The Department of Labor (“DOL”) has issued an information letter1 which provides guidance to plan sponsors on the use of private equity strategies in defined contribution (DC) plans. The information letter provides that as long as a prudent fiduciary process is undertaken, fiduciaries would not violate their duties2 solely because they offer a professionally managed asset allocation fund with a private equity component as a designated investment alternative3 for an ERISA covered individual account plan, such as a DC plan.
The guidance acknowledges that the asset allocation fund could be structured as part of a custom target date fund, or in the form of a pre-packaged investment option offered by a financial institution to individual account plans, such as a fund of funds structured as a collective trust fund or other pooled vehicle. It does not address vehicles that would allow a participant to invest in private equity directly.
While fiduciaries have included private equity investments in portfolios of professionally managed defined benefit (DB) plans, the DOL highlighted key differences between a fiduciary’s decision to include private equity investments in a DB plan, and the decision to include an asset allocation fund with a private equity component as part of the investment lineup for a participant-directed individual account plan.
Private equity investments tend to involve more complex organizational structures and investment strategies as well as longer time horizons. They also have more complex fees that are typically higher than public equity investments. A typical private equity investment is structured to reflect the longer-term nature of the commitments required to achieve the investment’s objectives. As compared to public market investments, private equity investments are subject to different regulatory disclosure requirements, oversight and controls. In addition, the valuation of private equity investments is more complex because private equity investments often have no easily observed market value, and there is often an element of judgement involved in valuing each of the portfolio companies prior to their sale by the investment fund or other liquidity event such as an initial public offering.
The letter states that as part of their fiduciary responsibilities4 in evaluating a particular investment alternative for consideration as a designated investment alternative, plan fiduciaries must engage in an objective, thorough and analytical process that considers all relevant facts and circumstances and then act accordingly.
Considerations in evaluating whether to include a particular investment vehicle with an allocation of private equity as a designated investment alternative
In evaluating whether to include a particular investment vehicle with an allocation of private equity as a designated investment alternative, the responsible plan fiduciary must evaluate the risks and benefits associated with the alternative. The plan fiduciary should consider the following:
The letter states that with respect to valuation and liquidity in particular, a plan fiduciary, for example, could require that the private equity investments in the investment alternative not be higher than a specific percentage, ensure that the private equity investments be independently valued according to agreed-upon valuation procedures that satisfy the FASB Accounting Standards Codification and require additional disclosures needed to meet the plan’s ERISA obligations to report information about the current value of the plan’s investments. Specifically, the letter does not address how to manage the liquidity of these products, other than to suggest that fiduciaries consider whether they follow the U.S. Securities and Exchange Commission (SEC) rule that includes a 15 percent limit on illiquid investments applicable to registered open-end investment companies.5 Further comment letters clarify that target date funds have sufficient flexibility under this rule to invest directly or indirectly into growth stage issuers, including unregistered funds or securities.6 As investment options in 401(k) plans need to allow plans to support daily contributions and withdrawals at the plan participant level, these are some of the ways that plan sponsors have addressed liquidity needs:
Because target date funds are allocated to multiple asset classes, most of the target date fund’s assets will still be able to satisfy daily liquidity and fund alternatives investments.
Plan and participant suitability evaluation: Consider the asset allocation fund with a private equity component in light of the plan’s features and participant profile, including participant ages, normal retirement age, anticipated employee turnover and contribution and withdrawal patterns. Make a considered decision about whether the characteristics of the investment alternative align with the plan’s characteristics and needs of plan participants. This assessment should take into account, among other things:
Sufficient disclosures to plan participants regarding character and risks: The fiduciary must also determine whether plan participants will be furnished adequate information regarding the character and risks of the investment alternative to enable them to make an informed assessment regarding making or continuing an investment in the fund. In a 2013 fact sheet for ERISA plan fiduciaries, the DOL lays out the types of information that 401(k) plan participants should receive about the fees and expenses associated with their plans, including specific fee and expense information about Target Date Funds (TDFs) and other investment options available under their plans.8 The DOL adds that this factor would be especially important in the case of a plan or responsible plan fiduciary claiming limited fiduciary liability under ERISA section 404(c)9 for participants exercising control over their accounts (see 29 CFR 2550.404c-1) and/or deciding that a particular investment alternative would be prudent to use as a qualified default investment alternative (QDIA) for the plan under 29 CFR 2550.404c-510.
