Joe Schick, Associate Member, University of Cincinnati Law Review
This June, the Department of Labor (“DOL”) answered the contentious, long-anticipated question of whether businesses that provide defined-contribution plans (eg. 401(k)’s) to their employees can offer exposure to private equity funds (“PE funds”). The DOL appeared to give the green light to employers to offer PE exposure under certain circumstances. Traditionally, defined contribution plans only offered funds made up of shares of publicly traded companies (colloquially known as “stocks”), bonds, and cash. An example of a public exchange is the New York Stock Exchange, where various entities (e.g. individuals, finance companies, governments, etc.) buy and sell financial securities that were issued by other entities to raise funds. PE funds, on the other hand, invest in companies that are not listed on a public exchange, meaning companies that have never made an offering of shares to the general public. These funds can have many different focuses. For instance, “venture capital” is a notorious form of PE that targets start-ups with high growth potential.
At the end of 2017, there were approximately 3,600 publicly traded companies listed on U.S. stock exchanges (notably half the amount that were public in 1997). For comparison, in 2017, there were an estimated 7.7 million companies in the U.S. that had at least one paid employee. This demonstrates that the number of companies that typically have access to funding through 401(k) contributions is a tiny fraction compared to the total number of business establishments in the U.S (3,600 out of 7.7 million).
At the end of the first quarter of 2019, there were approximately $8.2 trillion in defined contribution plan assets in the U.S. Total retirement assets in the United States were approximately $29.1 trillion in 2019, eclipsing the annual GDP (a measure of total economic output) of the United States by nearly a 1.5 multiple. If just 5% of 401(k) assets were transferred to PE funds, that would mean $410 billion dollars (roughly the GDP of New Jersey) would shift from traditional investments and potentially into non publicly-traded companies. Thus, the vast majority of companies in the United States do not enjoy access to one of the largest reservoirs of capital in the world.
Why would companies limit the ways their employees can spend their hard-earned money? Should companies not provide employees every opportunity they can to build the best nest egg possible for retirement? The answer speaks to the legal nature of defined contribution plans, and the inherent relationship between employer and employee. This article will explore the legal background behind why employers favor certain investments in their retirement plans and will analyze the pros and cons of offering PE exposure to employees.
II. ERISA Standard
The Employee Retirement Income Security Act of 1974 (“ERISA”) was enacted to address concerns about the corrupt management of non-public sector businesses retirement plans. Before ERISA, much of what governed employer-sponsored retirement accounts was from the common law of trusts. This body of law developed over generations through court precedents and was not tailored to the needs and incentives for employers and employees that Congress desired. ERISA provides that plan sponsors must meet fiduciary standards and ensure compliance with numerous factors to enable the tax-advantaged treatment of the accounts held within the plan.
The key legal concept implicating liability with 401(k) plans is the “fiduciary” relationship present between employers and employees. For example, this duty can be breached if an employer provides an investment fund that repeatedly underperforms alternatives, while not otherwise serving a valid purpose within the plan. Exposure to PE in defined-contribution plans like 401(k)’s has never been explicitly banned by ERISA or the DOL. With that said, there have been several instances where employers have been sued for investing in funds with PE exposure that underperformed alternatives and required unreasonably high fees for participation.
Under ERISA, the employer must meet the “prudent person” standard of care when choosing or eliminating available funds to its employees. This obligates employers to act solely for the benefit of employees, and diversify the funds available “so as to minimize the risk of large losses” unless there is a prudent reason not to. Courts use an objective standard to determine if an investment is imprudent, meaning employers will be judged by the standard of what a reasonable employer would do acting in a similar capacity and under the same circumstances. The court will not examine the merits of a fund choice based solely on a retroactive, performance basis. Instead, it focuses on “conduct in arriving at an investment decision. . .ask[ing] whether a fiduciary employed the appropriate methods to investigate and determine the merits.” It is not sufficient to only show that a more prudent fund option was available at the time. Ultimately, there typically has to be a showing of “clear incompetence” or acting in self-interest when choosing funds to state a claim for an imprudent investment option.
