My earlier posts discussed four of the six Factors in the DOL’s proposed regulation that apply to most investments in participant-directed private sector plans. This article discusses the first example of the application of the Liquidity Factor, which is one of the two Factors (along with the Valuation Factor) that specifically target illiquid, hard-to-value investments, such as private funds.
As background, the DOL’s proposed regulation on selecting investments, including alternative assets, 2026-06178.pdf, identifies six factors that should be considered in the process of selecting any investments for participant-directed plans, such as 401(k) plans and private sector 403(b) plans. The six factors are: Performance, Fees, Liquidity, Valuation, Performance Benchmark, and Complexity. The proposal describes each of those factors and provides 20 examples of their application.
In earlier posts, I covered four of the factors—Performance, Fees, Performance Benchmarks and Complexity, and their examples.
In my last article, Alternative Assets (22), I started the discussion of the Liquidity factor with the DOL’s description of that factor:
(i) Liquidity. The fiduciary must appropriately consider and determine that the designated investment alternative will have sufficient liquidity to meet the anticipated needs of the plan at both the plan and individual levels. For example, because participant-directed individual account plans are long-term retirement savings vehicles, particularly for participants early in their careers, there is no requirement that a fiduciary select only fully liquid products. Indeed, a prudent fiduciary process may regularly lead to a decision to sacrifice some plan- or individual-level liquidity, or both, in pursuit of additional risk-adjusted return.
(The bolding in this article is mine…just to emphasize the points that I consider the most important.)
This article looks at the first example of the application of the Liquidity factor:
- Participant-level liquidity—
(i) Facts. Certain participant-level events, depending on the terms of the plan, may trigger a plan’s need for immediate liquidity. Examples of these events include, but are not limited to, participant benefit withdrawals due to retirement, separation from service, or financial hardship, asset reallocations or reinvestments to other designated investment alternatives in the case of plans intended to meet the requirements of section 404(c) of ERISA, and plan loans.
Comment: This example illustrates the issues with liquidity for participants. That includes any number of transactions common to 401(k) plans, where participant expectations are for almost immediate execution, e.g., daily trading, distributions, loans.
As a practical matter, this may be the lesser problem, in the practical sense that many, if not all, plan fiduciaries will not accept investments into their core lineups unless the investments allow for daily transactions.
Nonetheless, the example and the discussion that follows make it clear that fiduciaries need to evaluate whether investments are liquid at the participant level and, if not, whether it is prudent to include them in the investment menu for participant direction. (Those core, or “menu”, investments are more technically referred to as designated investment alternatives, or DIAs.)
(ii) Plan fiduciaries must give consideration to the potential for such events when selecting designated investment alternatives, especially qualified default investment alternatives (as defined in 29 CFR 2550.404c–5), for a plan investment menu. Further, on the basis of such consideration, the plan fiduciary must determine that the designated investment alternative, at the time of selection, will have sufficient liquidity to meet the anticipated liquidity needs of the plan.
Comment: It isn’t surprising that the DOL takes the position that fiduciaries need to evaluate participant-level liquidity. While daily liquidity is not legally required, it is a practical expectation of virtually all participants (and likely a similar number of plan sponsors). In recognition of that fact, the DOL points to participant expectations of liquidity. It seems that participant liquidity is, as a cultural matter, baked into the cake. (Annuities may be an exception to that.)
I do find it surprising—at least a little surprising, though, that the DOL suggests that there is even a higher standard for QDIAs, qualified default investment alternatives. I’m looking at the word “especially”. The DOL doesn’t explain why, so we are left to guess. My first guess is that it is because fiduciaries default participants into the QDIAs and those participants have a right to get out of the QDIAs following the initial default into them. My second guess is that the DOL believes that special care should be taken in the evaluation of QDIAs since the fiduciaries place defaulting participants into them. However, from a pure legal perspective, the standard for selecting QDIAs is not higher than for any other investment. For all DIAs, the standards are prudence and loyalty.
(iii) Conclusion. The participant-level liquidity needs of a given plan depend on the type of plan at issue, its features, and the overall profile of the participants and beneficiaries of the plan as a whole, particularly with respect to a qualified default investment alternative (as defined in 29 CFR 2550.404c–5), as well as, to the extent they are different, the participants and beneficiaries likely to select the particular designated investment alternative under review. A plan fiduciary, however, is deemed to have met the consideration and determination requirements of paragraph (i) of this section, and section 404(a)(1)(B) of ERISA, with respect to the participant-level liquidity needs of a given plan in connection with a given designated investment alternative (including one that holds a percentage of assets that are not securities, non-publicly traded securities, or securities acquired in exempt offerings) that is a mutual fund registered as an open-end management investment company with the U.S. Securities and Exchange Commission under the Investment Company Act of 1940. Such mutual funds are required by rules under such Act to adopt and implement a written liquidity risk management program that is designed to assess and manage their liquidity risk. In the case of a designated investment alternative that is not such a mutual fund, a plan fiduciary will be deemed to have met the consideration and determination requirements of paragraph (i) of this section and section 404(a)(1)(B) of ERISA if three conditions are met. First, the fiduciary obtains a written representation from the person responsible for managing the designated investment alternative, or otherwise performs appropriate due diligence, that the designated investment alternative has adopted and implemented a liquidity risk management program that is substantially similar to a program that meets the requirements of such Act. Second, the fiduciary reads, critically reviews, and understands any written representation and consults a qualified professional where appropriate. Third, the fiduciary does not know, or have reason to know, other information which would cause the fiduciary to question any written representation.
