Defined Contribution (“DC”) participants remain one of the only institutional investor groups with no allocation to alternative investments. Endowments, foundations, family offices and pension plans have been long-time investors in private equity and hedge funds. These asset classes have historically improved the risk-adjusted performance of portfolios, but have faced a number of hurdles for Plan Sponsors with DC plans. At least one of those hurdles seems to be fading with a recent letter from the Department of Labor1.
On June 3, 2020 the Department of Labor issued an Information Letter giving the department’s views on the inclusion of private equity investments within DC plans. The letter states that “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 ERSIA covered individual account plan in the manner described…”
While the concept of private equity in the DC space is not new, the letter is the first explicit confirmation from the Department of Labor on the subject. For decades, institutional investors, including defined benefit plans have used private equity strategies to potentially increase returns and dampen volatility. Within DC plans, the hope is that these same traits can add to the value proposition of professionally managed diversified offerings such as target date funds.
While the letter may open the door for Plan Sponsors to consider the benefits of including private investments there are many potential challenges that sit between theory and implementation. Those challenges include2:
Perhaps the most notable obstacle to the use of private equity within the DC space is the associated liquidity mismatch. Private equity portfolios are long-term vehicles with liquidity typically offered as investment managers sell portfolio companies owned within a fund. Said differently, once a commitment is made, an investor is contractually obligated to meet future capital calls and their capital will not be returned for some number of years.
Compare this to the typical DC plan where participants are allowed to transfer assets, contribute and request redemptions on a daily basis. The SEC currently limits a registered fund’s ability to purchase illiquid assets to 15 percent of net assets. Liquidity considerations may likely limit the allocation to private equity further as Plan Sponsors consider their unique demographics with a particular focus on employee turnover. Liquidity considerations will vary between custom offerings where cash flows are unique and off the shelf products where plans are commingled.
In either scenario, the groups responsible for overall portfolio construction will need to conduct significant stress testing to understand how an illiquid private equity position will change during public market drawdowns or significant liquidity needs. Specific to custom offerings, Plan Sponsors will also need to consider the potential difficulties in unwinding a private equity allocation should their approach change in the future. Liquidity considerations will likely lead to more meaningful allocations to private equity occurring within longer dated target date vintages.
The private equity asset class is typically associated with high fees – with most offerings charging a combination of management fees and performance based incentive fees – typically 2 percent and 20 percent, respectively. Fees for investment products offered within DC plans have trended lower in recent years and, unsurprisingly, this is a main factor in the majority of lawsuits that have occurred in the space. It has led to the introduction of new share classes for mutual funds, a greater use of collective investment trusts and a shift toward more passively managed strategies have all been important drivers in this trend.
It is important to note that higher relative fees are not inherently a problem as performance net of fees is ultimately the barometer of success within portfolios. However, future returns are inherently unknown and there is no certainty that private equity’s historical ability to outperform public markets will continue indefinitely and over all periods. The sharp contrast between current DC offerings and private equity will likely increase the scrutiny placed on the addition of the asset class in managed portfolios.
1The Department of Labor information letter can be found at: https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/information-letters/06-03-2020
2A detailed examination of considerations for incorporating investment alternatives in DC plans can be found at: https://www.napa-net.org/news-info/daily-news/time-diversify-dc-risk-alternatives
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