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The Use of ERISA § 3(38) Investment Managers in Defined Contribution Plans

By Herbert A. Whitehouse, JD (see bio below). Mr. Whitehouse can be reached at 732.462.5583 or herbwhitehouse AT gmail.com.

Does a 401k "named" fiduciary, usually a committee appointed by the Plan Sponsor, reduce its liability when the committee's investment consultant continues to perform essentially the same role, but with discretion for decisions that the consultant otherwise would have merely recommended?

This is the central question that is now being asked about an approach that is being used more and more in the ERISA defined contribution investment world. Under this approach, the investment consultant takes on the role of an ERISA § 3(38) investment manager.

This is the question that is being asked and debated all over corporate America; but it is mostly the wrong question. At least it is the wrong question if the consultant /manager continues to do essentially the same work and that work is not consistent with the work of managing an investment portfolio. ERISA § 3(38), and the allocation of liability that comes with using an investment manager to manage an investment portfolio, is a very, very, dubious provision for a fiduciary committee to use if the consultant /manager is not actually managing an investment portfolio.

Following the form of ERISA § 3(38) without the substance is likely to result in a breach of fiduciary duty. The two ways that the named fiduciary committee can end up in "ERISA jail" are: 1) when its investment consultant does not actually manage an investment portfolio, but is hired over other consultants who won't accept manager status; and 2) when the consultant is being paid more -- again without actually managing a portfolio -- on the theory that liability is being shifted to the consultant / manager. The reason that either of these situations may be a breach of fiduciary duty is that the named fiduciary committee is making decisions primarily to benefit itself, and letting these hoped for benefits govern how much to pay the investment consultant, or who to hire as an investment consultant.

Bottom line, ERISA § 3(38) should be used in a DC plan in much the same way that it is used in DB plans; namely, with real investment managers who actually manage portfolios. This article will give you a head start in understanding why this common sense approach should be used, and why this approach reduces the liability of a named fiduciary committee precisely because it puts the interest of participants first. You may also wish to read a more in-depth treatment of this whole subject that I published on the Social Science Research Network here: http://ssrn.com/abstract=1811085.

Overview of Fiduciary Investment Governance Principles

First of all, it makes a lot of sense for the lay fiduciary committees of most pension and profit sharing plans to position themselves in an oversight role, rather than as managers. This principal is especially important when it comes to investment portfolios.

An important technique for doing this in both defined benefit pension plans and defined contribution pension and profit sharing plans is for the named fiduciary to select one or more investment managers. Each investment manager is expected to manage an investment portfolio in accordance with the investment policy statement (IPS) that the plan's named fiduciary sets up, usually with the help of an investment advisor. ERISA § 3(38) describes a dance that must be performed in order to shift liability for the investment decisions from the named fiduciary to the investment manager. The key step in that dance is that the investment manager must accept fiduciary responsibility with respect to the plan.

For administrative and cost reasons, many smaller defined contribution plans use mutual funds, but do not have an investment manager. A mutual fund can not be an investment manager; in fact, a mutual fund is technically a security that can be bought and sold by an investment manager just like any other investment security. But mutual fund managers don't accept fiduciary responsibility to any 401k plan. This can leave the named fiduciary committee acting in a manager role, with the liability that is normally shifted to an investment manager.

About fifteen years ago, Rick Burke, a Gray Robinson lawyer here in Orlando - in fact Rick's office is in the building right next door to my condo -- provided clients with the first, if not among the first, legal opinions pointing out how to use ERISA § 3(38) in a 401k plan. Essentially, if the named fiduciary and investment manager properly dance together as described by ERISA § 3(38), with the investment advisor/manager taking on the responsibility of a traditional investment manager, then investment management liability is also shifted from the named fiduciary in the ordinary way.

So what is the controversy? Actually, there should be very little controversy if the investment manager actually has discretion, and if the investment manager actually manages the portfolio. Here are a few of details that should be considered in using an ERISA § 3(38) structure:

I. Who will be responsible for our defined contribution plan's IPS?

II. What if my investment advisor only evaluates each mutual fund within its asset class, and does not provide any analysis or evaluation of how each mutual fund fits together with other mutual funds in terms of an overall portfolio?

III. Are there real portfolio management roles for a professional investment manager, even if my fiduciary committee continues to have a role in selecting mutual funds?

