Investing March 11, 2019

Don’t Let 3(38) Fiduciary Confusion Entangle Your Plan

Plan sponsors must take as much time as necessary to understand what it means to hire a 3(38) discretionary investment manager; setting clear goals and expectations is critical.
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Art by Alex Kiesling

According to Curcio Web Chief Compliance Officer and Consultant Elliot Raff, it doesn’t happen very often that a plan sponsor decides to go down the 3(38) investment outsourcing route and totally misunderstands what they are signing up for in terms of handing over fund menu discretion.

“However, there are occasionally some misunderstandings about the nitty-gritty details, which can be unsettling for plan sponsors,” says Raff, whose firm acts as a matchmaker between fiduciary investment advisers and retirement plan sponsors.

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Besides consulting with plan sponsors, a big part of Curcio Web’s business involves tracking the work of retirement plan advisers and other entities that provide Employee Retirement Income Security Act (ERISA) Section 3(38) outsourced fiduciary investment management services. Raff says providers in this space are constantly reevaluating their service models, and so plan sponsors may benefit from conducting a review of potential services providers. 

Phil Edwards, principal of Curcio Webb, explains that many of his firm’s clients are investigating 3(38) service providers because they lack internal expertise or sufficient time to allow staff to do the hard work of retirement plan investment monitoring.

“The biggest issue we hear about from our plan sponsor clients is the resource issue,” Raff agrees. “They need to free up time to allow staff to focus on the business.”

When it comes to helping plan sponsors make the most of 3(38) relationships, Raff and Edwards say setting goals and expectations up front is of paramount importance.

“One of our first questions for plan sponsors considering hiring an outsourced investment fiduciary is, what is the objective here?” Raff says. “What ideal outcomes are we managing to? This is important for defined contribution plans, but it is especially important for pension plans that are bringing in an outsourced chief investment officer. For example, when you have a pension plan sponsor that is leveraged and has constrained cash flows, they simply can’t afford to have a big bump in required contributions due to a downturn in the market. This is the sort of thing that should be articulated at the start of a 3(38) relationship.”

Raff and Edwards say plan sponsors must take as much time as necessary to understand these issues. Some questions to explore ahead of a 3(38) review process include the following: What functions does the sponsor want to hold onto? What functions is the company comfortable handing over? And what functions does the sponsor really want to get rid of?

“This is the line of questions that should drive and define a well-documented delegation of duties,” Raff adds. “You need to start thinking about the specifics at the earliest stage of the process. I think some companies may be thinking about jumping on the outsourcing bandwagon without really understanding why or what it means.  They hear about outsourcing as a way to reduce their liability and the amount of time they spend on the plan. But we know it’s much more than that.”

“We should clarify that these are not questions that plan sponsors are going to be able to just answer right off the bat if they have not thought about this sort of thing before,” Edwards says. “For plan sponsors just starting out, the RFP process itself can be a part of the learning curve. By the time you will have reviewed all the responding firms, you can get a good foundation for deciding what you want.”

Joe Connell, partner, retirement plan services, at Sikich Financial (and a former winner of a PLANSPONSOR Plan Adviser of the Year designation), says in his many years serving plan sponsors in this capacity, he has not had a lot of experience with clients regretting going down the 3(38) route. He credits this to the fact that he and his clients make it a priority to establish clear ground rules at the outset of the relationship.

Giving up investment selection and monitoring

Plan sponsors need to carefully consider the level of outsourcing they are comfortable with. Some plan sponsors just won’t feel comfortable giving over full investment menu discretion to an outside adviser, and that’s okay. These plans may be a better fit for 3(21) service, wherein the investment process is much more collaborative and discretion remains with the sponsor.

In Connell’s experience, even when a plan sponsor brings on an outside discretionary fiduciary under ERISA Section 3(38), the client is not necessarily trying to remove themselves entirely from all plan-related decisions. Instead the move is more about getting the right expertise in place for the challenging task of investment selection and monitoring, by the same token freeing up time for the plan sponsor to worry about other things.

Scott Matheson, managing director, defined contribution practice leader at CAPTRUST, says plan sponsor demand for 3(38) services continues to grow at a strong pace. According to Matheson, nearly all of the RFPs the firm filled out last year asked about 3(38) capabilities, and many of those asked for 3(38) pricing, even if the intent of the plan sponsor issuing the RFP was the hiring of a 3(21) adviser.

