21) investment adviser may provide well-reasoned recommendations as well as reports to support those recommendations, any of which the sponsor could fully reject for any reason at all.

When the 3(21) shares fiduciary responsibility with the nonprofessional, the adviser’s risk becomes entangled with decisions made by a novice. And when that novice makes a mistake, he may look for someone to blame. The facts surrounding what was recommended can become confusing. The 3(38), however, stands alone in complete clarity about what investments were selected and will be held to a purely professional standard of care. That seems to be the better position to defend.

When the 3(21) shares fiduciary responsibility with the nonprofessional, the adviser’s risk becomes entangled with decisions made by a novice.

Insurance Coverage

When 3(38) services became more popular, many fiduciary liability insurance carriers were skeptical of the perceived increased risk of the manager and excluded 3(38) discretionary services from standard insurance coverage. Special riders or policies were required to insure the risk. Current policies typically cover these services, but advisers are encouraged to confirm that they have no major coverage gap.

Even though the 3(38) assumes sole investment authority, the 3(21) adviser may actually face a higher risk of fiduciary liability.

Kimberly Shaw Elliott is a partner in The Wagner Law Group. She engages in a multidisciplinary practice helping clients navigate the complex intersection of ERISA, securities law, broker/dealer regulation and tax regulation.