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  • Home>Practice Management>Fiduciary Focus>What’s Wrong With Third Party 3(38) Investment Managers?

    What’s Wrong With Third Party 3(38) Investment Managers?

    In the retirement plan marketplace, the inmates are running the asylum when nonfiduciaries control the activities of fiduciaries, such as in the 3(38) outsourcing milieu.

    W. Scott Simon, 10/05/2017

    Sometimes when the sponsor of a retirement plan such as a 401(k) plan issues a request for proposal, it may include a requirement for proposers to provide the services of an investment manager pursuant to section 3(38) of the Employee Retirement Income Security Act of 1974, as amended (ERISA). A 3(38) investment manager accepts delegation from a plan sponsor to select, manage, and, if necessary, replace all (or some) of the investment options on a plan menu.

    A proposer that responds to such an RFP can either provide the requested 3(38) services directly itself or it can indirectly provide such services by outsourcing them to a Big Third Party 3(38). In either case, ERISA section 3(38) mandates that the investment manager be (1) a registered investment advisor (that is, an "adviser" under the Investment Advisers Act of 1940, as amended), (2) a bank, or (3) an insurance company. A 3(38) must also acknowledge in writing that it's a fiduciary with respect to the retirement plan in question.

    In my view, there's a significant difference in value between the direct and indirect provision of 3(38) services. A 3(38) that provides its services directly is free from the influence of an entity with the power to highly restrict the available universe of investment options from which an outsourced 3(38) must assemble a plan's investment menu.

    Who is responsible for such restrictions? In these RFP situations, it's often insurance companies or stockbrokers. For example, say that an insurance company answers an RFP calling for a 3(38) investment manager. It will not provide those services itself but will instead turn to a Big Third Party 3(38) to provide them.

    The insurance company requires a certain amount of revenue from a plan's investment options to help pay for its services to the plan. So it provides the Big Third Party 3(38) with a restricted menu of options including, say, mutual funds and/or exchange-traded funds from which the 3(38) must select. That selection is usually made with a wink and a nod, because the 3(38) pretty well knows the magic revenue number required by the insurance company. After all, Big Third Party 3(38)s have well-established relationships with insurance companies which reward them with business. Insurance companies do not rain manna from heaven on Big Third Party 3(38)s because they are uncooperative.

    Here's how this setup appears to a plan sponsor in the contract that it enters into with one Big Third Party 3(38) that was kind enough to draft it:

    "The [Fiduciary of the 401(k) Plan] acknowledges that [Big Third Party 3(38)'s] Services are subject to any limitations or changes in the investment universe generally made available to plans by the [insurance company’s] Recordkeeper, including, without limitation, any generally applicable investment option requirements, including any proprietary fund requirements. The [Fiduciary of the 401(k) Plan] further acknowledges and agrees that [Big Third Party 3(38)'s] Services may be subject to additional limitations imposed at the direction of the Plan's financial professional."

    The preceding language means, in effect, that the Big Third Party 3(38) (legally, not only a fiduciary pursuant to ERISA section 3(21)(A)(ii) but also a discretionary fiduciary pursuant to ERISA section 3(21)(A)(i)) is subject to the whims of the insurance company's record-keeper (a nonfiduciary).

    W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understandingis the definitive work on modern prudent fiduciary investing.

    Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals.

    For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com

    The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.