DOL Issues Guidance on 401(k) Plan Investments in Private Equity

On June 3, 2020, the U.S. Department of Labor (“DOL”) issued guidance in the form of an Information Letter that significantly expands the defined contribution retirement plan (including 401(k) plan) investment landscape by expressly permitting the use of private equity as an investment in limited circumstances.

Overview. Generally stated, the Information Letter clarifies that, under ERISA, 401(k) plan fiduciaries may prudently include private equity as one component of a plan’s larger diversified investment option, such as a target date fund (“TDF”) or a balanced fund (each of which are heavily diversified by nature), assuming a number of considerations (see below) are met when choosing the private equity investment.

Importantly, however, the guidance does not permit the use of 401(k) plan investment options that would allow a participant to invest directly in private equity funds, noting that such investments would present distinct legal and operations issues.

OBSERVATION: Accordingly, a 401(k) plan may allow participants to choose to invest in a TDF or balanced fund which includes private equity funds in its overall mix. However, the plan may not permit participants to invest directly in a separate investment option consisting solely of private equity funds.

Responding to Fiduciary Concerns. While private equity investments have been permissible for defined benefit pension plans for some time, fiduciaries have generally refrained from offering private equity (which is commonly considered riskier than more traditional investments) within 401(k) and other defined contribution plans, largely due ERISA fiduciary liability concerns.

The DOL seeks to alleviate these concerns, first by limiting the use of private equity monies to investment components within larger, heavily diversified funds (as explained above) and, second, by focusing on the prudence of the private equity investment selection process itself. By following these precepts, the DOL believes that fiduciaries “may offer an asset allocation fund with a private equity component . . . in a manner consistent with the requirements of Title I of ERISA.”

Factors to be Considered When Choosing Private Equity Investments. When choosing a private equity investment to be included as a component of a larger, diversified fund, a plan fiduciary should take into account the following considerations:

• The impact of the private equity investment on the larger investment option in terms of diversification, and its long-term expected return net of fees (including, for example, any management and performance fees);
• Whether the plan fiduciaries have the requisite skills required to evaluate and monitor private equity investments, or whether they should instead consider retaining an investment consultant or delegate the investment selection authority to a qualified investment manager;
• The percentage of the larger investment option that is to be invested in the private equity component;
• Whether the private equity component will include liquidity and valuation features that permit participants to take distributions, and to make investment option transfers, in a manner consistent with the terms of the plan;
• Whether the private equity component (and any potential liquidity restrictions) are consistent with the plan’s overall participant population (for example, participant age, employee turnover, participant contribution and withdrawal patterns);

COMMENT: Specifically, the concern is that the presence of the private equity component (along with any attendant liquidity restrictions) does not interfere with the ability of the representative participant population to take distributions or change investment options with their accustomed ease and frequency.

• The adequacy of plan participant disclosures regarding the risk characteristics of the larger plan investment option that includes the private equity component, so as to allow participants to make an informed decision as to whether to invest in the larger investment option.

Prohibited Transactions. Notably, the Information Letter does not address whether any investment in private equity could raise issues under ERISA’s prohibited transaction rules. As a practical matter, for this and related reasons, any contemplation of using private equity as a component in a larger, diversified 401(k) investment fund (such as a TDF) should be evaluated by a qualified ERISA attorney or other professional advisor.

Ability to Rely on Information Letter. The Information Letter was issued to the Groom Law Group in direct response to an inquiry involving two of the firm’s specific clients, and therefore it can only be directly relied upon by those two entities. However, because the letter represents the viewpoint of the DOL with respect to the relevant facts and issues, it should be safe to assume that the guidelines and sentiments expressed in the Information Letter can be applied to similar facts and circumstances.

The information and content contained in this blog post are for general informational purposes only, and does not, and is not intended to, constitute legal advice. As always, for specific questions concerning 401(k) retirement plan investments or other compliance issues, or for help in operating your plan during the current COVID-19 crisis, please consult your own ERISA attorney or professional advisor.