Q&A: Understanding the Differences Between a 3(21) Investment Advisor and 3(38) Investment Manager
For retirement plan sponsors, managing investments does not always come naturally. Many plan sponsors will engage with a 3(21) investment advisor to solicit advice and recommendations relative to their plan investments. Others opt to outsource the investment management altogether to a 3(38) investment manager.
Understanding the differences between these two fiduciary arrangements is critical to determining the best investment strategy for your plan. We recently spoke with David DuBrava, Managing Director at The MFA Companies, to explain the key differences between a 3(21) and a 3(38) investment fiduciary.
Q: At the highest level, how do these fiduciary arrangements differ?
DuBrava: Under ERISA – the Employee Retirement Income Security Act of 1974 – an investment fiduciary is essentially any person or entity responsible for someone else’s money. Typically, what you see with retirement plans is a co-fiduciary relationship, otherwise known as a 3(21) relationship. In this type of arrangement, the plan sponsor enters into a paid arrangement with a registered investment advisor for investment recommendations. The plan sponsor can either accept or reject those recommendations as the plan sponsor retains ultimate decision-making authority over the selection of investments in the plan. Under a 3(21) relationship, the advisor and the plan sponsor share the fiduciary responsibility for the plan’s investments.
A 3(38), on the other hand, shifts all investment decision responsibility to an investment advisor, who is given full discretion to make investment decisions and, with that, assumes the fiduciary risk for the plan’s investments.
Q: Let’s dive a little deeper into the differences between the two types of relationships. In working with a 3(21) co-fiduciary, what responsibilities can I expect them to assume?
DuBrava: In short, a 3(21) advisor is responsible for presenting investment recommendations to a plan sponsor for consideration and possible implementation. The actual execution of plan investment changes is up to the plan sponsor.
Q: And a 3(38), on the other hand, would have the responsibility of actually making investment decisions and executing those changes, yes?
DuBrava: Exactly. A 3(38) fiduciary is a trusted investment manager – not simply an advisor – so they have the capacity to execute plan investment changes as they see fit. They are given authority to select, monitor and remove/replace investment options offered in the plan. The plan sponsor would legally transfer the fiduciary liability associated with the investment plan to the investment manager, thereby reducing their own risk and placing that squarely upon the investment manager.
Q: What other benefits are recognized under a 3(38) arrangement?
DuBrava: The transfer of risk is typically the biggest motivator for plan sponsors. But additionally, the 3(38) can expedite much of the investment process that is oftentimes held up as a result of internal bureaucracy. For example, under a 3(21) investment advisor plan, it could conceivably take 6-9 months for an advisor to present recommendations to a retirement committee, have said changes approved by the committee, and then have those changes flow through the appropriate record-keepers. Under a 3(38) arrangement, the investment manager no longer needs to wait for committee approval on their recommendations; they have the implicit trust and legal authority to execute changes in a more efficient and timely manner, which can ultimately lead to positive effects for plan participants.
If you’re hiring for investment expertise, it’s a natural next step to rely on a fiduciary who can actually manage the investments and take the burden off the plan sponsor’s shoulders. There’s significantly more value in that type of service.
Internally, for the plan sponsor, this arrangement also frees up time, as there would be less need for frequent committee meetings to review and approve changes to the investment plan. There’s an efficiency gain that can be realized – not to mention a general peace of mind that your plan’s investments are being managed and monitored by an investment expert.
Q: The benefits of the 3(38) are compelling. Are there instances when it makes sense for a plan sponsor to stick with a 3(21) adviser?
DuBrava: Like most things, I think there’s a time and a place for each. We often see larger plans that have investment experts actually sitting on their retirement committees, so they’re able to provide their own expertise relative to the plan investments. In cases such as this, the plan sponsor may only be looking for outside recommendations – rather than investment management services – to add a second set of eyes, for example.
Plan sponsors that typically don’t have the time, resources or necessary expertise to manage their own plan investments would be ideal candidates to engage in a 3(38) investment management solution.
Q: Is a plan sponsor relinquishing control of their investments through a 3(38)?
The sponsor always has the authority to end the relationship if it becomes unfruitful. I don’t generally hear concerns about relinquishing control; typically plan sponsors interested in a 3(38) arrangement are looking to offload risk and rely on proven expertise. The plan sponsor does have control over and has a continuing responsibility to monitor whether the investment manager is actually performing the services agreed upon. Plan sponsors always ultimately have control over the plan as they decide what relationships and partnerships they establish on the plan’s behalf. So there’s a certain level of control over the arrangement that plan sponsors have – to conduct appropriate due diligence of the fiduciary.
At the end of the day, this shifting of fiduciary responsibility is the key distinction — and core advantage — of using a 3(38) investment manager. In the face of increasing litigation and the heightened regulatory scrutiny we’re seeing, many plan sponsors want this extra layer of protection, especially if they are not comfortable making the plan’s investment decisions themselves.
To discuss fiduciary options for your organization’s retirement plan, please contact us.
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