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Why advisors should care about 401(k) fiduciaries

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Defined contribution plans like 401(k)s offer substantial contribution limits, allow employees to defer taxes and give employers the option to offer profit sharing and matching contributions that can be deducted from their business income. Yet many employers, especially owners of small businesses, lack the knowledge and time to properly administer a retirement plan as a plan sponsor.

This is important work, not only to prevent penalties and fines but also to maintain a plan’s qualified tax status. And given there were over 83,000 ERISA-related lawsuits in the past decade alone, liability is a significant concern.

The good news is that advisors can help employers manage not just their retirement plans but their fiduciary liability as well, effectively shifting much of the responsibility — and liability — from the plan sponsor to the fiduciary advisor themselves.

In doing so, advisors provide yet another way to add client value, while also helping businesses deliver on a key goal of a robust workplace retirement plan: to attract and retain top talent.

Finding and keeping good talent has always been difficult, but in today’s market it has become even more challenging. As recently as August 2019 there were still nearly 1.4 million more job openings than there were unemployed persons looking for work. Some qualified job seekers have found so many opportunities that many employers are being “ghosted” by candidates during the interview process or, in some cases, even after they’ve made a legitimate offer of employment.

According to the 19th Annual TransAmerica Retirement Survey of Workers released earlier this year, 86% of workers cited a 401(k) or a similar plan as an important benefit, while 81% agreed that retirement benefits would be a major factor in deciding to accept a job offer.

One might think of a 401(k) as table stakes. But aside from the obvious costs associated with offering and maintaining a 401(k) plan, there is a non-trivial administrative compliance burden that must be fulfilled, and potential liability exposure for employers who fail to comply. These two factors contribute greatly to why employers shy away from offering such plans. Failure to properly administer a plan can jeopardize its qualified status and thus, the special tax treatment associated with plan assets.

Plan sponsors are also responsible for selecting investment options for all plan participants unless they make other arrangements to delegate the responsibility. And while participants generally retain the right and responsibility to allocate between those pre-selected options, evaluating the vast world of mutual funds and other eligible investment vehicles for inclusion in a 401(k) lineup can be a daunting task, especially for those with limited investment experience of their own.

To make matters worse, plan sponsors are generally liable for both the investment lineup they offer as well as for properly administering the plan itself. Plan trustees — often the business owner or a human resources professional, who by definition are fiduciaries of the plan — can be held personally liable for any errors and/or imprudent investments within the plan.

Thankfully, for those plan sponsors and fiduciaries who want or need help in meeting these obligations, the Employee Retirement Income Security Act of 1974 (ERISA) provides for several options where advisors can help them to both fulfill their fiduciary obligations and/or reduce their fiduciary liability, including:

  • Hiring a 3(21) fiduciary to provide investment recommendations,
  • Hiring a 3(38) fiduciary to outsource investment management, and
  • Hiring a 3(16) fiduciary to outsource plan administration.

One way in which employers and plan trustees can attempt to reduce the liability associated with their 401(k) plan is to hire an advisor to serve as a 3(21) fiduciary. Under Section 3(21) of ERISA, someone is considered a fiduciary to an ERISA plan if:

“(i) [they] exercise any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets, (ii) [they] render investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so, or (iii) [they] have any discretionary authority or discretionary responsibility in the administration of such plan. Such term includes any person designated under section 405(c)(1)(B).”

Note that Section 3(21) of ERISA describes any and all plan fiduciaries, which includes plan trustees as well as 3(38) and 3(16) fiduciaries. However, when the term 3(21) fiduciary is used, it is generally meant to describe an individual who is providing investment advice to a plan — and more precisely, to the plan trustees — for a fee. This article uses the term in a similar manner.

Thus, while anyone can technically be a 3(21) fiduciary, those offering 3(21) fiduciary services are generally providing counsel as an RIA.

In fact, because Section 202(11) of the Investment Advisers Act of 1940 generally limits the offering of investment advice for compensation to an RIA — whereas other professionals such as brokers, dealers and accountants may only provide advice that is solely incidental to their business/profession — those marketing themselves as 3(21) fiduciaries generally must be affiliated with an RIA or may be limited in their ability to actually provide such services.

The fees a 3(21) fiduciary charges must be reasonable, but such fees may be calculated in a variety of ways. For example, a 3(21) fiduciary may charge by flat fee, or on a per-participant basis. The most common way to charge for such services is as a percentage of plan assets, where as plan assets increase, the fee being charged typically decreases.

