The U.S. Department of Labor (“DOL”) recently issued a guidance document explaining that 401(k) plans are permitted to invest in private equity funds, albeit only indirectly. The DOL touts its new guidance as a policy that “level[s] the playing field for ordinary investors” and helps “ensure that ordinary people investing for retirement have the opportunities they need for a secure retirement.” However, allowing 401(k) plans to invest in risky, high-fee investment vehicles such as private equity funds may very well invite imprudent decision-making by the people entrusted to ensure that workers’ retirement savings are invested wisely.
Your Employer’s Fiduciary Duties Regarding Your 401(k) Plan
A 401(k) is an employer-sponsored defined contribution retirement plan that enables workers to make tax-deferred contributions from their salaries to the plan. As sponsors of 401(k) plans, employers—as well as the people employers retain to provide recordkeeping and investment management and advisory services to the plan—have fiduciary obligations to participating employees.
Employers’ fiduciary obligations to plan participants have been codified in the Employee Retirement Income Security Act of 1974 (“ERISA”). Specifically, under ERISA, employers and other plan fiduciaries are subject to the twin duties of loyalty (requiring fiduciaries to act for the “exclusive purpose of providing benefits to participants”) and prudence (requiring fiduciaries to act with the “care, skill, prudence, and diligence” that can be reasonably expected of them under the circumstances).
ERISA is designed to ensure that employees know that their retirement savings will be managed well. To this end, ERISA requires that, in selecting and monitoring the investment options available in your 401(k) plan, your employer must create an investment portfolio with an appropriate degree of risk and expected return, and “avoid wasteful idiosyncratic risk.” It is not sufficient for your employer to be well-intentioned but misguided in managing your 401(k) plan—as one court put it colorfully, “[a] pure heart and an empty head are not enough” to meet the fiduciary duties imposed by ERISA.
Private Equity Funds: Potentially High Returns—Along with High Fees and High Risk
In announcing its recent guidance, the DOL stated that it “will help Americans saving for retirement gain access to alternative investments that often provide strong returns.” While investing in private equity funds indeed has the potential for high returns, those potential returns come along with high investment management fees and a high risk of substantial losses.
As their name suggests, private equity funds invest in privately-owned companies—that is, companies that are not publicly listed or traded. Privately owned companies are not subject to the reporting requirements that the Securities and Exchange Commission (“SEC”) imposes on publicly traded companies. SEC reporting requirements ensure that investors get a clear view of what is happening in a company on a quarterly basis. This transparency helps to reduce the risk of investing in a company. Because privately-owned companies are not obligated to create this kind of transparency, it is riskier to invest in such companies—and therefore riskier to place your retirement assets in a fund that invests in such companies.
Furthermore, private equity funds themselves are often also less transparent than regular mutual funds. Whereas the SEC regulates the information that mutual funds have to provide to their investors, private equity funds are not required to report their performance, assets held, or the fees charged in a standardized way. As a result, investors in private equity funds may well be in the dark about the—often exorbitant—fees charged by the managers of those funds, the risk to which they are exposed, or the actual returns on their investments for the people whose money they are supposed to manage. Where the average expense ratio for passive index funds that invest in publicly traded stocks and bonds is 0.6%, and the average expense ratio for actively managed funds is 1.4%, the expense ratio for private equity investments has been estimated to be about 7%, if not more. And, as one recent commentator put it, although “[h]igh fees may be justified where the outcome is itself outstanding,” the high fees charged by private equity funds are little more than a “rentier’s bonanza” when, as has been the case in recent years, “the returns after fees from private equity have barely exceeded those from a stock market tracker fund.”
Permitting 401(k) Plans to Invest in Risky, High-fee Private Equity Funds May Well Invite Imprudent Fiduciary Decision-making—And Thereby Expose Fiduciaries to Class Action Litigation
While private equity funds might be a sensible option for high-net-value and risk-hungry investors, such funds are widely perceived as a poor fit for ordinary workers who are saving for their retirement. Indeed, it seems that even the DOL appears to recognize the dangers inherent in opening the door to letting 401(k) plans invest in private equity, as its recent guidance only allows indirect investment in private equity funds—that is, a multi-asset investment vehicle made available to plan participants may include private equity among its holdings, but plans are not permitted to offer private equity funds themselves as investment options to plan participants. Many of the investment options that are available in a typical 401(k) plan are multi-asset vehicles, including the target-date funds that many plans have selected as their default option.
Even if only done indirectly, it may well be imprudent for 401(k) plans to invest workers’ retirement savings inexpensive and risky private equity funds. When the fiduciaries of a 401(k) plan choose to include investment options that are too risky or too expensive, its participants need not stand by idly. ERISA permits plan participants to bring a class action when fiduciaries breach their obligations by including unwise investment options, and many class actions have been brought successfully in recent years. Your retirement savings represent one of your most valuable assets. If you believe your employer is mismanaging your 401(k) plan, please reach out to Sanford Heisler Sharp's financial services attorneys for a free evaluation of your plan.
 See Press Release, U.S. Dep’t of Labor, U.S. Department of Labor Issues Information Letter on Private Equity Investments (June 3, 2020). Id. Codified at 29 U.S.C. §§ 1001 et seq. See ERISA Section 404(a), codified at 29 U.S.C. § 1104(a). Max M. Schanzenbach & Robert H. Sitkof, Financial Advisers Can’t Overlook the Prudent Investor Rule, J. of Financial Planning (Aug. 2016), http://www.law.harvard.edu/programs/olin_center/papers/pdf/Sitkoff_872.pdf. Donovan V. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983). See Press Release, supra note 1. These reporting requirements are imposed by various federal securities laws. See U.S. Securities & Exchange Comm’n, The Laws That Govern the Securities Industry (Oct. 1, 2013), https://www.sec.gov/answers/about-lawsshtml.html. See, e.g., Katherine Ross, Why Investing in Private Companies Is Ridiculous Even If the SEC Allows it, The Street (Sept. 9, 2018), https://www.thestreet.com/opinion/why-investing-in-private-companies-is-ridiculous-even-if-the-sec-allows-it-14705951. See Simon Clark, Investors Urge Private-Equity Industry to Improve Transparency, Wall Street Journal (Jan. 7, 2020), https://www.wsj.com/articles/investors-urge-private-equity-industry-to-improve-transparency-11578409754. See id.; see also Editorial, Private Equity Must Show More Transparency, Financial Times (Oct. 14, 2019), https://www.ft.com/content/e5efa950-ec17-11e9-85f4-d00e5018f061. For an estimate of the average expense ratios of passively and actively managed mutual funds, see Pam Krueger, Active vs. Passive Investing: What’s the Difference?, Investopedia (Sept. 5, 2020), https://www.investopedia.com/news/active-vs-passive-investing/. For an estimate of the fees charged by private equity funds, based on the fees charged to CalPers, California’s public pension plan, see Robin Kaiser-Schatzlein, Letting Private Equity Billionaires Rob Worker Retirement Funds, American Prospect (June 18, 2020), https://prospect.org/economy/letting-private-equity-billionaires-rob-worker-retirement-funds/. Jonathan Ford, Private Equity Fees Have Become a Rentier’s Bonanza, Financial Times (Aug. 30, 2020), https://www.ft.com/content/377a8850-d72b-40a2-94d0-0abf1848bca2. See, e.g., Kaiser-Schatzlein, Private Equity Billionaires, supra note 12. See Press Release, supra note 1.