The 401(k) Investment Menu
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Who is responsible for it and what are the plan sponsor's options?

The impact of the last decade's economic and market volatility has caused broad scrutiny of 401(k) plan investment options and fees. Legislation was passed and implemented that requires investment fee disclosure for 401(k) plans. In conjunction, the Department of Labor (DOL) stepped up its monitoring and enforce­ment efforts through more plan audits, and the number of 401(k) lawsuits has increased.1,2,3 Typically, employees are responsible for choosing how they allocate their assets among the investments avail­able in their 401(k) plans. However, plan sponsors are responsible for managing the 401(k) plan investment lineup. Plan sponsors may outsource this responsibility to investment advisors who can take on various levels of fiduciary responsibility. More than ever before, it is critical for 401(k) plan sponsors to evaluate and understand their options for managing the investment lineups of their 401(k) plans.

According to ERISA (Employee Retirement Income Security Act of 1974) section 404(c), the 401(k) investment menu requires a minimum of three investments of varying levels of risk such that par­ticipants can diversify their assets according to their risk tolerance. However, 401(k) investment lineups have grown increasingly com­plex. The average number of investment options in a 401(k) plan today is between 18 and 19.4,5,6 Additionally, the types of investment vehicles available have increased to not only include mutual funds categorized by capitalization and asset class, but also manager mod­els, target date investments, target risk options, exchange traded funds (ETFs), separate accounts, annuity options, and others. The 401(k) plan Investment Fiduciary/Manager (whether it's a third party or the plan sponsor), as a prudent expert, should design and im­plement a prudent investment selection and monitoring process. A comprehensive investment policy statement (IPS) should outline the investment due diligence, monitoring, selection, and replacement process. Critically, the investment policy must be properly followed.

The DOL states: "The duty to act prudently is one of a fiduciary's central responsibilities under ERISA. It requires expertise in a variety of areas, such as investments. Lacking that expertise, a fiduciary will want to hire someone with that professional knowledge to carry out the investment and other functions."

Unless delegated, a plan sponsor is the plan's Investment Fiduciary (Manager). This means the sponsor bears the ultimate responsibility for establishing the plan's investment process, following the process and determining the investment menu choices made for the plan. A plan sponsor's business card doesn't list corporate titles, such as "401(k) Investment Fiduciary/Manager" or "401(k) Plan Sponsor," and a sponsor wouldn't typically describe this role as part of the day-to-day job requirements. However, plan sponsors carry this "silent" title. 401(k) plan participants depend on the judgment and insight of plan sponsors to honestly evaluate their expertise to retain such a role. Importantly, plan sponsors should strongly consider the DOL's advice because ERISA contends the Investment Fiduciary role is part of a plan sponsor's day job. Therefore, plan sponsors should seriously consider whether or not they are qualified for it or if they want it.

Who is the Investment Fiduciary (manager)?

When it comes down to figuring out who is the 401(k) plan's Invest­ment Fiduciary, the litmus test is…

Who has the discretion or the authority to direct the recordkeeper to make changes to the plan's investment menu?

According to ERISA, 401(k) fiduciaries:

  • Exercise discretion or control over management of the plan
  • Exercise discretion or control over plan administration
  • Exercise authority or control with respect to the management and disposition of plan assets
  • Render investment advice for a fee or other compensation

The following are the typical 401(k) fiduciaries:

Fiduciary Role ERISA Section Responsibility Typical Party
Named Fiduciary 402(a) Day-to-day operations of plan Plan Sponsor
Plan Administrator 3(16) Document filings, participant disclosures, hiring service providers Plan Sponsor
Trustee 403(a) and 403(b) Discretion over management and control of plan assets Plan Sponsor or recordkeeper (directed trustee)
Investment Fiduciary/Manager 3(38) Full investment discretion and full accountability for monitoring, selecting, and replacing investment options Plan Sponsor (plan sponsor may delegate this authority to a bank, RIA (Registered Investment Advisor), or insurance company)
Investment Advisor 3(21) No investment discretion and limited accountability for advice/recommendations regarding monitoring, selecting, or replacing investment options Bank, RIA, or Insurance Company (broker dealers do not typically permit their representatives to take on a fiduciary role)

Plan sponsors may believe or simply assume their broker/advisor/consultant and/or recordkeeper at minimum share the responsibility for having a prudent process and deciding which investments to offer to participants. These parties provide data and suggestions and may even narrow down a list of investments, but they don't typically design, implement, oversee the process, recommend changes, or have the discretion to implement them.

The following are common assumptions plan sponsors make:

  • The advisor or recordkeeper selects the investments in the plan.
  • The advisor or recordkeeper is responsible for the fiduciary process because of recommending the investments to make available to participants in the plan.
  • The advisor is a plan fiduciary.
  • The advisor or recordkeeper narrows down a list of investments to choose from, so he or she is responsible (or at least partially responsible) for choosing the investments in the plan.

A plan sponsor should know the scope of services the advisor and/or recordkeeper provides. It cannot be assumed. In most cases, the scope of services is outlined in a master service agreement and/or fee schedule. The contract should specifically state whether or not the advisor has a fiduciary role and it should explain the detail of the role.

Many 401(k) service providers either don't want a fiduciary role related to the selection of investments or their organizations won't allow them to have it. Having a fiduciary role requires implementing a prudent process, providing detailed documentation, and ulti­mately taking responsibility for advice and recommendations. If the fiduciary has decision-making authority, the responsibility is even higher. It is a job for a specialist who is competent and experienced in performing the various responsibilities required and who is willing to accept the fiduciary responsibility. In April of 2016, the DOL published their "Fiduciary Rule", which  aims to broaden the definition of a fiduciary to include some advisors and brokers who previously were not covered by the fiduciary standards of ERISA.  As the rule is implemented, many advisors will have to decide whether to accept a higher level of responsibility or resign as a 401(k) advisor.

