Defined Contribution Plans Gain Some Regulatory Clarity That Traditional Pension Plans Enjoy, but More Progress Still Needed
An ancient proverb cautions people to not “strain at a gnat but swallow a camel,” which we often do – we get smaller things right but let larger issues slide.
Sometimes regulators do the same. The Department of Labor (DOL) historically created a more robust regulatory environment under ERISA for traditional pension plans but left the larger world of defined contribution plans with less guidance on alternative investments.
While the DOL has given more guidance lately and private industry innovated, gaps remain in moving towards safe harbor rules that will bring clarity and reduce regulatory risk for advisors and firms in the defined contribution space.
Wealthtech firm RealBlocks, which develops customized investor portals for alternative investment managers to onboard investors and expand distribution for private investments, holds $77 billion in assets under administration and demonstrated rapid growth from 9 employees in 2020 to 42 this year.
With 30 years’ experience, Scott Brooks, the firm’s COO, has raised over $35 billion in new assets during his career. Brooks keeps close watch over regulatory developments involving alternative investments.
We caught up with Brooks to ask about the current state of development of ERISA rules for defined contribution (DC) plans, the progress already made and what’s still needed.
WSR: Describe the current state of the ERISA rules regarding alternative investments in defined contribution plans. How does it differ from the way alternative investments are generally governed outside of ERISA regulation? What opportunities may investors miss under these rules?
Brooks: ERISA rules, which require a DC plan fiduciary to act under a “prudent person” standard, do not specifically preclude the use of alternative investments in DC plans. The DOL has also provided recent guidance to further clarify how fiduciaries should consider the use of these investments within DC plans.
Historically, corporate pension plans, covered under ERISA as well, have invested a material portion of their assets in real estate and alternative investments.
Outside of ERISA, real estate and alternative investments are governed in the U.S. by SEC and FINRA regulations, which rely predominantly on accreditation and due diligence standards for financial advisors and their investors.
While there is a growing acceptance and use of private real estate and alternative investments by investment advisors for their accredited investor and qualified purchaser clients, ERISA DC plans have not had the same advantage as non-retirement investors and pension plan investors to utilize and access these funds as part of professionally managed solutions.
WSR: What legal and compliance problems do the ERISA rules governing alternatives create for investors, advisors and asset managers? What are the regulatory risks? What are the litigation risks?
Brooks: In short, ERISA rules do not specifically discuss real estate and alternative investments and the use of these in pension or defined contribution plans outside of the “prudent person” fiduciary standards. The “advisor’s” role as a fiduciary or as a broker will dictate the legal and compliance issues they face.
For RIAs acting in a “co-fiduciary” role, they are again held to the same “prudent person” standard as the plan sponsor. In similar fashion to the RIA, an asset manager is held to these standards as well. These fiduciaries have in practice identified the key issues in the use of alternative investments being daily liquidity and daily valuation.
Given that the DC market has been a daily valued retirement plan offering for plan participants, alternative investments have similar requirements as a result of this industry practice. Forward thinking asset management firms have developed products to address daily liquidity and daily valuation, which does place an increased legal and regulatory onus on these firms.
With the development of these products that are consistent with the DC market, plan sponsors and their advisors now have a more diversified set of investment options for use in the solutions created for plan sponsors and their investors.
The regulatory risk here for plan fiduciaries is similar to their existing responsibilities to offer a diverse set of investment options to allow for DC plan participants to allocate their contributions. There is a strong group of investment consultants and outsourced chief investment officer resources available to DC plan sponsors to help conduct the proper due diligence required to meet current best practices in the market.
Litigation risk for DC plan sponsors has been quite high over the past 10+ years. The large majority of these suits have not involved alternative investments at all but rather have focused on plan sponsors not utilizing the least expensive share classes or fund offerings for their plans.
The very few suits involving the use of alternatives to date have been successfully defended, given the nature of the suits themselves and the fiduciary process used in selecting alternative investments for use in particular solutions.
WSR: What is the current status of lobbying efforts at the DOL to change these rules? What are the probable future outcomes?
Brooks: There have been extensive efforts to educate regulators as well as members of Congress on the benefits of using real estate and alternative investments given the benefits they provide. These include the potential to improve investor outcomes, reduced reliance solely on public equities and bonds, the potential to reduce volatility, improved diversification and as a non-correlated source of income.
Groups such as the Institute for Portfolio Alternatives (IPA), the Defined Contribution Alternatives Association (DCALTA), the Defined Contribution Real Estate Council (DCREC) and the Defined Contribution Institutional Investment Association (DCIIA) have been heavily involved along with legal teams from some of the largest ERISA practices in the country including Groom Law, Morgan Lewis and others to educate regulators on the need to provide a safe harbor for investment professionals and plan fiduciaries to use these investments in the same ways that pension plans have used them for decades.
We have seen strong support across regulators, legislators and industry members to improve the “fairness” of our retirement system between traditional pension plans, which cover relatively few American workers, and defined contribution plans, which represent the retirement savings for a large majority of Americans.
Michael Madden, Contributing Editor & Research Analyst at Wealth Solutions Report, can be reached at firstname.lastname@example.org