In earlier posts in my Plan Sponsor and Fiduciary 2.0 series I promised to provide a cheat sheet for fiduciaries confronting the push to add private equity and other alternative assets to 401(k) plans. Here it is, with a focus on private equity assets, because that is where most of the initial action currently is and will be – although the same approach will provide protection with regard to other types of alternative assets as well.
I am not going to say in this cheat sheet whether plan sponsors and fiduciaries should or should not add such assets into their plans, nor am I going to tell them here what decisions to make. As the recent Intel case makes clear, there are circumstances in which a valid argument for adding private equity investments to a plan can be made – but that does not mean it is the right decision in all or even most cases. And it continues to be my view that, first, the onus remains on the proponents of this idea to demonstrate that adding private equity investments to plans will decrease volatility and/or increase returns for participants, and, second, that in the absence of such proof, it is hard to see a valid reason for adding such assets to plans.
From a 30,000 foot level, there are two primary risks for plan sponsors, plan fiduciaries and plan participants from adding private equity or other alternative investment options into plans. For the first two – sponsors and fiduciaries – it is the substantial risk of getting sued by the class action bar on the theory that it was imprudent to include such assets in plans. For the remaining group – the plan participants – it is the risk of incurring losses that, absent such investments, they would not have incurred. These risks obviously overlap, in that the greater any losses to plan participants, the greater the likelihood of class action litigation and, moreover, fiduciary liability. Plan sponsors and fiduciaries who add private equity or other alternative investments into their plans will not be able to completely avoid these risks, but they can reduce the risks they face in this regard by following certain approaches in adding those assets into their plans.
Here is my six step cheat sheet for plan sponsors and fiduciaries looking to reduce their future litigation risk and potential fiduciary exposure as private equity and other alternative assets are moved into plans.
1. Be Skeptical About Their Inclusion in Target Date Funds, Consider Pushing Back on It, and Document Doing So
First, plan fiduciaries should think about how private equity or other alternative investments would gain access to their plans. The push to include private equity as part of asset allocation funds, such as target date funds, is not to the benefit of plan fiduciaries. It means that far more plan participants will end up holding the assets than would otherwise be the case if, for instance, plan participants were required to affirmatively elect a fund in the lineup that is solely offering such assets. It also increases the likelihood that a large number of plan participants will end up exposed to private equity risks without knowing it. For these and other reasons, burying the private equity assets in target date funds is likely to increase the amount of potential losses and of potential fiduciary exposure, than would be the case if private equity assets were added to a plan only in their own capacity, rather than as a potential co-morbidity with other investments.
I can see many reasons why including private equity assets in a target date fund would be in the best interest of sellers of financial products, but that doesn’t mean it is the best way for plan participants to access, or sponsors to add, that exposure in plans. A plan sponsor or fiduciary should leave a documented trail of seeking to have them instead added only as a separate free standing investment option and excluded from any asset allocation funds in the plan – I am skeptical that any plan fiduciaries will succeed in such an effort, but the very nature of seeking that solution and documenting that it could not be done will go far towards demonstrating prudent and reasonable conduct if forced to defend against a breach of fiduciary duty class action.
2. Watch Out for Private Equity Assets Being Back Doored Into Existing Fund Options
Second, along the same lines, a big question to me continues to be whether private equity investments will simply be added into the mix of holdings in target date funds that are already in plans, thus entering plan holdings by sort of the back door and under the radar, instead of through the front door for all to see, with their arrival heralded to the fiduciaries and plan participants right at the outset. Personally, I am skeptical if, by the time regulatory rewrites on this issue have occurred, fund vendors are not free to unilaterally add private equity assets into the mix of investments in target date funds that are already in plan investment options and already held in vast amounts by plan participants. If those participants take losses because of the addition of these assets, which were added to their holdings without them affirmatively deciding to take on that risk, plan fiduciaries will be sued for allowing it to happen.
Plan fiduciaries should keep a close eye on this issue and avoid allowing private equity investments to creep into their plans in this way without demonstrating an effort to avoid it. Plan fiduciaries should document that they either affirmatively came to the conclusion that this occurring was a good thing for participants and thus affirmatively decided to allow it, or else should document that they engaged in industry appropriate efforts to avoid it. A future defense against class action lawsuits related to this type of backdoor “asset creep” is going to require proof of one or the other.
3. Focus on Exploiting the Upcoming Safe Harbor
Third, there is absolutely no question that regulatory developments in this regard will add some form of a safe harbor for plan fiduciaries who add private equity assets into plans. However, we have more than enough experience with safe harbors, including with litigating their scope, to know that they are not a perfect “get out of jail free” card in this context. Nonetheless, they are better than nothing and, depending on various factors, could be a lot more help than that in this circumstance. As a result, plan sponsors and fiduciaries considering adding private equity assets to plans should look very closely at the nature of any regulatory safe harbor in this context and make sure that they approach adding private equity assets to plans in a manner that will maximize any protection that may be provided by such a safe harbor. Equally importantly, they should document anything necessary to invoke that protection.
4. Overcommunicate with Participants
Fourth, fiduciaries must demand broad disclosure of relevant financial information concerning private equity investments, including costs, volatility, fees, past performance, etc., and thoroughly vet that information, including using outside experts to do so if necessary. They must then provide that information in an understandable format to plan participants. Nothing will look worse for plan fiduciaries in class action litigation than the argument that not only did plan participants suffer losses from adding private equity investments into plans, but they also weren’t even told enough information to make educated decisions about whether or not to hold the asset in their accounts.
5. Fully Investigate the New Investment Assets
Fifth, and this is related to the one above but distinct from it, fiduciaries should conduct a thorough and detailed investigation of the finances of the investment option and the case for inclusion in the plan. This really does need to be a searching inquiry, and not simply a review of vendor representations of past performance and predictions of future performance (particularly given the caveats with regard to each that will almost certainly be provided to plan sponsors and fiduciaries). In my experience, few but the most sophisticated plan sponsors will have the internal expertise to sufficiently conduct this examination, so most plan fiduciaries should retain excellent outside experts to review and report to them on these issues. Plan fiduciaries should be careful about who they hire for this purpose, as well – just hiring anyone to do it won’t be enough, as it will open plan fiduciaries up to the charge in class action litigation that they may have sought outside expertise but they failed to properly select and utilize experts, which is almost as bad as being charged with having brought no expertise to bear on the issue at all.
6. Make it a Settlor, Not Fiduciary, Decision
Sixth and finally, whatever a fiduciary decides to do about this – including excluding private equity from plan assets – they should put it in the plan document. One of the more interesting defense theories – and proactive tactics for preparing for possible future class action suits – that is currently in vogue is the idea of protecting plan fiduciaries by transforming decisions into plan settlor, rather than fiduciary, decisions, through the tool of making them part of the design of the plan, outside of the discretionary decision making of the plan’s fiduciaries. This is a perfect place for that tactic. Sponsors and fiduciaries should fully examine the question of whether to allow private equity investments into plans, but then should have the plan amended one way or the other on this question. They need to remember, though, not to deviate from the treatment of this option as written into the plan itself – doing so will bring its own host of litigation problems.