Private Equity in a 401(k) Plan

By: Scott Fischer

In June, the US Department of Labor (Department) issued a Letter stating that it is possible for individual account plans subject to the Employee Retirement Income Security Act of 1974 (ERISA) to offer limited private equity investments in designated investment alternatives in a manner that complies with ERISA, provided certain suitability issues are considered by plan fiduciaries.

Designated investment alternatives are investments such as target date funds and target risk funds which a plan sponsor offers participants to default into. The letter concludes that the plan fiduciary would not violate the fiduciary duties listed in ERISA by adding a private equity component to an asset allocation fund. The letter does not suggest that private equity is a suitable investment option on its own. In addition, the letter mandates that when making such a selection for an individual account plan, the fiduciary must engage in an objective, thorough, and analytical process that compares the asset allocation fund with appropriate alternative funds that do not include a private equity component.

The following are issues a plan fiduciary must consider when investing plan assets in an asset allocation fund with private equity components:

  • The impact of the private equity allocation on diversification and expected returns net of fees (including management fees, performance compensation, or other fees or costs that would impact the returns) on a multi-year basis
  • Whether the plan fiduciary has the skill necessary to manage the private equity investments or whether the fiduciary should hire the help of experts or give investment power to investment professionals who can manage the private equity investments
  • Whether the investment option will include liquidity features that allow participants to take benefit distributions and exchange into other plan investment options
  • The percentage of the investment option to be invested in private equity; the Department notes that the Securities and Exchange Commission (SEC) implemented a 15% limitation on illiquid investments applicable to registered open-end investment companies (i.e., mutual funds and exchange traded funds)
  • Whether the long-term nature of private equity investments align with the plan’s features and participant profile (including, e.g., participant ages, normal retirement age, anticipated employee turnover, and contribution and withdrawal patterns)
  • Whether the plan participants will be furnished adequate information regarding the character and risks of the investment alternative to enable them to make an informed assessment as to whether to invest in the investment option, particularly if the plan is designed to shield plan fiduciaries from investment losses that result from participants’ investment directions, in accordance with ERISA 404(c)

As of now, I would not expect designated investment alternatives to be adding private equity to their portfolios. Though this seems unlikely that we will see these funds become mainstream anytime soon, it may be something you may need to revisit in the future. If you have any questions about this topic, please feel free to email me at sfischer@enzafinancial.com.

Access to information about Hedge Funds is limited to investors who either qualify as accredited investors within the meaning of the Securities Act of 1933, as amended, or those investors who generally are sophisticated in financial matters, such that they are capable of evaluating the merits and risks of prospective investments.

When considering alternative investments, including hedge funds, you should consider various risks including the fact the some alternative investment products: often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as other registered products, often charge high fees, and in many cases the underlying investments are not transparent and are known only to the investment manager.

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