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Delivering Investment Advice: Key Differences between 403(b) vs. 401(k) Plans

This article originally ran on October 13, 2015.

By Amy Simonson and Robert J. Toth

For many participants looking to make the best possible decisions about saving, investing and preparing for retirement, a little bit of education and advice along the way is important. Asset allocation models are among the key drivers that advisors use to provide this kind of support.

Whether or not the provision of asset allocation models will be considered “advice” for ERISA plans is one of the “sticky” issues which is going to be resolved in the final version of the Department of Labor’s (DOL) fiduciary rule. But asset allocation models raise a whole different set of issues for the 403(b) investment adviser, whether it be an ERISA or a non-ERISA plan. This is because investments in 403(b) plans do not enjoy the same exemptions from securities laws, as do 401(k) plan investments.

We do need to put our disclaimer right up front, given the sensitive nature of the issues we’re discussing. It is important to remind you that this is not intended to be legal advice, and should not be taken as such. This should, instead, be taken as a reminder to those 403(b) registered reps and investment advisers who deal with asset allocation models to check in with their compliance and legal support to make sure they are aware of the manner in which their firms deal with these issues. 

Q1. Many 403(b) plan providers offer participant tools to help assess risk tolerance and investment preferences, based on their 401(k) plan service models. Some tools go as far as to suggest specific investment allocations or model portfolios, and offer options to elect periodic rebalancing to keep allocations in line with original targets. Is this a problem?

A1. This raises the issue of an asset allocation program being considered by the Securities and Exchange Commission (SEC) as a mutual fund which needs to be registered. The SEC published a rule, called Rule 3a-4, to address it. Pure participant modeling tools are not typically viewed as discretionary services, as the adviser has no authority. So this should not be a problem when:

  • the participant is merely given information about the different asset allocation models;
  • the participant gives the provider periodic rebalancing instructions;
  • the participant can leave the model at any time; and
  • there is no unitized value. 
Q2. An RIA working with an open-architecture platform and designing an investment menu for a plan may select a record keeper that supports the ability to add model portfolios to the plan menu. This allows the RIA to manage these allocations over time as market conditions change, on behalf of the participants in those models. Are these allocation models considered discretionary services

A2. It is these circumstances where the SEC rules governing 403(b) and 401(k) plans begin to diverge. Where this is no problem for the 401(k) plan investments, the RIA for the 403(b) plan will need to pay close attention to the details of the arrangement. It is one thing for the plan’s fiduciary to hire the RIA to mange the available investments under the plan and to change available funds; it is quite another to actively manage a participant’s 403(b) investments in an asset allocation model. It begins now to look like a mutual fund. Though this practice generally can be done under certain circumstances, it requires the proper design. The adviser should seek advice of their compliance department to determine the particulars of providing this type of service.

Q3. Depending on the capabilities of different record keepers, model portfolio investment options may be limited to the plan's investment menu, or, may contain investments that are not directly available to participants in the plan. In building allocation portfolios and including investments not directly available on the participant menu, does this raise issues for the RIA?

A3. Merely making certain plan investments available only to those who choose to participate in a model portfolio is unlikely to cause concern as long as there are no discretionary investment advisory services being provided, as described in Q1. However, if the discretionary services described in Q2 are involved, then this design becomes a factor in determining whether or not the model portfolio is to be considered a mutual fund. So it will be important to check with your compliance staff.

Q4. Holdings in model portfolios may be shown on a participant statement, or, these models may be “unitized” and reported on statements with a daily net asset value, similar to a mutual fund. What are the implications of unitization for 403(b) plans?

A4. This is where the SEC rules governing 403(b) and 401(k) plans seriously diverge. Unitizing a model portfolio in a 401(a) plan has been a regular practice for decades, even back to the “balance-forward” days of plan administration. This has been possible because of the securities laws exemptions for 401(a) plans. However, the “unitized” unit of a 403(b) model portfolio does not have the same exemptions. It may well be a security that needs to be registered. Unitizing is also likely one of those factors which would trigger the registration of the model portfolio as an investment company. If you are engaged in this practice, seek advice of your legal or compliance staff.

Q5. Collective investment funds, CIFs, seem to be getting more attention in the world of 401(k) managed account options. Since CIFs are regulated by the Office of the Comptroller of the Currency, are they eligible investment vehicles for 403(b) plans?

A5. A CIF, even though regulated by the Comptroller of the Currency, can also be formally organized and registered with the SEC as investment company (merely having a CUSIP doesn’t count, by the way). If this happens, the CIF can be used in a 403(b) plan. However, non-registered CIFs likely cannot be used, for two reasons. First, Code Section 403(b) only permit investments in mutual funds and annuity contracts, and a unitized CIF is neither one of these. Secondly, even if you wanted to “look through” the CIF to the underlying mutual fund to qualify under 403(b), this would require share accounting of the investments (which is a virtual impossibility). But even if you could do share accounting, the CIF would still likely be treated by the SEC as having to be registered as a mutual fund. 

We have long been aware of the significant differences which exist between 401(k) plans and 403(b) plans. The current investment marketplace is now forcing us to consider the difference in the manner which investment rules apply as well.

Amy L Simonson, AIF, is Vice President, Finance & Operations, Verity; Robert J. Toth, Jr., is Principal at the Law Office of Robert J. Toth, Jr., LLC.

Opinions expressed are those of the author, and do not necessarily reflect the views of NTSA, or its members.

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