One central characteristic of 3(21) fiduciaries is that they only recommend how the plan should choose the investment options it provides to its participants. The plan sponsor retains final word as to whether to actually implement those 3(21) advice recommendations. The sponsor also remains responsible for taking action to implement those decisions.

Accordingly, activities of a 3(21) fiduciary hired to provide investment advice are limited in scope to the provision of that investment advice, but do generally include advising a plan sponsor on which funds should be selected for initial inclusion in the 401(k) lineup; ongoing monitoring and analysis of existing investment options; and recommending eliminations, additions and/or other changes to an existing lineup. Such fiduciaries may also provide plan education to participants.

Example No. 1: Duff Beer Co. offers a 401(k) plan for its employees, but the plan trustees don’t feel entirely comfortable in their ability to select and monitor funds for inclusion. As such, they hire Let’s Get Fiscal Financial Planning to provide ongoing 3(21) investment advice.

During a regular review of the plan’s funds in early 2019, Let’s Get Fiscal recommended that Duff replace three funds from its current lineup. Sid Duffman, a Duff Beer plan trustee, has a substantial amount of his own plan assets invested in one of the funds recommended for replacement. As such, he watches the fund closely and truly believes that it is a solid investment. He is convinced that keeping it as part of the plan lineup is in the best interest of plan participants.

Duffman consequently decides to replace two of the three funds recommended for replacement, but will leave the third fund alone for now. Furthermore, Duffman the trustee, and not the 3(21) fiduciary, must take action to facilitate the investment change.

Since plan sponsors ultimately are responsible for the selection and monitoring of investments when engaged with a 3(21) fiduciary, it’s only logical that they retain liability for those decisions. Of course a 3(21) fiduciary is also a fiduciary of the plan, since they are providing advice to it and thus also have liability as any RIA would for the investment recommendations it makes to a client. That liability, however, comes in addition to the liability of the plan sponsor, and is not created by shifting liability away from the plan sponsor to the 3(21) fiduciary.

A 3(21) fiduciary’s ability to help a plan sponsor reduce their investment liability is ultimately more about helping the sponsor make good decisions, such that participants remain confident the sponsor is operating the plan in accordance with their best interests in mind, and less about removing the legal burden of the plan sponsor. Specifically, the 3(21) fiduciary provides expertise and guidance to the plan sponsor so they can competently perform the investment functions required of them, and that they would otherwise find difficult to do.

Offering 3(21) fiduciary services essentially helps plan sponsors handle their fiduciary risk by making good plan decisions, as opposed to shifting their fiduciary risk away. Thus, if a participant disagrees with the investment decisions of the sponsor and believes they have not met their fiduciary duty — then sues the sponsor and successfully proves the point — the sponsor remains liable to the participant.

But by adding a 3(21) fiduciary, a plan sponsor can potentially reduce and even eliminate this possibility by making better investment decisions and offering a better investment lineup. In a worst-case scenario they would give themselves a better defense by having the 3(21) fiduciary’s analyses and recommendations to substantiate why the investment decision was made.

Example No. 2: Duffman ultimately decided against Let’s Get Fiscal’s advice, and chose to keep a fund recommended for replacement. This proved to be a poor decision, as the fund was both more expensive than its peers and underperformed for a sustained period of time.

As such, a lawsuit has recently been filed against the plan for failing to meet its fiduciary obligations in monitoring that fund. The plan, as well as the trustees — including Sid Duffman — remain fully liable for that decision.

The 3(21) fiduciary could also be named in such a suit, but given they provided prudent advice and the plan sponsor retains ultimate liability for investment decisions — and acted against the 3(21) fiduciary’s advice — they would likely be insulated from any liability that might arise.

While a 3(21) fiduciary may give some plan sponsors enough confidence to act in a manner that is sufficient to meet their fiduciary obligations, some plan sponsors may wish to further remove themselves from the responsibility of actually doing the work of investment selection and monitoring. In such cases plans may wish to consider engaging the services of a 3(38) fiduciary, i.e., an investment manager.

Per Section 3(38) of ERISA, an investment manager is someone other than an already named fiduciary (i.e., the plan trustees) who:

  • “Has the power to manage, acquire, or dispose of any asset of a plan,”
  • “Is a registered investment adviser, bank, or insurance company,” and
  • “Has acknowledged in writing that he is a fiduciary with respect to the plan.”