Moreover, as noted above, the fiduciary responsible for including the fund on the plan’s investment menu always retains responsibility for ensuring that the decision to retain the fund is consistent with the fiduciary responsibility provisions of Section 404 of ERISA.
In conclusion, a plan fiduciary would not violate the fiduciary’s duties under ERISA solely because it offers a professionally managed asset allocation fund with a private equity component as a designated investment alternative for an ERISA covered individual account plan. It would not violate these duties as long as the fiduciary engages in an objective, thorough and analytical process that includes comparing the asset allocation fund with appropriate alternative funds that do not include a private equity component and consideration of the anticipated opportunities for investment diversification and enhanced investment returns, as well as the complexities associated with the private equity component.
Strategies for including private equity in DC plans
While the DB plans have invested in private equity for years, the current allocation to private equity in DC plans remains small. For example, a recent survey of custom target date funds estimates that private equity makes up approximately 1 percent of asset allocation.11 A a 2020 survey of TDF managers conducted prior to the DOL’s information letter found that no respondents reported allocating to private equity within an off-the-shelf target date series, and only 8 percent planned to incorporate private equity products within the next 12 months.12 Separately, while the DOL letter addresses the use of private equity in managed products for DC plans, it is worth noting that a quarter of target date managers indicated that they currently allocate to real estate (17 percent) or plan to incorporate an allocation to private real estate in the next 12 months (8 percent).
With the release of the DOL letter, Segal Marco expects more private equity products for DC plans to be offered in the marketplace and for plan sponsors to engage in early stage discussions regarding the inclusion of private equity in an investment sleeve within a broader fund such as a custom target date fund. Plan sponsors who are contemplating using custom-designed target date funds can leverage their advisors to negotiate pricing and work with their advisors to thoroughly research the products being offered.
To illustrate the use of alternatives in DC plans, we turn to a case study of a plan sponsor in the U.S. which was an early adopter of private markets investments into its DC plan offerings. This public plan acts as a fiduciary investment manager for more than a dozen retirement plans, both DB and DC plans, covering public employees, teachers, school employees, law enforcement officers, firefighters and judges.
For three decades the sponsor has been making commitments into private market investment, specifically in private equity, real estate and real assets, for the defined benefit plans it manages. Returns over time have been well above average, which it believes is due to the illiquidity premium captured by its private market investments. In the 1990s, the state created a new hybrid retirement plan that has both a DB and DC component.
Participants are able to select their investment options in the DC portion of the plan. A group of plan participants encouraged the plan to find a way to include private market investments. The plan developed an investment option that has a similar portfolio construction and discipline as the DB component. Participants who elect it benefit from exposure to the same private market investments as those available in the DB plan.
In 1995, the plan began to implement this investment option and in 1996, the state approved this as a default option for participants in the hybrid plan. The new investment option is now the largest investment in the hybrid plan with $8.5 billion in assets and more than 60 percent of participants investing in it.
The plan believes that participants have benefited from this new investment option and having private market exposure. Its private market investments have materially outperformed its public equity investments over the past 1, 3, 5, 10 and 20 years, and have achieved an outperformance of 2.8 percent over 20 years.
In light of the positive outcomes for participants, the plan started in 2016 to explore making an allocation to private market investments in the target date funds available to certain state governmental employees. The project team is taking into consideration investment issues of managing the proper allocation to private markets throughout a TDF’s glide path, legal analysis of the fiduciary issues and addressing operational issues of liquidity, pricing and record keeping methodologies.
DC plans in several countries have adopted the use of alternatives. Australian superannuations offer a helpful case study of how retirement plans can incorporate alternatives such as private equity into their default retirement plan options.13 Typically these superannuations have a 60 percent allocation to equity and 40 percent fixed income, and between 2-15 percent of the portfolio invested into alternatives which sits in the equity bucket. Buys and sells are made with cash and liquid investments other than alternatives. DC plans in Chile, Malaysia, Mexico and the United Kingdom have also included alternatives into their investment strategy with the goal of improving retirement outcomes.
