My last three articles, Things I Worry About (15), Things I Worry About (16) and Things I Worry About (17), reviewed  the President’s August 7 Executive Order (EO) entitled Democratizing Access to Alternative Assets for 401(k) Investors (Democratizing Access to Alternative Assets for 401(K) Investors – The White House) and some of the misunderstandings about the EO.

This article focuses on the DOL’s guidance in a 2020 Information Letter issued by the first Trump administration on the inclusion of private equity in 401(k) plans. 06-03-2020.pdf The discussion in that Information Letter is relevant because it is foundational for any guidance that will be issued by the DOL in response to the EO.

While the EO broadly covers “ alternative assets” (which includes private funds generally and private equity specifically), the 2020 guidance discussed the inclusion of private equity within asset allocation vehicles (e.g., collective investment trusts, or CITs). The guidance did not apply to standalone investments in private equity in 401(k) plans. (“In no case would the private equity component of the asset allocation fund be available as a vehicle for direct investment by plan participants and beneficiaries on a standalone basis.”)

In discussing the fiduciary responsibilities for selecting an asset allocation investment that includes a private equity allocation, the DOL said:

“Of particular relevance to your request, under Title I of ERISA, plan fiduciaries have duties to prudently select and monitor any designated investment alternative under the plan, and liability for losses resulting from a failure to satisfy those duties. See, e.g., 29 CFR 2550.404c-1(d)(2)(iv) and 29 CFR 2550.404c5(b). In evaluating a particular investment alternative for consideration as a designated investment alternative, the fiduciary must engage in an objective, thorough, and analytical process that considers all relevant facts and circumstances and then act accordingly.”

The Information Letter then explained the DOL’s thinking about why a fiduciary process for allocating assets to private equity involves considerations is different than the selection process for asset allocation funds that only use mutual funds that hold publicly traded securities.

“As compared to typical public market investments available in individual account plans, private equity investments tend to involve more complex organizational structures and investment strategies, longer time horizons, and more complex, and typically, higher fees. A typical private equity investment is structured to reflect the longer-term nature of the commitments required to achieve the investment’s objectives. The typical structures also allow the vehicle’s investment professionals to guide the management and operations of the portfolio companies in which the vehicle invests to maximize the returns for investors over a multiyear period during which investors’ ability to redeem or sell to obtain a return of capital may be limited. As compared to public market investments, private equity investments are subject to different regulatory disclosure requirements, oversight, and controls. In addition, valuation of private equity investments is more complex because private equity investments often have no easily observed market value, and there is often an element of judgment involved in valuing each of the portfolio companies prior to their sale by the investment fund or other liquidity event (e.g., initial public offering).”

With that explanation, the DOL turns to a discussion of the fiduciary process for evaluating an investment vehicle that includes allocations to private equity:

“In evaluating whether to include a particular investment vehicle with an allocation of private equity as a designated investment alternative, the responsible plan fiduciary must evaluate the risks and benefits associated with the investment alternative. In making this determination, the fiduciary should consider

(i) whether adding the particular asset allocation fund with a private equity component would offer plan participants the opportunity to invest their accounts among more diversified investment options within an appropriate range of expected returns net of fees (including management fees, performance compensation, or other fees or costs that would impact the returns received) and diversification of risks over a multi-year period;…”

Comment: While that process could be good risk mitigation—in the sense that plan fiduciaries could respond favorably to a plaintiffs’ attorney or a DOL investigator, I question whether it is a fiduciary requirement. As a general premise, if plan fiduciaries prudently select and monitor a 3(38) investment manager, they are not responsible for the allocation or investment decisions made by that manager. That is the significance of using an investment manager that qualifies under ERISA §3(38).

Expanding on my comment about risk  management, if there were problems with the private equity (or other alternative asset) component of the investment fund,  the fiduciaries could possibly be viewed more favorably if they can  show that they considered the benefits and detriments of the allocation to and selection of the private equity component; obtained guidance from an adviser who is knowledgeable about private equity (or other alternative investments); and reasonably concluded that it would likely be beneficial for their participating employees and that the allocations to alternative investments were prudent. In one decided case—the Intel decision (22-16268.pdf), a Court of Appeals favorably pointed to the plan committee specifically including private funds to mitigate volatility and communicating that to the participants (including the fact that the custom target date fund could underperform in bull markets).