That language consequently prohibits broker/dealers from acting as 3(38) fiduciaries, as they do not meet the second requirement outlined above. An investment advisor on the other hand may offer both 3(21) and 3(38) fiduciary services. Some advisors only offer one of these while others offer both, and will let plan sponsors pick the option that best suits their needs. As is the case with 3(21) fiduciary services, advisors have a wide degree of latitude when deciding how to bill for 3(38) fiduciary services, though most charge plans based on a percentage of AUM.

Like 3(21) fiduciaries, 3(38) fiduciaries’ primary obligation is to ensure that only appropriate funds are included in a plan’s investment lineup. But whereas 3(21) fiduciaries lack the authority to implement their recommendations, 3(38) fiduciaries have discretion over plan assets and thus, have the authority to do so. Conceptually then, 3(38) fiduciaries are not so much advisors as they are also hands-on managers of the plan assets.

In other words, 3(38) fiduciaries don’t recommend adding, removing or replacing a fund from a plan’s lineup; they just do it. The discretion they exercise is akin to how RIAs with discretion over a client’s individual investment account simply make the trades to manage the account.

Operationally, this sort of relationship can be beneficial for plan sponsors and investment advisors seeking to provide services to plans. From the plan’s perspective, the fact that the 3(38) fiduciary can act on their own has appeal, as it eliminates an activity that would otherwise fall to the plan trustees themselves. In small businesses the trustee is often the business owner and/or another high-ranking employee, whose time would likely be better spent elsewhere.

From the advisor’s perspective, providing services as a 3(38) fiduciary can reduce operational friction and increase business efficiencies. When a change is called for, the 3(38) fiduciary can simply act to make the change they believe to be in the plan participant’s best interest, rather than wading through plan bureaucracy — e.g., first communicating a recommended change to the plan contact, then waiting for that individual to relay the suggestion to the plan investment committee, then waiting for the investment committee to meet and arrive at a decision, then waiting for the investment committee’s decision to finally be implemented, etc.

Another significant difference between 3(21) and 3(38) fiduciaries relates to investment liability. When a 3(38) fiduciary is engaged by the plan, liability for investment decisions actually shifts from the plan sponsor to the 3(38) investment manager. By contrast, when a plan engages a 3(21) fiduciary, the plan sponsor retains liability — which is just shared with the 3(21) fiduciary to the extent of that fiduciary’s investment advice recommendations.

More specifically, Section 405(d)(1) of ERISA states:

“If an investment manager or managers have been appointed under section 402(c)(3), then, notwithstanding subsections (a)(2) and (3) and subsection (b), no trustee shall be liable for the acts or omissions of such investment manager or managers, or be under an obligation to invest or otherwise manage any asset of the plan which is subject to the management of such investment manager.”

Once a 3(38) fiduciary has been hired by a plan to provide ongoing investment management, the plan sponsor and trustees are generally relieved of most of the liability related to the 3(38) fiduciary’s investment decisions. The one caveat is while hiring a 3(38) fiduciary advisor shifts the liability for investment decisions from the plan sponsor to the fiduciary, it does not absolve the plan sponsor of the fiduciary obligation to show that it acted prudently in selecting its 3(38) fiduciary.

Meeting that obligation would generally entail making inquiries as to the fiduciary’s skill and reputation, as well as benchmarking the fees paid for such services against other comparable vendors.

To account for this added liability, some advisors charge more for 3(38) than for 3(21) services. Other advisors charge the same fee for either service, and are willing to accept the added liability of being a 3(38) as a value-add to potential clients, and/or in exchange for the operational efficiencies it creates.

Example No. 3: After Duff Beer resolved its previous matter, it decided to engage Let’s Get Fiscal for 3(38) fiduciary services. Unfortunately, during the course of providing this service Let’s Get Fiscal added a fund to the plan for which there was a less expensive share class available. The error was only uncovered after another plan participant brought suit.

Duff Beer, however, was not liable for the fund selection error. Rather the liability was borne by Let’s Get Fiscal Financial Planners in their capacity as the Duff Beer plan’s 3(38) fiduciary advisor for recommending and implementing the wrong share class in the plan’s investment lineup.

One thing most plan sponsors would readily acknowledge is that there’s a lot more to successfully running a 401(k) than just having good investment options.

