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The Different Flavors of ERISA Fiduciaries

There's a big difference between an ERISA section 3(38) and an ERISA section 3(21) fiduciary.

W. Scott Simon, 12/03/2009

My recent four-part series on Delegation for Plan Sponsors has created some confusion among a number of readers about a certain issue. That issue involves the significance of the added protection afforded a plan sponsor when it utilizes the services of an advisor serving as a fiduciary under section 3(38) of the Employee Retirement Income Security Act of 1974 as opposed to an advisor serving as an ERISA section 3(21) fiduciary.

ERISA Selection, Monitoring, and Replacing Functions
The sponsor of a qualified retirement plan such as a 401(k) plan is charged with a myriad of legal duties under ERISA. A critical duty is the sponsor's legal responsibility (and therefore legal liability) to select, monitor, and (if necessary) replace the plan's investment options. This duty is so central to any ERISA-qualified retirement plan that its breach is often pleaded in the recent cases filed against plan sponsors involving plan investment options bearing costs that are not reasonable. The word "reasonable" here is not just a word but the operative word in ERISA section 404(a)(1)(A) which follows the great "sole interest" and "exclusive purpose" rules there: "defraying reasonable expenses of administering the plan." The appropriate fiduciary of a plan must (affirmatively) find costs to be reasonable in order to justify their expenditure for the corresponding services rendered.

Many, many plan sponsors, of course, haven't the foggiest idea how much their plans actually cost them and their plan participants. The reason for this is that plan providers have no duty (fiduciary or non-fiduciary) under ERISA to tell sponsors about the total all-in costs of, say, a 401(k) plan. Given that unfortunate fact of life, plan sponsors have no way to know whether the services they pay for are reasonable under ERISA section 404(a).

It's a cruel irony: non-fiduciaries (that is, plan providers) have the power to keep fiduciaries (that is, plan sponsors) from performing the job they're required to do prudently under ERISA. This irony is cruel because it leads to the creation of retirement plans that feature investment options rife with high (and hidden) costs, and risks that are entirely unnecessary. That helps in placing plan participants behind the eight ball in terms of having enough money for a comfortable retirement. Certain politicians and academics pick up on this and, in typical knee-jerk overreaction, whine about doing away with qualified retirement plans such as 401(k) plans instead of fixing a system in which non-fiduciaries can block fiduciaries from being prudent.

The fact that the selection/monitoring/replacing functions involving a retirement plan's investment options are at the very heart of much of current ERISA litigation should alert advisors, plan sponsors, and others of the central role these functions play in a plan. This fact should also alert plan sponsors to the significance of the added protection afforded them when they retain an advisor willing to assume, in writing, such functions as a fiduciary.

An ERISA Section 3(38) Fiduciary
ERISA provides that a plan sponsor can delegate the significant responsibility (and therefore significant liability) of the selection/monitoring/replacing functions to an ERISA section 3(38)-defined "investment manager" who, upon delegation, then becomes an ERISA section 405(d)(1)-defined "independent fiduciary." An ERISA section 3(38) fiduciary can only be (a) a bank, (b) an insurance company or (c) a registered investment adviser (RIA) subject to the Investment Advisers Act of 1940. This means that a stand-alone broker-dealer, for example, cannot be an ERISA section 3(38) fiduciary. If a broker-dealer has dual registration (that is, as a broker-dealer and an RIA), however, the RIA wing of this entity has the ability to become an ERISA section 3(38) fiduciary.

An ERISA 3(38) fiduciary has ERISA legally defined "discretion" that makes it a decision-maker. This means that a 3(38) fiduciary actually makes decisions for which it is legally culpable (and for which the plan sponsor is no longer legally culpable). An ERISA 3(38) fiduciary decides what investment options such as stand-alone mutual funds or model portfolios should be placed on a plan's menu, whether to remove them from the menu and, if it does remove them, what investment options will replace them.

A good 3(38) fiduciary will always consult with the plan sponsor that appointed it and discuss its rationale for selecting and/or replacing given plan investment options before actually doing so. But at the end of the day, it is the 3(38) fiduciary that has sole legal responsibility (and therefore sole legal liability) for making such calls; the plan sponsor no longer has any such responsibilities because the sponsor has delegated them to the 3(38) fiduciary.

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