The issue for registered investment companies (“mutual funds”) that hold allocations of alternative assets is somewhat more complex, since an adviser to the mutual fund is not an ERISA fiduciary and therefor the plan fiduciaries cannot benefit from the protections afforded by using a 3(38) investment manager. Even there, though, the law is likely that the plan fiduciaries must prudently select and monitor the adviser to the mutual fund (e.g., a target date series) and determine if the adviser is competent to determine whether allocations to alternative assets are prudent, to determine whether the allocation amounts are appropriate, and to prudently select and monitor the alternative assets used to populate the allocations.

(ii) whether the asset allocation fund is overseen by plan fiduciaries (using third-party investment experts as necessary) or managed by investment professionals that have the capabilities, experience, and stability to manage an asset allocation fund that includes private equity investments effectively given the nature, size, and complexity of the private equity activity; and…

Comment: If the asset allocation “fund” is in a collective investment trust (CIT) or is a managed participant account, the adviser (and the trustee) to the CIT and the adviser to the participant account would be fiduciaries under ERISA. In that case, the plan fiduciaries should evaluate the competency of the investment adviser—experience, performance, credentials, and so on. Assuming that the adviser (and also for the CIT, the trustee) can be prudently selected (and, in the future, prudently monitored), the plan fiduciaries will not be responsible for the investment selections or allocations by the advisers (and trustee) because of the relief provided for selecting 3(38) investment managers.

The issue is similar, but somewhat more complicated, for the selection of a mutual fund that has allocations to private funds. For the moment, under the securities laws, open-end mutual funds cannot hold illiquid private funds. However, the SEC staff has issued guidance to permit closed-end funds (CEFs) to, in effect, hold illiquid alternative assets without limit (other perhaps than practical limits such as needs for operating cash). SEC.gov | ADI 2025-16 – Registered Closed-End Funds of Private Funds  In that case, it appears that open-end mutual funds could invest in CEFs that hold private funds. As an example, closed-end funds could emerge that are specialized to particular types of alternative assets and then open-end target date funds could select from among those CEFs to invest their allocations to alternative assets.

(iii) whether the asset allocation fund has limited the allocation of investments to private equity in a way that is designed to address the unique characteristics associated with such an investment, including cost, complexity, disclosures, and liquidity, and has adopted features related to liquidity and valuation designed to permit the asset allocation fund to provide liquidity for participants to take benefits and direct exchanges among the plan’s investment line-up consistent with the plan’s terms. With respect to valuation and liquidity in particular, a plan fiduciary, for example, could require that the private equity investments in the investment alternative not be higher than a specific percentage, ensure that the private equity investments be independently valued according to agreed-upon valuation procedures that satisfy the Financial Accounting Standards Board Accounting Standards Codification (ASC) 820, “Fair Value Measurements and Disclosures,” and require additional disclosures needed to meet the plan’s ERISA obligations to report information about the current value of the plan’s investments.

Comment: These are each important issues and, as best practices and perhaps risk mitigation, plan fiduciaries should obtain the relevant information to evaluate each of the issues mentioned in the quoted language, but they may not all be fiduciary duties.

For example, on the first issue, a determination of the appropriate allocations to private equity (or other alternative assets), that should be the responsibility of the ERISA fiduciary investment advisers and managers. That would be true for a fiduciary manager of a participant account and for the adviser and trustee of a CIT. To be safe, plan fiduciaries should ensure that the agreements specify that the advisers and trustees are assuming the responsibilities for allocation and selection. With regard to mutual funds, the plan fiduciaries would need to rely on the prospectus and the experience and abilities of the advisers to the mutual funds. While those advisers are fiduciaries under the securities laws, that standard is less demanding than ERISA’s, particularly with regard to investing primarily for the retirement objectives of participants. Stated differently, advisers to mutual have a securities law duty to all of their investors, including those who are not investing for retirement purposes.

Similarly, on the issues of valuation and liquidity, most plan fiduciaries—other than for the largest companies with the most resources—will need to rely on the advisers to participant accounts, the advisers and trustees of CITs, and the advisers to mutual funds. For risk management purposes, plan fiduciaries should work with their advisers to understand how the liquidity and valuation issues will be handled.

Finally, on the matter of participant disclosures, that falls squarely on the shoulders of the plan fiduciaries. Since, in most cases, disclosures are prepared by 401(k) recordkeepers, plan fiduciaries, with the help of their advisers, should obtain assurances from their recordkeepers that compliant disclosures will be provided to the participants. This would include, for example, the 404a-5 investment disclosures.

However, the Information Letter did not end with this discussion. My next article will pick up where this one leaves off.

The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Faegre Drinker.