The Department of Labor (DOL) recently issued an information letter under the Employee Retirement Income Security Act (ERISA) making it clear that fiduciaries of defined contribution plans — e.g., 401(k) plans — may prudently include private equity as a component of a professionally managed multi-asset class vehicle structured as a custom target date, target risk or balanced fund.
To that end, the letter provides an important roadmap for plan sponsors to establish a prudent ERISA process when evaluating and monitoring investments that include private equity. The letter does not authorize the direct investment by plan participants in private equity.
ERISA Fiduciary Considerations
ERISA fiduciaries must discharge their duties “solely in the interest of the plan’s participants and beneficiaries and with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”
These standards require a 401(k) plan fiduciary to prudently select and monitor investment options and “engage in an objective, thorough, and analytical process that considers all relevant facts and circumstances …”
DOL’s View on Investment Options With a Private Equity Component
A plan fiduciary does not violate the fiduciary’s duties solely because the fiduciary offers an investment fund with a private equity component. However, the DOL advises fiduciaries to consider a number of factors when evaluating any such fund.
- The unique characteristics of private equity funds: They have more complex structures and investment strategies, longer time horizons, more complex and typically higher fees.Fund investment managers guide management and operations of portfolio companies.The ability of investors to redeem or sell to obtain capital may be limited during multi-year periods.Funds are subject to a different regulatory regime (e.g., disclosure requirements, oversight, controls) than public market investments.Valuation is more complex due to no public market value.
- They have more complex structures and investment strategies, longer time horizons, more complex and typically higher fees.
- Fund investment managers guide management and operations of portfolio companies.
- The ability of investors to redeem or sell to obtain capital may be limited during multi-year periods.
- Funds are subject to a different regulatory regime (e.g., disclosure requirements, oversight, controls) than public market investments.
- Valuation is more complex due to no public market value.
- Whether adding the fund would offer participants the opportunity to invest among more diversified investment options within an appropriate range of expected returns net of fees, including management fees, performance compensation or other fees or costs, and diversification of risks over multiple years.
- Whether the plan fiduciary has sufficient expertise to evaluate investment options with private equity components or whether the fiduciary should retain investment professionals with appropriate capabilities, experience and stability.
- Whether the fund limits private equity exposure to address its unique characteristics, including cost, complexity, disclosures and liquidity. The DOL suggests a fiduciary ensure that the fund’s private equity component not exceed a specified percentage (e.g., no more than 15 percent of the fund should be invested in illiquid assets) and that the private equity investments are independently valued according to acceptable accounting standards and subject to annual audit.
- The DOL suggests a fiduciary ensure that the fund’s private equity component not exceed a specified percentage (e.g., no more than 15 percent of the fund should be invested in illiquid assets) and that the private equity investments are independently valued according to acceptable accounting standards and subject to annual audit.
- The plan’s features and participant profile (e.g., participant ages, normal retirement age, anticipated employee turnover, and contribution and withdrawal patterns), and whether the investment is consistent with the plan’s characteristics and participant needs, taking into account the fund’s allocation and strategy, fees and other expenses, the nature and duration of any liquidity restrictions, and participant ability to access plan funds (e.g., loans and distributions) and change investment options.
- How to comply with ERISA’s information and disclosure requirements and enable participants to make informed assessments regarding investing or continuing an investment in the fund.
Key Takeaways
An information letter is not binding on the DOL or private plaintiffs, so it is not clear what impact the letter will have on defined contribution plans or market practices generally. Those plan sponsors that wish to evaluate funds with private equity components should take care to address the considerations the DOL notes and pay attention to inherent valuation issues associated with private equity investments and ERISA’s prohibited transaction rules. Engaging a third-party financial expert may be useful to buttress the prudence of the evaluation process. Note also that the letter reflects the current views of the current administration, either or both of which could change.
For questions regarding the information letter or qualified plan investments generally, please contact any member of the McGuireWoods employee benefits team.