This article outlines the issues which are central to ERISA plans when such plans invest in hedge funds. The information comes from a report prepared by the Government Accountability Office and provides hedge fund managers with a good informational foundation of the issues which matter to ERISA plans. As ERISA is a very important set of federal laws a hedge fund manager should be especially diligent about making sure all proposed transactions are lawful. In a recent ERISA article we discussed how a hedge fund’s assets were frozen because of an unlawful transaction between the hedge fund manager and an ERISA fiduciary .
Please also note that with regard to the article below, HFLB has not prepared any of the items in here but we have added titles and brackets. A complete copy of the GAO report can be found here. If a manager has a specific ERISA question the manager should talk to an attorney to discuss the specific facts of the ERISA matter.
ERISA Prudent Man Standard
Private sector pension plan investment decisions must comply with the provisions of ERISA, which stipulates fiduciary standards based on the principle of a prudent man standard. Under ERISA, plan sponsors and other fiduciaries must (1) act solely in the interest of the plan participants and beneficiaries and in accordance with plan documents; (2) invest with the care, skill, and diligence of a prudent person with knowledge of such matters; and (3) diversify plan investments to minimize the risk of large losses. Under ERISA, the prudence of any individual investment is considered in the context of the total plan portfolio, rather than in isolation.*
Hence, a relatively risky investment may be considered prudent, if it is part of a broader strategy to balance the risk and expected return to the portfolio. In addition to plan sponsors, under the ERISA definition of a fiduciary, any other person that has discretionary authority or control over a plan asset is subject to ERISA’s fiduciary standards.** The Employee Benefit Security Administration (EBSA) at Labor [the U.S. Department of Labor] is responsible for enforcing these provisions of ERISA, as well as educating and assisting retired workers and plan sponsors. Another federal agency, the Pension Benefit Guaranty Corporation (PBGC), collects premiums from federally insured plans in order to insure the benefits of retirees if a plan terminates without sufficient assets to pay promised benefits.
* ERISA’s prudent man standard is satisfied if the fiduciary has given appropriate consideration to the following factors (1) the composition of the plan portfolio with regard to diversification of risk; (2) the volatility of the plan investment portfolio with regard to general movements of investment prices; (3) the liquidity of the plan investment portfolio relative to the funding objectives of the plan; (4) the projected return of the plan investment portfolio relative to the funding objectives of the plan; and (5) the prevailing and projected economic conditions of the entities in which the plan has invested and proposes to invest. 29 C.F.R. § 2550.404a-1(b) (2007).
** Under ERISA, a fiduciary is a person who (1) exercises discretionary authority or control over plan management or any authority or control over plan assets; (2) renders investment advice regarding plan moneys or property for direct or indirect compensation; or (3) has discretionary authority or responsibility for plan administration. 29 U.S.C. §1002(21).
Discussion of State Sponsored Plans
In the public sector, governments have established pension plans at state, county, and municipal levels, as well as for particular categories of employees, such as police officers, fire fighters, and teachers. The structure of public pension plan systems can differ considerably from state to state. In some states, most or all public employees are covered by a single consolidated DB [defined benefit] retirement plan, while in other states many retirement plans exist for various units of government and employee groups. Public sector DB plans are not subject to funding, vesting and most other requirements applicable to private sector DB plans under ERISA, but must follow requirements established for them under applicable state law. While states generally have adopted standards essentially identical to the ERISA prudent man standard, specific provisions of law and regulation vary from state to state. Public plans are also not insured by the PBGC, but could call upon state or local taxpayers in the event of a funding shortfall.
Hedge Fund Investments Allowed under ERISA; Due Diligence Required; 25% Threshold
Although ERISA governs the investment practices of private sector pension plans, neither federal law nor regulation specifically limit pension investment in hedge funds or private equity. Instead, ERISA requires that plan fiduciaries apply a prudent man standard, including diversifying assets and minimizing the risk of large losses. The prudent man standard does not explicitly prohibit investment in any specific category of investment.* Further, an unsuccessful individual investment is not considered a per se violation of the prudent man standard, as it is the plan fiduciary’s overall management of the plan’s portfolio that is evaluated under the standard.** In addition, the standard focuses on the process for making investment decisions, requiring documentation of the investment decisions, due diligence, and ongoing monitoring of any managers hired to invest plan assets.
