Executive Summary

On June 3, 2020, the U.S. Department of Labor issued guidance stating its view that plan sponsors of 401(k) and other defined contribution plans may offer participants access to alternative assets (including private equity funds) through broadly diversified investment options such as target date funds. Although this guidance does not change the law, it may encourage plan sponsors who have been hesitant to offer such products to incorporate alternative assets into their plans.

As the various stakeholders choose to prepare for this opportunity, the following initial steps should be considered:

  • Target date fund managers will need to decide whether and how they will incorporate alternative investments into their product offerings and how they plan to address the valuation and liquidity needs of plan sponsors and their participants.
  • Alternative asset allocators (such as fund of funds managers) should consider how to construct durable asset allocation products that include a good pipeline for future opportunities as 401(k) plan participants' needs change over time and that can scale up or down in size. Additionally, they should consider how they will comply with their fiduciary duties under ERISA.
  • Alternative fund managers should begin to explore whether and how they can tailor products and investments to better suit the needs of defined contribution plan investors.
  • Plan fiduciaries should follow an objective, thorough and analytical process, which considers all relevant facts and circumstances, when evaluating investment products such as alternative assets.

Introduction

On June 3, 2020, the U.S. Department of Labor (DOL) issued long-awaited guidance clarifying its views on defined contribution plans, including private equity investments as part of a broader diversified investment option. The guidance, which comes in the form of an information letter,1 has the potential to accelerate the existing trend toward including a measured level of alternative asset exposure in these types of plans.

The letter demonstrates the DOL's recognition of the role that private equity and other alternative asset classes can play for participants by enhancing diversification of investment risk, facilitating potentially greater investment returns, and providing investment options whose performance may be less correlated to the traditional options available to plan participants. Participants in traditional pension plans have benefitted from exposure to these types of investments for years, and the letter may help level the retirement plan playing field.

The letter does not change the legal standards under ERISA, but it offers important guidelines for plan sponsors and asset managers. It will also have important implications for target date fund managers, alternative asset allocators (e.g., fund of funds managers) and private equity and other alternatives managers who seek to work with these types of plans. The letter may also help to curb the risk of class action lawsuits against plan sponsors who take appropriate steps in evaluating and adopting investment options incorporating private alternatives exposure. The wave of 401(k) fiduciary breach and fee litigation class actions over the last decade has had a chilling effect on efforts by plan sponsors and asset managers to offer these types of investment options, due in part to their higher fees and greater level of complexity versus a typical mutual fund or ETF. To date no court has weighed in on this question, but the DOL's recognition of the ability for a plan sponsor to offer a product with alternatives exposure could give confidence to plan sponsors that they are acting in a manner consistent with their fiduciary duties in offering these products.

The remainder of this alert describes and analyzes the guidance provided in the letter and sets out some further factors that plan sponsors, target date fund managers, asset allocators, and alternatives managers should consider as they evaluate how to proceed following this guidance.

Common Investment Structures the DOL Addressed

The letter addresses managed multi-asset class asset allocation funds ("Allocation Funds") that include alternatives investments along with publicly traded securities and other liquid investments.2 It describes each Allocation Fund as having a large enough pool of assets to provide sufficient exposure to a diverse mix of private equity and other investments that have varying risk and return characteristics and investment horizons. In addition, the fund's overall exposure to alternative assets would have a target allocation that would not exceed a specified portion of the fund's total assets, with the remainder of the fund's portfolio invested in publicly traded securities or other liquid investments with readily ascertainable market values.3 This means that the Allocation Fund will need to provide sufficient liquidity to participants to take distributions and to direct exchanges among the plan's investment line-up in accordance with the plan's terms, but it will not impose additional liquidity restrictions on the underlying alternatives funds.

Footnotes

1 An information letter is a piece of official DOL guidance that states a well-established interpretation or principle of ERISA without being binding on the DOL with respect to any particular factual situation.

2 One example of an Allocation Fund would be a collective investment trust (CIT) that is a target date fund, target risk, or balanced fund. As a CIT, the vehicle would have to be maintained by a bank or trust company and it would be subject to regulation by the U.S. Office of the Comptroller of the Currency, but it would not be subject to the Investment Company Act of 1940. Moreover, as a CIT, it would be open only to certain limited categories of investors, including 401(k) and other retirement plans, but not IRAs or individual investors.

3 In a footnote, the DOL referenced the SEC's 15% limitation on illiquid investments applicable to registered open-end investment companies (i.e., mutual funds and exchange-traded funds). As the products addressed by the letter are not subject to SEC regulation, the 15% limit would not apply. This example may or may not guide market behavior.

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Originally published by Ropes & Gray, on June 2020

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.