Top of Mind


Fiduciary vs. Investment Manager: What’s the Difference?

In an environment of increased fiduciary litigation, advisors and other service providers have ramped up their marketing efforts to provide risk management services to plan sponsors. Such efforts have resulted in plan sponsor confusion as to the type of services that are being offered, as well as the type of services that are preferable (e.g., is it better to engage a 3(21) fiduciary, or a 3(38) investment manager?).  This latest edition of Top of Mind will attempt to get past all of the marketing hype so that plan sponsors can make productive decisions in this area.

ERISA has three definitions that are relevant to plan sponsors: an “administrator” under ERISA Section  3(16), a “fiduciary” under ERISA Section 3(21), and an “investment manager” under ERISA Section 3(38). An administrator under 3(16) has complete responsibility for all administrative functions of the plan, including selection of service providers and investment management.  Since the use of 3(16) administrators is quite uncommon for all but the smallest of plans, we will focus our attention on the ERISA definitions of fiduciary and investment manager.

Under ERISA Section 3(21) a fiduciary (often called a “3(21) fiduciary”) is defined as follows:

(A)

Except as otherwise provided in subparagraph (B), a person is a fiduciary with respect to a plan to the extent (i) he exercises 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) he renders 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) he has any discretionary authority or discretionary responsibility in the administration of such plan. Such term includes any person designated under section 1105(c)(1)(B) of this title. (Note, this related to fiduciaries that are named in a plan document)

(B)

If any money or other property of an employee benefit plan is invested in securities issued by an investment company registered under the Investment Company Act of 1940 [15 U.S.C. 80a–1 et seq.], such investment shall not by itself cause such investment company or such investment company’s investment adviser or principal underwriter to be deemed to be a fiduciary or a party in interest as those terms are defined in this subchapter, except insofar as such investment company or its investment adviser or principal underwriter acts in connection with an employee benefit plan covering employees of the investment company, the investment adviser, or its principal underwriter. Nothing contained in this subparagraph shall limit the duties imposed on such investment company, investment adviser, or principal underwriter by any other law.

To translate the legalese, anyone who exercises discretion over plan assets or administration is a fiduciary EXCEPT investment providers, to the extent that they are providing investment management services for a specific investment option in the plan. In addition, those who render investment advice for a fee are fiduciaries. Most advisors would fall under this latter definition of fiduciary. It is important to understand that not all advisors are fiduciaries; the agreement between the advisor and the plan sponsor should stipulate whether the advisor is a fiduciary under 3(21) or not.

If the advisor contractually agrees to be a 3(21) fiduciary, the plan sponsor would be afforded more protection from liability than they would from an advisor (or other service provider) that is not a 3(21) fiduciary. However, it is equally important to understand that the definition of fiduciary (with the exception of named fiduciaries) is a functional one, so a court can determine that an advisor or other third party is a fiduciary if they exercises discretion over plan assets and/or administration, regardless of what the contract with the plan sponsor states.

An investment manager (also referred to as a “3(38) fiduciary”) is defined in ERISA Section 3(38) as follows:

The term “investment manager” means any fiduciary (other than a trustee or named fiduciary, as defined in section 1102(a)(2) of this title)—

(A)

who has the power to manage, acquire, or dispose of any asset of a plan;

(B)

who (i) is registered as an investment adviser under the Investment Advisers Act of 1940 [15 U.S.C. 80b–1 et seq.]; (ii) is not registered as an investment adviser under such Act by reason of paragraph (1) of section 203A(a) of such Act [15 U.S.C. 80b–3a(a)], is registered as an investment adviser under the laws of the State (referred to in such paragraph (1)) in which it maintains its principal office and place of business, and, at the time the fiduciary last filed the registration form most recently filed by the fiduciary with such State in order to maintain the fiduciary’s registration under the laws of such State, also filed a copy of such form with the Secretary; (iii) is a bank, as defined in that Act; or (iv) is an insurance company qualified to perform services described in subparagraph (A) under the laws of more than one State; and

(C)

has acknowledged in writing that he is a fiduciary with respect to the plan.

So, an investment manager is a fiduciary that has acknowledged in writing (typically in the contract with the plan sponsor) that they are one.  For example, insurance companies, banks, and registered investment advisors (most advisors that are investment managers fall in the latter category). However, it is clause (A) that is the primary difference between an advisor that is an investment manager and one that is only a fiduciary. Investment managers can manage, acquire, and dispose of plan assets.

Back in the 1970s when this section of ERISA was written, this was a huge difference, since defined benefit (DB) plans were the dominant retirement plan type. Plan sponsors directed the investments in defined benefit plans and could effectively outsource that direction to an investment manager, who would not only select the underlying investments for the plan, but would also buy and sell plan investments and determine the timing of such transactions. A fiduciary who was not an investment manager could only recommend plan investments, not select them, and could certainly not buy or sell investments on the plan’s behalf. Thus, for a defined benefit plan, investment managers clearly provided additional services over non-investment manager fiduciaries.

But of course, defined benefit plans are no longer the dominant type of retirement plan type. When the investment manager definition was written, 401(k) plans did not exist and 403(b) plans were generally not subject to ERISA. Today, defined contribution (DC) plans are the dominant plan type. Unlike DB plans, investments in DC plans are participant-directed. Thus, there is less of a need for an investment manager in 401(k), 403(b) and other defined contribution plans where investments are participant-directed, since one of the key services of an investment manager, buying and selling plan investments, is moot.

However, an investment manager can still add value to a DC plan, such as a 401(k) or 403(b), because they can select the underlying plan investments from which a participant makes their investment allocation. A fiduciary that is not an investment manager can only advise a plan sponsor as to the investments to offer, with the plan sponsor making the final decision. It is the opposite for the investment manager, since they select the investment options without the plan sponsor’s involvement; the plan sponsor essentially outsources this function to the investment manager.

Which type of advisor is better for the 401(k)/403(b) plan sponsor: the 3(21) fiduciary or the 3(38) investment manager? The 3(38) investment manager provides an additional service (selecting plan investments, as opposed to advising as to the selection of plan investments), but that service typically comes at an added cost to the plan. Furthermore, while the concept of “outsourcing” the investment selection function appears to be attractive from a risk management perspective, it is unclear whether the use of an investment manager actually affords the plan sponsor additional protection from liability, since the legal definition of an investment manager was not written in the context of a participant-directed plan.  And finally, some plan sponsors would prefer to not give up having a say in the selection of plan investments, which hiring an investment manager essentially requires them to do (though it is still the responsibility of plan fiduciaries to monitor the performance of the investment manager and replace an investment manager if it is prudent to do so).

Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.

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