The Department of Labor's recent pronouncement on the permissibility of investing 401(k) and other defined contribution plan assets in private equity has gotten wide-spread attention. Yet the guidance, which was issued in the form of an information letter, does not establish any new fiduciary principles, or provide any exemptions under the Employee Retirement Income Security Act of 1974 ("ERISA"). Nevertheless, the guidance is of great significance to the industry and this blog discusses why.
The information letter confirms that a plan fiduciary would not violate the fiduciary's duty to act prudently solely because the fiduciary selects as an investment option for a 401(k) plan a professionally managed asset allocation fund with a private equity component, as described below. The information letter focuses on an investment option structured as a multi-asset class custom target date, target risk, or balanced fund that has a sufficient pool of assets to diversify the exposure of plan participants to the private equity component with other investments in a range of asset classes with different risk and return characteristics and investment horizons. The investment option's overall exposure to private equity investments would not exceed a specified portion of the option's assets, with the remainder of the plan's portfolio invested in publicly-traded securities or other liquid investments with readily ascertainable market values. The investment option could either be a custom designed portfolio structured by the plan's investment committee, or a prepackaged investment option offered by a financial institution as a "fund of funds" (structured as, e.g., a collective trust fund or other pooled vehicle) that invests in other funds, with one of the underlying funds being a fund that invests primarily in private equity. In no case would the private equity component be made directly available to plan participants on a stand-alone basis.
Does the information letter provide a safe harbor to plan fiduciaries that select an investment option with a private equity component? While the information letter does not provide a formal safe harbor for plan fiduciaries that select a target date, target risk or balanced investment option with a private equity component, it provides significant comfort to plan fiduciaries that such a decision would not be per se imprudent for a defined contribution plan. It also sets forth the guidelines that a prudent fiduciary should follow when making such an investment decision.
Numerous research studies, white papers, consultant reports and other studies have emerged in recent years supporting the investment case for inclusion of private equity, direct real estate and other less liquid asset classes in target date and other multi-asset investment portfolios, see Fiduciary Framework for Investment by Defined Contribution Plans in Alternative Assets. At the same time, the range of available investment products designed to permit defined contribution plans to access private equity, direct real estate and other illiquid asset classes has grown significantly. Nevertheless, many 401(k) plan fiduciaries have had concerns about their ERISA liability risk given the amount of litigation focused on alleged excessive and hidden fees and investment options that are alleged to be too risky, complex or that otherwise deviate from the historical norm for defined contribution plans. Such litigation risk tends to encourage "herd mentality," or at a minimum, creates understandable barriers for forward-looking fiduciaries seeking to improve the investment outcome for plan fiduciaries. The Department's information letter goes a long way to clear the barriers by providing practical guidance on how plan fiduciaries may satisfy their fiduciary duties when selecting an investment option with a private equity component.
Does the information letter provide comfort for defined contribution plan investment in direct real estate or other less liquid and alternative asset classes? The information letter was issued in response to a request from two private equity fund of funds managers and focuses exclusively on the inclusion of such products in a defined contribution plan portfolio. However the fiduciary principles and guidelines set forth in the information letter should be valid for other asset classes that may have similar perceived barriers for defined contribution plan fiduciaries. For example, the information letter notes that a prudent plan fiduciary could address the less liquid nature of the private equity component by limiting the percentage allocation to that component within the target date portfolio. The 15% illiquidity restriction applicable under Securities Exchange Commission ("SEC") rules to mutual funds and exchange traded funds is sited as a model that plan fiduciaries could follow to ensure that their plan investment options continue to afford sufficient liquidity for plan participant trading. This guiding principle could be applied to other less liquid asset classes. Similarly, the information letter acknowledges that while more complex asset classes, such as private equity, may have higher fees than publicly-traded securities, a prudent fiduciary should evaluate more broadly whether adding the particular investment option with a private equity component would offer plan participants the opportunity to invest their accounts among more diversified investment options within an appropriate range of expected returns net of fees and diversification of risks over a multi-year period. This principle should equally assist plan fiduciaries evaluating the inclusion of other private, less liquid asset classes that may improve the investment offering and potential retirement outcome for their plan participants.
Does a plan fiduciary have greater risk if the investment option with an allocation to private equity is the default option under the plan? Section 404(c) of ERISA and regulations thereunder (see 29 CFR 2550.404c-1) limit fiduciary liability of plan fiduciaries for investment decisions made by plan participants. Furthermore, to the extent that a participant in a 401(k) plan fails to affirmatively direct the investment of his or her account, plan fiduciaries will be protected from fiduciary liability for the investment of the participant's account if the default option under the plan is a qualified default investment alternative, or QDIA. A QDIA is defined as an investment alternative that "applies generally accepted investment theories, is diversified so as to minimize the risk of large losses and that is designed to provide varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures. . . .," such as a balanced fund or target date fund (see 29 CFR 2550.404c-5(e)). Diversification of a QDIA into the broader range of asset classes considered prudent by investment experts and consultants for institutional portfolios should be consistent with the QDIA definition.
In order for the participants to be able to exercise control over the investment of their accounts, the participants must be able to make informed investment choices. The information letter notes with respect to the inclusion of private equity in a QDIA that plan fiduciaries should determine whether plan participants will be furnished adequate information regarding the character and risks of the investment alternative to enable them to make an informed assessment regarding making or continuing an investment in the fund. Accordingly, plan fiduciaries can mitigate their risks by ensuring that the disclosures to plan participants provide clear, plain English descriptions of the asset classes included in the QDIA and the risks associated with such asset classes.
As is generally the case with the selection of a QDIA or other investment option for a 401(k) plan, the plan fiduciaries remain responsible for the prudent selection and monitoring of that investment option. The guidelines in the Department's information letter should be very helpful for plan fiduciaries to document their prudent investment and oversight procedures.
For further discussion of fiduciary considerations for investment of defined contribution plan assets in alternative asset classes, see Fiduciary Framework for Investment by Defined Contribution Plans in Alternative Assets.
Originally published June 8, 2020
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