Private equity investments in target date funds: The DOL supplements its 2020 guidance
On June 3, the Department of Labor (DOL) published an information letter confirming that the Employee Retirement Income Security Act (ERISA) does not prohibit defined contribution (DC) plan fiduciaries from offering asset allocation funds (e.g., target date funds) that include a private equity (PE) component.1 However, on December 21, 2021 the DOL published a supplemental statement cautioning that most fiduciaries of small DC plans may not have the expertise to evaluate the appropriateness of PE.2
Including private equity in asset allocation funds is not new. For several years, a small number of 401(k) plan sponsors have been offering custom target date funds with an allocation to PE. But after two lawsuits were filed against one large plan sponsor, claiming that the inclusion of PE in its target date funds was imprudent, other sponsors were concerned about potential fiduciary liability if they added PE to their target date funds.
The 2020 guidance
In its 2020 information letter, the DOL noted that there are differences between a fiduciary’s decision to include private equity in a professionally managed defined benefit plan and including it as a component of an asset allocation fund offered to participants in DC plans. Compared with public market investments included on a DC plan menu, PE investments tend to be more complex, with longer time horizons; they are typically less liquid and are subject to different regulatory disclosure rules. In addition, the valuation of PE investments is more complex, and their fees are typically higher. The DOL highlighted a number of questions fiduciaries should considering when evaluating whether to include a fund that has an allocation to PE, including:
- Do fiduciaries have the skills, knowledge and experience to evaluate the fund, or should they seek assistance from a qualified investment professional?
- Is the fund overseen by capable, experienced fiduciaries or investment professionals?
- How does the inclusion of PE impact the fund’s expected return net of fees?
- What are the limits on the portion of the fund that can be allocated to PE? The DOL notes that SEC rules impose a 15% limit on illiquid investments in mutual funds.
- How does the fund handle valuation issues?
- Does the fund provide liquidity to permit participants to take distributions and make exchanges among other plan investments?
- Does the fund align with participant characteristics and needs? On this point, the DOL refers to its fact sheet “Target Date Retirement Funds—Tips for ERISA Plan Fiduciaries.”2
- Will participants be given adequate information about the fund, especially if the fund will be a component of the plan’s qualified default investment alternative?
The 2021 supplemental statement
In the supplemental statement, the DOL did not reverse its 2020 guidance that ERISA doesn’t prohibit the inclusion of PE in asset allocation funds. However, they issued the supplement statement in part “to ensure that plan fiduciaries do not expose plan participants and beneficiaries to unwarranted risks by misreading the [June 3, 2020] Information Letter as saying that PE . . . is generally appropriate for a typical 401(k) plan.” The DOL notes that fiduciaries of large defined benefit plans with PE may have the expertise to evaluate PE for their defined contribution plans. However, fiduciaries of small defined contribution plans “are not likely suited to evaluate the use of private equity investments in designated investment alternatives . . . .”
A road map for fiduciaries considering PE or other private investments
In its PE information letter, the DOL lays out the issues prudent fiduciaries should consider and the questions they should ask when thinking about incorporating PE into an asset allocation fund—essentially, providing a road map for a process for fiduciaries to follow. But the process the DOL describes could also be helpful for DC fiduciaries considering target date funds that incorporate other private investments, such as direct real estate.
Although an information letter from the DOL does not carry the same weight as a regulation, courts generally give deference to a regulatory agency’s views on matters within its authority and expertise. So following the due diligence path the DOL outlines in the information letter may also help convince a court that the fiduciaries lived up to ERISA’s standards in the event participants bring a lawsuit claiming fiduciaries were imprudent.
Whether to include PE as a component of an asset allocation fund is a decision fiduciaries – especially those who oversee small plans – should approach carefully and consider whether they have the expertise to evaluate the prudence of that decision.