DC plans can offer investment funds with private equity, DOL says 

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A recent Department of Labor (DOL) information letter says designated investment alternatives with private equity components can be part of a prudent mix of investment options under 401(k) and other ERISA-covered individual-account plans. Although defined benefit plans sometimes invest in private equity, fiduciaries of defined contribution (DC) plans have been reluctant to do so in the absence of DOL guidance. DOL’s letter outlines ERISA fiduciary considerations in evaluating these options for a plan’s investment lineup. But the letter doesn’t address potential issues under other federal or state laws.

Private equity in managed asset-allocation funds

The information letter discusses whether DC plans can offer professionally managed asset-allocation funds — such as target date, target risk and balanced funds — that include private equity investments. The private equity component would be limited to a specified portion — the letter suggests no more than 15% — of the fund’s assets, with the remainder invested in a range of asset classes with different risk and return characteristics, including publicly traded securities and other liquid investments.

Potential benefits of private equity investments. The request to DOL asserted a number of reasons fiduciaries of individual-account plans might want to offer funds with private equity to participants, who generally won’t meet the requirements to invest in private equity directly. For example, the funds could allow participants to invest in privately held companies during their early growth stages, which could help participants with long investment horizons see enhanced returns over time. The funds might also contribute to overall diversification of participants’ accounts. In addition, private equity might provide a hedge against market downturns, since these investments might not move in lockstep with the public market — although this effect may be due to the difficulty associated with valuing private equity investments.

Fiduciary considerations

The letter confirms that fiduciaries won’t violate ERISA just because they select funds with a private equity component for individual-account plans. However, these investments raise unique concerns for DC plan fiduciaries. Compared with publicly traded securities, private equity investments often have more complex organizational structures and investment strategies, longer time horizons, and more complex and often higher fees arrangements. Private equity is also subject to different regulatory and oversight requirements than public securities are. And valuation is more complex since private equity investments often have no easily observed market value.

ERISA fiduciaries must always engage in an objective, thorough and analytical decision-making process when selecting and monitoring any investment fund. For individual-account plan funds with a private equity component, DOL says the considerations include:

  • Whether the fund offers participants further opportunities to diversify investment options and risks over several years within an appropriate range of expected net returns
  • Whether the fund is overseen by plan fiduciaries (using investment experts as necessary) or a professional investment manager qualified to manage a fund with a private equity component
  • Whether the fund limits the private equity component to address the unique characteristics of those investments (such as fees, complexity, disclosures and liquidity) and ensures sufficient liquidity to allow participant withdrawals and exchanges with other investment options, consistent with plan terms
  • Whether the fund is an appropriate investment in light of the plan’s features and participant profile (e.g., participant ages, normal retirement age, anticipated employee turnover, and contribution and withdrawal patterns) and the fund’s characteristics (e.g., the investment allocation and strategy, fees and other expenses, any liquidity restrictions, and participants’ ability to access their funds and change investment selections frequently)
  • Whether participants — especially in plans claiming limited fiduciary liability under ERISA Section 404(c) for participants’ investments — will receive adequate information about the character and risks of the funds to make informed decisions about investing in these funds

Fiduciaries should also consider whether they have the skills, knowledge and experience to make informed decisions about funds that include private equity. If not, the fiduciaries may need to retain qualified investment advisers or other investment professionals to assist with the evaluation. Fiduciaries will have an ongoing duty to monitor the investments, which might also require the assistance of qualified advisers.

Guidance limited in scope

Information letters express what DOL believes to be well-settled principles and interpretations of issues, but aren’t binding on any particular set of facts. However, the scope of the letter is limited to reviewing whether offering managed asset-allocation funds with a private equity component can be consistent with a fiduciary’s duties under ERISA. In a footnote, DOL cautions that the letter does not address any potential prohibited transaction issues with the investments or any issues that may arise under federal securities, banking, or tax laws, or other federal or state laws. The agency also notes that its analysis does not apply to direct investments in private equity, which present distinct legal and operational issues.

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