“To the extent we see friction points with plan sponsors accepting a 3(38) engagement, it tends to come during the transition period as plan sponsor employees and/or committee members are settling into their newly evolved roles,” Matheson says. “Much of this, however, can be reduced or avoided by proper expectation setting and by advisers ensuring a good fit for plan sponsors before transitioning them to a 3(38) service model.”

Matheson agrees that plan sponsors that are very interested in the investment selection and monitoring process are likely not good fits to transition to a 3(38) approach and, as such, would likely experience more friction during a transition period. 

Monitoring the 3(38) investment manager

“When they engage us as a 3(38) investment manager, clients often ask how they should monitor us,” Matheson observes. “We have a unique perspective in answering this question because, in the course of business, we evaluate and monitor the investment managers whose products are present in our clients’ investment lineups. In fact, we have a dedicated team doing this every day, and the rigor we apply to that process influences how we suggest that you monitor a plan-level investment manager.”

Matheson shares a long list of questions plan sponsors should consider:

  • Has the investment manager acknowledged in writing that it is acting as a plan fiduciary? 
  • Is the investment manager adhering to the plan’s investment policy statement (IPS)?
  • Is the investment manager selecting plan investment options consistent with the plan’s IPS?
  • Is the investment manager monitoring (and replacing, if needed) investment options consistent with the plan’s IPS?
  • Does the investment manager report performance compared to each strategy’s objective, appropriate benchmarks, and peer groups?
  • Does the investment manager provide adequate rationale and documentation for investment changes made?
  • Does the investment manager work with your provider to execute fund changes on your behalf?

Matheson also suggests that plan sponsors, after bringing in a 3(38) provider, periodically ask the investment manager questions about its organization, perhaps annually, to ensure the firm has not changed in a significant way that could impact its ability to fulfill its duties.

When conducting these annual reviews, Matheson says the following questions are relevant:

  • Have there been any changes to the management or ownership of the firm?
  • Have there been any organizational changes to the firm that may impact plan management?
  • Has there been a change to the firm’s status under the Investment Advisers Act of 1940? 
  • Has the firm been the subject of an investigation by any regulatory or government agency?
  • Has the firm been routinely examined by regulators or independent auditors? 
  • Has the firm been the subject of any litigation (settled, pending, or threatened)?
  • Have there been any material changes to the firm’s fidelity bond or errors and omissions insurance?
  • Have there been any changes to the firm’s written fiduciary status related to the plan?
  • Have there been any changes to the firm’s roles and responsibilities related to the plan?
  • Has the firm disclosed all sources of compensation?
  • Does the firm have any conflicts of interest with any of the plan’s investment managers or other providers?
  • What are the investment manager’s 3(38) assets under advisement? 
  • What is the total number of plans for which the investment manager acts as 3(38)?
Investing March 7, 2019

Responsible Approaches to Tactically Managing TDFs

Target-date fund (TDF) providers use tactical strategies to support goals of the funds’ glide paths, but responding to a report from a professor of finance at London Business School, providers question whether there is a point where a tactical approach goes too far.
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Art by Jenice Kim
Art by Jenice Kim
Art by Jenice Kim

Following the Great Recession of 2008, the dismal performance of many target-date funds (TDFs), whose 30- to 40-year glide paths are predetermined by age, exposed the risk of adhering to a rigid glide path. This prompted many TDF managers to begin to consider tactical deviations based on market conditions and forecasts.

In fact, the 2017 PLANSPONSOR Target-Date Fund Buyer’s Guide found that 55% of TDF managers now employ a tactical strategy at least to some extent. Of the 18 fund managers that allow for a deviation, 78% may deviate from the glide path in all of their TDF funds, while 23% use a deviation in some funds and not in others, ostensibly shying away from the deviation in the near-term vintages so as to minimize risk in the portfolios of those about to retire.

SEI Institutional has long employed tactical strategies to its defined benefit (DB) plans, prompting it seven years ago to begin to apply it to its target-date series, says Jake Tshudy, director of defined contribution investment strategies at SEI Institutional in Oaks, Pennsylvania. SEI does this by including the Dynamic Asset Allocation fund as one of the underlying funds in the series, Tshudy says, with its contribution to the series never exceeding 10%. As participants approach retirement, the allocation to the Dynamic Asset Allocation fund is brought down to 0%, he says.

