DOL Affirms That 401(k) Plans Can Offer Funds With a Private Equity Component

The DOL has issued an information letter affirming that, in appropriate circumstances, the fiduciaries of participant-directed individual account plans (including 401(k) plans) can offer designated investment alternatives with a private equity component without violating ERISA. The letter responds to a request by firms that developed collective investment trusts designed to invest in private equity, while maintaining sufficient liquidity to facilitate participant deposits and withdrawals. The firms proposed that the investments would be offered as part of an asset allocation fund (such as a target date, target risk, or balanced fund) with multiple asset classes. The asset allocation fund might be organized by a plan’s investment committee as a separately managed account, or it might be a prepackaged investment option offered by a financial institution as a “fund of funds.” The firms noted that many defined benefit plans include private equity investments, but plan sponsors have been reluctant to offer private equity in individual account plans because of concerns about fiduciary liability.

The DOL’s letter affirms that individual account plans may offer asset allocation funds with a private equity component but cautions that private equity investments raise unique risks and benefits that must be evaluated by the plan fiduciary. Compared to typical public market investments, private equity investments have more complex organization structures and investment strategies, longer time horizons, and complex (and often higher) fees. They are subject to a different regulatory scheme than public investments, have limited liquidity, and often have no easily observed market value. Given these characteristics, the letter highlights three issues fiduciaries must address: (a) whether adding the private equity investment would give participants more diversified options within an appropriate range of expected returns (net of fees) and risk diversification; (b) whether the fiduciaries or professional investment managers can manage the investment effectively; and (c) whether the fund appropriately limits the investment. The letter stresses that the responsible fiduciary would need to consider whether the investment aligns with the plan’s features and participant profile (such as participant ages, normal retirement age, anticipated turnover, and contribution and withdrawal patterns), and whether the fiduciary is able to make the required determinations or will need assistance from an investment professional. The fiduciary would also have to determine whether participants will be furnished adequate information about the investment, which will be especially important in a plan designed to limit the fiduciary’s liability using ERISA § 404(c), or one that offers the investment as a qualified default investment alternative. The DOL notes that the letter does not address potential ERISA prohibited transactions or other applicable laws, such as federal securities and banking laws.

EBIA Comment: The DOL’s letter opens the door to private equity investments by 401(k) plans, but only as a relatively limited component of a larger collective investment, and only when plan fiduciaries can conclude that the unique characteristics and burdens of private equity—e.g., limited liquidity, long investment horizons, and higher fees—can be justified by the potential benefits. That analysis appears to be considerably more complicated than the analysis required when selecting public market investments, particularly in the post-Dudenhoeffer era (see our Checkpoint article). Still, the opportunity to participate in the returns achieved by private companies that will never go public, or that may be in a growth phase prior to going public, may lead some fiduciaries to decide it is worth the effort. For more information, see EBIA’s 401(k) Plans manual at Sections XXV.D (“Selecting the Plan’s Investment Funds”) and XXVI.B (“Limiting Fiduciary Exposure Through ERISA § 404(c) Protection”).

Contributing Editors: EBIA Staff.