First, let me say that I am not an attorney. So, as I wade into interpretation of ERISA, I gratefully acknowledge my reliance on the previous work and wise counsel of numerous ERISA attorneys who have been kind enough to share their opinions with me.

With that disclosure, I will attempt to shed light in a two-part series on an issue that is receiving an increasing amount of attention in the 401(k) marketplace: The roles of ERISA section 3(21) fiduciary investment advisors and section 3(38) fiduciary investment managers.

The growing awareness of these roles seems to be driven by two key factors:

1. Numerous 401(k) lawsuits over the past few years have made plan sponsors increasingly aware of their fiduciary responsibility and liability, which they are now keenly interested in limiting.
    
2. The investment industry is aware of this growing concern and is seeking to capitalize on the “fiduciary” business opportunity.

While ERISA has always defined the various roles of fiduciaries to retirement plans, most industry practitioners have simply not been aware of the finer points and how those can benefit plan sponsors and participants. Now, however, as more plan sponsors seek out the services of fiduciaries, Wall Street is increasingly marketing itself as such, especially under the “co-fiduciary” label. So it is imperative that plan sponsors, and those that advise plan sponsors, understand the key differences between the various fiduciary roles.

There are a variety of functional fiduciaries in the operation of a qualified retirement plan, including the plan administrator, trustee(s) and members of the investment/benefits committee. Our focus here, however, will be on clarifying the roles of “Investment Advisor” and “Investment Manager.”

In a white paper commissioned by SageView Advisory Group, attorneys Fred Reish and Joe Faucher of the Reish & Reicher law firm explained the 3(21) Investment Advisor and 3(38) Investment Manager roles this way:

Where committee members lack the needed technical knowledge to properly select the investments, they are required to hire knowledgeable advisers. In ERISA, those investment advisers are sometimes referred to as section 3(21) fiduciary investment advisers. However, while the use of knowledgeable advisers is evidence of a prudent process (particularly if the adviser is independent), the committee continues to be the primary investment fiduciary. As a result, it remains the primary “target” for plaintiffs’ attorneys and the U.S. Department of Labor (DOL).

Where committee members desire additional protection, they should consider appointing a discretionary investment manager to select and monitor the investments. In ERISA, those discretionary managers are referred to as 3(38) fiduciaries. Appointing an investment manager insulates the fiduciaries against losses (or inadequate gains) arising out of claims that the investments were not appropriate or prudent. Fiduciaries who appoint an investment manager to control the selection and monitoring of the plan’s investments are responsible only for the prudent selection and monitoring of the investment manager which, for attentive fiduciaries, is a manageable task.

The essence of the difference between these two designations is that a 3(21) advisor makes recommendations and a 3(38) manager makes decisions.

So, if a plan sponsor wants to retain the responsibility for investment selection and monitoring, hiring a 3(21) investment advisor can be part of a prudent fiduciary process. But if a plan sponsor wants to be insulated from the responsibility and liability for investment selection and monitoring, then a 3(38) investment manager should be engaged.

Most groups holding themselves out as “investment advisors” in the 401(k) industry are operating as 3(21) advisors (if, indeed, they are acting as fiduciaries at all.) The 3(38) manager designation requires a greater level of fiduciary responsibility, and only a minority of firms are willing to accept the increased liability that comes with the 3(38) designation.

In Part II, I will provide guidance on how to identify what type of fiduciary you may be working with now.

“We must all suffer from one of two pains: The pain of discipline or the pain of regret. The difference is discipline weighs ounces while regret weighs tons.”
                                                                                                      -- Jim Rohn

Recently a participant in a 401(k) plan for which we serve as the fiduciary advisor called me with some concerns.

“I’m just a little worried because the market seems to be headed down again,” she said. “Do you think I should change to a more conservative strategy?”

I asked the woman whether there had recently been any major changes in her life that would warrant a change in strategies. She assured me there had not – just that she had concerns about the market volatility. After I spent some time reassuring her that market volatility was an unpleasant, but unavoidable, part of equity investing, she finally calmed down and agreed to stay the course.

