ERISA Strategist
This Bulletin is intended as a broad overview of important considerations for plan fiduciaries in evaluating alternatives for potential inclusion in DC plan investment lineups. Using the fiduciary principles under the Employee Retirement Income Security Act of 1974 (“ERISA”), the “highest duty known to the law”1 these considerations may also inform the development of prudent processes for non-ERISA DC plans to explore the use of alternatives.
What are alternative assets?
The term “alternative assets” is used to describe investment options that are not traditional assets like stocks, bonds or cash. Some examples include real estate, private equity, venture capital, private debt, private credit, infrastructure and hedge funds. Alternatives typically have a lower correlation to traditional assets and may provide greater diversification, less portfolio volatility, and enhanced returns. However, unlike traditional assets, alternatives may have complex structures, longer holding periods, less liquidity, difficulties in valuation and higher costs. Alternatives are not registered with the Securities and Exchange Commission, are subject to less regulation, and can be less transparent than registered investment products like mutual funds. As a result, alternatives have historically only been available to institutions and other sophisticated investors. For example, defined benefit pension plans, where a plan sponsor bears investment responsibility, have used alternatives for many years. As defined contribution plans have become the dominant workplace retirement savings vehicle in the United States, there is a desire to make the benefits of alternatives more widely available to DC plan participants, where appropriate. However, plan sponsors, advisers and consultants have generally been slower to introduce them to DC plan investment lineups due to lack of sponsor awareness and the attributes listed above. As with any innovation in DC plan design, there is also the fear of litigation.
How can alternatives be included in DC plans?
Alternatives are not typically offered as investment options that participants may select individually. Instead, they have predominantly been included as part of professionally managed vehicles like target date funds and managed accounts, where a portion of the portfolio may be allocated to alternative asset classes such as real estate or infrastructure. Alternative asset managers may also offer a “fund of funds” approach through a Collective Investment Trust (CIT) with a mix of alternative investments and traditional assets in order to manage liquidity.
How might plan participants benefit from exposure to alternatives in DC plans?
Many participants would not normally have access to alternatives because they do not meet the required asset thresholds and lack the investment experience to be considered “sophisticated investors” under applicable regulatory requirements. Alternatives offered through a DC plan and professionally managed can afford opportunities previously reserved for institutions and sophisticated investors, including:
- greater investment diversification due to low correlation with other plan options
- higher return potential
- higher income potential
- inflation protection
- fiduciary oversight by plan sponsors and investment professionals
Does the Employee Retirement Income Security Act of 1974 (“ERISA”) permit the use of alternatives?
ERISA does not contain a list of investments that are permitted or prohibited in DB or DC plans. Instead, plan fiduciaries must follow ERISA’s core fiduciary duties under ERISA section 404(a)2 as they evaluate, select, and monitor plan investments. Those core responsibilities include:
- The duty of loyalty, to act solely and exclusively in the interest of plan participants and beneficiaries, avoiding conflicts and controlling expenses,
- The duty of prudence, to act with the care, skill, prudence and diligence of a person in a like capacity in an enterprise with like character and like aims, and familiar with the subject matter (“prudent expert rule”) and in the event a plan sponsor does have the requisite expertise, they must hire the right experts to carry out a prudent and well-documented process
- The duty to diversify plan investments to minimize the risk of large losses over a long-term horizon consistent with the accumulation and growth of plan assets in preparation for retirement, and
- The duty to follow the terms of all plan documentation, including the plan’s investment policy.
Has the U.S. Department of Labor (“DOL”) issued regulations approving the use of alternatives?
The DOL has not issued regulations or other formal, binding guidance on the use of alternative investments. However, in response to an inquiry from two private markets firms regarding the use of private equity investments in DC plans, the DOL issued an Information Letter in 20203 and a related Supplemental Statement in 2021.4 While these communications are not formal, binding guidance, and do not create any kind of “safe harbor”, they provide important insights on the DOL’s views as well as a framework for plan fiduciaries to follow together with their advisor or consultant when considering any of the alternative assets referenced above. With emphasis on the fiduciary nature of the decision, core ERISA fiduciary duties, and the need for plan sponsor analysis based on the specific facts and circumstances, the main points are summarized as follows:
- A fiduciary may find that alternatives to be appropriate for a DC plan but only after engaging in an objective, thorough and analytical process that evaluates anticipated opportunities for investment diversification and enhanced investment returns, as well as the associated complexities.
- A fiduciary must understand the various products available in the marketplace, associated risks, liquidity, fees, and the type of product whether target date fund (including glide path) or managed account or other product and if not, engage an investment professional.
- As part of a prudent process, a fiduciary must also consider whether an investment product including alternatives is appropriate based on its own participant demographics, including, but not limited to age, tenure, salary, availability of other retirement plans (a DB plan, for example), investment sophistication, rates of employee turnover and the plan sponsor’s industry. In addition to the points highlighted by the DOL, other considerations include, but are not limited to the ability of the plan recordkeeper’s platform support the investment product, whether to apply a percentage limitation to the level of alternative assets within the selected product, and whether the selected product will be designated as the plan’s Qualified Default Investment Alternative (“QDIA”).
Actions for plan fiduciaries reviewing alternative investments
The decision to offer alternative assets in a DC plan involves important considerations. The potential benefits to plan participants give fiduciaries a reason to take a closer look. To learn more about including alternatives as an investment option in their DC plans, plan fiduciaries should:
- Engage with Investment Professionals: Consult with investment advisors or consultants who work with alternative assets to gain insights into the benefits, risks, and implementation strategies.
- Conduct Due Diligence: Perform thorough due diligence on potential alternative investment options, evaluating their structure, liquidity, fees, historical performance, and associated risks.
- Review Regulatory Guidance: Stay informed about regulatory developments and guidance from bodies like the DOL to ensure compliance with fiduciary duties under ERISA.
Key takeaways
The use of alternatives in DC plan investment lineups is a new concept for many DC plans and may be beneficial to participants. Alternatives can be offered through different investment products commonly found in DC plans, and have been offered through professionally managed vehicles for many years. More widespread adoption among asset managers is increasing attention in the DC plan space. A thorough evaluation based on plan-specific circumstances, together with the expertise of an advisor or consultant can help fiduciaries follow a prudent process, as required by ERISA to determine what is appropriate for a plan. Now is the time to get curious!