Parsing DOL Guidance On Private Equity In DC Plans

In June 2020, the (Trump Administration) Department of Labor issued an Information Letter with respect to the inclusion of private equity investments as a “component” of a fund (e.g., a target date fund) included in a fund menu in a participant directed defined contribution plan. On December 21, 2021, the (Biden Administration) DOL issued a “Supplemental Statement” with respect to the 2020 Information Letter, qualifying and limiting the application of the (2020) Information Letter in some respects.

In this note, we review the basic points of the (2020) Information Letter and the additional points made by the (2021) Supplemental Statement.

2020 Information Letter

Framework: The Information Letter considered PE investments in a specific framework, as a limited part (e.g., a specified percentage) of “a multi-asset class vehicle structured as a custom target date, target risk, or balanced fund.” Thus, the appropriateness of a separate PE-only fund in which participants could invest was not considered.

DC PE investments are not per se prohibited under ERISA: DOL stated that “a plan fiduciary would not … violate [ERISA fiduciary rules] solely because the fiduciary offers a professionally managed asset allocation fund with a private equity component as a designated investment alternative for an ERISA covered individual account plan in the manner described in [the] letter.”

PE investments, however, do present significant issues in participant directed DC plans: DOL nevertheless emphasized that “there are important differences between a fiduciary’s decision to include private equity investments in the portfolio of a professionally managed defined benefit 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.” Specifically, private equity investments “involve more complex organizational structures and investment strategies, longer time horizons, and more complex, and typically, higher fees.” They generally have “different regulatory disclosure requirements, oversight, and controls” and “often have no easily observed market value.”

When PE is included in a participant-directed DC plan, the fiduciary must consider specific factors: Fiduciaries of DC plans should generally consider whether, e.g., a target-date fund that includes PE:

Offers plan participants an opportunity to diversify investments “within an appropriate range of expected returns net of fees … and diversification of risks over a multi-year period.”

Is overseen/managed by fiduciaries or investment professionals with “the capabilities, experience, and stability” to manage this sort of investment.

Appropriately limits its private equity allocation given the issues raised by PE investment (discussed above).

[A]lign[s] with the plan’s characteristics and needs of plan participants.”

The ERISA duty of prudence raises issues of expertise: Under ERISA, the fiduciary must determine whether it has the skill/competence to evaluate the investment or should seek help from an outside expert. It should periodically review the continued prudence of the investment. And it “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.”

2021 Supplemental Statement

DOL’s (2021) Supplemental Statement (1) emphasizes certain elements of the Information Letter and (2) includes additional cautions.

Emphasis on certain elements of the Information Letter: The (2021) Supplemental Statement emphasizes the following points included in the (2020) Information Letter:

The Information Letter did not endorse PE investments and raised specific issues with respect to them: The Supplemental Statement restates the concerns raised in the Information Letter with respect to the appropriateness of PE investments in participant directed DC plans, including their complexity, longer time horizons, reduced liquidity, “different regulatory … and disclosure rules than other more traditional [DC] plan investment options,” and higher fees.

The Information Letter identified specific issues that fiduciaries of participant directed DC plans should consider: The fiduciary’s prudence obligation requires “an objective, thorough, and analytical process that evaluates anticipated opportunities for investment diversification and enhanced investment returns, as well as the complexities associated with the PE component.” The fiduciary “should compare the fund with funds that do not include PE.” The fiduciary must have “sufficient information to understand the investment and its attendant risks.” And the fiduciary must consider the specific factors (discussed above) that apply with respect to PE investments in participant directed DC plans.

Additional cautions: In light of “questions and reactions [to the Information Letter] from a range of stakeholders” and a 2020 Securities and Exchange Commission “Risk Alert” with respect to compliance issues in PE funds, and in order to “ensure that plan fiduciaries do not expose plan participants and beneficiaries to unwarranted risks by misreading the letter as saying that PE – as a component of a designated investment alternative – is generally appropriate for a typical 401(k) plan,” DOL added the following cautions with respect to PE investments.

The Information Letter may have overstated the benefits of PE investments: In the (2021) Supplemental Statement DOL stated that the discussion in the (2020) Information Letter of the benefits of PE investments “reflected the perspective of the PE industry; the representations were not balanced with counter-arguments and research data from independent sources.” Generally, claims about PE investment performance must be “carefully analyzed” because these disclosures are “are not standardized or regulated.” Moreover, participants may not have the financial sophistication to understand them. And claims that PE investments are appropriate for participants with “longer investment horizons” may not consider early investment liquidation on, e.g., a job change.

Fiduciaries of small, participant directed DC plans “are not likely suited to evaluate the use of PE investments”: The (2020) Information Letter was issued in response to questions from employers that sponsor both DB and DC plans. These sorts of sponsors have “experience evaluating PE investments in a defined benefit pension plan to diversify investment risk [and therefore] may be suited to analyze these investments for a participant directed [DC] plan, particularly with the assistance of a qualified fiduciary investment adviser. The Department cautions against application of the Information Letter outside of that context.”

Takeaway for plan sponsors

DOL’s new guidance is, generally, a restatement of basic ERISA law and the (2020) Information Letter.

Nevertheless, it differs in tone – it is less positive about the appropriateness of PE investment in participant directed DC plans. And it particularly emphasizes the cautions in the Information Letter about these investments.

It raises issues about the appropriateness of PE investments in participant directed DC plans, e.g., with respect to the ability of participants to understand PE disclosures and the assumption that certain participants can tolerate the issues presented by PE investments because they have longer “investment horizons.”

It explicitly questions whether PE investments could be appropriate for smaller participant directed DC plans or (indeed) where plan fiduciaries do not have the sort of investment sophistication that a DB investment fiduciary has.

Finally, we note that private equity investment in participant directed DC plans has been a litigation target. Sponsors considering such an option will want to review these issues with counsel.