More specifically, there is a slew of operational tasks and administrative burdens depending on the size of an employer, the provisions included in the plan and other factors. For plan sponsors who wish to outsource these duties, and in so doing further reduce liability, hiring a third type of fiduciary, a 3(16) fiduciary — sometimes referred to as an administrative fiduciary — may be worth exploring.

Note that while employers work with specialized vendors known as third-party administrators, or TPAs, to help manage the operational requirements of their retirement plans, such vendors generally serve only in an operational advice capacity and often have no discretionary authority over the administration of a plan.

Thus, even though they are compensated for their services because such administrators may only provide advice regarding operational issues and not about investments, they are not fiduciaries as defined by ERISA. Therefore they do not actually remove any of the administrative fiduciary liability from plan sponsors. To actually shift liability away from a plan sponsor, the service provider must actually be responsible for doing something on the plan sponsor’s behalf, i.e., with discretion, or provide specific advice with respect to the plan sponsor’s investment matters.

Some TPAs may offer 3(16) fiduciary services, whereby they may take over discretionary control of some or all of a plan’s administrative and operational functions. Indeed, when someone acts as a 3(16) fiduciary they are the plan administrator. Such activities might include:

  • Filing and signing the plan’s annual Form 5500
  • Distributing required documents to participants, e.g., the Summary Plan Description, fee disclosures, tax notices and enrollment packages
  • Verifying whether a Domestic Relations Order (DRO) meets the requirements of a QDRO
  • Interpreting plan language and making decisions, e.g., who is eligible to participate in the plan, accordingly
  • Correcting plan errors
  • Signing off on distributions to participants
  • Ensuring contributions are processed in a timely and proper manner

When a plan sponsor engages a 3(16) fiduciary, they aren’t just shifting the responsibility for completing operational tasks. Because the 3(16) fiduciary literally becomes the plan administrator for the activities so agreed on, the liability for those activities is shifted to the 3(16) fiduciary as well.

For instance, if a 3(16) fiduciary fails to file a plan’s Form 5500, the 3(16) fiduciary is liable for any penalties or other costs that arise from that failure.

Like other plan fiduciaries, 3(16) fiduciaries can bill for their services in a variety of ways. Some charge flat fees while others do so based on a percentage of AUM. Commonly, however, the fee 3(16) fiduciaries charge for their services is determined in part by the number of plan participants — given the work of an administrator generally increases and decreases in proportion to the number of participants in the plan.

When it comes to professional assistance with a plan’s investment activities, a plan sponsor will choose between a 3(21) or a 3(38) fiduciary, but will not retain both. As while there is no rule preventing a plan from hiring a 3(21) fiduciary to provide additional guidance, a 3(38) fiduciary is already taking on the liability for and responsibility to implement those decisions. In essence, it wouldn’t make sense for a 3(38) fiduciary to assume investment responsibility themselves and then hire their own 3(21) fiduciary to get investment advice assistance.

Investment advice and administrative duties, however, are two completely different animals. That’s why a plan sponsor can hire both a 3(21) and a 3(16) fiduciary if they want to outsource administrative duties but retain final say over investments, or — if a plan sponsor wants to relieve as much liability as possible — may engage both a 3(38) and a 3(16) fiduciary.

Technically there is no rule that prevents a person or business from acting as both an investment and an administrative fiduciary. That said, the specialized knowledge required to competently handle these discrete specialties typically means separate professionals are hired for each role.

All this said, plan sponsors always retain some responsibilities. They alone must ensure that they exercise prudence when selecting any and all advisors to be the fiduciaries with whom the plan will engage. Furthermore, the plan sponsor must still carefully evaluate the cost of the advisor’s services, especially if some or all of those costs will be passed on to plan participants instead of the plan sponsor. This is not just a prudent business practice, but a way of ensuring the business owner would not be found liable for choosing an overpriced firm if the additional costs borne by the participants cannot be defended.

Ultimately, the key point is that there are different fiduciary service options that advisors can offer to support the plans that businesses provide their employees. While 3(21) fiduciaries offer investment guidance and share liability together with the plan trustee, 3(38) fiduciaries have discretionary investment authority and essentially shift liability for investment decisions from the plan owner/trustee to themselves. Meanwhile, 3(16) fiduciaries deal only with administrative issues and assume liability only as it pertains to the aspects of the plan for which they are responsible.

Given the range of choices, advisors, too, have a range of options for kinds of services they may or may not want to provide. The key is to ensure they understand the various ways they can fill a fiduciary need for their business clients.

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