The Use of ERISA § 3(38) Investment Managers in Plans Offering Mutual Fund Investment Options to Participants

Abstract

The paradigm shift that is developing in the defined contribution world is one that involves the twin principles of investment delegation and a focus on the portfolio. In no way is this development radical. In fact, the new paradigm essentially brings to the defined contribution world the long established governance principles of the defined contribution fiduciary’s elder brother, the defined benefit fiduciary. The defined benefit fiduciary may use a discretionary trustee to manage its overall portfolio; but even the trustee will commonly use ERISA § 3(38) investment managers to manage sub-portfolios. These managers are charged with specific implementation of a plan’s investment policy, and each manager is required to acknowledge its fiduciary responsibility to the plan. In order to achieve the same type of portfolio management that a defined benefit plan (or a large defined contribution plan) obtains from § 3(38) investment managers, the defined contribution fiduciary commonly uses mutual funds. But mutual fund managers will not accept fiduciary responsibility, and they will not even look at a plan’s funding or investment policies. Where the defined benefit fiduciary world has long been engaged in sophisticated portfolio optimization with respect to specific funding policy objectives, this approach to portfolio investing is still being developed by the defined contribution fiduciary. The reasons for this are obvious. First, when the sub-portfolio manager has no fiduciary obligation to the plan or to the overall investment policy for that plan, the integration of these sub-portfolio managers into an optimized overall plan portfolio is at best a derivative exercise. The investment strategy and the approach of the real asset class managers are not ordered with respect to any overall portfolio efficiency objectives; rather, a fund can be chosen because its underlying approach, within the constraints expressed in the fund’s prospectus, is appropriate for overall portfolio optimization. In addition, of course, most defined contribution plans allow participants to create their own portfolios. Moreover, for a long time fiduciaries had a concern about taking on additional liability for assisting participants, even though every named fiduciary who needs the advice of an investment advisor knows that the portfolios created by unsophisticated participants will grossly fail to serve participants as a whole. Plus, it is much easier to measure the performance of investment options against a particular asset class benchmarks for each fund than to measure whether participants had created optimized portfolios for themselves. But we are already seeing the use of many alternative participant paths to portfolios. These approaches generally require fiduciary delegation and the use of governance structures built around the use of sophisticated § 3(38) investment managers. All of this is improving participant outcomes; and improved outcomes increase the return on a plan sponsor’s defined contribution plan investment. Moreover, the named fiduciaries who move away from the old paradigm reduce their own liability risks and the liability risks of the sponsor’s board of directors. Plan sponsors are beginning to pay attention to setting funding policy and establishing the plan’s governance structure. The overall coordinating “named” fiduciary appointed by the plan sponsor under this governance structure will increasingly move out of a direct “management” role and toward the appointing and monitoring discretionary trustees and/or § 3(38) managers to support participants in the use of efficient portfolios. The world is changing around thousands of old paradigm investment advisors who are not yet prepared to support these new paradigm portfolio and participant outcome objectives. Any advisor offering to perform a § 3(38) manager role over an entire defined contribution portfolio based solely on its skill and experience in the evaluation, selection, and monitoring of mutual funds within individual asset class silos will no longer be viewed as adequate by coordinating fiduciaries. The old discredited paradigm is simply not adequate for a world where participant outcomes matter. The selection of an investment advisor who does not adequately address the portfolio combination implications of individual fund selection, monitoring, and evaluation -- especially any such advisor claiming to be an ERISA § 3(38) investment manager -- is just out of sync with an outcome oriented paradigm. In addition, such a selection is per se imprudent. *An earlier version of this article originally appeared in the New York University Review of Employee Benefits and Executive Compensation -- 2007, published by LexisNexis Matthew Bender. Copyright © 2007 New York University.