June 15, 2020
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Those responsible for overseeing their company’s 401(k) plan may be pleased to learn that recent DOL guidance provides that private equity investments may be offered to plan participants if included as part of a multi-asset class vehicle. The guidance, issued in a June 3, 2020 Information Letter from the Employee Benefits Security Administration of the Department of Labor (DOL), provides additional factors a prudent plan fiduciary must take into account when deciding to offer an investment option with a private equity component.
Due to their complex and opaque nature, 401(k) plan fiduciaries have typically avoided including private equity investments in designated investment alternatives offered to plan participants. As a result, 401(k) plan participants have not had access to the same investments as actively managed defined benefit plans, which expanded their exposure to private equity following 2006 amendments to ERISA that reduced certain “plan asset” risks associated with those investments. Additionally, defined contribution plans in certain other countries already enable private equity investments.
The investment alternatives for which the Information Letter provides relief involve asset allocation funds, such as target-date, target risk or balanced funds with a private equity component. In addition to the private equity component, these funds would have a sufficient pool of assets to ensure diversification among other asset classes with different risk and return characteristics. To that end, the fund would have a target allocation of private equity investments that does not exceed a specified portion of the fund’s assets. The remainder of the fund would be invested in liquid assets with readily ascertainable market values, such as publicly traded securities.
The Information Letter provides that the relief would not be available if private equity investments were offered on a stand-alone basis as a vehicle for direct investment by plan participants. Although not explicitly prohibited, the DOL states that these types of investments present distinct legal and operational issues for fiduciaries of ERISA-covered individual account plans. Examples of asset allocation funds that may include a private equity component include both separately managed accounts that are managed by the plan’s investment committee with the assistance of an ERISA Section 3(21) fiduciary, as well as accounts in which a Section 3(38) fiduciary has been delegated investment responsibility. In addition, the plan could offer a pre-packaged “fund of funds,” with one of the underlying funds being a fund that invests primarily in private equity.
As stated above, the asset allocation fund must include sufficient liquid investments with readily ascertainable market values to ensure participants can take distributions and make exchanges among the plan’s investment line-up. Although this requirement ensures the fund would have adequate cash to meet its obligations with respect to its investors and its investments (such as private equity capital calls), an open question remains as to how to value the asset allocation fund on a daily basis. To that end, a prudent fiduciary will need to understand how the private equity component is valued and may consider requiring an independent valuation based on agreed upon procedures in accordance with FASB.
ERISA requires that plan fiduciaries prudently select and monitor all designated investment alternatives under the plan. As opposed to publicly traded securities, private equity investments involve more complex structures, longer time horizons, generally higher fees, illiquidity, less stringent disclosure and oversight, as well as an element of subjectivity in regards to valuation. As a result, the Information Letter states that plan fiduciaries evaluating an investment option with a private equity component should consider the following:
To the extent the plan’s fiduciary does not feel it has the skills, knowledge and expertise to make this determination on its own, it must seek assistance from a qualified investment adviser or other professional. Further, the fiduciary must periodically review the investment to determine whether it continues to be prudent and in the best interests of the plan’s participants.
On June 1st, the DOL sent to the Office of Management and Budget for approval a new fiduciary rule, which will once again address the fiduciary responsibilities of those providing advice to retail retirement investors. Although its contents remain a mystery, we expect that the new rule will be less onerous that the rule vacated by the Fifth Circuit of Appeals in 2018 and will more closely adhere to the Securities and Exchange Commission Regulation Best Interest, which is to become effective on June 30, 2020. One area to keep an eye on is how the rule treats rollover recommendations, and whether such recommendations will constitute covered investment advice.
The DOL’s guidance should be viewed as welcome news to both ERISA-covered individual-account plan fiduciaries, as well the participants in these plans. In light of the reduction in the number of public companies over the past two decades, private equity investments provide an opportunity for enhanced diversification and greater returns, as well as a hedge against downturns in the public markets. Although open questions remain, including surrounding valuation, individual account plan fiduciaries can feel confident that by following proper procedures they can offer their plan participants the opportunity to join the private equity market.
 The idea of including private equity and other long-term alternative investments in defined contribution plans has been utilized in other countries for some time. For example, in Australia, defined contribution superannuation plans are generally more “sponsor-directed” rather than “participant-directed,” thus providing professional management of a participant’s account. In addition, because these plans are not sponsored by employers, they can more readily offer illiquid assets since a participant’s account will not be liquidated following a change in employment. In limiting the types of investments that may include a private equity component, the guidance seeks to address these issues as they relate to U.S. retirement plan investors.