According to ERISA, an investment manager is a fiduciary who:

  • Has the power to manage, acquire, or dispose of plan assets;
  • Is either a registered advisor under state or federal law or is exempt from registration; and
  • Acknowledges in writing that he or she is a plan fiduciary.

Advisors who are fiduciaries must be part of a Registered Investment Advisory firm, bank, or insurance company. Additionally, they should acknowledge their fiduciary status in writing. There is a significant difference between an advisor who has a fiduciary role and an advisor who not only takes on a fiduciary role, but also accepts the appointment as Investment Fiduciary/Manager.

An advisor who is a co-fiduciary is often referred to as a limited scope section 3(21) advisor. The §3(21) advisor may give in­vestment advice and make recommendations to the plan spon­sor, but he or she does not have the authority or responsibility to implement investment changes. These decisions remain the responsibility of the plan sponsor.

A section 3(38) Investment Fiduciary/Manager accepts full in­vestment discretion. The §3(38) Investment Fiduciary/Manager is not only a plan fiduciary, but he or she also has the authority and responsibility to select the investments made available to plan participants. In other words, when a plan sponsor hires a §3(38) Investment Fiduciary/Manager, the plan sponsor dele­gates investment discretion to him or her.

What are the plan sponsor's options?

Corporate leaders' attention is directed toward managing their business. As plan sponsors, corporate leaders can hire various third-party professionals to manage different aspects of the 401(k) plan. Almost all plan sponsors choose to outsource the recordkeeping of their 401(k) plans. Similarly, plan sponsors can outsource or choose to retain responsibility for the investment process and decisions. According to the DOL,7 "A fiduciary can hire a service provider or providers to handle fiduciary functions, setting up the agreement so that the person or entity then assumes liability for those functions selected."

Options Functional Impact to Plan Sponsor Plan Sponsor's Investment Fiduciary Liability
Hire non-fiduciary advisor Plan Sponsor retains all decision-making responsibility and authority; may receive investment advice, but advisor is not held to the fiduciary standard 100% - retains role
Hire §3(21) Investment Advisor Plan Sponsor receives advice but retains all decision-mak­ing responsibility and authority; advisor held to the fiduciary standard for advice given 100% - retains role
Hire §3(38) Investment Fiduciary/Manager Plan Sponsor delegates decision-making responsibility and authority to the advisor; advisor is the investment fiduciary 0% - delegates role

The limited scope §3(21) solution is good for the sponsor who de­sires to retain control over the process and the investment decisions. However, this structure clearly leaves the responsibility of choosing the investments with the plan sponsor, whose time and expertise are typically limited.

The §3(38) Investment Fiduciary/Manager solution is worthwhile for the sponsor who wants a professional investment manager to take responsibility for the process and all investment menu decisions. Hiring an Investment Fiduciary/Manager allows the plan sponsor to focus on monitoring the investment professionals rather than trying to be an investment professional.

Other than giving up control, a common concern of hiring a §3(38) Investment Fiduciary/Manager is how to appropriately monitor him or her. Per the DOL, the employer is required to monitor the manag­er periodically to ensure that he is handling the plan's investments prudently and in accordance with the appointment. ERISA clearly considers this; while investment managers must be prudently select­ed and monitored, plan trustees generally are not liable for the acts or omissions of an investment manager.10 The §3(38) Investment Fiduciary/Manager should follow a prudent process, adhere to the investment policy statement, and make overall decisions that are in the best interest of the plan and its participants.

When hiring an Investment Fiduciary/Manager, the following should be considered:

  • What is the investment manager's process for investment selec­tion?
  • What level of due diligence is conducted for investments con­sidered, monitored, selected, and/or removed from the plan?
  • What services are provided per the service and fee agreement?
  • What are the credentials of the individuals who will manage your account?
  • How will the investment manager be compensated?
  • Will the investment manager recognize his or her fiduciary status in writing?
  • Is the investment manager properly insured in the case of legal action against the plan?

Conclusion

401(k) plans are the most prevalent retirement savings benefit plan offered by employers today. For many Americans, their 401(k) balances represent a significant part of their retirement savings. The omnipresence of 401(k) benefits, market and economic volatility, coupled with legislative changes, has increased focus and trans­parency on 401(k) investment lineups and how they are managed. While employees are responsible to take advantage of the tremen­dous benefits a 401(k) offers to them, plan sponsors are responsible for prudently evaluating their ability to perform the duties outlined in ERISA.

If a plan sponsor is confident in his or her ability to make investment menu decisions on behalf of the participants, then hiring a limited scope §3(21) advisor in order to help with the investment process—and ideally increase the opportunity for the plan to have competitive investments—may be sufficient.

If a sponsor wants to delegate the responsibility for the plan's investment process and decisions, he or she should hire a §3(38) investment manager. When doing this, regardless of the sponsor's confidence in his or her ability to choose investments, the sponsor puts the responsibility of the investment choices in the hands of a professional who is dedicated to making these types of decisions on a daily basis. Additionally, it mitigates the company's risk, the partici­pant's risk, and potentially the sponsor's personal risk.

It is not a question of whether or not to hire a §3(21) or §3(38) advisor; rather, it is a matter of understanding the different roles and responsibilities and deciding which one is most appropriate.

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