Jacobs v. Verizon Communications, Inc. is an ongoing case where the Southern District of New York denied a motion to dismiss over an imprudent investment breach of fiduciary duty. In Jacobs, a Verizon 401(k) participant brought suit against her former employer for not properly monitoring a fund Jacobs was invested in, which included underperforming and complex “alternative investments.” Alternative investments refer to anything other than publicly traded stocks, bonds, and cash (in Jacobs, it was a PE fund). The fund had a high and complex fee structure and underperformed its benchmark by nearly 10% over 10 years, earning barely more than a money market savings account.  Jacobs claimed Verizon breached its fiduciary duty by not effectively monitoring fund managers, who should have removed the poorly performing fund, thus failing to meet the prudent standard.
The court found the employee sufficiently stated a claim for relief, meaning the motion to dismiss should be denied and that the question of breach of fiduciary duty should be decided by a jury. The court cited several cases that demonstrated when an actively managed, underperforming fund with high fees was the controversy, it was enough to sustain a claim against an employer for an imprudent investment. The case is currently awaiting class action certification before proceeding. The outcome of Jacobs could result in a harsh judgment against Verizon if a breach is found.
This outlines the concern employers have when considering adding unorthodox investments to their retirement plan fund options. The relatively low threshold of sustaining a claim for an imprudent investment means that employers can be scared off even by the threat of litigation, which can be costly and drag on for years. This is especially true for most employers with 401(k)’s in the U.S., as the vast majority of them do not have the size and resources to fight lawsuits like Verizon does. These concerns are the backdrop to the DOL’s most recent guidance, which allows for PE in defined contribution plans, if managed properly.
III. DOL Information Letter 06-03-2020
The DOL is a cabinet-level executive agency tasked with assuring the rights and welfare of workers and retirees in the U.S. The DOL issues statements called “information letters” in response to formal requests for the government’s interpretation of ERISA. These forms of administrative guidance are non-binding in court in the event of litigation, but can provide clarity in areas of law that are vague and complex.
The information letter released June 3, 2020, states that the DOL views exposure to PE in defined contribution plans as being compliant with ERISA if certain considerations are appropriately weighed by fiduciaries. The DOL provided a laundry list of factors for employers to consider, including: whether adding the fund would provide a diversified option to employees within an appropriate range of expected returns net of fees; whether fund selection is overseen by a third-party investment expert; whether the fund is designed to address unique liquidity issues inherent with PE; whether the fund aligns with the retirement plan participants needs as a whole; and whether the employer feels they have the requisite knowledge and experience to make an informed decision on these funds.
These considerations add to the already vague, fact-specific nature of the inquiry employers must go through when deciding which funds to provide their employees. The DOL prefaced its guidance on considerations for employers by explaining the unique nature of PE makes it difficult to incorporate into financial products that would be compliant with the specific ERISA requirements for reasonable fees and transparent disclosures. PE on average involves more complex investment structures, higher management fees, and less publicly available information regarding the true valuation of companies it invests in. These investments tend to be more expensive because of the higher risk associated with smaller companies, as well as the lengthy-time horizons required to achieve a desirable return.
An issue with incorporating PE into defined contribution plans is that employees may need to pull money out of funds for various reasons. PE funds typically lack liquidity (the ability to meet short term financial obligations) due to their long-time horizons, therefore the pulling of funds is a crucial concern. This is why PE fund companies like Pantheon Ventures and Partners Group have developed diversified funds that include a PE component, while including other asset classes to address risk, expenses, and liquidity. The PE fund would be a “fund within a fund”, where a handful of other funds that complement each other were bundled in with the PE fund to create one large fund. Inquiries about these diversified products are specifically what the DOL was responding to in its information letter.
With these new products making it functionally possible to add exposure to PE, the question remains whether employers will be willing to take on added risk for something that most of their employees likely do not understand, nor likely care about at this moment. Other questions remain, such as: how should the Jacobs case be resolved? Will there be more PE involvement in 401(k)’s? And finally, what are the broader societal implications for Congress and the DOL shaping retirement plan asset allocation?
