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Sizing Up Trustee- vs. Participant-Directed Retirement Plans

Are a plan sponsor and its advisor better off for choosing to stay with a trustee-directed plan instead of a participant-directed plan?

W. Scott Simon, 11/03/2011

Two kinds of qualified retirement plans provided for under the Employee Retirement Income Security Act (ERISA) are "participant-directed" plans and "trustee-directed" plans. An example of a participant-directed plan is a 401(k) plan, which is a defined contribution (DC) plan in which a plan participant (and the employer/plan sponsor if it so chooses) can make certain legally determined "contributions" to the participant's plan account.

A trustee-directed plan, in contrast, can be either a DC plan or a defined benefit (DB) plan in which the sponsor of a DB plan is legally required to make certain actuarially determined contributions to the plan on behalf of a plan participant that will generate certain actuarially determined "benefits" to be paid to the participants in retirement. (Please note that this month's column will discuss a qualified retirement plan that's "trustee-directed"--and not a "directed trustee"--which is a whole different kettle of fish.)

Two questions posed to me recently raise some issues that advisors may wish to ponder as they are sitting around digesting their Thanksgiving dinner. First, in a trustee-directed DB plan where an advisor works with a plan sponsor on the pooled account, is the advisor an ERISA section 3(38) Investment Manager? (Such "work" would include creating and supplying an Investment Policy Statement, documenting the investment review process, and managing the portfolio in which the plan's pooled assets are invested.) Second, is a plan sponsor and/or its advisor better off or worse off for choosing to stay with a trustee-directed plan instead of a participant-directed plan? (Let's assume that the investments in both kinds of plan are the same.)

Recapping an ERISA Section 3(38) Investment Manager
ERISA section 3(38) provides that only a bank, a registered investment advisor, or an insurance company can become an "Investment Manager," at which point it then also becomes an ERISA section 405(d)(1) "Independent Fiduciary." A 3(38) has the sole responsibility (and liability) to select, monitor, and replace the investments in a qualified retirement plan.

When ERISA was first put on the books in 1974, the world of retirement plans was quite different from today. Most retirement plans were DB plans. A DB plan then (as now) held assets collectively in a "pooled account," which was composed of a single portfolio invested on behalf all participants in the plan. The drafters of ERISA knew that the typical sponsor of a qualified retirement plan, including those at large companies, had little expertise in running a plan. That's why they allowed plan sponsors to delegate some of their duties, with such delegations being subject to certain carefully defined safeguards. In the 3(38) sphere, for example, these safeguards include the requirement that the sponsor determine its initial delegation to the 3(38) to be prudent and the ongoing monitoring requirement that the sponsor determine its initial delegation continues to be prudent.

One cluster of these delegable duties involves plan investments. Under the ERISA statutory scheme, every plan sponsor has the inherent duty to select, monitor, and replace the investments in a qualified retirement plan whether they're the pooled assets that are invested in the single portfolio of a trustee-directed pooled account in a DB plan, or the discrete investment options in a participant-directed DC plan.

A plan document, when properly drafted, provides for the appointment of an ERISA 3(38) Investment Manager. However, the actual process of appointing an ERISA 3(38) is rarely explained or provided for in detail in the plan document. It's even rarer when a 3(38) is actually explicitly identified by name in a plan document. Nonetheless, there must be authorization to appoint a 3(38) in the plan document. Failing that authorization to appoint in the plan document, the board of directors of the plan sponsor must pass a resolution providing for authorization to appoint before delegation to any 3(38) can take place.

Far, far better for the legal protection of the sponsor when appointing a 3(38) directly would be for it to appoint, say, a retirement plan committee and provide that one of the committee's powers would be to conduct searches for, and retentions of, a 3(38) Investment Manager. Upon completion of a successful search, the committee--not the sponsor--would then enter into a written agreement with an advisor in which the advisor acknowledges (in blood) that it will be the plan's 3(38) fiduciary.

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 Understanding is 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.

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