“You’re right,” she said. “Thank you so much. I just wish I had listened to you last year. I panicked and got out for a few months, but I won’t make that mistake again.”

As I hung up the phone, her last comment kept nagging at me. When had she gotten out? I wondered. And what was the impact on her portfolio?

After some brief research into the plan’s monthly statements, my worst fears were confirmed. The participant got out of the market on … wait for it … March 9, 2009 … the absolute bottom of the bear market. She then got back in about two months later on May 11.

The market has gained quite a bit since May 11, so it can be tempting to think she has done just fine even though she missed the first two months of an historic rally.

But when we consider what she actually missed in those two months we see the real damage done: In missing the first two months of the recovery, this participant missed out on a gain of 23.83%! And this was in a balanced portfolio of 60% stocks / 40% bonds; had she been more heavily invested in equities the opportunity cost would have been much worse.

In hard dollars, this not-hypothetical 401(k) participant’s $200k portfolio missed out on $47,660 in gains that were there for the taking. And with the loss of compounding on that amount over the next ten years (when she will reach retirement age), her momentary lack of discipline could end up costing her roughly $102,000 (assuming a hypothetical return of 8% for her portfolio).

Clearly, as in this case, we can’t always save participants from themselves; ultimately they make their own decisions about what to do with their money. Still, as fiduciaries, we must constantly strive to help participants avoid critical mistakes like this any way we can. We must continuously remind participants that saving for retirement is a long-term endeavor. We must help them avoid the short-term “noise” and stay invested in a well-diversified, low-cost portfolio.

If we don’t then they (and we) may face the long-term pain of regret that is far worse than the short-term pain of discipline.

“Where all the women are strong, all the men are good looking, and all the children are above average.” This was Garrison Keillor’s famous description of his fictional home town, but superiority bias is applicable far beyond the shores of Lake Wobegon. It also permeates the world of 401(k) plans.

In our work as an independent fiduciary advisor, we review a great many investment line-ups for plan sponsors. And, as you might imagine, the vast majority of plan sponsors believe their investment offerings are above average.

“Scott, just look at these five-star funds we have… they are from some of the largest fund companies in the country…these funds have tremendous track records…”

And there is the rub. Most 401(k) committee members are investment laymen and the easily understood method for evaluating an investment option is past performance. The only problem is that the fine-print disclaimer, “Past performance is not a guarantee of future results,” is there for a reason. There has never been a single study that found any correlation between past performance and future results. That’s why the regulators require that disclosure.

So here’s how it happens in the hypothetical “ABC 401(k) Plan”: 

1. In constructing the line-up, the committee chooses an extensive menu of five-star funds from the “recommended list” of their provider (which also happens to be compensated by those very same funds).
2. Over time, with the inevitable variability of returns, some of those five-star funds begin to under-perform. So, the funds are added to the watchlist and eventually replaced by the latest five-star funds suggested by the provider.
3. The churning continues. As yesterday’s winners become tomorrow’s losers, they are replaced by the latest batch of five-star funds in the endless quest for an above-average fund line-up.

But who is missing from this conversation? The participant. The person whose best interests all fiduciaries are duty-bound to protect. Participants are the ones who actually have to invest in these “above average” funds that rarely remain above average going forward. The unfortunate reality in most plans is that participants invest in a fund with great historical performance only to get in too late and ride the fund down to its inevitable reversion to the mean. The fund is then replaced and the cycle is repeated. It’s the classic “buy high / sell low” experience that dooms the average retail investor.

How do we solve this problem? As with anything, the first step is acknowledging that there is a problem. In the wake of the downward slide of 2008 and the whipsaw rebound of 2009, I see many more plan sponsors awakening to the fact that the old model of chasing five-star funds hasn’t worked.

Plan sponsors are recognizing that participants are struggling. And an increasing number of plan sponsors are taking their fiduciary responsibility seriously and are taking a hard look at their perhaps not-so-above-average investments and their not-so-above-average “advisor”.

