What’s the Alternative(s)?

Author | Bonnie Treichel

Defined benefit (DB) plans have long benefited from the alpha and broader diversification associated with “alternative” investments such as private equity and real estate (and more recently cryptocurrencies). However, defined contribution (DC) plans have historically been reluctant to adopt these strategies due to concerns about their relative lack of transparency, liquidity constraints, potential volatility, cost, and the complexity of valuation. There may soon be a shift. Alongside increased concerns about shrinking diversification in traditional markets, alternative investments have continued to evolve and are making their way into the DC plan conversation.

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Let’s Dive In…

Special Asset Classes

Even in an era when pre-mixed asset allocation solutions like managed accounts, model portfolios, and TDFs are popular, prudent fiduciaries remain mindful of the importance of having a diversified menu available to participants. It is common for fiduciaries to be attentive to guideposts like Morningstar’s style box to fill out the equity and fixed income components of an investment menu, as well as a cash equivalent.

That said, there are plenty of attractive investment options beyond the basic asset classes. Real estate has long been an outlier alternative in DC plans, and more recently, other alternative investments including private equity are getting more attention. There has also been explosive interest in cryptocurrency – particularly by younger savers, bringing with it a host of new issues and concerns – even drawing the attention of the DOL in an unprecedented and controversial Compliance Assistance Release that was issued in 2022.¹

The concept of alternative investments as an asset class on a retirement plan investment menu is broad and encompasses several investment types – again, likely because of the ability to add diversification, higher returns, and downside protection. Here are a few common examples that fit within this asset class:

Real estate: Real estate could include actual real property or could incorporate real estate investment trusts (REITs) which are companies that own, operate or finance income by owning real estate.

Private markets: Private markets includes both private equity and private credit and broadly refers to financial markets where securities, investments, or assets are bought and sold through private transactions rather than being publicly traded on an exchange like the NYSE or NASDAQ. This may involve private equity firms.

Hedge funds: A hedge fund is a privately managed investment fund that pools capital from accredited investors or institutions to invest in a wide range of assets – creating diversification – using advanced strategies to generate high returns. Unlike mutual funds, hedge funds are less regulated and can use techniques like short selling, leverage, and derivatives to manage risk and maximize gains.

What’s Required?

Let’s consider three basic requirements under ERISA:

1. Duty to Diversify: ERISA’s diversification rule requires, generally, that fiduciaries: (1) reduce the risk of large losses and (2) construct a portfolio with a risk/return on the efficient frontier. In participant-directed plans – such as a 401(k) plan – those requirements are generally satisfied by offering an investment menu that meets the requirements of ERISA Section 404(c) (described further below). ERISA does not prohibit investment in any asset class, but fiduciaries are required to consider the effect of investment in a particular asset class on the portfolio’s overall risk/return profile.
2. Duty of Care/Prudence: ERISA includes a separate requirement that a plan fiduciary diversify plan investments “so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.” ERISA’s prudence requirement is also generally understood to require diversification.
3. Duty of Loyalty: ERISA requires fiduciaries to consider the best financial interest of participants and beneficiaries. That requirement includes considering the overall population of participants in their entirety and not a single participant’s preferences.

Finally, the DOL regulation under ERISA section 404(c) provides a roadmap for participant-directed plans. It generally requires (among other requirements) that the plan provide at least three investment alternatives: equity (stock), fixed income (bond), and capital preservation (money market or stable value) option.

How do alternative investments meet these requirements?

Arguably, real estate, private equity, hedge funds and even crypto might be seen as providing creative ways to reduce certain kinds of risk or maximize certain kinds of return and may well serve that function in a well-designed portfolio. As a practical matter, however, all that you need to do to achieve diversification is that the plan’s portfolio include a sufficiently diverse collection of uncorrelated risks to put it somewhere on the “efficient frontier,” which is defined as “the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.”

In other words, the investments selected by the plan fiduciaries to be included in the investment line-up should be sensitive to different kinds of risk – and should provide the opportunity to respond favorably to different types of investment environments. The prudent fiduciary will need to demonstrate that alternative investments do so while at the same time meeting the other requirements under ERISA.

Regulatory Review: Where Things Stand

In addition to the ERISA basics, the DOL has weighed in on some aspects of alternative investments in recent years and is expected to provide further guidance during the coming years. As it relates specifically to private equity, in December 2021, the DOL published a statement² (which was a follow-up to a prior letter it issued on the topic). 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 designated investment alternative) 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’s participants and beneficiaries.

That said, the publication also expressed the DOL’s 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.

As noted above, in March of 2022, the DOL published a Compliance Assistance Release on cryptocurrency in participant-directed DC plans. The DOL provided a strong cautionary note against putting cryptocurrency as a direct investment option in a retirement plan—or even as a self-directed brokerage option in the plan. More specifically, the DOL not only said fiduciaries must “exercise extreme care” in making that kind of option available, but that those who chose to do so “should expect to be questioned” about that decision, and the factors underlying it. The DOL did not, however, outright explicitly prohibit the decision to include cryptocurrency in retirement plans.

What This Means for Plan Fiduciaries

In short, while ERISA, nor the DOL, explicitly prohibit investing in alternative assets – including crypto – plan fiduciaries must fulfill their fiduciary duties by prudently selecting, monitoring, and replacing investment options. This entails conducting thorough due diligence, assessing the appropriateness of the asset class holistically within the plan’s investment line-up, and providing adequate education and resources for participants to make informed choice(s) with regard to those options. There is an additional requirement to identify and understand special guidance from the DOL when issued and how it applies to particular asset classes and conduct due diligence accordingly. Ultimately, the decision to include alternative investment options on the plan menu – as with any investment option– should be acknowledged in the plan’s investment policy statement (IPS), and be prudent, well-considered, documented, and in the best interests of plan participants and beneficiaries.

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Action Items for Plan Sponsors

1. Get educated to understand the landscape of alternative investments and what is available on the plan’s recordkeeping platform. Understand the applicable guidance described in this update.
2. Determine if alternative investments are appropriate for your plan and document accordingly. The plan fiduciaries may also consider utilizing asset allocation platforms and solutions – managed accounts or TDFs, for example – as a means of providing access to alternative assets with professional investment management oversight and review.
3. Review the plan’s IPS to ensure that it allows for the addition of alternative investments, if applicable, and provides a structure for ongoing review and monitoring.
4. Where necessary, be sure to document the considerations described herein.

¹ DOL, Compliance Assistance Release No. 2022-01, 401(k) Plan Investments in “Cryptocurrencies” (2022).
² DOL, U.S. Department of Labor Supplement Statement on Private Equity in Defined Contribution Plan Designated Investment Alternatives (2021).