Facing expectations of modest investment returns, a growing number of plan sponsors have expressed an interest in exploring the addition of non-traditional investment opportunities for their plan participants. While the Employee Retirement Income Security Act of 1974 (ERISA) does not specifically preclude any particular investment as part of an investment strategy or platform, plan fiduciaries, ever sensitive to their duties of prudence and the litigious environment in which they sponsor a retirement plan for their employees, have rightfully been cautious about being creative in their investment offerings, particularly in the absence of clear regulatory or interpretive guidance. Thus, it is of significance that the U.S. Department of Labor’s Employee Benefits Security Administration (the Department), responsible for the administration and enforcement of ERISA, recently issued guidance, in the form of an Information Letter (the Letter),1 setting forth its views on the inclusion of private equity (PE) investments as a component of a designated investment alternative in a participant-directed individual account plan.2
While cautionary, the Department’s guidance, dated June 3, 2020 (the PE Letter), affirms that a retirement plan fiduciary would not run afoul of ERISA solely because the fiduciary includes a professionally managed asset allocation fund with a PE component as part of a plan’s investment platform. It is important to note that the Department did not address private equity as a standalone or independent investment offering.
As noted, the largely favorable guidance from the Department comes as plan sponsors continue to seek ways to improve retirement outcomes in the face of modest return expectations from traditional stocks and bonds — and it may encourage more defined contribution (DC) plan fiduciaries to consider following the trends of both the U.S. defined benefit market and markets outside the U.S. According to Willis Towers Watson’s Global Pension Assets Study 2020, the allocation to private assets and other alternatives has increased to 23% (estimated as of 12/31/2019), an increase of 17% since 2009. Most recently, the extreme volatility brought on by the COVID-19 crisis has prompted increased focus on the diversification benefits of alternative asset classes and the downside protection that they may provide. But, as is often the case with agency guidance, the Department’s letter is certainly not definitive or all-encompassing. So how should plan sponsors incorporate this guidance into their processes, and what questions should they ask of their asset managers?
By way of general background, the PE Letter is not the first time the Department has addressed alternative investments. In a 1996 Information Letter, the Department discussed the fiduciary considerations applicable to the utilization of derivatives as part of a pension plan’s asset management strategy.3 Not surprisingly, there are similarities in the Department’s application of ERISA’s fiduciary principles. The Department’s PE Letter, however, shares the Department’s current views on alternative investments and applies those views in the context of a participant-directed individual account plan.
In addressing PE investments in the PE Letter, the Department limited its consideration to private equity investments that would be offered as part of a multi–asset class vehicle structured as a custom target date, target risk or balanced fund, with respect to which each fund would have a sufficient pool of assets to diversify the exposure of plan participants to PE investments with other investments with different risk and return characteristics and investment horizons. Also, the funds would need to be designed to provide sufficient liquidity to allow participants to change investments or take benefit distributions.
As with the Department’s 1996 Information Letter, the PE Letter lays out guideposts for plan fiduciaries as they determine if and how to include PE investments as part of their retirement plan investment platform. In evaluating whether to include an allocation of PE as a designated investment alternative to a particular investment vehicle, the responsible plan fiduciary must evaluate the risks and benefits associated with the investment alternative. The factors to be considered include the following:
It is interesting to note that, in the context of discussing the importance of ensuring adequate disclosures generally, the Department underscores the importance of such assessments for plan fiduciaries seeking to claim limited fiduciary liability under ERISA section 404(c) for participants exercising control over their accounts and/or in determining the prudence of using a PE investment fund as an allocation within a qualified default investment alternative (QDIA). Given the potentially higher risk and fees attendant to funds with a PE allocation, particular care may be needed to ensure the adequacy of the investment-related disclosures when the exposure is intended to serve as part of a QDIA.
In its concluding remarks, the Department notes that, in making an investment selection 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 have a PE component. This review includes anticipating opportunities for investment diversification, enhanced investment returns, and complexities associated with the PE component. And, of course, as with any investment offering, plan fiduciaries have an ongoing obligation to monitor the investment to ensure its offering is consistent with ERISA’s fiduciary principles.
State Street’s Experience
Following the guidance laid out in this this PE Letter, we will continue to assist clients seeking to evaluate the opportunity that alternative asset classes present in a DC context. In doing so, we will rely on our defined contribution and alternatives expertise:
There are various types of nonregulatory guidance that the Department of Labor’s Employee Benefits Security Administration (EBSA) has issued for purposes of sharing its interpretive view on provisions of ERISA and related regulations. They include the following:
1 Pursuant to ERISA Procedure 76-1, Section 3, an “Information Letter” calls attention to a “well-established interpretation or principle” of ERISA, without applying it to a specific factual situation. Section 11, caveats that such a letter is “informational only and is not binding on the department with respect to any particular factual situation.”
2 Information Letter, dated June 3, 2020, at: https://www.dol.gov/sites/dolgov/files/EBSA/about-ebsa/our-activities/resource-center/information-letters/06-03-2020.pdf
3 Information Letter to Eugene A. Ludwig, Mar. 21, 1996 at: https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/information-letters/03-21-1996.
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