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Alternative Investments and 401(k) Plans

Alternative Investments Will be Allowed in Defined Contribution Retirement Portfolios

Will retirement planners be comfortable with investments that are not regulated by the SEC? The participants of defined benefit pension funds have long enjoyed the potential for higher returns in alternative investments. So why haven’t these investment options been included in defined contribution (DC) plans? After all, private equity deals and hedge funds further diversify asset mix, increase potential return, and help provide capital for small businesses. These are just some of the reasons this unregulated asset class, once reserved for the very wealthy, will now be permitted by the Department of Labor (DOL) under ERISA protections.

Impact on Retirement Plans

The guidance came about after a review by the DOL, which then issued a letter dated June 3, 2020. The letter specifically offers legal protection to target-date-funds (TDF) that include allocations in private equity investments.  The main purpose of the guidance is to assure companies that offer investments in funds that include private equity, that they are permitted, thereby reducing their liability. The formal letter was prompted by lawsuits from employees, against Intel, Verizon, and others. Their cases caused other companies to steer away from these investments. The uncertainty of suitability effectively limited the options of employees seeking to diversify or maximize the potential for their retirement savings. Employees may still choose options that don’t include non-registered investments, but for those that want the potential benefit, their employers may now comfortably offer them.  

According to the Employee Benefits Security Administration, Acting Assistant Secretary Jeanne Wilson, “This [DOL information] letter should assure defined contribution plan fiduciaries that private equity may be part of a prudent investment mix and a way to enhance retirement savings and investment security for American workers.

The DOL letter highlights that private equity should not be available as a stand-alone option when creating a plan that has protection under the guidance, as well as other considerations, including:

  • The impact of the private equity allocation on diversification, expected return, and fees on a long term basis.
  • The ability of plan fiduciaries to oversee private equity investments vs. hiring an expert consultant.
  • The percent invested in private equity, noting that the limits illiquid assets to 15% for registered open-end investment companies.
  • Whether plan participants will be permitted to take benefit distributions and move into other investment options.
  • Agreement by plan fiduciaries to value private equity investments according to accounting standards and subject those investments to an annual audit.
  • Whether the long-term nature and liquidity restrictions of any private equity investments align with the ability of plan participants to take distributions or change investment options as they wish.
  • The adequacy of disclosures provided to participants regarding the character and risks of the plan investment option that includes a private equity component, so as to allow participants to make an informed assessment before investing.

Take Away

Investment options that include private-equity may now legitimately be offered in 401(k), 403(b) and 401(A) plans to participants without the employee first qualifying as an accredited investor. Target-date-funds with longer investment horizons can include unregistered equity-based options that may enhance retirement growth when compared to investment choices containing only publicly traded securities. The option of asset allocation TDR funds with a private equity component gives individuals access to options used by professionally managed defined-benefit pension plans. Private equity investments within TDFs would provide further diversification, perhaps reducing investment risk and could lead to enhanced returns for participants above returns achieved solely in the public market.

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