As a 401(k) plan investor, you may soon have access to a limited range of private equity investment options previously available only to institutional and accredited investors. Department of Labor (DOL) guidance in the form of an Information Letter issued June 3, 2020, stipulates that companies with 401(k) plans can now safely offer certain private equity funds to their employees. 

Key Takeaways

  • Recent guidance from the DOL provides legal protection allowing companies to include certain types of managed private equity funds in 401(k) plans.
  • This ruling provides employees access to investments that are normally only available to wealthy investors and institutions.
  • Proponents believe the new guidance will result in diversification and higher returns for small investors.
  • Opponents think alternative investments are too risky and fee intensive.
  • DOL guidance does not allow for direct investment in private equity.

Legal Protection for Companies

The main purpose of the guidance is to assure companies that offer certain types of target-date funds (TDFs) and other investments that include private equity, that they have legal protection. This comes in the wake of employee lawsuits against companies such as Intel and Verizon that included alternative investments in TDFs. These lawsuits caused other companies to avoid these types of investments. 

According to Employee Benefits Security Administration (EBSA) Acting Assistant Secretary Jeanne Klinefelter 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.

DOL guidance provides no protection for stand-alone private equity funds—only those types of managed funds mentioned in the Information Letter.

DOL Guidance

Funds addressed by the guidance include those that may carefully include private equity as a component of ERISA plans—for example, target-date funds, which are designed to decrease risk as the investor's retirement date approaches. Standalone funds that only invest in private equity are not protected by DOL guidance.

The DOL letter points to additional considerations that would be a factor in deciding whether a fund had protection under this guidance:

  • 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 Securities and Exchange Commission (SEC) 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 investments options as they wish; and
  • 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.

Experts Weigh In on PE Investing in 401(k) Plans

When it comes to evaluating the new DOL guidance, opinion is mixed. U.S. Secretary of Labor Eugene Scalia says, “This Information Letter will help Americans saving for retirement gain access to alternative investments that often provide strong returns.”

Robert R. Johnson, PhD, CFA, CAIA, professor of finance at Creighton University, says it's a mistake to give 401(k) investors access to private equity through their plans. "Private equity structures are complex and opaque to the average investor," says Johnson, noting that "the asset class embeds large fees in the structures and the returns differ widely by firm and vintage."

The DOL letter addresses the point that private equity investments have long been used by portfolio managers at defined-benefit funds, but weren't available to those with defined-contribution funds. Adding "private equity investments offered as part of a professionally managed multi-asset class vehicle structured as a target date, target risk or balanced fund...would increase the range of investment opportunities avaialbe to 401(k)-type plan options," the letter states.

Kathleen Owens, fiduciary-financial advisor at Aurora Financial Planning & Investment Management LLC in San Francisco, is concerned that the average 401(k) participant will not understand the increased risk of investing in private equity. Owens also notes an onslaught of lawsuits against 401(k) plan sponsors for breach of fiduciary duty. "Now, they want to add private equity to the mix?" she says. "I can imagine trial attorneys' gleeful reaction to this news."

David R. Kuzma, AIF, financial advisor and retirement plan specialist for McLean Wealth Partners’ Corporate Retirement Services in McLean, Va., offers a glance at both pros and cons. On the plus side he says, "The inclusion of private equity as an additional asset class in a target-date fund should result in a higher return for the investor over the long term. It gives access to those growth companies that are staying private longer due to...regulations...[and]...could help to minimize lagging performance from fixed-income positions in a rising-rate environment in the future."

Kuzma cautions, however, "You have now unleashed new buyers (Vanguard, Fidelity, Schwab, etc.) with trillions of dollars chasing new private equity ventures all to satisfy a portion of the asset class in their target-date funds. This will completely disrupt the PE [private equity] markets." 

The Bottom Line

Here's how the DOL sums up its guidance" "In conclusion, a plan fiduciary would not, in the view of the Department, violate the fiduciary’s duties under section 403 and 404 of ERISA solely because the fiduciary offers a professionally managed asset allocation fund with a private equity component as a designated investment alternative for an ERISA covered individual account plan in the manner described in this letter."

Acknowledging that fiduciaries may have a variety of reasons to select an asset allocation fund with a private equity component, the DOL points to the considerations noted above to distinguish participant-directed individual account plans from defined benefit plans. With cautions in place and prudent analysis by the fiduciary, the DOL says, investors now have additional opportunities for diversification and enhanced returns.

Individual 401(k) investors should consider both these opportunities and warnings in selecting among any funds enhanced with private equity components that show up as options for their retirement savings. Research what is included in the fund and watch especially for additional fees and potential risks. And keep individual investment goals, risk tolerance, and time frame in mind. Those decades away from retirement have the most freedom to take risks; those approaching it need to employ more caution.