Jun 8, 2020

Department of Labor Provides Guidance on Offering Private Equity Investments in Defined Contribution Plans

abstract photo of private equity

On June 3, 2020, the Department of Labor (DOL) issued an information letter setting out circumstances under which the DOL will not object to the selection by a fiduciary of a defined contribution plan of an investment fund that includes, as part of its underlying investments, investment in private equity. This letter also outlines many of the factors a plan fiduciary would consider in deciding whether to include a private equity component in a defined contribution plan.

Background on Private Equity Investments.  Many defined benefit plans (primarily very large plans) have had investments in private equity investments for quite some time.  These investments can add (i) diversification of return and risk of investments, and (ii) the potential to obtain higher returns from investments in privately held companies.

However, investments in private equity under defined contribution plans (e.g., 401(k) and profit sharing plans) have been rare, possibly because these investments often are illiquid, carry higher risk, and are difficult to monitor because of the dearth of information available on the underlying investments.  In addition, participants have sued fiduciaries claiming that private equity investments in 401(k) plans have resulted in excessive fees and underperformance of investments, which hurt participants’ retirement savings.

Requirements for Private Equity Investments.  In the information letter, the DOL confirmed that it would not consider a fiduciary of a defined contribution plan to have violated its fiduciary duty solely because the plan offers a fund that includes a private equity component as long as each of the following requirements are satisfied:

  • The plan must be a defined contribution plan that allows participants to select investments from among a group of investment options;
  • The fund that holds the private equity investment must be a multi-asset class vehicle structured as a target date, target risk or balanced fund;
  • The fiduciary must prudently select (i) a professionally-managed fund with an investment in private equity, or (ii) a custom fund managed by the fiduciary or its own investment manager with an investment in private equity, only after taking into account (among other items fiduciaries generally should consider) various criteria based on (i) the demographics of the plan’s participant population, and (ii) the manner in which the private equity may impact that population.

It is important to note that the DOL did not sanction an investment directly in a private equity fund as a standalone investment.

Process for Selecting and Evaluating Private Equity Investments.  Some of the factors the DOL says that a fiduciary should consider in deciding whether to offer an investment fund option with a private equity component are:

  1. Whether the asset allocation is overseen by plan fiduciaries or professional managers with the capabilities, experience and stability to effectively manage a fund that includes private equity investments;
  2. Whether the fund (i) has limited the allocation of investments in private equity in way that addresses cost, complexity, disclosures and liquidity, and (ii) has adopted features related to liquidity and valuation that allow participants to take distributions in compliance with the plan terms (for example only, does the fund limit private equity investments to a specified percentage of assets);
  3. Whether, based on (i) plan features, (ii) participant ages, (iii) normal retirement age, (iv) anticipated employee turnover, and (v) contribution and distribution patterns, the fund will satisfy the needs of participants;
  4. Whether the fiduciary needs the assistance of a registered investment advisor to assess the fund with private equity investments; and
  5. Whether the participants will be furnished adequate information regarding the character and risks of the fund.

In other words, the fiduciary must engage in an objective, thorough and analytical process that compares the fund with a private equity investment to appropriate alternative funds that do not have private equity components.  For all but very large plans, the DOL’s guidelines will likely lead plan fiduciaries to conclude that the potential benefits of private equity investments are not sufficient to overcome the liquidity, valuation and other concerns identified by the DOL.

Continued Possibility of Participant Lawsuits.  It is important to note that this information letter only protects fiduciaries from challenges from the DOL as to this type of fund selection.  The letter does not protect fiduciaries from the types of challenges that participants have made to this type of investment through fiduciary breach litigation.  For example, the plan fiduciaries of a large 401(k) plan were recently sued by participants claiming that the custom funds with private equity components selected by the fiduciaries were excessively expensive and underperformed commercially available funds.  While the DOL’s information letter may give courts some guidance as to how to assess these claims, the letter will only be a guide and not a protection for fiduciaries.

If you have questions about private equity investments in defined contribution plans or other issues relating to retirement plan investments, please contact your Executive Compensation and Employee Benefits Counsel at Smith, Gambrell & Russell, LLP.


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