Fiduciary Rule Shines Spotlight on 3(21) and 3(38)

By Lynn Brackpool Giles

As if advisors didn’t have enough to worry about with the fiduciary rule, experts warn that they’d better have a firm understanding of ERISA 3(21) and 3(38), including the specific nuances affecting their responsibilities. And though knowledge has come a long way in the last 10 years, it’s vital that advisors fully grasp their duties while also ensuring plan sponsors understand ERISA distinctions.

A 3(21) advisor is generally described as one who can provide counsel and guidance, but does not have final discretion in investment decisions. They can monitor investments and make recommendations; provide participant education, including one-on-one advice; and advise the plan sponsor in terms of following a fiduciary process, including the development of an Investment Policy Statement.

And though 3(21) advisors have a share of the fiduciary liability, the ultimate responsibility for investment decisions falls on the plan sponsor.

Roger Levy says the fiduciary rule has put an even brighter spotlight on 3(21) duties.

“When it was originally developed, the statute stated that if you give investment advice in return for compensation, you are a fiduciary. There was no wiggle room.”

But Levy, managing director of Cambridge Fiduciary Services, adds that broker/dealers still wanted to service 401(k) plans, just not as fiduciaries.

“The securities industry howled at the broad 3(21) definition of a fiduciary when ERISA came out in 1974, so the Department of Labor came up with five-point test a year later to determine if you were a fiduciary,” he says. “The result meant that, for the most part, brokers were excluded, allowing them to make recommendations and still receive commissions.”

Levy says that led the brokerage industry to push boundaries by calling brokers “financial advisors,” which led to consumer confusion over RIAs, who always operate under a fiduciary standard.

Fast forward to the DOL fiduciary rule, which Levy says is trying to bring the industry closer to the original intent of 3(21).

Though the fiduciary rule attempts to place everyone under the same guidelines, there are still nuances between a 3(21) advisor and a broker, says Michael Savage, manager of retirement compliance for Paychex, Inc.

“For RIAs, nothing will really change, and the spirit of being a 3(21) advisor will remain,” Savage says. He adds that the “heavy lifting” under 3(21), like monitoring investments, will continue, but that the decision-making ultimately rests solely with the plan sponsor.

Savage adds that broker/dealers are rapidly adapting to comply with fiduciary rule compliance by retooling their pricing and compensation models, abiding by the Best Interest Contract Exemption to disclose any issues or switching to a level-fee model.

Since 3(38) does not apply to brokers, the views surrounding it are less muddy.

Section 3(38) names investment managers with discretionary authority as fiduciaries and requires that the firm be structured as an RIA, bank or insurance company. Under 3(38), the firm must specifically acknowledge its fiduciary status, says Savage.

“Bottom line is that brokers can’t operate under 3(38),” he says.

It does make sense to outsource fiduciary responsibilities if the plan sponsor doesn’t think they can devote the time and attention to the management aspect but also can’t shirk their oversight role.

Levy adds that 3(38) is an opportunity for advisors because taking on portfolio management discretion can provide advisors with increased revenue while limiting the client’s role in managing plan investments.

“It’s a good tradeoff,” he says. “Employers see 401(k) plans as an employee benefit. But they don’t want to be in the investment management business. If you offer them a way out, it’s a big plus for them and a win-win for participants.”

An advisor must still demonstrate that his fee for taking on this discretion is reasonable and competitive, he says,

Both Levy and Savage agree that the uptick in fiduciary-related litigation has created more awareness of the responsibilities between advisor and plan sponsor.

“The plaintiff’s bar is driving litigation and testing the waters, especially around what are considered reasonable fees,” says Savage

He says he’s seen a concentrated effort by providers to better educate plan sponsors on the role of a fiduciary, overall compliance and litigation and regulatory risks.

“Without question, plan sponsors are more aware and appreciative of fiduciary responsibilities than they were seven years ago when the genesis of the DOL rule began to take form,” Savage says.

And though the fiduciary rule offers brokers a chance to explain their conflicts, Levy wonders why any would take that route as a normal course.

“They are still adjusting and searching for a business model where they don’t have a conflict,” he says.

He says there is a simpler path and offers this example as an illustration: If a plan sponsor interviews an unconflicted advisor, as well as one who has a conflict yet discloses it via the BICE—saying they will still manage a plan in the client’s best interest—there is still an inherent risk that the advisor can get it wrong. Why would a client then select the advisor who resorts to a BICE?

“Brokers need to look at changing their business model or risk getting squeezed out of the 401(k) equation,” Levy concludes. “They need to look at becoming true 3(21) advisors or find a new focus.”