*However, ERISA may indirectly limit a pension plan’s ability to invest in specific hedge funds or private equity funds. Under Labor’s plan asset regulation, if the aggregate investment by benefit plan investors in the equity interest of a particular entity is “significant,” and that equity interest is not (i) a publicly-offered security, (ii) issued by a registered investment company, such as a mutual fund, nor (iii) issued by an operating company, then the assets of that entity are deemed assets of each benefit plan investor (i.e., plan assets). See 29 C.F.R. § 2510.3-101 (2007). As a result, any person who exercises management authority over the entity now deemed to hold plan assets will become subject to ERISA’s fiduciary standards. The equity investments by benefit plan investors are considered “significant” if at any time the aggregate investment of the benefit plan investors represents 25 percent or more of the value of any class of equity in the entity. According to one industry expert, in order to avoid being deemed a plan fiduciary (and assuming all of the liabilities that accompany that status), many managers of hedge funds, which generally are not publicly-traded, not registered investment companies, nor operating companies, carefully monitor the level of investments in the hedge fund by benefit plan investors to ensure that their aggregate investment remains below the 25 percent threshold. Prior to the Pension Protection Act of 2006 (PPA), the calculation of the 25 percent threshold pertained to investments by ERISA plans and certain non-ERISA covered plans, such as public sector and foreign retirement plans. However, in accordance with section 611(f) of the PPA, investments by certain plans, including public sector and foreign retirement plans, are now excluded from the calculation. Pub. L. No.109-280, § 611(f), 120 Stat. 780, 972 (codified at 29 U.S.C. § 1002(42)). This modification may facilitate an increase in the level of investments by pension plans in hedge funds and private equity funds.
**With some exceptions, ERISA does prohibit plans from investing more than 10 percent of plan assets in the sponsoring company’s stock. See 29 U.S.C. § 1107. In addition to requiring plan fiduciaries to adhere to certain standards of conduct, ERISA also prohibits plan fiduciaries from engaging in specified transactions. See 29 U.S.C. § 1106.
Best Practices in Hedge Fund Investing
Although there are no specific federal limitations on pension plan investments in hedge funds, two federal advisory committees have, in recent years, highlighted the importance of developing best practices in hedge fund investing. In November 2006, the ERISA Advisory Council recommended that Labor publish guidance describing the unique features of hedge funds, and matters for consideration in their adoption for use by qualified pension plans.* To date, Labor has not acted on this recommendation. According to Labor officials, an effort to address these recommendations was postponed while Labor focused on implementing various aspects of the Pension Protection Act of 2006.**
However, in April 2008, the Investors’ Committee established by the President’s Working Group on Financial Markets, composed of representatives of public and private pension plans, endowments and foundations, organized labor, non-U.S. institutions, funds of hedge funds, and the consulting community, released draft best practices for investors in hedge funds.*** These best practices discuss the major challenges of hedge fund investing, and provide an in-depth discussion of specific considerations and practices that investors in hedge funds should take. While this guidance should serve as an additional tool for pension plan fiduciaries and investors to use when assessing whether and to what degree hedge funds would be a wise investment, it may not fully address the investing challenges unique to pension plans leaving some vulnerable to inappropriate investments in hedge funds.
*The ERISA Advisory Council was created by ERISA to provide advice to the Secretary of Labor. 29 U.S.C. § 1142.
**The PPA is the most recent comprehensive reform of federal pension laws since the enactment of ERISA. It establishes new funding requirements for DB pensions and includes reforms that will affect cash balance pension plans, defined contribution plans, and deferred compensation plans for executives and highly compensated employees.
***Principles and Best Practices for Hedge Fund Investors: Report of the Investors’ Committee to the President’s Working Group on Financial Markets, April 15, 2008. The President’s Working Group on Financial Markets includes the heads of the U.S. Treasury Department, the Federal Reserve, the SEC, and the Commodity Futures Trading Commission.
How Hedge Funds Report Investments to Labor
Labor does not specifically monitor pension investment in hedge funds or private equity. Labor annually collects information on private sector pension plan investments via the Form 5500, on which plan sponsors report information such as the plan’s operation, funding, assets, and investments. However, the Form 5500 includes no category for hedge funds or private equity funds, and plan sponsors may record these investments in various categories on the form’s Schedule H. In addition, because there is no universal definition of hedge funds or private equity and their strategies vary, their holdings can fall within many asset classes. While EBSA officials analyze Form 5500 data for reporting compliance issues—including looking for assets that are “hard to value”—they have not focused on hedge fund or private equity investments specifically.* According to EBSA officials, there have been several investigations and enforcement actions in recent years that involved investments in hedge funds and private equity, but these investments have not raised significant concerns.
*“Hard to value” assets are those that are not traded on an exchange. “Hard to value” assets may include hedge funds, private equity funds, and real estate. It is difficult to distinguish the type of investment with the information provided. Federal agency officials use the Form 5500 report data to enforce ERISA pension requirements, monitor plan compliance, develop aggregate pension statistics, and conduct policy and economic research.
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