The Prudent Fiduciary

Scott Pritchard | Principal

A look at the major issues that are shaping fiduciary best practices today.

All Fiduciaries Are Not The Same-Part II

August 2010

Judging by the tremendous response to Part I on this topic, it is safe to say that plan sponsors and their advisors now have a keen interest in the fiduciary issue.

Whether driven by high-profile lawsuits or a genuine desire by plan sponsors to do the right thing, this increased interest will hopefully lead to improvements in fiduciary governance of the nation’s retirement plans and greater retirement security for millions of Americans.

In Part I on this subject, we differentiated between the two main types of fiduciary advisors to retirement plans: ERISA Section 3(21) fiduciary advisors and ERISA Section 3(38) investment managers. As you will recall, the main differentiator is the following:

   • 3(21) fiduciary advisors make recommendations

   • 3(38) investment managers make decisions

This would seem to be a very clear distinction. However, given how many service providers are now attempting to capitalize on plan sponsor interest in the term “fiduciary,” how does a plan sponsor specifically identify which type of fiduciary they are dealing with, or if they are even dealing with a true fiduciary at all?

  1. Perhaps the easiest way is to consider your investment selection process. From the very beginning of the relationship with your service provider, how were the investments for your plan selected?

    In most plans, the service providers proudly present their line-up of five-star funds* to the trustees. The trustees say “Wow, looks great” and sign the document approving the line-up. Then, in periodic follow-up meetings, the service provider offers up monitoring reports that track the performance of the funds in the plan. When some of those previously stellar funds begin to underperform, the service provider suggests replacement funds. Typically, the trustees say “sure, looks good” and the change is made.

    But pay close attention to what just happened: the service provider never made actual decisions; they simply made recommendations. The tacit approval of the trustees is what triggers an actual decision. And the party that makes the decision has the fiduciary responsibility for that decision.

    This is not to impugn all service providers who make recommendations. A fee-only Registered Investment Advisor (RIA) can serve as a 3(21) fiduciary advisor and make recommendations that truly do assist plan sponsors in making investment decisions. But these fiduciaries are clear in describing their role and do not attempt to mislead plan sponsors about who is making the ultimate decision.

    In contrast, if the service provider actually makes the investment decisions for the plan and shares those with the trustees in the course of following a prudent fiduciary process, then the plan sponsor is dealing with a 3(38) investment manager. The fiduciary liability for investment selection and monitoring has then been shifted from the trustees to the investment manager.
  2. As obvious as it may seem, read the contract. Many of the largest service providers to retirement plans talk about “fiduciary” in their marketing materials or offer (my personal favorite!) the “Fiduciary Warranty” (complete with an official looking seal), yet clearly state in their contracts that they are not fiduciaries.

    Your contract with the service provider should clearly address the fiduciary issue; the service provider should state if they are a fiduciary and if so, in what capacity. Also, be wary of the term co-fiduciary; no such term exists in ERISA. It’s akin to being “a little pregnant.” Either a service provider is a fiduciary or they are not.
  3. If you’re still unsure about the fiduciary status of your service provider, ask. I’ll warn you, it may be a somewhat uncomfortable question, especially if you’ve been with this service provider for years. To now ask about their fiduciary status may feel like you are questioning their honor, but as a plan sponsor you have the right to know. (Indeed you have the duty to know.) Not only can it affect participants and their beneficiaries, but the service provider’s fiduciary status can directly affect your own personal liability as a fiduciary.

Ultimately, plan sponsors must understand their fiduciary duty to comply with ERISA and how their service providers assist in that duty. If a plan sponsor doesn’t meet the “prudent expert” standard on their own, engaging a true fiduciary to meet that duty is critical.

In today’s environment of uncertainty around fiduciary roles and responsibilities, an increasingly popular best practice is the engagement of separate 3(21) fiduciary advisors and 3(38) investment managers. The 3(21) guides the plan sponsor through a fiduciary process, including the prudent selection of a 3(38) who takes full discretion for investment selection and monitoring. The 3(21) then assists the plan sponsor in ongoing oversight of the 3(38).

This structure may not be appropriate for all plan sponsors, but it certainly is a vast improvement over the fiduciary uncertainty that haunts the majority of 401(k) plans.

*For more on the fallacy of five-star funds, refer to my 2009 entry on “The Lake Wobegon 401(k) Plan”.

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