The place of private equity in a 401(k) plan's investment lineup
Fiduciaries of defined benefit pension plans have increasingly used alternative asset classes as a part of the plan’s overall investment portfolio in order to seek greater returns and increased diversity over a strategy based solely on publicly traded securities. Despite this shift in investment strategy for traditional pension plans, participants in defined contribution plans such as 401(k) plans have generally not had access to investments in private equity and other alternative products, largely due to the concerns of plan fiduciaries who must balance their obligations under Title I of the Employee Retirement Income Security Act of 1974, as amended (ERISA), with the wide and varying range of investor knowledge and sophistication associated with 401(k) or other individual account plan participation. Accordingly, although assets in defined contributions plans are in the trillions, this is an underserved market.
In a June 3, 2020 Letter, the Department of Labor (DOL) sets forth its views on the use of private equity investments in designated investment alternatives as part of a 401(k) plan lineup, concluding that it believes a plan fiduciary of an individual account plan may offer an asset allocation fund with a private equity component consistent with the requirements of ERISA. The DOL specifically stated that the Letter does not address direct participant investments in private equity funds and that direct participant investments present distinct legal and operational issues for plan fiduciaries.1
While the DOL’s decision not to address direct investments may be a disappointment, the guidance provided in the Letter offers a potential framework for private equity fund sponsors and defined contribution plan fiduciaries seeking to meet the diversified investment needs of plan participants.
As described in the Letter, Pantheon Ventures (US) L.P. and Partners Group (USA), Inc. had each developed private equity portfolios, which may be composed of investments in and alongside third-party funds and managers, designed to be used as a component of a professionally managed asset allocation fund that would be an investment option in an individual account plan. The investments could be structured in a number of ways. For example, the asset allocation fund could be a custom target fund structured by the plan investment committee as a separately managed account. In another example, which Pantheon and Partners Group have employed, the asset allocation fund with a private equity component could be in the form of a prepackaged investment option offered by a financial institution to individual account plans, structured as a collective investment trust.2
ERISA sections 403 and 404 establish standards that govern fiduciary conduct. The Letter notes that of particular relevance to the inquiry is that plan fiduciaries must prudently select and monitor any designated investment alternatives under the plan, and have liability for losses resulting from a failure to satisfy those duties.
The DOL outlines some of the significant ways in which investments in private equity differ from investments in public markets: the complex organizational structures and investment strategies, longer time horizons and longer-term nature of the commitments required to achieve the investment’s objectives, lack of liquidity, different regulatory structures and complex valuations.
In the Letter, the DOL states that in making a determination as to whether to include a particular investment vehicle with an allocation of private equity as a designated investment alternative, the fiduciary should consider:
- whether adding the particular asset allocation fund 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
- whether the asset allocation fund 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 such a fund effectively and
- whether the asset allocation fund 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 asset allocation fund to provide liquidity for participants to take benefits and direct exchanges among the plan’s investment lineup consistent with the plan’s terms.
The Letter suggests some possibilities with respect to valuation and liquidity in particular. For example, a plan fiduciary could require that the private equity investments in the investment alternative not be higher than a specific percentage3 of the assets of the investment alternative, ensure that the private equity investments be independently valued according to agreed-upon valuation procedures that satisfy the Financial Accounting Standards Board Accounting Standards Codification (ASC) 820, and require additional disclosures needed to meet the plan’s ERISA obligations to report information about the current value of the plan’s investments. The profile of participants in the plan is also a consideration for the responsible fiduciary.
Overall, the Letter provides some specific guidance for how a private equity component can be added to a multi-asset investment alternative. Plan fiduciaries now have criteria they can use for evaluating the inclusion of such options and can work with interested plan managers in creating a new investment solution that can work with a plan.
Now that private equity fund sponsors have guidance as to the inclusion of a private equity component in a multi-asset investment fund that can be offered to plan participants, fund sponsors may wish to conduct a review of existing funds and funds in development in order to determine whether it is desirable and feasible to align the sponsor’s products with the DOL’s guidance. Fund managers with products that align with the guidance should consider a strategy for initiating discussions with individual account plan fiduciaries and multi-asset class fund managers regarding the inclusion of private equity funds as one component of a multi-asset fund.4
Ultimately, plan fiduciaries seeking to provide better returns for defined contribution plan participants will be examining their existing lineup in light of the new guidance for additional opportunities to provide better diversification and investment performance for participants, and there should be opportunities for fund sponsors and fund managers to meet these needs with appropriate structures.
Learn more about the implications of the Letter by contacting any of the authors.
1 Among other things, direct participant investments in, or indirect participant-determined allocations to, private equity funds would present “look-through” challenges for purposes of a fund’s exemption from registration under the Investment Company Act of 1940, as amended.
2 A collective investment trust is an entity that is formed solely for investment by benefit plans. The tax-exempt trusts are generally sponsored by banks which act as trustees and managed by professional managers, While subject to both Internal Revenue Code and ERISA regulation, they are generally a lower cost alternative to mutual funds and are not registered under the 1940 Act.
3 The Letter cites the 15 percent limitation on illiquid investments applicable to open-end investment companies registered under the 1940 Act as an example of a threshold that a plan fiduciary could adopt.
4 Private equity fund sponsors also should be mindful of their funds’ ERISA “plan assets” positioning when exploring possible inclusion of a private equity component in an asset allocation fund as well as possible prohibited transaction issues. The DOL specifically stated that the Letter does not address any potential prohibited transaction issues or the possible application of prohibited transaction exemptions.
