Employers that are fiduciaries of participant-directed individual account plans (such as 401(k) plans) subject to the Employee Retirement Income Security Act of 1974, as amended (‘Plans” and “ERISA”, respectively) should be pleased with the position taken by the Department of Labor (“DOL”) in an information letter dated June 3, 2020 (the “Letter”) addressing the use of private equity investments in designated investment alternatives offered in Plans. The DOL states that, subject to the standards and considerations set forth in the Letter (and summarized below), a Plan fiduciary would not violate its duties under sections 403 (29 U.S.C. 1103) and 404 (29 U.S.C. 1104) of ERISA solely because the fiduciary offers a professionally managed asset allocation fund with a private equity component as a designated investment alternative in a Plan.
The Letter, issued in response to a query on behalf of a manager of private equity investments, is informational only and not binding on the DOL with respect to any particular factual situation. Nevertheless, the Letter should provide some assurance to Plan fiduciaries that inclusion of a designated investment option with a private equity component will not be a fiduciary breach under ERISA, provided the standards set forth in the Letter are followed.
Standards and Considerations for Providing Private Equity Investments in Plans
The Letter states that, when evaluating whether to offer a particular investment vehicle with an allocation of private equity as a designated investment alternative in a Plan, the Plan fiduciary must evaluate the risks and benefits associated with the investment alternative, specifically, whether the asset allocation fund 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;
- is overseen by Plan fiduciaries (using third-party investment experts as necessary) or managed by investment professionals that have the capabilities, experience, and stability to manage an asset allocation fund that includes private equity investments effectively given the nature, size, and complexity of the private equity activity;
- has limited the allocation of investments to private equity in a way that is designed to address the unique characteristics associated with such an investment, including cost, complexity, disclosures, and liquidity; and
- has adopted features related to liquidity and valuation designed to permit the fund to provide liquidity for participants to take benefits and direct exchanges among the Plan’s investment line-up consistent with Plan terms.
The DOL cautions that the Letter does not address fiduciary or other ERISA- issues with respect to allowing direct investments in private equity and specifically notes that such direct investments “present distinct legal and operational issues” for Plan fiduciaries.
In the Letter, the DOL points to the importance of fiduciaries considering the Plan participant profile (such as, participant ages, anticipated employee turnover, and contribution and withdrawal patterns) when evaluating the appropriateness of an asset allocation fund with a private equity component. In addition, the Letter provides examples of other relevant factors that fiduciaries should take into account, including the investment alternative’s fees and other expenses, and the nature and duration of any liquidity restrictions, the participants’ ability to access funds in their accounts, and their ability to change investment selections on a potentially frequent basis.
The Letter also highlights the importance of evaluating the adequacy of the information that will be provided to participants regarding the character and risks of the investment alternative to enable them to make an informed investment decision. This factor would be especially relevant if the Plan is intended to comply with ERISA section 404(c), or if the particular investment alternative may serve as the Plan’s qualified default investment alternative.
The skills and expertise of the Plan fiduciary are another relevant factor identified in the Letter. The DOL states that the fiduciary must consider whether it has the skills, knowledge, and experience to make the required determinations or whether the fiduciary needs to seek assistance from a qualified investment adviser or other investment professional.
Finally, the DOL reiterates the application of the basic fiduciary requirements of ERISA Section 404 to the decision making. That is, the Plan fiduciary must periodically review whether the investment vehicle continues to be prudent and in the best interests of plan participants, taking into account the considerations outlined above and any other factors that the plan fiduciary deems appropriate in light of its fiduciary duties under ERISA. Here, the process should include comparing the asset allocation fund with appropriate alternative funds that do not include a private equity component and consideration of the complexities associated with a private equity investment component.
Employers that are Plan fiduciaries may now wish to consider selection of an asset allocation fund with a private equity component as a designated investment alternative for their Plans. The Letter provides an important roadmap for going that route, which the DOL confirms is an available option – in appropriate circumstances. As the Letter makes clear, deciding whether to include a private equity investment option will entail a complex analysis and thorough consideration of multiple factors consistent with ERISA’s fiduciary obligations. Accordingly, before beginning the selection process, Plan fiduciaries should retain a third-party investment adviser that is familiar with private equity investments.