In selecting and monitoring a plan’s investments, a prudent process requires that fiduciaries act “with the care, skill, prudence, and diligence … that a prudent person…familiar with such matters would use.” Because of the phrase “familiar with such matters,” this is sometimes called the “prudent expert rule.” Fortunately, where plan fiduciaries aren’t “prudent experts,” they can hire the expertise. That is, they can hire knowledgeable advisors to help with the selection and monitoring of the investments that the plan offers to its participating employees.

Before discussing the hiring of advisors, let’s briefly look at the kind of knowledge that is needed to satisfy the requirement that fiduciaries be “familiar with such matters.” Here are some of the factors that fiduciaries should consider in selecting plan investments: share classes of mutual funds; revenue sharing; indirect payments to other plan service providers; 12b-1 fees; sub-transfer agency fees; and expense ratios. If fiduciaries aren’t familiar with those concepts, they should hire the “expertise,” that is, they should engage an advisor who is knowledgeable about those terms and the payments they describe. In case after case, judges have confirmed that fiduciaries don’t need to be experts about investment issues for retirement plans, but they do need to consult with experts where they lack the necessary expertise.

Once the fiduciaries at a plan sponsor make the decision to hire that expertise, they need to decide whether to engage, in retirement plan terminology, a 3(21) or a 3(38) investment advisor. But what is the difference and why does it matter?

Both types of advisors are fiduciaries and therefore are subject to the same standards as the plan fiduciaries.

Those numbers are just references to different sections in ERISA. Both types of advisors are fiduciaries and therefore are subject to the same standards as the plan fiduciaries—the prudent person rule and the duty of loyalty. As a result, those advisors must act prudently and in the best interest of the participants. But, in other ways, there are meaningful differences between the two types of advisors.

In the first case—a 3(21) investment advisor, the reference is to a non-discretionary advisor. A non-discretionary advisor is one who makes investment recommendations to the plan fiduciaries. The plan fiduciaries then make the decisions—to select or replace a plan investment. That arrangement provides fiduciary support for the officers and managers who are plan fiduciaries, but they remain the primary investment fiduciaries. As a result, they must evaluate the recommendations, ask the advisor for more information or explanations if needed, and then make a prudent decision. As any number of courts have said, the primary investment fiduciaries can’t “rely blindly” on their advisors. Having said that, though, the use of non-discretionary, or 3(21), advisors is evidence that the plan fiduciaries have engaged in a prudent process to make their decisions.

On the other hand, a 3(38) advisor is a discretionary fiduciary investment manager. In other words, a 3(38) investment manager actually makes the decisions about selecting, monitoring, removing, and replacing investments. While the 3(38) advisor may periodically report to the plan fiduciaries, a discretionary advisor doesn’t need consent or approval before making investment changes. The role of plan sponsor fiduciaries in this case isn’t to evaluate investment recommendations but instead to prudently select and monitor the 3(38) investment manager.

As this discussion suggests, if a 3(21) advisor is used, the role of the plan fiduciaries is to select and monitor the investments with the help of the advisor. In addition, plan fiduciaries also must prudently select and monitor the investment advisor. But if a 3(38) advisor is used, the role of plan fiduciaries is to select and monitor the advisor (for example, by considering its qualifications and adherence to its advisory agreement).

Since the primary investment fiduciary will be the plan sponsor fiduciaries where a 3(21) advisor is used, the responsibility and potential liability for selection of underperforming investments will be on the plan sponsor fiduciaries … since they select and monitor the investments. The plan fiduciaries may point to the use of a 3(21) investment advisor as evidence of a prudent process, but they will still be the primary target of any claims.

However, where a 3(38) advisor is used, claims of a fiduciary breach for failure to prudently select or monitor a plan’s investments will be filed against the advisor. If there’s a claim against the plan sponsor fiduciaries, it would be for failure to prudently select and monitor the advisor. In that case, the selection of an advisor who is experienced and well-qualified to oversee plan investments would be the first line of defense.

Of course, the primary objective is to provide participants with well-managed and reasonably priced investments. In that case, the use of a knowledgeable and experience investment advisor is of critical importance. Both 3(21) non-discretionary advisors and 3(38) discretionary investment managers can help plan sponsors accomplish that goal.

Concluding Thoughts

The first step in fiduciary compliance for the selection of plan investments is to determine if the plan sponsor and its officers and managers have the expertise to satisfy the requirements of the prudent person rule. Realistically, that won’t always be the case. Where it isn’t the case, the law mandates that the plan sponsors engage a knowledgeable investment advisor to help them satisfy their duties of prudence and loyalty. That can be accomplished with either a 3(21) advisor who makes recommendations to the plan sponsor fiduciaries or by use of a 3(38) advisor who makes the investment decisions. The key is to use an advisor who is experienced in working with retirement plans and who is knowledgeable about investment issues for retirement plans.