IV. Fiduciary litigation often relates to the appropriateness of using high cost share classes for mutual funds because of the higher revenue sharing and other payments that these share classes provide for offsetting plan administration costs. Will my investment manager take responsibility for those decisions?

V. Our named fiduciary committee has always taken charge of the communications and notice requirements that go along with mutual fund changes. In fact, the employee (participant) relations impact of mutual fund changes has always played a role in at least the timing of any fund change. Will this impact our ability to use an investment manager?

So lets address these points one at a time.

I. Who will be responsible for our defined contribution plan's IPS?

An important role for any investment consultant has always been helping the named fiduciary create an IPS. The IPS is the basis for selecting and evaluating mutual funds. And while the mutual fund does not have any allegiance to the IPS of any particular plan, the consultant's role still includes helping the named fiduciary benchmark fund performance, and tracking such things as investment style "drift" against the IPS mandate.

This will not change. An investment advisor who takes on the role of an investment manager, a role that traditionally only implements policy, will continue to advise the named fiduciary on the policy that it will then implement as an investment manager. As strange and convoluted as it sounds, this will be the situation most of the time, in a role best characterized as an investment manager/A role. But the investment manager/A, will not take responsibility for the IPS in either its investment advisor or investment manager roles.

Prudent DB and DC pension plan fiduciaries have always engaged an investment advisor with a strong practice discipline built around an understanding of modern (and now, post-modern) portfolio theory. The reason is that, at least for the last half century, the practice standard (for a named fiduciary who wants to exercise the care, skill, prudence, and diligence of other similarly situated fiduciaries) no longer permits an evaluation of a fund in isolation. Instead, it requires that any fund evaluation consider the fund's strengths and weaknesses in terms of the contributions that the fund makes to the efficiency of various portfolio combinations.

One advantage from having its investment advisor take investment manager responsibility is that the investment manager accepts fiduciary responsibility and liability for the proper management of the portfolio. An investment advisor can more easily leave portfolio responsibility to the named fiduciary. But an ERISA § 3(38) governance structure will necessarily transfer all investment decision responsibility, including portfolio management, from the named fiduciary to the investment manager. Accordingly, a prudent investment advisor without a well developed portfolio management practice will be reluctant to take on investment manager responsibility.

Note: The named fiduciary committee is still responsible for the initial determination that the investment manager will adequately perform its portfolio management responsibilities.

III. Are there real portfolio management roles for a professional investment manager, even if my fiduciary committee continues to have a role in selecting mutual funds?

Yes. The old defined contribution investment paradigm based on the fictitious ability of participants to come any where near putting together "efficient" (high expected returns for a given level of risk or low risk for a given level of expected return) portfolios is dead. This basically dishonest paradigm is being rapidly replaced by an outcome oriented "path to portfolio" paradigm.

Accordingly, as managed account services and other path to portfolio options are offered to plan participants, whether risk based portfolios, target date portfolios, or risk and time horizon combinations, the use of traditional ERISA § 3(38) portfolio managers becomes a natural part of any defined contribution fiduciary investment governance structure.

The traditional use of an investment manager has always involved the management of investment portfolios. The investment manager has complete discretion, and is expected to use that authority and discretion over every aspect of portfolio management. In fact, investment managers are expected to act on its authority on a daily, hourly, and minute by minute basis without checking in to obtain named fiduciary consent. This type of management may be possible with ETF based investment platforms; but it is not possible with a mutual fund based platform.

Still, even defined contribution plans that use mutual funds have a need for investment managers. These are the managers of the managed account services, and the managers of the various investment portfolio options that are offered to participants. Here there is real management of the allocation mix - within the limits of the plan's investment policy and the constraint of a mutual fund based investment approach - even if the named fiduciary controls the selection, monitoring, and the decisions on making changes to the individual funds in that mix.

In fact, these portfolios will usually contain only a mix of the other individual funds that are available to participants, in part, because this is a requirement for status as a QDIA portfolio.

No. We have already suggested that an investment manager/A will probably not take responsibility for the IPS. Part of the reason is that an IPS is logically and legally ordered to a plan's funding policy, and this funding policy controls the policy for payment of plan expenses.

Now having a funding policy is a core requirement for all ERISA DB and DC pension and profit sharing plans. In fact, having an IPS is not explicitly required by ERISA; but having a funding policy is. One aspect of any funding policy is especially relevant to the IPS for any DC Plan; namely, the policy on the sources of monies used to cover plan administration, record keeping, and other participant services.