Comment: The Conclusion offers fiduciaries a safe harbor of sorts, with its position that, for mutual funds (more technically, registered investment companies), fiduciaries can, with regard to participant liquidity issues, rely on the fact that mutual funds must comply with the SEC’s liquidity requirements. The process for investments other than mutual funds, for example, CITs, is somewhat more demanding. But, even there, fiduciaries can rely on representations unless they know or should know that the representation is not correct.
Fiduciary reliance on the SEC regulation of mutual funds and the representations from other investment vehicles is about immediate, or near immediate, liquidity, as I read it. In that case, plan fiduciaries would not need to give any further consideration to the liquidity of the investment at the participant level. However, where there are liquidity issues—such as timing for private funds or MVA or CDSC restrictions for stable value funds or general account products, fiduciaries must engage in a prudent process to determine whether the additional value offered by the product more than offsets the impact of the limitations.
The preamble discusses this Factor as follows:
Paragraph (i)(1) of the proposed regulation contains a positive example of how a plan fiduciary may be deemed to have appropriately considered the participant-level liquidity needs of the plan when selecting a designated investment alternative, including one that holds a portion of illiquid, non-publicly traded securities. The example reflects the reality that some participants contribute to their plan knowing they can take hardship withdrawals or loans because their investments offer daily liquidity. Likewise, the example acknowledges that some plans cover workers with high turnover rates, who, pursuant to the plan terms, often roll their money out of the plan upon separation. The example also posits that when plan terms allow frequent trading, some participants avail themselves of this option. In all these cases, despite the decades they have to save before attaining retirement age, plan participants with long time horizons until retirement may nonetheless expect and need daily liquidity.
The example concludes that one approach available to plan fiduciaries is to obtain a written representation from the person responsible for managing the designated investment alternative regarding the designated investment alternative’s liquidity risk management program. For a designated investment alternative that is a mutual fund registered as an open-end management investment company with the SEC under the Investment Company Act (a ‘‘mutual fund’’), the example notes that mutual funds are required by rule 22e–4 under the Investment Company Act to adopt and implement a written liquidity risk management program that is reasonably designed to assess and manage their liquidity risk. For any designated investment alternative not described in the preceding sentence, such as a collective investment trust, the written representation must express that the designated investment alternative has adopted and implemented a liquidity risk management plan that is substantially similar to a program that meets the requirements of such Act. The example also recognizes that a plan fiduciary may otherwise perform appropriate due diligence regarding the designated investment alternative’s liquidity risk management program that would satisfy the safe harbor even in the absence of obtaining a written representation for investment alternatives that are not mutual funds. The conclusion in this example depends on the plan fiduciary reading and critically reviewing any written representation (independently or with assistance of a qualified investment professional if necessary) and not knowing (or having reason to know) other information which would cause the fiduciary to question any written representation.
In developing this example, the Department understands that participant-level liquidity needs of plans are highly variable, ultimately depending on factors such as the type of plan at issue, its features, and the overall profile of the participants and beneficiaries of the plan as a whole. That variability notwithstanding, the outcome in this example illustrates a deliberative process under which the plan fiduciary assures itself that the designated investment alternative has adopted and implemented a program such that the designated investment alternative is likely to be able to meet the liquidity expectations of the participants and beneficiaries, even in cases when the plan promises participants daily liquidity and the designated investment alternative holds assets it cannot easily sell.
Comment: The preamble discusses in more detail the practical issues from a participant perspective. That illustrates the reason for fiduciaries to proceed carefully when evaluating designated investment alternatives that have restrictions on liquidity.
The preamble discussion also reinforces the ability of fiduciaries to rely on SEC governance of mutual funds and their liquidity policies. In my view, that actually adds a burden to fiduciary processes. At this point I don’t think that most fiduciaries have even thought about mutual fund liquidity…everyone just seems to accept it. Now, at the least, there should be something in the fiduciary file and the IPS about mutual fund liquidity.
For CITs, there now is a duty to gather information about the liquidity policies and practices of the CIT. I imagine that it is all readily available, but it should be obtained and reviewed—and the IPS should have a provision about that process.
Concluding Thoughts
I think the primary consequence of the Liquidity factor at the participant level will be that investment policy statements will need to be amended to include a liquidity provision and information will need to be gathered and evaluated to satisfy the factor’s conditions for receiving the fiduciary safe harbor under the regulation.
I imagine the burden will fall primarily on plan advisers to revise their IPS forms and to help gather and evaluate the needed information.
