3(38) vs. 3(21) investment fiduciary services: the pros and cons for 401(k) advisers

As lawsuits targeting 401(k) plan sponsors have proliferated and buzz around the Department of Labor’s fiduciary rule…

As lawsuits targeting 401(k) plan sponsors have proliferated and buzz around the Department of Labor’s fiduciary rule continues building, demand for investment fiduciary services has grown among employers, and advisers have evolved to meet the demand.

But there are different flavors of fiduciary services, each with their respective benefits and drawbacks for retirement plan advisers and their clients.

The services fall into two camps: 3(21) and 3(38), which refer to specific sections of the Employee Retirement Income Security Act of 1974.

A 3(21) investment adviser is a co-fiduciary role, whereby an adviser provides advice to an employer with respect to funds on a 401(k) investment menu, and the employer retains the discretion to accept or reject the advice.

A 3(38) adviser has the discretion to make fund decisions. The plan sponsor has less liability in this relationship, because they offload fiduciary risk for investments to the adviser; however, employers still carry a fiduciary duty to monitor the adviser.

The former is the more prevalent relationship – 82% of retirement plan specialist advisers, whose primary business focus is workplace retirement plans, offered a 3(21) service in 2016, while 47% were willing to serve as a 3(38), according to data from Ann Schleck & Co., an affiliate of fiduciary consulting firm fi360 Inc.

‘SEEING THE DEMAND’

However, there’s been a clear upswing over the past five years toward offering 3(38), with the number more than doubling, from 20%, since 2011, while the co-fiduciary service has remained flat.

“I’m definitely seeing the demand [for 3(38)],” Fred Barstein, founder and CEO of The Plan Sponsor University said. Employers are realizing, as their awareness of fiduciary responsibility grows, they may not have the requisite expertise, he explained.

At the same time the service has proliferated among specialists, broker-dealers such as LPL Financial Inc. and Morgan Stanley Wealth Management are providing more access to packaged, outsourced 3(38) services for less-specialized advisers to use with clients.

EASIER, QUICKER

Although serving as a 3(38) carries more risk for the adviser, several advisers find it to be easier and quicker than a 3(21).

For example, a 3(38) adviser can take action immediately if there’s a need to add or remove a fund. The co-fiduciary adviser, though, must explain to an employer and the plan’s investment committee the recommended course of action and wait for the committee to come to a consensus.

Being a 3(38) also allows advisers to apply their best investment thinking across several different clients, Robin Green, head of research at Ann Schleck & Co, said.

“Boy, if everyone was a 3(38) we’d only be monitoring 20 funds instead of 500 funds,” said Susan Shoemaker, a partner at Plante Moran Financial Advisors, whose firm offers both types of fiduciary services.

Some plan sponsors may have had a fund in the plan for a long time and don’t want to remove it, or are adamant about certain funds or asset classes they want, Ms. Shoemaker said. And sometimes clients take a long time – perhaps six months to more than a year – to implement recommendations.

But some advisers question the benefit of a 3(38) service for plan sponsors and participants.

“I’ll very often say, I don’t think it’s a great idea,” especially if clients pay a premium for the 3(38), said Kevin Mahoney, senior institutional consultant at The Mahoney Group of Raymond James.

Mr. Mahoney explained that his fund screening and due diligence process “doesn’t change one iota” between both types of fiduciary services. He was skeptical the additional 3(38) fees, paid for essentially the same amount of work, truly benefit employees.

PATH OF LEAST RESISTANCE?

“I worry about taking the path of least resistance,” he said, adding that 3(38) may be easier for advisers and employers, but advisers have to ensure the service is in the best interest of participants.

Similarly, Jeff Snyder, senior consultant at Cammack Retirement Group, said a plan would need to get a real rate of return for a premium to make sense, especially because the employer is “still on the hook” for monitoring the adviser.

However, clients may be unaware of this obligation to oversee an adviser in a 3(38) relationship, making client disengagement a concern, some said.

“I think it’s critically important you’re in front of the client letting them know what you’re doing and why you’re doing it,” Mr. Mahoney said.

For advisers that charge a premium for the 3(38) service, it is often 20-25% higher than their average retainer fees, according to Ann Schleck. That’s roughly 10 to 15 percentage points higher than for 3(21) services.

For those charging on assets, the premium is often between five and 10 basis points.

However, only 25% actually charge extra. For those that don’t, advisers may bake the cost into their service offering as a business differentiator to win business or to justify their current fees, Ann Schleck’s Ms. Green said. It may also be a useful client retention tool, she added.

However, more advisers are likely to start charging for 3(38) services “as the demands increase and advisers have to adjust their insurance levels to match that risk,” Ms. Green said.

SMALL MARKET

The greatest demand for 3(38) services is from employers with small 401(k) plans, advisers said. They often don’t have staff members dedicated to overseeing retirement plan benefits, and are more focused on running their small business than paying attention to fiduciary responsibility.

Ms. Shoemaker of Plante Moran said plans with between $2 million and $10 million in assets are typically the ones seeking a 3(38) adviser.