On June 3, 2020, the U.S. Department of Labor (DOL) issued an information letter providing guidance as to how individual account plans subject to the Employee Retirement Income Security Act of 1974, as amended (ERISA) (such as 401(k) and 403(b) defined contribution plans), can include an investment in private equity as part of an asset allocation investment fund offered under the plan.
Note that the letter does not address any ERISA issues that would apply if a defined contribution plan permitted participants to invest their accounts directly in private equity funds on a stand-alone basis. Instead, the DOL, pursuant to the request of two private equity fund managers, provided its views on the use of private equity investments included in a plan-designated investment alternative that constituted “a multi-asset class vehicle structured as a custom target date, target risk, or balanced fund.”
The DOL explained that the private equity allocation would be a limited portion of the multi-asset class fund and suggested that a plan fiduciary should consider whether to require a 15 percent limitation on those investments consistent with the Securities and Exchange Commission rule applicable to mutual funds that limits investments in illiquid investments to 15 percent of a mutual fund’s investments. The DOL contemplated that the remainder of the multi-asset class fund would be invested in publicly traded securities or other liquid investments to provide sufficient liquidity to allow participants to change investment elections and receive distributions from the plan.
The DOL indicated that a fiduciary of a defined contribution plan would not violate its duties under sections 403 and 404 of ERISA solely because the fiduciary offers a professionally managed multi-asset class fund with a private equity component as a designated investment alternative. The DOL highlights the following factors that a plan fiduciary should consider when selecting and monitoring such designated investment alternatives under the plan:
- whether adding the particular 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 (including management fees, performance compensation or other fees or costs that would affect the returns received) 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 experienced investment professionals
- whether the asset allocation fund has limited the allocation of investments to private equity in a way 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 DOL indicated that a plan fiduciary should ensure that the private equity investments be appropriately and independently valued and require additional disclosures to meet applicable ERISA disclosure requirements. In addition, according to the DOL, a plan fiduciary should consider whether the characteristics of the multi-asset class fund, with a private equity investment, align with the plan’s characteristics and plan participants’ needs.
Last, the DOL notes that private equity investments present additional fiduciary considerations for defined contribution plans that are different from those involved in defined benefit plans. Therefore, when selecting such investments, plan fiduciaries must have an objective, thorough and analytical process to compare the asset allocation fund with appropriate alternative funds that do not include a private equity component, anticipated opportunities for investment diversification and enhanced investment returns as well as complexities associated with the private equity component.
Sidley’s Analysis
The DOL information letter does not change the basic requirement for plan fiduciaries to fulfill their fiduciary duties under ERISA in selecting and monitoring investment options offered under a defined contribution plan. In addition, there is nothing in ERISA, nor stated in this letter, that would specifically prohibit a defined contribution plan from offering alternative investments, such as private equity investments, as a stand-alone investment option under the plan provided that the investment option is prudent and satisfies the other requirements of ERISA. However, the information letter provides no comfort regarding these types of investment options.
The letter indicates that the private equity fund managers who requested the guidance developed a collective investment trust specifically designed to be included in a multi-asset class fund offered under a defined contribution plan with a liquidity component for participant-directed withdrawals. This type of private equity fund is not the typical illiquid private equity fund offered to third-party investors, requiring a long-term commitment. As a practical matter, it may be difficult for a multi-asset class fund offered under a participant-directed defined contribution plan to include an allocation to the more typical illiquid type of private equity fund where participants are permitted to elect to change investment decisions on a daily basis. Whether the managers of multi-asset class funds offered to defined contribution plans decide to include an allocation to private equity in accordance with the guidance issued by the DOL remains to be seen.
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