5 Questions You Should Ask About Private Assets

Tamiko Toland and Patrick Williams

As private assets make their way into managed accounts and target-date funds, plan sponsors retain fiduciary responsibilities they cannot outsource, no matter who is managing the money. The “embedded 3(38)” is a term we are seeing more often in the defined contribution world, referring to an investment manager not directly hired by the plan sponsor but nested inside of an investment strategy such as a target-date fund or a fund within a managed account portfolio.

Though the idea is not new, the introduction of investments such as private assets (private credit and equity) and other alternatives has elevated its importance. For plan sponsors accustomed to evaluating mutual funds or collective investment trusts by their daily net asset value and a standard benchmark comparison, private assets introduce a new set of questions that require a different framework entirely.

As plan sponsors and advisers explore incorporating private asset funds, the concept of the embedded 3(38) can provide assurance that a fiduciary uses specialized expertise that prudently expands investment breadth within the fund lineup for participants. Outsourcing for expert advice is the cornerstone of investment lineup management, but outsourcing comes with its own obligations, even when a 3(38) investment manager assumes the highest degree of responsibility.

In short, the plan sponsor never relinquishes the role of fiduciary. While this structure allows the plan sponsor to hire experts, the plan sponsor still must establish and monitor factors that allow it to identify red flags suggesting investment drift or other changes.

At a high level, this amounts to using a prudent process to make sure the expert is qualified to make the investment decisions for which they were selected and is performing appropriate due diligence. After selection, the plan sponsor must perform ongoing monitoring on a regular basis. Advisers can be instrumental in helping plan sponsors think through appropriate criteria and stay on top of warning signs that should trigger a deeper review.

To that end, we offer five questions that every plan sponsor should be prepared to answer and ask when private credit or other alternative assets become part of their investment menu.

1. How are the underlying instruments valued, and who performs the valuation?

This is the threshold question for any private asset, and it has no easy answer. When a plan sponsor reviews a conventional equity fund, the end-of-day price is a shared, market-established fact. Private assets have no equivalent. Ideally, an independent third-party agent provides values for the underlying holdings using models, comparable transactions and professional judgment.

Plan sponsors do not need to become valuation experts. They do need to understand who is making these determinations, how often and whether the methodology is consistent with industry standards. Any change to valuation practices, including a shift in frequency, a new methodology or a change in the party performing the valuation, should be treated as a red flag.

2. How does liquidity factor into fund mechanics?

Private asset funds constructed for the defined contribution marketplace offer daily liquidity, facilitated through liquidity inside the fund. Plan sponsors should understand how an added liquidity sleeve affects performance and, when used within a portfolio, whether there are redemption rules that affect other investments.

Importantly, are there constraints or valuation effects from extraordinary redemptions, such as a wholesale shift to another fund? Are there any conditions under which the fund can delay or suspend redemptions?

3. How is this investment benchmarked, and is that comparison appropriate?

Benchmarking private assets requires judgment that benchmarking public assets simply does not. For example, there is no private equity equivalent of the S&P 500. Each approach has its own strengths and weaknesses.

Plan sponsors should understand what benchmark is being used, why, and whether it enables a genuinely fair assessment of manager performance. An ill-fitting benchmark can make mediocre performance appear strong or vice versa. A benchmark change is a red flag.

4. What is the all-in cost, including any payments to the adviser or recordkeeper?

Fee transparency is a baseline fiduciary requirement, but private asset structures can layer costs in ways that make the expense picture harder to untangle. Management fees, performance fees, administrative fees and payments to intermediaries—including the plan’s own adviser or recordkeeper—all need to be identified, surfaced and documented.

This is not a theoretical concern, as revenue-sharing arrangements and sub-advisory fees embedded in fund structures have been the subject of ERISA litigation for years.

5. Has anything changed since our last review?

Ongoing monitoring is where fiduciary responsibility lives in practice. A plan sponsor that conducted thorough due diligence at the time of selection but failed to monitor thereafter will find that initial diligence offers little protection if problems emerge later.

At each periodic review, plan sponsors should confirm that nothing material has changed: no shift in the investment team, no change in the investment mandate or strategy, no new fee arrangements, no modification to liquidity terms. Changes in any of these areas could be benign, but they could be a red flag that warrants a formal watch-list designation.

Documented Vigilance

At the end of the day, any investment may not perform as expected or hoped, but that is not the standard to which plan sponsors are held. The introduction of new asset classes to the mix does not alter the fundamental procedures that plan sponsors use, though it does warrant new questions that reflect differences in the new asset classes.

The strongest tool in the plan sponsor’s tool kit remains the same as it ever was: documentation of a prudent process that tracks both investment selection and ongoing monitoring. Many people point to the rise of target-date funds as a sign of the industry’s ability to adapt. Though that was fueled by a safe harbor, the lesson is a good one. No matter what investment strategies plan sponsors use in defined contribution plans in the coming years, a strong fiduciary process will prevail.

Tamiko Toland is the founder and CEO of the 401(k) Annuity Hub, an independent service for retirement plan fiduciaries to select and compare options for plan sponsors to offer participants. An award-winning industry expert on annuities and retirement income who is affectionately known as the “annuity Yoda,” she has focused on simplifying the complex topic of lifetime income for 25 years. She is also co-founder of IncomePath and a fellow at the LIMRA Retirement Income Institute.

Patrick Williams is the co-founder of Fiduciary In A Box and a fiduciary governance specialist with 40 years of experience helping employers and plan sponsors strengthen oversight of retirement, health and welfare plans. Fiduciary In A Box is a cloud-based fiduciary governance platform that helps employers and consultants organize, manage and document retirement and health plan fiduciary responsibilities in one centralized, audit-ready system.