DOL Gives OK to Private Equity in Diversified 401(k) Funds

Fiduciaries should prudently evaluate funds with private equity holdings

June 16, 2020
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DOL Gives OK to Private Equity in Diversified 401(k) Funds

On June 3, the U.S. Department of Labor (DOL) issued Information Letter 2020-06-03 under the Employee Retirement Income Security Act (ERISA). The new guidance for the first time allows plan sponsors to add private equity as a component of diversified asset allocation funds available as an investment for 401(k) and similar defined contribution plans.

Diversified funds include target-date, target-risk and balanced funds that are often used as default investments when new employees are automatically enrolled into a 401(k) or similar plan. Private equity refers to investments in companies that are not publicly traded.

The DOL "believes that a plan fiduciary of an individual account plan may offer an asset allocation fund with a private equity component" in a manner consistent with ERISA requirements, the guidance stated.

The information letter does not authorize making private equity investments available for direct investment on a stand-alone basis. It also reminds plan fiduciaries that they "have duties to prudently select and monitor any designated investment alternative under the plan, and [are liable] for losses resulting from a failure to satisfy those duties."

Secretary of Labor Eugene Scalia said that allowing 401(k) participants to invest in private equity "will help Americans saving for retirement gain access to alternative investments that often provide strong returns."

From Pensions to 401(k)s

Private equity investments have long been part of the investment portfolios used by defined benefit pension plans to fund retirement benefits for workers, but they generally have not been incorporated into investment funds used by defined contribution plans.

The information letter—issued to Groom Law Group principal Jon Breyfogle—marks the first time the DOL has addressed the use of private equity in defined contribution retirement plans.

"For decades, institutional investors like traditional pension plans and endowments have invested in private equity, but 401(k) plan fiduciaries have been reluctant to add the asset class to their plans in the absence of specific guidance from the DOL," Breyfogle said. The new guidance "is important because it gives fiduciaries more legal certainty if they want to consider additional asset classes as part of a diversified 401(k) investment option."

Research published in 2018 by the Georgetown University McCourt School of Public Policy's independent think tank, Center for Retirement Initiatives, and consultancy Willis Towers Watson found that a diversified target-date fund, including private equity, could increase investors' annual retirement income.

However, funds with private equity holdings also may have higher management costs and charge plan participants higher fees than standard investment funds. 

A Framework for Fiduciaries

The guidance "provides a framework for a prudent process if [plan fiduciaries] choose to explore it as a component of a larger diversified, managed fund," according to the Groom Law Group in Washington, D.C. "While the guidance is novel, the department has taken similar action in the past, issuing guidance that has established guideposts for new types of investments, such as derivatives, liability-driven investment strategies and annuities."

The DOL identified these important issues for fiduciaries to consider:

  • The long-term impact of the private equity allocation on the plan investment option in terms of diversification and expected return net of fees, including management and performance fees.
  • Whether the fiduciaries overseeing the asset allocation fund have the requisite skills to evaluate and monitor private equity investments, or if they should use an investment consultant or delegate investment selection authority to an investment manager.
  • Whether the investment option will include features regarding liquidity and valuation that allow participants to take benefit distributions and exchange into other plan investment options.
  • Whether the long terms of private equity investments and any potential liquidity restrictions align with the plan participant population, such as participants' ages and rates of employee turnover.
  • The adequacy of disclosures to be provided to participants regarding the character and risks of the plan investment option that includes private equity, to allow participants to make an informed assessment as to whether to invest in this option.

Higher Fees, Greater Diversification

"Concerns have been raised in recent years that private equity investments may not be suitable for individual account plans because they typically have higher investment management fees than mutual-fund and similar investment vehicles included in these plans," noted an alert from law firm Paul Hastings. "However, the DOL confirmed … that the relevant inquiry should be the anticipated range of returns, net of fees, not fee levels themselves."

Lennine Occhino, a partner at law firm Mayer Brown in Chicago, wrote, "Many 401(k) plan fiduciaries have had concerns about their ERISA liability risk given the amount of litigation focused on alleged excessive and hidden fees and investment options that are alleged to be too risky, complex or that otherwise deviate from the historical norm for defined contribution plans. The department's information letter goes a long way to clear the barriers by providing practical guidance on how plan fiduciaries may satisfy their fiduciary duties when selecting an investment option with a private equity component."

The guidance, she added, "acknowledges that while more complex asset classes, such as private equity, may have higher fees than publicly traded securities, a prudent fiduciary should evaluate more broadly whether adding the particular investment option with a private equity component would offer plan participants the opportunity to invest their accounts among more diversified investment options within an appropriate range of expected returns net of fees over a multiyear period."

[SHRM members-only toolkit: Designing and Administering Defined Contribution Retirement Plans]

Opposition Voiced

Some were critical of the DOL guidance.

"The last thing the Department of Labor should be doing is enabling or encouraging retiree money to be diverted from transparent public markets with significant disclosure and investor protections to high-risk, dark private markets with little disclosure and few investor protections," Dennis Kelleher, CEO of Better Markets, said in a statement. Better Markets is a nonprofit that advocates financial market reform to protect investors.

On June 12, Sen. Sherrod Brown, D-Ohio, the top Democrat on the Senate Banking Committee, and six other senators, including Elizabeth Warren, D-Mass., and Bernie Sanders, I-Vt., sent a letter to Scalia asking the DOL to reconsider its position that plan fiduciaries would not violate their duties by allowing private equity investments in defined contribution plans. 


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