The Many Facets of ERISA Fiduciaries

March 30th, 2011
by Jonathan Leidy

Fiduciaries of ERISA-governed retirement plans, e.g. 401(k), 403(b), etc., must undertake a host of regular activities to ensure that their company’s employees are being offered sound retirement options. One such responsibility is the selection, monitoring, and maintenance of plan investments. If this duty is not performed correctly, penalties can be levied on both the sponsoring company as well as on each of the company’s executives individually. Given the significant potential liability, as well as the expertise required to do the job properly, many plan sponsors look to offload, or at least share, some of their fiduciary responsibility. ERISA allows for delegation of investment functions, however, understanding the nuances of the various arrangements can be challenging.

Before looking at the opportunity to delegate investment responsibilities specifically, a review of fiduciary duty in general is in order. A fiduciary, in the context of ERISA, is an individual with the following responsibilities:

As highlighted above, ERISA fiduciaries can delegate many of their duties to third-party vendors, including investment oversight and monitoring. However, certain functions, i.e. being a prudent manager-of-managers, cannot be sidestepped. In this way, plan sponsors and their executives can significantly curtail, but never fully eliminate, their overall responsibility to plan participants.

One method of reducing fiduciary responsibility relating to investments is to hire a “Limited Scope” or 3(21) Fiduciary. A bank, insurance company, or Registered Investment Advisor (RIA) can act in this capacity; a broker/dealer or their representatives cannot.

A 3(21) Fiduciary (named after the same section of ERISA code) provides advice and recommendations to plan sponsors regarding the structure, cost and quality of a plan’s investments. These individuals are referred to as “Limited Scope” for two reasons:  1) they do not have discretionary authority over the investment decisions and 2) to differentiate them from an entirely different class of 3(21) Fiduciaries, “Full Scope” 3(21)s, who are responsible for all of the governance and management decisions associated with the plan.

A Limited Scope 3(21) Fiduciary can be viewed as a co-fiduciary. They share investment responsibility with the plan sponsor, often sitting on the plan’s Investment Committee. As the investment professionals of that group, they will likely take the lead in the selection, monitoring, and maintenance of the investment menu as well as the education efforts for plan participants. 3(21)s should also institute policies and procedures to help plans sponsors document their fiduciary processes. Note, however, that 3(21)s do not have discretion over, and hence responsibility for, the final investment decisions. Thus, hiring a 3(21) Fiduciary helps plan sponsors mitigate their liability associated with investment selection, but it does not eliminate it.

The other option for plan sponsors is to hire an “Investment Manager,” or 3(38) Fiduciary. 3(38)s are discretionary advisors under ERISA, i.e. they have full authority over investment decisions within the plan. Again, this role can only be fulfilled by a bank, insurance company, or RIA. This individual or firm, selects, monitors, and replaces the investment options, and may do so without previously consulting the plan sponsor. In the case of pooled investment accounts, a 3(38) may also use his or her discretion to hire other 3(38)s to perform more specialized investment functions.

At first blush, the 3(38) option may seem less appealing for plan sponsors. Although most sponsors value some form of professional investment assistance, many would like to remain involved in the process. For those sponsors, perhaps the services of a Limited Scope 3(21) are preferable.   However, assigning full-discretion over investment decisions to a 3(38) Fiduciary has its advantages. Namely, plan sponsor that use 3(38)s have legally delegated all of their investment-related responsibilities (and the associated liability), less one:  monitoring the 3(38) Fiduciary. Moreover, although a 3(38) is within his or her rights to act without consulting the plan sponsor before making changes, few do. Practically, it is in the best interest of all types of fiduciaries to be as consultative and transparent as possible.

Not every investment professional acts in each fiduciary capacity. Some professionals and advisory firms only provide one type of fiduciary service, operating exclusively as either a Limited Scope 3(21) or a 3(38). Others, act in both capacities, depending upon the desires of the plan sponsor. It is important to note that the functions are mutually exclusive, i.e. a firm cannot be a Limited Scope 3(21) and a 3(38) Investment Manager to a plan simultaneously.

In addition, a plan sponsor, as the manager-of-managers, must take the time to truly understand which entities in the marketplace are legally permitted to perform fiduciary functions. Large brokerage firms, e.g. Morgan Stanley Smith Barney, Merrill Lynch, Goldman Sachs, etc., and their agents are prohibited by law from performing these duties, as are smaller independent broker/dealers. Insurance companies have the legal right to offer fiduciary services, but in practice the vast majority chose not to do so.

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