Pension & Benefits News Private equity investments within professionally managed asset allocation funds may be offered in ERISA-covered individual account plan
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Thursday, June 25, 2020

Private equity investments within professionally managed asset allocation funds may be offered in ERISA-covered individual account plan

By Pension and Benefits Editorial Staff

A plan fiduciary would not violate the fiduciary’s duties under ERISA Secs. 403 and 404 solely because the fiduciary offers private equity investments within professionally managed asset allocation funds that are designated investment alternatives for ERISA-covered individual account plan, including participant-directed individual account plans, according to a Department of Labor (DOL) information letter. However, plan fiduciaries must evaluate whether the investment would be appropriate for the plans and the participants.

The DOL has been asked for its views on the use of private equity investments in designated investment alternatives that would be available to participants and beneficiaries in individual account plans, such as 401(k) plans under ERISA. Without ERISA Title I guidance, plan sponsors are concerned that they may have fiduciary liability even where they believe that providing prudently selected and monitored exposure to private equity investments is in the best interest of their individual account plan participants.

Private equity investments have been designed to be used as a component of a managed asset allocation fund in an individual account plan. It is represented that these investment alternatives offer plan participants, who have longer investment horizons, an equities-based investment choice that may enhance retirement outcomes when compared to investment choices containing only publicly traded securities. Also, certain private equity investments may present the opportunity for enhanced diversification of investment risk and for greater returns on participant investments than could be achieved solely in the public market. The private equity investments would be offered as part of a professionally managed multi-asset class vehicle structured as a target date, target risk, or balanced fund. In no case would the private equity component of the asset allocation fund be available as a vehicle for direct investment by plan participants and beneficiaries on a stand-alone basis.

ERISA Secs. 403 and 404 establish comprehensive standards to govern fiduciary conduct. Among other things, employee benefit plan fiduciaries must discharge their duties with respect to a plan solely in the interest of the plan’s participants and beneficiaries, and with the care, skill, prudence and diligence under the circumstances 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. In particular, under Title I of ERISA, plan fiduciaries have duties to prudently select and monitor any designated investment alternative under the plan, and liability for losses resulting from a failure to satisfy those duties.

The Department believes that a plan fiduciary of an individual account plan may offer an asset allocation fund with a private equity component of the type described in a manner consistent with the requirements of Title I of ERISA. However, The DOL noted that, compared to typical public market investments available in individual account plans, private equity investments tend to involve more complex organizational structures and investment strategies, longer time horizons, and more complex, and typically, higher fees.

A typical private equity investment is structured to reflect the longer-term nature of the commitments required to achieve the investment’s objectives, according to the DOL. The typical structures allow the vehicle’s investment professionals to guide the management and operations of the portfolio companies in which the vehicle invests to maximize the returns for investors over a multi-year period during which investors’ ability to redeem or sell to obtain a return of capital may be limited. As compared to public market investments, private equity investments are subject to different regulatory disclosure requirements, oversight, and controls. In addition, valuation of private equity investments is more complex because private equity investments often have no easily observed market value, and there is often an element of judgment involved in valuing each of the portfolio companies prior to their sale by the investment fund or other liquidity event.

The DOL stated that, in evaluating whether to include a particular investment vehicle with an allocation of private equity as a designated investment alternative, the responsible plan fiduciary must evaluate the risks and benefits associated with the investment alternative. In making this determination, the fiduciary should consider (i) 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 and diversification of risks over a multi-year period; (ii) 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 an asset allocation fund that includes private equity investments effectively given the nature, size, and complexity of the private equity activity; and (iii) 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 line-up consistent with the plan’s terms.

A plan fiduciary could require that the private equity investments in the investment alternative not be higher than a specific percentage, 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, “Fair Value Measurements and Disclosures,” and require additional disclosures needed to meet the plan’s ERISA obligations to report information about the current value of the plan’s investments, according to the DOL.

The DOL explained that it would also be important for the responsible fiduciary to consider the asset allocation fund with a private equity component in light of the plan’s features and participant profile (including, e.g., participant ages, normal retirement age, anticipated employee turnover, and contribution and withdrawal patterns) and make a considered decision about whether the characteristics of the investment alternative align with the plan’s characteristics and needs of plan participants.

Also, the plan fiduciary must consider whether it has the skills, knowledge, and experience to make the required determinations or whether the plan fiduciary needs to seek assistance from a qualified investment adviser or other investment professional. The DOL stated that the fiduciary must periodically review whether the investment vehicle continues to be prudent and in the best interests of plan participants. Additionally, the fiduciary must determine whether plan participants will be furnished adequate information regarding the character and risks of the investment alternative to enable them to make an informed assessment regarding making or continuing an investment in the fund.

The DOL concluded that a plan fiduciary would not violate the fiduciary’s duties under ERISA Secs. 403 and 404 solely because the fiduciary offers a professionally managed asset allocation fund with a private equity component as a designated investment alternative for an ERISA-covered individual account plan in the manner described. However, in making such a choice for an individual account plan, the fiduciary must engage in an objective, thorough, and analytical process that compares 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, and the complexities associated with the private equity component.

“This Information Letter will help Americans saving for retirement gain access to alternative investments that often provide strong returns,” U.S. Secretary of Labor Eugene Scalia said. “The Letter helps level the playing field for ordinary investors and is another step by the Department to ensure that ordinary people investing for retirement have the opportunities they need for a secure retirement.”

Source: DOL Information Letter, June 3, 2020

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