The Jacobs case is unique in that the defendant, Verizon, owns their own investment company for the sole purpose of managing their employee retirement plans, something the vast majority of employers in the U.S. do not share in common. Verizon essentially charged employees high fees for funds they created themselves, which could violate Verizon’s fiduciary duty to make investment decisions solely for the benefit of its employees. Additionally, Verizon cannot shift liability onto a third-party financial professional, because the decision-makers surrounding the funds were under Verizon’s complete supervision. The fund also underperformed for at least 10 years, through the global financial crisis of 2008 and the recovery therefrom. This may be enough time to establish that the fund underperformed through different conditions in the business and credit cycle. If it could be shown that the fund outperformed the broader market during the recession, the fund could possibly be justified as a useful hedge-like tool for investors to use. Since this does not appear to be the case, the fund likely does not serve as a defensive hedge to the employees. Under the factors considered, it is very likely a jury would conclude Verizon breached its fiduciary duty by providing an imprudent investment option to its employees.
As for PE playing a larger role in defined contribution plans, there will likely be slow and steady growth of the hybrid funds that include PE. However, the novel nature of these funds, vague standards set out by caselaw and the DOL, and availability of low risk well performing alternatives will likely lead to less sophisticated employers avoiding PE for a long time to come. Most employers, especially in during the current business conditions, simply have more pressing things to address with their operations.
There is also a sense of inevitability in the growth and popularity of PE. In 2019, there were roughly $3.9 trillion of assets invested with PE firms, making it an already lucrative space for investors. PE has generally been dominated by massive hedge funds and highly influential individuals with generational wealth since the advent of modern private equity markets in 1946. It should be no surprise that hybrid products offering exposure to PE are being rolled out, as the $8.2 trillion in defined contribution plan assets are seen by PE groups as an untapped gold mine. Undoubtedly, there will be a greater need for transparency with these firms to gain the trust of employers and the DOL. However, with tremendous wealth and influence backing the PE wave, many knew it was only a matter of time until the DOL addressed the issue and gave its soft approval.
With the number of publicly traded companies reduced by half in the past 20 years, there are more 401(k) dollars than ever chasing fewer and fewer available shares of companies. The S&P 500 index, generally used as a benchmark for the performance of the market, has hit multiple all-time highs since crashing in March from COVID lockdowns. This is despite consistent 10%+ unemployment and 31.4% annualized drop in GDP since the initial lockdowns. People are recognizing that there is a general disconnect between the health of the overall economy, and how the public equity stock market is performing. The largest corporations get the immense privilege of being heavily weighted in popular, low cost index funds that receive a steady flow of contributions from 401(k) plan participants. With these funds performing so well in the past ten years, any deviation from these funds by employers will appear more and more irrational. The more incentives there are for employers to play it safe with fund offerings, the more dollars will be pumped into mega-corporation’s stock prices, which need the capital far less than other areas of the economy.
Policy makers should be careful of creating a de facto state-sponsored investing strategy, and by proxy promoting funds that disproportionately pour money indiscriminately into mega-corporations selected by ratings agencies. Small to medium-sized private businesses are struggling more than ever, and do not have the luxury of lucrative equity financing options that the largest businesses have due to the constant flows of retirement investors. PE funds are not the perfect solution to bridge this gap, but it may be the first step to spreading access to the $8.2 trillion of wealth in defined contribution plans more broadly amongst struggling U.S. businesses.
 Jon W. Breyfogle, Information Letter 06-03-2020, Dept. of Labor (Jun. 3, 2020) https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/information-letters/06-03-2020. (last visited Sept. 29, 2020).
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 James Chen, PE, Investopedia (Apr. 30, 2020) https://www.investopedia.com/terms/p/privateequity.asp.
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 Jacobs v. Verizon Communications, Inc., 16 Civ. 01082 PGG, 2020 WL 4601243 (S.D.N.Y. Jun. 1, 2020).
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 The Department of Labor Puts Limits on “Guidance” — And Employers and Fiduciaries May Get More Interpretative Flexibility, Lexology (Sep. 30, 2020) https://www.lexology.com/library/detail.aspx?g=f9a76a36-2082-4253-80c3-c991aa2829e3.
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Breyfogle, supra note 1.
 As is the typical structure of actively managed mutual funds.
 Breyfogle, supra note 1.
 Jacobs, supra note 19.
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