So, if you are a plan sponsor, or if you advise a plan sponsor, challenge your process for selecting investments. In an effort to truly fulfill your fiduciary duty to serve the best interests of plan participants and their beneficiaries, look beyond past performance and star ratings. Choose funds that provide the broadest asset class coverage at the lowest cost.

Perhaps we’ll never get to where “all plan sponsors are prudent, all advisors are objective, and all participants are well-diversified”, but it never hurts to dream.

When I began this series I realized that it takes faith to write a multiple-part series. One always has to wonder if the key points you seek to make will still be relevant when the series is complete. This was especially true when I began this series in January. We had just completed the second-worst year of returns in the history of the stock market and the New Year was starting out with no glimmer of hope.

But I believed then, and still do, that these concepts are applicable for 401(k) plans in any economic environment.

And as 2009 has progressed each of these key points is not only still relevant, but their importance has only increased.

Point #1: A strong “do-it-for-me” solution
Now more than ever, participants realize they don’t want to manage their own assets and aren’t very good at it when forced to do so. Yet the highly publicized failings of many target-date funds during 2008 (many 2010 funds, believed to be defensive portfolios, lost even more than the broad market) has highlighted that not all “do-it-for-me” solutions are created equal. As a result, plan sponsors are now searching for, and participants are demanding, a truly strong solution.

Point #2: Fee transparency
This issue is certainly picking up steam as evidenced by the 401(k) Fair Disclosure and Pension Security Act of 2009 currently under consideration in the House of Representatives. This legislation would remove the onus for seeking fee transparency from plan sponsors and would mandate that plan providers clearly disclose all compensation they receive, which certainly seems like a common sense approach that should have been put in place long ago.

Point #3: Utilization of a fiduciary advisor
In another move toward common sense, the Obama administration has recently proposed that brokers be held to a fiduciary standard. And surprisingly, the brokerage world’s main lobbying group has voiced support for the idea. It now seems that everyone agrees that someone giving advice to a 401(k) participant should do so solely in that participant’s best interest. The as-yet-unresolved, but critical, question however is: “Will brokers step up to the current fiduciary standard, or will the fiduciary bar be lowered to accommodate brokers and others with inherent conflicts of interest?” For the sake of participants and plan sponsors let’s hope the bar will not be lowered.

So, it has been affirming that all three of these principles of fiduciary prudence have held up in the light of recent history.

The final fiduciary best practice is also, without a doubt, a timeless concept:

Point #4: Following a well-documented process
Here’s a deep question for you: If you follow a prudent process, but you don’t have the documentation to prove it, did it really happen? In the eyes of regulators and the court system, the answer may be “no.” A well-documented process is key.

Fiduciary best practices dictate that a well-documented process begins with an Investment Policy Statement (IPS). A well-written IPS serves as the strategic plan for the oversight of a 401(k) plan. It provides detail on the goals of the plan, the roles and responsibilities of all parties involved, and provides a framework for ongoing monitoring. Yet surprisingly, only about half of all plan sponsors currently have an IPS. And experience shows that those who do have not reviewed it in years. To truly follow best practices, a viable, active IPS is a must for plan sponsors.

The second component of following a well-documented process is to have a single repository for 401(k) documentation. You would be amazed (or perhaps not) at how many plan sponsors cannot locate a copy of their Adoption Agreement, or maybe a copy of the minutes from their last committee meeting, or the service agreements with providers.

The source of this confusion, and a clear hurdle for a well-documented process, is that different documents seem to be the responsibility of different parties and are kept in different offices by different people. By creating one, single repository (for example, we call the one we create for our clients the “Prudent Fiduciary Process Binder”), plan sponsors can ensure that they are not only following a prudent process, but that they have the documentation to prove it.

Conclusion
As I laid out back in January, ERISA requires that plan sponsors act “…with the care, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of and enterprise of a like character and with like aims.” (Section 404(a)(1)(B))

I believe that plan sponsors following each of the four steps I have mentioned in this series will surely exhibit the care, prudence and diligence required of a “prudent person” in a post-2008 environment. And not only will plan sponsors have fulfilled their fiduciary duty, but plan participants will experience a much more secure retirement.