Plan governance Understanding private markets in defined contribution plans

Hearing about private markets for 401(k) plans? You’re not alone. What was once more limited to the defined benefit (DB) space is now getting more attention in the defined contribution (DC) market.

Private markets refer to those financial asset types that are not traded on the public market. This includes real estate, private equity, and private credit, among others. This update will focus specifically on:

• The challenges and opportunities of bringing the private markets to DC plans
• A prudent framework for fiduciaries to select and monitor private market options under the Employee Retirement Income Security Act (ERISA)
• Practical considerations and next steps for DC plan fiduciaries

Challenges and opportunities

The US has the most diverse public and private markets in the world, yet most US retirement plans have not been able to leverage the performance and diversity of private markets on their home field, except for in DB plans.

However, recent shifts in the public markets — and innovations in the private markets — create new considerations. From 1996 to 2020, there has been a 50% decline in the number of publicly traded companies.¹ As public companies are consolidating, investible opportunities are shrinking. At the same time, private markets may be able to provide:²

• Diversification through reduced correlation to the traditional equity and bond markets
• Historically higher return potential versus the traditional public markets
• Volatility mitigation and income potential

Despite the potential benefits, there has been reluctance to leverage private market options in DC plans for several reasons:

• Potential liquidity constraints when companies undergo changes such as divestment and changing business lines
• Challenges with funding rebalancing when equities experience large drawdowns
• Higher fees than more traditional asset classes in DC plans; the “J-Curve” effect may also be present, which means there could be a negative impact on returns initially, but the longer-term effect may be positive
• Complexity in design and characteristics may exceed the expertise of plan fiduciaries
• Perceived difficulty in communicating to participants about private markets given the complicated nature of the asset class
• Mixed messages expressed by the Department of Labor (DOL) regarding the inclusion of private markets in DC plans

A prudent framework

For ERISA-covered retirement plans, the same framework applies for private markets that applies to other investment types in the plan. This means that the duty to diversify, duty of loyalty, and duty of care under ERISA Section 404 applies. It also means that in circumstances where a plan fiduciary lacks the requisite expertise to understand and assess the universe of investment types (particularly as they increasingly seem more and more complicated), the plan fiduciary is allowed (and should), engage the services of an investment consultant or investment manager to assist with the selection and monitoring process.

• First, the duty to diversify generally requires that fiduciaries reduce the risk of large losses. Implied in the duty of care is also the duty to diversify, which requires that fiduciaries minimize the risk of large losses. While ERISA does not prohibit investment in any specific asset class, it does require that plan fiduciaries evaluate the overall investment mix and consider the effect of the investment in a particular asset class on the portfolio’s overall risk/return profile.
• Second, the duty of loyalty requires that plan fiduciaries put the financial interests of participants and beneficiaries first. This requirement includes considering the overall population of participants in their entirety, rather than a single participant’s preferences.
• Third, under the duty of care requirement, the plan is required to follow an objective process and may consider implementing a component in its investment policy statement (IPS) or other stated investment objectives that incorporates the qualitative and quantitative factors that will be considered for selecting private market options. 

How do private markets fit?

While the notion of including private markets as a standalone investment option in DC plans has been discussed over the years, adoption has been rare — and for good reason based on those points covered above.³ However, similar to mutual funds, private markets can be part of an investment menu as a component of a professionally managed portfolio, specifically managed accounts or target date funds (both custom and off-the-shelf).⁴ In cases where the plan seeks to include private markets as a sleeve of a professionally managed portfolio, such as a managed account or target date fund, key considerations may include:

• What percentage of the portfolio is comprised of the private market option?
• In what part of the glidepath are the private market investments included and does that align with the plan’s workforce and philosophy?
• Are there any liquidity constraints because of the incorporation of the private market component? How will liquidity at the portfolio level be managed?
• Are there any operational issues or limitations with the custodian or recordkeeping platform because of the inclusion of the private market sleeve?
• Is daily valuation available for the private assets? Is the methodology reasonable?
• What is the available track record or historical return for this option?
• Are there any concerns with fee disclosures or notice requirements for DC plans?
• What is the investment philosophy of the investment manager and underlying managers?

Regulatory guidance

In December 2021, the DOL published a statement (which was a follow-up to a prior letter it issued on the topic in 2020). In that update, the DOL stated that a plan fiduciary would not violate the fiduciary’s duties under ERISA sections 403 and 404 solely by reason of offering a professionally managed asset allocation fund with a private equity component as an investment offered in the investment line-up (also known as a DIA) subject to the conditions set forth in the letter. The DOL confirmed that as with any plan investment, plan fiduciaries must determine that an investment that includes private equity is, among other things, prudent and made solely in the best interest of the plan participants and beneficiaries. While the DOL specifically addressed private equity in this series of letters, it is largely understood in the marketplace that the DOL was referring to private equity as well as other private markets and similarly situated investment options. 

In the same publication, the DOL also expressed the view that plan fiduciaries of smaller plans typically will not have the expertise necessary for the complex evaluation required to determine the prudence of private equity investments in participant-directed plans. However, there was not a set asset or participant level defined as a smaller plan that was “required” to avoid private equity.

It is important to note that although the current administration’s DOL⁵ is expected to soon issue guidance promoting the use of private markets in DC plans, plan fiduciaries should proceed with the current guidance and monitor closely for the guidance that may be forthcoming.

Practical considerations and next steps for plan fiduciaries

While the same prudent process framework applies, private markets may feel more daunting to retirement plan fiduciaries. Plan fiduciaries may want to consider these next steps when evaluating their overall investment menu design and how private markets may be considered as a part of their next plan governance and investment menu review.

• Education: The landscape of private markets has changed significantly over the last several years — from the regulatory landscape to the shifts in the markets, and more recently recordkeeping accommodation. There are new considerations for DC plans. Plan fiduciaries are not prohibited nor required to add private markets, including real estate, private credit and other options, to the plan; however, in view of the new considerations, plan fiduciaries may well want to get educated on these developments and understand the changes and options. For many of the challenges that once existed, there are now solutions. For example, liquidity used to be a major concern, but given that private market options are generally not a large component of a professionally managed portfolio, liquidity may no longer be as much of a concern. Similarly, as valuation capabilities and technologies have evolved, those concerns have been muted, if not eliminated.
• Governance: As always, plan fiduciaries should ensure their governance practices are in line with the investment options and practices. The IPS should be aligned with what the plan is actually doing and should consider the qualitative and quantitative factors being considered as it relates to the plan’s investment options. There may be other policies or addendums to the IPS that require updates, but at a minimum, the plan fiduciaries should ensure the documents do not conflict with the plan’s practices. For example, there may be a rebalancing policy that outlines the cash flows and nature of cash flow for the plan within target asset allocations, but only to the extent that this can be managed and to the extent necessary.
• Investment process: Plan fiduciaries should consider the overall investment menu to determine if updates are required to its structure and design. While professionally managed portfolios are popular today, not all plans leverage these vehicles. This may be a good opportunity for an overall investment menu design review, including review of private markets and the opportunity they afford.
• Communication: If making changes to the investment menu, consider the impact on participant communications, particularly if incorporating more complex investment options. While these options can potentially provide greater rewards for participants, they may require a different approach to participant communications.

Engage your partners and determine what next steps may be appropriate based on the needs of the plan and its participants.