Benchmark Properly for Access to Alternatives

After precedent-setting decisions, plan sponsors may have a clearer road ahead for incorporating alternative investments in defined contribution plans.

For defined contribution plan sponsors to offer participants access to alternative investments, it’s all about—not the Benjamins—the benchmarks.

There is greater transparency for plan fiduciaries when incorporating alternative investments into DC plans after courts ruled in favor of Intel Corp. and its investment committees in a protracted Employee Retirement Income Security Act case, according to an ERISA expert.  

The pair of court decisions from the U.S. Supreme Court and U.S. District Court for the Northern District of California helped to clarify key aspects of the pleading standards that apply to fiduciary breach claims brought under ERISA, says Kevin Walsh, principal at Groom Law Group.  

The rulings could lead to increased plan sponsor allocations to traditional alternatives—private equity, private credit, hedge funds and private real estate—in 401(k) plans, Walsh explains.

“The Intel decision has really done a great job of highlighting the importance of benchmarking in terms of adoption of funds that have allocations to these asset classes,” which was a legal issue that continued to arise before the Intel decision was settled, Walsh explains.

The courts made clear that ERISA lawsuits brought against plan sponsors were being based on inappropriate fee comparisons. Plaintiffs, in complaints, would often compare a target-date fund with an allocation “to traditional alternatives to a target-date fund that just was purely indexed,” he says.

“It seemed as though the [plaintiffs’] argument that was being made was ‘the fees are higher,’” Walsh says. “Since that decision, there’s been a better recognition that the key metric really is risk-adjusted performance net of fees. [Courts were] reminding plaintiffs that if you’re going to benchmark, don’t just pick the thing with the lowest fees, pick something that’s going to get you the same risk-adjusted performance net of fees.”

Walsh adds that this legal position was strengthened by the 6th U.S. Circuit Court of Appeals ruling this month in favor of the defendants in an ERISA lawsuit targeting CommonSpirit Health, a large not-for-profit corporation that provides hospital services across the United States.

“[That] case highlighted the importance of apples-to-apples benchmarking,” he explains.

The court rulings could lead to greater access to alternatives in DC plans. Walsh distinguishes traditional alternatives from “emerging” alternatives, such as digital assets and cryptocurrencies.

“In the long run, it makes it easier for there to be more adoption of products that allocate to traditional alts, and it does so because it reminds folks that when you benchmark, you need to benchmark something that is comparable, as opposed to benchmarking against just the lowest fee option, even if it’s not designed to get you some more investment performance,” Walsh says.

President Joe Biden’s administration has let stand Department of Labor guidance issued under the Trump administration that confirmed plan fiduciaries can allow select private equity strategies in DC plans without violating ERISA. Late last year, the Biden DOL issued a supplemental statement cautioning plan fiduciaries from including private equity investments that targeted smaller plan sponsors.

Retirement industry experts say that the DOL statement did not reverse policy or constitute a substantive change to the prior guidance.

Walsh explains that while alternatives have grown in DC plans, movement in the space is “incremental,” he says.

“The big shift that we’re seeing is that consultants are now talking about target-date funds that allocate to alternatives more broadly,” he says.

State and local government 457 DC plans, which are not governed by ERISA, can readily innovate by offering access to alternatives more easily. 

“Because of the different regulatory structures of governmental plans versus private pension plans, it’s a lot easier for governmental plans to allow defined contribution participants to essentially buy a slice of the defined benefit plan than it is for a private employer to do that, and that’s really the cutting edge,” he says.

Mega DC plans with a legacy DB plan, closed to new workers, are also innovating in the space by unitizing slices of the pension for access by 401(k) participants, Walsh adds.

“What they’re doing is they’re essentially allowing their defined contribution plan participants to put money into the basket that they’re already managing for the defined benefit plan,” he says. “It’s the most sophisticated plans that seem to be identifying the value. That DOL second letter was targeted more at the most sophisticated plan fiduciaries and so I think that’s where we’re seeing the most uptake.”