Characteristics of private equity products designed for DC plans
At the time of writing, there are few reliable statistics regarding the number of private equity products on the market designed for use in DC plans and targeted fundraising. We looked at a few of the products on the market and looked for common characteristics across liquidity, pricing, benchmarking, fees and governance related to incorporating alternative investments into target date funds. Ultimately, the products designed and sponsored by investment managers will have to meet the operational requirements of daily liquidity and valuation when incorporated into a larger structure such as a target date fund.
In one example, an investor may have daily liquidity, subject to restrictions on the amount of redemptions in one quarter (such as up to 5 percent of holdings in one quarter, and more than 5 percent of holdings with up to 12 months of advance notice. In certain circumstances, redemption requests may also be satisfied in whole or in part via a distribution in-kind of units in the fund). Unlike typical private equity funds, these products do not make capital calls and the investor can invest more at their discretion. Like an evergreen fund, the investor decides on the amount to invest and the dollars are automatically invested in the fund upon entry. In other words, an investor’s total commitment is fully funded upfront. The fund may manage liquidity by managing inflows against outflows, maintaining a cash buffer and credit facility, and a significant listed securities allocation to maintain liquidity. The portfolio may also see significant realizations from earlier vintages, which is another source of liquidity. Typically these products also automatically reinvest cash from distributions to reduce the impact of cash drag. The other source of liquidity is to sell positions in the secondary market.
In another example, the private equity product has quarterly liquidity representing up to 5 percent of its net asset value (NAV), although such recommendations may exceed 5 percent of the fund’s NAV subject to board approval. Monthly subscriptions may be available. Investment managers have observed that newer products in the marketplace have less liquidity than earlier products, as plan sponsors have become more comfortable with how these private equity products are being used and their liquidity experience. It is anticipated that within a target date fund structure, liquidity needs from redemptions are less frequent due to the inherently passive nature of investing in TDFs.14
Portfolios may be fully funded, which reduces the impact of capital calls and may be diversified across private markets asset classes, holdings, sectors, geographies and vintage years. For instance, products may invest across direct private equity, secondaries and private debt and may have 10-15 holdings in a single vintage. A valuation or net asset value can be calculated daily through a methodology that pegs illiquid assets to the actual trading market through marketable assets and indices.15 Performance may be benchmarked to public equity indices such as the S&P 500, with the caveat that asset allocations may differ vastly from the index.
Products may be offered in transparent, highly regulated structures such as a closed end investment company registered under the Investment Company Act of 1940, as well as Collective Investment Trusts (CITs), which are overseen by an independent board of managers and have independent administrator and custodians and third-party oversight of their valuation process and valuations. Portfolio holdings are transparent and disclosed to the SEC.
In one example, fees are charged on invested capital, instead of the more typical fees on committed capital in private equity which can be a long term drag on returns. Most charge an asset based management fee and do not charge a performance fee, which is in line with many of the products offered to DC plans.
Plan sponsors should evaluate all investments on the basis of potential net of fee returns and their risk profile in different market conditions. That being said, management fees on these products can range from 1.45 percent to 2 percent, which is high compared to the average fee of 0.43 percent that DC plans pay for domestic equity funds, 0.36 percent for domestic bond funds and 0.51 percent for target date funds16, but low compared to the typical 2 percent management fee and 20 percent performance fee across the private equity and alternatives space. Segal Marco believes that as assets grow in the space, the economies of scale will translate into slightly lower fees over time. Plan sponsors and their advisors will need to explore if the potential performance value add and risk mitigation characteristics justify the increase in blended fees at the custom target fund level.
 ERISA, under section 403 and 404, establishes comprehensive standards to govern fiduciary conduct. Among other things, fiduciaries with respect to an employee benefit plan must discharge their duties with respect to a plan solely in the interest of the plan’s participants and beneficiaries and with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.
 “Designated investment alternative” refers to any investment alternative designated by the plan into which participants and beneficiaries may direct the investment of assets held in, or contributed to, their individual accounts.
 Under Title I of ERISA, plan fiduciaries have duties to prudently select and monitor any designated investment alternative under the plan and liability for losses resulting from a failure to satisfy those duties.
