Private equity (PE) is gaining traction in 401(k)s, and while PE investments in retirement accounts are not a new phenomenon, they are becoming more prevalent with recent industry developments. From an executive order that will encourage more PE and private-market investments in defined contribution plans, to large investment firms such as Empower, Blue Owl, and JP Morgan announcing their plans to ramp up their offerings of private market investments in 401(k) plans, the tides are changing. While this can be seen as an opportunity for long-term savers, this development adds complexity and liability to advisors and employers managing retirement plans. Plan sponsors will face increased fiduciary responsibilities, and with new investment options or plan features to manage, the margin for error continues to grow.
Evaluating the pros and cons
Retirement experts are weighing the good and bad of more PE and private markets investments. On one side, there is the potential for higher returns as PE has historically outperformed public markets over long periods. It also provides greater diversification in plans, encouraging a healthier mix of portfolio risk. Lastly, we have seen a resurgence in private market growth. Encouraging more investment in private markets allows retail investors to participate in and reap the benefits of this growth, which was previously limited to institutions or ultra-wealthy investors.
There have also been arguments over the risks for investors. While PE investments can yield higher returns, they are also associated with higher risks due to their illiquid nature. Investors cannot access their funds quickly, which can be a burden during market volatility or when they need to make necessary withdrawals. Moreover, PE investments are known to have higher management and performance fees and lack transparency when compared to public markets, presenting a new level of complexity.
The risky minefield for plan sponsors
For plan sponsors specifically, the addition of these asset classes to 401(k)s accounts introduces a whole host of operational, legal, fiduciary, and communication complexities. Fiduciary risks are bound to increase. Under the Employee Retirement Income Security Act of 1974 (ERISA), plan sponsors are mandated to act in the best interests of plan participants; however, the nature of PE investments makes this particularly tricky. Plan sponsors will need to conduct thorough due diligence to ensure that private market investments are prudent and suitable for participants. However, with these asset classes lacking transparency, it becomes difficult to monitor performance and conduct daily valuations.
The sophistication and nuance of PE and private markets investments mean that plan sponsors need specialized knowledge to navigate, manage and monitor these funds. For smaller businesses that offer retirement plans, this can be especially challenging, as they may not have the necessary resources to support investments of this nature.
These converging factors can increase the likelihood of an alleged breach of fiduciary responsibility, and in an environment where ERISA-related litigation is on the rise, even well-intentioned plan sponsors can find themselves in hot water. In 2024, there were 136 ERISA-related lawsuits, for varying reasons, including excessive fees and forfeiture-related claims. Injecting PE investments will more likely than not result in legal exposure. Plan sponsors must remain vigilant in ensuring they have the proper guardrails in place to avoid the risk of lawsuits.
Risk management preparation is imperative
Given the nature of investment risks, risk management should be a top priority for plan sponsors. When looking to introduce PE and private markets investments, sponsors should adopt a robust and well-documented framework to assess if these asset classes are appropriate for their plan participants. The frameworks may be lengthy, but should include characteristics to evaluate fund structures and risks.
To ensure proper fiduciary steps are taken, plan sponsors must engage in thorough vetting of fund managers to verify that their strategy aligns with the interests of participants, has a proven track record, and meets the standards of credibility and compliance with relevant regulations. Additionally, plan sponsors will need to stay vigilant in monitoring for any conflicts of interest from fund managers that could impact participant outcomes.
Effective communication with plan participants is also key. To avoid any missteps and minimize the risk of costly litigation, plan sponsors should ensure that participants receive proper education and communication to effectively navigate changes to their retirement accounts. Most plan participants have limited understanding of PE, which can lead to misunderstandings, disengagement, or misinformed decision-making, increasing the reputational risk for sponsors.
Ultimately, precise preparation, proper documentation, and active monitoring will be the foundation for plan sponsors in this space. Establishing a routine schedule to reassess fiduciary duties and compliance protocols is equally important to ensure continued alignment with current regulations and best practices. Technology can play a key role in these efforts. Compliance and investment monitoring platforms help streamline oversight and reduce manual errors. Additionally, integrated tools designed to simplify plan administration and enhance participant communication can improve both operational efficiency and employee engagement.
With the proper support and systems in place, plan sponsors can move forward with greater confidence and resilience, despite the complexities of today’s retirement plan environment.
Beyond the bond: The crucial role insurance plays in protecting plan sponsors
Many plan sponsors understand that ERISA requires a fidelity bond, but what’s often overlooked is its limited scope. ERISA bonds only cover losses due to fraud or dishonesty, leaving plan fiduciaries exposed to a much wider range of legal and financial risks. With PE investments adding additional complexities, it is in the best interest of plan sponsors to look beyond fidelity bonds.
To fully protect against the growing threat of fiduciary breaches and subsequent litigation, fiduciary liability insurance should be considered a critical component of any risk management strategy. This type of insurance - commonly available in $1 million increments - offers broad coverage for claims of mismanagement, breaches of fiduciary duty, and other errors in administering employee benefit plans. Importantly, fiduciary liability insurance is designed to protect plan sponsors, as well as employers, from liability arising from the ERISA legislation and any additional amendments. Fiduciary liability insurance also covers legal defense costs and potential settlements, which can quickly add up, even in unfounded cases.
While some employers may hesitate over perceived costs, both ERISA bonds and fiduciary liability policies are cost-effective, especially when compared to the steep fines issued by the Department of Labor and the rising expenses tied to defending against compliance-related lawsuits.
An additional consideration for organizations offering retirement plans is that under ERISA, anyone with discretionary authority over plan decisions can be held personally liable. Director and Officer (D&O) liability insurance becomes extremely relevant, as it covers corporate directors and officers against personal financial losses that can result from claims of mismanagement of the plan. However, a unique trait of most D&O policies, is a specific exclusionary language for any liability coming out of ERISA. Therefore, it is important to thoroughly verify any D&O policy that lacks such exclusionary language.
Proactive protection is a must for 401(k) plans
Changes are certainly brewing in the retirement space and the growing wave of 401(k)s and retirement accounts will not be slowing down anytime soon. Now more than ever, it remains crucial for plan sponsors and related executives to stay alert and ensure they have robust risk mitigation and protection strategies in place. Staying prepared for new complexities is the only way forward and implementing these measures will be key to the success of plan sponsors.
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