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?

The Guidance

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.

Fiduciary Considerations

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:

• Whether the plan fiduciaries overseeing the fund have the necessary skills to evaluate and monitor PE investments, or whether they should rely on an outside consultant or delegate investment selection responsibility to an investment manager.
• The long-term impact of the PE allocation in the fund in terms of diversification and expected return net of fees, including management and performance fees.
• The percentage of the fund to be allocated to PE. In a footnote, the PE Letter references a U.S. Securities and Exchange Commission regulation that establishes a 15% limitation on investment in illiquid assets for registered open-end investment companies. Although not necessarily controlling for purposes of DC plans, this footnote does provide some indication of the Department’s general thinking on this issue.
• Whether the investment option will include features regarding liquidity and valuation that allow participants to take benefit distributions and exchanges into other plan investment options within the plan. The potential limitation on PE investments mentioned above could serve to provide the necessary liquidity through the other investments in the fund; or, alternatively, the PE portion of the fund could be structured in such a manner to provide that needed liquidity directly.
• Whether the long-term nature of the PE investments and any potential liquidity restrictions align with the plan participant population in terms of how participant age, employee turnover, and contribution and withdrawal patterns may affect the ability of participants to take distributions or change investment options with the frequency they would desire.
• The adequacy of disclosures to be provided to participants regarding the character and risks of the plan investment option that includes PE, so as to allow participants to make informed decisions as to whether to invest in the fund.

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:

• State Street Global Advisors has been managing asset allocation portfolios since 1982 and target-date funds since 1995. Today, we manage over $86 billion in target retirement strategies through collective investment trusts, mutual funds and custom strategies (as of May 31, 2020). A key to our asset growth has been applying our robust framework to expand beyond traditional asset classes to include alternative, illiquid and actively managed components to best meet the needs of our clients.
• State Street has a long, deep and broad history in alternatives. We started investing in real estate in the 1950s, private equity in the 1970s, and hedge funds in the early 1990s. Today, State Street Global Advisors manages more than $13 billion in alternative assets (as of March 31, 2020), through relationships with hundreds of top-tier general partners and direct deals sourced by our team of more than 40 investment professionals.

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:

• Advisory Opinion: Per ERISA Procedure 76-1, Section 3, an Advisory Opinion (AO) represents the Employee Benefit Security Administration’s (EBSA) interpretation and application of the law in a specific factual situation. Per section 10, only the parties described in the request may rely on the AO. However, over time, the Department has often has cited particular AOs as representing EBSA’s general views.
• Information Letter: 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.”
• Field Assistance Bulletin (FAB): Unlike Advisory Opinions and Information Letters, which respond to inquiries from the regulated community, FABs are issued by EBSA as guidance to their National Office of Enforcement and Regional Offices on issues of significance. FABs typically, and sometimes in the form of frequently asked questions, set forth EBSA’s interpretive views on provisions of the statute and/or regulations. FABs are released to the public to ensure that the regulated community has the benefit of EBSA’s current views of the law.