Is the Plan Sponsor to pay all or some of these expenses? Are participants to pay an equal per head fee, an equal percentage applied to each participant's account, or will there be some combination? Alternatively, are administration expenses to be paid from revenue sharing and other payments to come from a mutual fund?

A funding policy might say that for a plan that costs 20 basis points on all assets; and that each participant is charged 20 basis points on the assets that they direct to each fund, less the revenue sharing or other payment toward administrative expenses made by that fund. It is obvious that such a funding policy is necessarily prior to any decision to use a particular share class; but it is also necessary even to create an IPS. For example, if a funding policy called for the Plan Sponsor to pay all plan administrative expenses, it would be grossly imprudent for either a named fiduciary or an investment manager/A to select high revenue sharing funds. In short, the funding policy is essential.

Of course, one of the consequences of using an ERISA § 3(38) governance structure is that the investment manager will want clarity on these funding policy decisions for its own protection. But a clear funding policy will remove a lot of the ambiguity in policy and accountability that has been at the root of fee litigation in this area. In addition, improved use of the ERISA required funding policy will move some breach of fiduciary duty issues entirely out of the scope of fiduciary decision making, and into the status of non-fiduciary "settlor" decisions.

In addition, while a funding policy is neither the responsibility of an investment advisor nor an investment manager/A, the clear accountability that an investment manager has for taking into account a plan's funding policy will further help to reduce named fiduciary liability. As a personal observation, I suggest that it is likely that an investment advisor who has previously understood the central role of the funding policy to prudent investment management will have a leg up in being selected for the increased accountability of an investment manager/A role.

Managed account services and changes to risk based portfolios that do not require advance participant notice naturally fit into a ERISA § 3(38) governance structure. But changes to existing funds, when those changes require advance notice to participants, are a more complicated subject.

Employee relations, participant communications, and the notice implications related mutual fund changes and additions are not typically a material part of an IPS. These considerations have always been considered part of implementation. In fact, there is sometimes a tension between an investment advisor who recommends a change for investment reasons, and a named fiduciary committee who holds off on implementation. The committee may want to better coordinate the investment change with other investment or non-investment benefit changes; or even because it is reluctant to make too many changes in too short a period of time. In short, employee relations considerations come into play. Sometimes a committee will agree to add new funds, but it will refuse to take away existing investment options to such an extent that an investment advisor will refer to these plans as having a "graveyard of bad funds."

So will the employee relations, communications, and legal notice aspects of these decision be shifted to an investment manager? This is not likely. But an investment manager/A will now have to consider these factors in its decisions. Moreover, the manager must have the "power" to make an investment decision regardless of these other considerations; and the significance of these traditionally non-investment factors may make some DC plans poor candidates for an ERISA § 3(38) investment manager structure.

On the other hand, where a named fiduciary committee is willing to take a back seat implementation role, rather than a decision making role, the need to integrate notice and communications considerations into defined contribution mutual fund decisions should not defeat the idea of investment manager discretion. But the discretion must be real and not just pretend.

Conclusion

Bottom line, if the liability shifting that is expected from an ERISA § 3(38) structure is a secondary consideration to a real desire to move management from the named fiduciary to the investment manager, then the decision making reality is more likely to be consistent with the discretion that an ERISA § 3(38) structure requires.

ERISA § 3(38) investment governance structures are a great fit for any DC plan that uses real investment managers to actually manage investment portfolios.

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About Mr. Whitehouse

Herb Whitehouse has a long history with 401k investments, design, plan administration, and fiduciary governance. He led the team at Johnson & Johnson that helped to introduce the 401k to corporate America. See Whitehouse, Herbert A., Toward a More Complete History: Johnson & Johnson's 401k Nursery. EBRI Notes, Vol. 24, No. 12, December 2003. Available at SSRN: http://ssrn.com/abstract=488902

Herb has looked at compensation and benefits from a variety of perspectives, having worked both for the public employee labor union, AFSCME, and as the Secretary of the Employee Benefits Review Committee of the Board of Directors' Committee at Chase Manhattan Bank.

Until moving to Florida in 2006, Herb was a director of Great Eastern Bank in New York City, and a Commissioner on the New Jersey Employment and Training Commission. Herb's publications can be found in many university publications, including Columbia University's Columbia Journal of World Business and the Annual Review of Banking & Financial Law at Boston University's School of Law. He received his BA and MA in Political Science from Drew University, and his JD degree from Rutgers.

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