Burr & Forman

07.15.2020   |   Blog Articles, Employment Tax, Federal Tax, Tax Law Insights

DOL Cracks Open the Door for Private Equity in 401(k) Plans

The U.S. Department of Labor (the “DOL”) recently released an information letter that concludes, if certain conditions are met, a plan fiduciary will not violate his fiduciary duties under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) by offering a “professionally managed asset allocation fund with a private equity component as a designated investment alternative for an ERISA covered individual account plan.” This information letter (DOL Information Letter to Jon W. Breyfogle, June 3, 2020; hereinafter referred to as the “Information Letter”) is the first step in the introduction of private equity investments into 401(k) plans.

Many 401(k) plans are structured with a view of qualifying as a “404(c) Plan.” Generally, Section 404(c) of ERISA provides that if an individual account plan (such as a 401(k) plan) permits a participant or beneficiary (hereafter collectively referred to as a “Participant”) to exercise control over the assets in his or her account and the Participant in fact exercises control over assets in the account, then the plan fiduciaries are not liable for losses arising from the Participant directed investments in a 404(c) plan.

However, the protections afforded to an ERISA Section 404(c) plan are not complete. The ERISA Section 404(c) protections are limited to losses arising from the Participant’s exercise of control of the investment of their account balances. Importantly, under an ERISA Section 404(c) plan, the fiduciaries retain the responsibility to prudently select and monitor the investments offered under the plan.

The Information Letter notes that, in evaluating a particular investment alternative: (1) a fiduciary has a duty to prudently select and monitor investments offered under the plan, (2) a “fiduciary must engage in an objective, thorough, and analytical process that considers all relevant facts and circumstances;” and (3) a fiduciary is responsible “for securing sufficient information to understand the investment and its attendant risks.”

Significantly, the Information Letter deals with an investment alternative that has a relatively limited private equity component. The type of investment discussed in the Information Letter is an asset allocation fund with: (1) a sufficient pool of assets to diversify the fund’s investment over a “range of asset classes with different risk and return characteristics and investment horizons”; (2) a limited private equity investment which “does not exceed a specified portion of the fund’s assets, with the remainder of the fund’s portfolio invested in publicly traded securities or other liquid investments with readily ascertainable market values”; and (3) sufficient liquidity for participant distributions and participant investment election changes and “to meet periodic capital calls on the private equity investments.” (hereinafter “investments with a private equity component” will be referred to as “PE Investment(s)”). The Information Letter cites custom target date, target risk or balanced funds as the likely PE Investments.

The Information Letter observes that PE Investments have “more complex organizational structures and investment strategies, longer time horizons and more complex and typically higher fees” than public market investments available to individual account plans.

The Information Letter indicates that, in making a determination as to an investment alternative, the fiduciary must evaluate the risks and benefits of the investment. The fiduciary should consider: (1) whether adding the PE Investment provides an opportunity to invest “among more diversified investment options within an appropriate range of expected returns net of fees (including management fees, performance fees, or other fees or costs that impact the returns received)”; (2) whether the PE Investments’ management have the “capabilities, experience, and stability” to manage the PE Investment given its unique characteristics; and (3) whether the PE Investment limits the private equity component in a manner that addresses the unique characteristics associated with the private equity component (including cost, complexity, liquidity, disclosures and valuation), and has adopted features sufficient for Participants to take distributions and make investment election changes consistent with the plan’s terms.

Additionally, the Information Letter notes that the fiduciary will need to evaluate the plan’s features and the plan’s participant profile to determine whether the investment is appropriate for the plan.

Significantly, the Information Letter notes that, in making the investment decision, the fiduciary must consider whether the fiduciary “has the necessary skill, knowledge, and experience to make the required determinations or whether the fiduciary needs to seek” qualified assistance. The requestors of the Information Letter indirectly addressed this issue by indicating that the typical structure of the PE Investment would be an asset allocation fund either: (1) structured by a plan committee with the assistance of an independent ERISA 3(21) fiduciary investment adviser; (2) managed by an ERISA 3(38) investment manager pursuant to the delegation of investment duties by a plan committee; or (3) offered by a financial institution to qualified plans as a “fund of funds.” Presumably, under the first two structures, the plan committee could obtain the necessary skill, knowledge and experience through the retention of a fiduciary investment adviser or investment manager.

Finally, the Information Letter notes that a “fiduciary must also determine whether plan participants will be furnished adequate information regarding the character and risks of the investment alternatives to enable them to make an informed assessment regarding making or continuing an investment in the fund.” Given that ERISA 404(c) plan status may be lost if the Participants do not receive sufficient information to exercise control over their investments, a continuing area of concern for fiduciaries will be satisfying these disclosure requirements with respect to a PE Investment.

In the immediate future, the presence of PE Investments in individual account plans/401(k) plans will likely mirror the presence of PE Investments in defined benefit/pension plans with PE Investments being limited to larger plans with sophisticated fiduciaries who retain additional fiduciary support (i.e., ERISA 3(21) investment advisers or ERISA 3(38) investment managers). However, with the passage of time and the development of additional PE Investment vehicles, PE Investments will likely establish a foothold in 401(k) plans.

In summary, if certain conditions are satisfied, a fiduciary will not violate his ERISA fiduciary duties by designating a PE Investment as a designated investment alternative for a 401(k) plan/individual account plan. However, in connection with the designation of such an investment alternative, the fiduciary must consider the unique characteristics of the PE Investment, the characteristics of the plan and the plan’s participants, whether the fiduciary has adequate expertise to evaluate the risks and rewards of the investment (or seek qualified assistance) and whether sufficient participant disclosures will be made with respect to the PE Investment. Given the complexity of issues arising with respect to PE Investment alternatives, fiduciaries will be well served by either (1) retaining an ERISA 3(38) investment manager to manage the PE Investment; or (2) retaining an ERISA 3(21) investment adviser to assist in the selection and monitoring of the PE Investment.


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