During the Trump administration, the Department of Labor issued a controversial information letter confirming that under certain circumstances, private equity investments could be permissible as part of target-date, balanced or similar investment fund that was an option on a retirement plan menu. Critics responded that their lack of transparency, relatively high fees, lack of liquidity and hard-to-value assets made private equity investments inappropriate for 401(k) plan participants. Critics also questioned whether plan fiduciaries or participants had the expertise to understand and evaluate private equity investments.
The DOL has now clarified its earlier advice in guidance that stresses the responsibilities of fiduciaries whose plans offer these investments, and makes clear that the prior guidance wasn't an endorsement or recommendation of private equity investments.
In January, a federal court in California also addressed this issue and dismissed claims that Intel’s inclusion of investment options with alternative investments, including private equity, in its 401(k) menu was per se imprudent. That court also dismissed unsupported claims that Intel’s custom funds were imprudently designed compared to claimed benchmark funds.
Where does that leave 401(k) plan fiduciaries who are considering these investments? The bottom line is that private equity investments may still be appropriate for certain plans and participant groups if there is a cap on the fund’s private equity investments and fiduciaries do their homework in selecting and monitoring the funds.
As the Supreme Court recently ruled in its decision in Hughes v. Northwestern University, fiduciaries must evaluate each fund in their menus individually for prudence and may not rely on a defense that participants have a menu of funds to choose from that includes some prudent investments. This rule applies to menu selection even if the fiduciaries rely on the safe harbor protecting them from liability for losses when participants control the investment of their accounts.
If fiduciaries don't have the expertise to understand and evaluate these investments, they must engage professional assistance, such as an investment adviser or an investment manager described in Section 3(38) of ERISA. However, nothing in the old or new guidance addresses the situation in which participants might make direct private equity investments, which the DOL states in a footnote “present distinct legal and operational issues for fiduciaries.”
In its recent guidance, the DOL stressed that the information letter dealt with the situation in which fiduciaries who made private equity investments for their defined-benefit plans and were already familiar with them were considering such investments for their 401(k) plans. The DOL, in fact, cautions at the end of its latest guidance that “[e]xcept in a minority of situations, plan-level fiduciaries of small individual account plans are not likely suited to evaluate the use of PE investments in designated investment alternatives in individual account plans.”
In addition to the considerations above, the DOL provides the following guidance for fiduciaries who must engage in an “objective, thorough and analytical process,” either alone or with the assistance of a qualified professional, when considering adding private equity exposure to their plans:
• The fiduciaries should evaluate whether the investment arrangement being considered complies with securities, banking and other relevant laws.
• The fiduciaries should evaluate three compliance areas highlighted by the SEC: conflicts of interest, fees, and policies and procedures regarding material non-public information.
• The fund must provide sufficient liquidity to provide benefit distributions and direct exchanges to other investment funds as required by the plan. (Note that the Section 404 (c) safe harbor requires the right to change investments in core options to be available at least quarterly.)
• Fiduciaries should consider the plan’s participant profile as it relates to the longer term investment horizon and liquidity restrictions of private equity investments, including participants’ ages, the plan’s normal retirement date, turnover rates, and contribution and withdrawal patterns.
The DOL suggests that the plan fiduciary could deal with the asset valuation issues (presumably, the difficulty of valuing some assets and potential subjectivity) by requiring that the private equity investments be independently valued in accordance with procedures that satisfy the FASB’s ASC 820 on “fair value” and could also require additional disclosures needed to report the current value of plan assets to participants.
While not analyzed in the DOL guidance, plan fiduciaries should also consider whether the fund is managed by an ERISA fiduciary or is not treated as holding plan assets, and whether the investment would require reliance on prohibited transaction exemptions.
To further protect themselves, plan fiduciaries should be comfortable that the investment disclosures given to participants accurately disclose the risk profile, fees and other material aspects of these investments.
Plan fiduciaries should be aware that despite the Intel decision, they will probably increase their risk of being sued even if they apply the procedures above, as Intel is not likely to be the last word on alternative investments in 401(k) plans. The risk is higher than if these investments are made in defined-benefit plans, given that the plan sponsor must make up investment losses in a defined-benefit plan, whereas participants bear the loss in defined-contribution plans. This puts a premium on documenting their adherence to good fiduciary processes.
Carol Buckmann is a founder and partner at law firm Cohen & Buckmann.
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