 The SEC rule limiting illiquid investments to 15 percent is applicable to registered open-end investment companies (i.e. mutual funds and exchange traded funds.) See Investment Company Liquidity Risk Management Programs, Release No. 33-10233; IC -32315 (October 13, 2016) at www.sec.gov/rules/final/2016/33-10233.pdf. The rule formalized a similar longstanding SEC guideline that generally limited registered open-end funds’ aggregate holdings of “illiquid assets” to no more than 15 percent of the fund’s net assets.
 See generally Concept Release on Harmonization of Securities Offering Exemptions, Release 33-10649, Section IV (June 18, 2019) (at www.sec.gov/rules/concept/2019/33-10649.pdf). See also Comment Letter of Fidelity Investments (Sept. 24, 2019) (at www.sec.gov/comments/s7-08-19/s70819-6190605-192467.pdf)
 See K&L Gates’ Alert on “Private Equity in 401(k) Plans – a Trillion Dollar Opportunity?” dated June 17, 2020 at https://www.klgates.com/private-equity-in-401k-plans-a-trillion-dollar-opportunity-6-17-2020.
 Please see the fact sheet at https://www.dol.gov/sites/dolgov/files/EBSA/about-ebsa/our-activities/resource-center/fact-sheets/target-date-retirement-funds.pdf.
(i) Provides an opportunity for a participant or beneficiary to exercise control over assets in his individual account (see paragraph (b)(2) of this section); and (ii) Provides a participant or beneficiary an opportunity to choose, from a broad range of investment alternatives, the manner in which some or all of the assets in his account are invested (see paragraph (b)(3) of this section). Source: https://www.law.cornell.edu/cfr/text/29/2550.404c-1
 29 CFR 2550.404c-5 implements the fiduciary relief provided under section 404(c)(5) of the Employee Retirement Income Security Act of 1974, as amended (ERISA or the Act), 29 U.S.C. 1001 et seq., under which a participant or beneficiary in an individual account plan will be treated as exercising control over the assets in his or her account for purposes of ERISA section 404(c)(1) with respect to the amount of contributions and earnings that, in the absence of an investment election by the participant, are invested by the plan in accordance with this regulation. Source: https://www.law.cornell.edu/cfr/text/29/2550.404c-5
 Based on the Defined Contribution Institutional Investment Association (DCIIA) YE 2018 survey of 14 asset allocators of the custom target date funds that they manage, which was published in May 2020. Source: https://cdn.ymaws.com/dciia.org/resource/resmgr/docs/DCIIA-RRC_cTDFSurvey_052020.pdf.
 Sources: https://www.napa-net.org/news-info/daily-news/guaranteed-income-private-equity-slated-next-gen-tdfs and https://www.cerulli.com/about-us/press/2020-december-us-asset-and-wealth-management-edition/
 Planadviser, “Strategies for Including Private Equity in DC Plans,” (January 16, 2020) available at https://www.planadviser.com/strategies-including-private-equity-dc-plans/
Plan Sponsor, “2019 Target-Date Fund Survey,” (September 18, 2019) available at https://www.plansponsor.com/research/2019-target-date-fund-buyers-guide/2/#Industry%20Snapshot.
 Planadviser,“Strategies for Including Private Equity in DC Plans,” (January 16, 2020) available at https://www.planadviser.com/strategies-including-private-equity-dc-plans/
 “The BrightScope/ICI Defined Contribution Plan Profile: A Close Look at 401 (k) Plans,” 2017, published in August 2020, available at https://www.ici.org/pdf/20_ppr_dcplan_profile_401k.pdf.
Segal Marco Advisors provides consulting advice on asset allocation, investment strategy, manager searches, performance measurement and related issues. The information and opinions herein provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. Segal Marco Advisors’ R2 Blog and the data and analysis herein is intended for general education only and not as investment advice. It is not intended for use as a basis for investment decisions, nor should it be construed as advice designed to meet the needs of any particular investor. Please contact Segal Marco Advisors or another qualified investment professional for advice regarding the evaluation of any specific information, opinion, advice, or other content. Of course, on all matters involving legal interpretations and regulatory issues, investors should consult legal counsel.
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