News
June 11, 2020

Department of Labor Expresses Views on Private Equity Inclusion in Defined Contribution Plan Investment Alternatives

Advisory

On June 3, 2020, the US Department of Labor (DOL) issued an information letter stating its view that private equity (PE) investments may be part of a professionally-managed asset allocation fund investment alternative under a participant-directed retirement plan, provided the plan fiduciaries comply with their ERISA duties in selecting the fund. The letter responds to a request for the DOL's view with respect to a multi-asset target date, target risk or balanced fund that includes a PE component among other publicly traded securities and liquid investments with readily ascertainable market values.

The Employee Retirement Income Security Act of 1974 (ERISA) does not expressly prohibit fiduciaries responsible for determining the investment alternatives of participant-directed defined contribution plans (such as 401(k) plans) from including PE among the plan's menu of investment alternatives. While PE investments have been included within some fund offerings to defined contribution plan participants, many plan fiduciaries have felt less comfortable with alternatives that include material allocation of PE investments. According to the DOL press release accompanying the letter, the DOL intends to encourage plan fiduciaries and investment professionals to broaden the inclusion of these investment offerings, and to offer helpful insight on factors plan fiduciaries and investment professionals should consider when selecting such investment options. Plan fiduciaries may also want to review any investment alternatives which currently include a material allocation of PE assets in light of this information letter.

The DOL provides that fiduciaries selecting an asset allocation fund with a PE component 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, as well as the complexities associated with the private equity component." The letter provides specific factors that fiduciaries should consider when weighing the risks and benefits of adding the fund to a plan's investment line-up. Fiduciaries selecting the fund should document their consideration of these and other relevant factors, and they should consult with investment professionals who have the skill, knowledge and experience to assist them in assessing these factors, as needed. The fiduciaries should also remember that their job is not done once they decide to include the fund in the investment menu; they must also periodically revisit whether the inclusion of the fund remains a prudent investment option and take appropriate action if they deem it is no longer prudent.

Specific factors to be considered include:

  • Does the asset allocation fund offer participants more diversification opportunities in light of the diversification risks over a multi-year period and the range of expected net returns?
  • Will the asset allocation fund be managed by plan fiduciaries or investment professionals who "have the capability, experience and stability" to do so, "given the nature, size and complexity of the private equity component"?
  • Will the allocation to PE be restricted to account for the unique characteristics of the investment, such as its cost, complexity, liquidity and disclosures?
  • Will the allocation to PE have liquidity and valuation procedures (such as a cap on the percentage of the fund that may be allocated to PE and agreed upon valuation methods), to ensure that the fund has appropriate liquidity to pay benefits, make participant loans and permit frequent inter-plan investment changes?
  • Is the investment allocation strategy, expenses and liquidity restrictions of the fund appropriate in light of (among other things) the participants' ages, normal retirement age under the plan, anticipated employee turnover and contribution and withdrawal patterns?
  • Will the participants be provided adequate information regarding the characteristics and risks to make an informed decision to invest in, remain invested in or dispose of their investment in the fund?

The DOL's guidance may be welcome news for plan fiduciaries who choose investment alternatives as well as to investment managers and professionals structuring asset allocation funds a part of an asset class, under circumstances similar to those described in the letter. However, it is important to note the limits of the letter and what it does not do: the DOL does not address stand-alone PE investment options or address plan investments in other types of alternative investment vehicles, such as hedge funds, venture capital funds and real estate funds; nor does the DOL address prohibited transaction rules or federal security, tax and other applicable laws, all of which would need to be carefully scrutinized; moreover, the letter is an "information letter", and as such, it is a statement of the DOL's current view (which might change with different administrations) and as noted in ERISA Procedure 76-1, it is "informational only and is not binding on the [DOL] with respect to any particular factual situation"; and most important, the letter will not necessarily deter participants and their lawyers from claims of fiduciary breach based on their particular facts (indeed, the road map laid out by the DOL for fiduciaries may also serve as a road map for plaintiffs lawyers to allege fiduciary breach claims). That said, the DOL's guidance may be helpful to plan fiduciaries who, after carefully weighing the factors laid out by the DOL with its investment advisors and counsel, determine that it is appropriate and in participants' best interest to add an asset allocation fund with a material PE component to the investment alternative line-up.

© Arnold & Porter Kaye Scholer LLP 2020 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.

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