The fund manager looks for economic disjoints and places trades that are high conviction for the longer term, he says. For example, “the most recent large bet the fund took was to go short on the Euro. At the same time, if we decide there is a longer-term opportunity with high yield and emerging debt, we might make those trades in the fund if we think we are going to hold those positions for a long time. The fund has a high tracking error because it is meant to exploit longer-term bets.”

In addition, SEI has added “a risk parity fund tied to volatility that takes a similar approach but trades with more frequency,” Tshudy says.

Prudential’s Day One TDF series also “has the ability to react to significant market events,” says Doug McIntosh, vice president, investments, at Prudential Retirement in Newark, New Jersey. “There is a firm-wide reassessment of market environments on an annual basis, and our portfolio managers update their capital markets forecasts every quarter,” McIntosh says. However, the Day One funds typically only adjust their holdings annually.

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‘Remaining True to the Glide Path’

“There is a definite place for tactical moves”—to equities, fixed income, commodities, real estate and Treasury Protected Securities—McIntosh says, but because “target-date funds are long-term products, we also want to make sure we are remaining true to the glide path. We are not so stuck on our own projections that we don’t change them as time goes by,” he says. That said, McIntosh adds, “We are focusing more of our intellectual horsepower on the long term to get that right.”

This is why the Day One funds typically only permit deviations in the 50 to 100 basis point range on alpha and 1% on volatility, he says. Like SEI’s Dynamic Asset Allocation fund, this tactical approach is dialed down as people approach retirement. “The 2020 fund ought not to be in a place that leaves it vulnerable,” McIntosh says.

At TIAA, the TIAA-CREF Lifecycle Funds are overseen by a monthly committee of asset class leaders and economists, says John Cunniff, managing director at Nuveen and manager of the TIAA-CREF Lifecycle funds. Four years, ago, TIAA incorporated a tactical component, he says. “The tactical management component makes adjustments on a forward-looking basis and is limited to no more than +5% or -5% of the portfolio,” Cunniff says. “We see ourselves as an extra player on the team adding alpha.”

Like Prudential, TIAA says the overriding principle guiding the TIAA-CREF Lifecycle Funds is the long-term glide path, followed by the relative performance of the underlying portfolio managers and then the tactical element.

As for how much the tactical component boosts performance, Cunniff says TIAA’s “goal is to be within 1/10th of its tracking error, which ranges from 1% to 2.5%.” As a result, the tactical approach has added 10 to 25 basis points to the funds’ performance over the past three years, he says.

Taking Tactical TDFs a Step Further

Francisco Gomes, professor of finance at London Business School, recently issued a report calling for tactical target-date funds to go a step further by relying on short-term market data based on variance risk premiums to adjust funds’ asset allocations on a quarterly basis and permit annual portfolio turnover as high as 213%. By comparison, according to Gomes’ paper, “Tactical Target Date Funds,” portfolio turnover for a standard TDF is 23% and 78% in a typical mutual fund. The goal of the fund is to minimize downside risk, which also results in diminished returns on the upside.

Tshudy says that this approach to minimizing risk is in agreement with its Dynamic Asset Allocation and Multi Asset Accumulation funds. “We agree with the smoothing of risk. The difficulty of this approach, where the rubber meets the road, is that protecting the downside does cause issues when the market is trending upward,” Tshudy says. “There are periods in between when it is hard to make [the case for tactical overlays] when performance won’t look as good.”

In addition, Gomes’ theory relies heavily on variance risk premiums, Tshudy adds. “That could be exploited to the point that the predictive power is minimized as [other] investors become aware [of the approach],” he says.

McIntosh is unsure whether relying on a variance risk premium is well-suited to a target-date series of 12 funds. “The notion of allocating on a changing risk premium is one I have seen used in the defined benefit world,” he says. “That concept is well suited to the DB world, where you are making one single omnibus trade, rather than trading across 12 funds. Across numerous portfolios, it becomes a little bit complex from a trading perspective.” He also thinks a 213% portfolio turnover is quite high.

Cunniff notes that Gomes’ back-tested theory would permit a tactical TDF to trade 10% of its portfolio either up or down to look for “anomalies within volatility in order to find alpha.” This range results in “a band of 30%. That is higher than most of the industry players—more than double the average,” he says.

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