Recent developments clarify a pathway for private equity investments in defined benefit plans.

For years, private equity has been a kind of mirage for many defined contribution plans—always tantalizing but often out of reach, because of practical and regulatory hurdles. In 2020, it appeared that the way might become easier, with a U.S. Department of Labor information letter suggesting that “designated investment alternatives” such as custom target date, target risk and balanced funds could be appropriate for DC plans in certain circumstances. Still, despite the potentially constructive role of private equity in seeking risk-adjusted return and diversification, many sponsors remained cautious given the potential for political change and backtracking on policy.

Fast-forward to January 2022, and we have indeed seen new guidance on private-equity usage, but it could prove surprisingly constructive. Specifically, the DOL issued a clarification letter on the use of private equity in DC plans (as discussed in the information letter), indicating that while it could be well-suited to large, sophisticated plans, its use should be more carefully considered in smaller plans that might not have the expertise to assess private equity and the special issues it poses, including risks, cash flows and illiquidity.

On its face, this stance would seem to introduce new obstacles to the widespread incorporation of private equity in DC plans, but it actually reinforces an idea that we have been communicating all along: the importance of sponsors fully understanding the nature of their private equity choices. For large plans, the right level of expertise may be present in extensive staffing, but we believe that smaller funds should not lose heart—as the use of outsourced CIO relationships and consultants could provide the level of sophistication that the DOL is looking for.

Roadblock Removal

In another potentially constructive development, Intel recently won a protracted court battle over its use of alternative investments in target date funds. In California, a federal district court judge dismissed “with prejudice” claims by a plan participant that the company’s 37.2% allocation to nontraditional assets in a target date fund and up to 56.22% in a designated investment alternative were “per se” imprudent, noting that the allocations were partly meant to reduce risk. She also held that the plaintiff failed to provide an appropriate benchmark in seeking to establish the alternative allocations’ imprudence.

Since 2015, when it was first filed, the Intel lawsuit has proven a major deterrent for plans seeking to give participants access to the benefits of private equity. We are hopeful that, in combination with the new DOL guidance, the net effect will be to help plan sponsors finally move forward—particularly as expectations for traditional asset classes have become more pessimistic in light of high valuations and low but increasing interest rates.

That said, we believe it is important to create parameters around private equity usage to assure that DC plan sponsors effectively meet fiduciary obligations. Along those lines, this is how we would suggest sponsors think about private assets:

  • If a DC plan wishes to include private equity, it should be as an allocation within a long-term focused, multi-asset fund option (such as a target date fund) on a DC plan menu.
  • The private equity portfolio and allocations should be managed by a professional asset manager or fiduciary with a strong knowledge of the asset class.
  • Target date fund allocations to private equity should be determined by a fiduciary who is knowledgeable about the asset class or a consultant that has been hired for their capabilities.
  • As with any asset class offered in a DC plan, the fiduciaries should look at how the addition of that asset class might improve overall participant outcomes.

The path toward introducing private equity into DC plans continues to be winding and slow, given the needed level of sophistication and the importance of approaching decisions with intellectual clarity, data support and deep focus on fiduciary responsibility. However, we believe that the guidance provided by the DOL, as well as the positive outcome for Intel, should provide a degree of confidence as plan sponsors seek to achieve better long-term outcomes for participants.

Opportunities in Private Companies Continue to Grow

Opportunities in Private Companies Continue to Grow 

Source: PitchBook and World Federation of Exchanges. Data as of December 2020, the most current available data from the World Federation of Exchanges.