Benefits February 15, 2024

DB Plans’ Experience Provides No Playbook for DC Plans to Incorporate Private Equity

According to a Morningstar report, large private sector pension funds’ experience allocating to PE is not particularly instructive for defined contribution sponsors looking to do likewise.

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For U.S. defined contribution plan sponsors looking to include private equity assets among their investments, the country’s largest private defined benefit pension funds offer few insights, according to new research from the Morningstar Center for Retirement and Policy Studies.

Morningstar researchers considered information from the 20 largest defined benefit plans that allocated to private equity over a 12-year span—2009 through 2020. The research found no consistent approach that defined contribution plan sponsors can implement.

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“There’s not a consistent approach that can be taken from the DB pension side and immediately implemented in the defined contribution or 401(k) side,” explains Lia Mitchell, a senior analyst of government affairs at Morningstar. “There’s not just one solution, one answer [informing DC sponsors] ‘This is going to be the correct allocation,’ the correct way to go about doing it on the 401(k) side, which I’m sure is not the answer plan sponsors want to hear.”

Morningstar’s analysis paired data on pension plans with additional data and insights from PitchBook on PE funds, which allowed Morningstar researchers to identify the PE funds in the DB plans’ portfolios. The methodology was designed to provide a more holistic measure of performance than internal rate of return, performance quartiles or benchmarking a single fund in a strategy, according to the paper.

The report ultimately determined that it is difficult, with the tools available, to determine the best way to include PE in DC plans.

“Under [the Employee Retirement Income Security Act], the prudential duty for pension and DC plans must meet a high bar, and the lack of transparency in the PE market makes this duty difficult to meet,” the authors wrote. “If a PE index fund existed, such an option could potentially be a great addition to a DC or pension plan.”

 

DB Learnings for DC?

Morningstar’s analysis, “Does Private Equity Enhance Retirement Investment Outcomes? Evidence from the Experience of Pension Funds,” found significant variations in DB plans’ allocations to PE, ranging from less than 1% to nearly 30%.

Investigating the returns of PE funds selected by pension plans mirrors the PE fund universe at large, the paper found.

The “actual results of pension plans that invest in PE indicate that there is no single approach that can be broadly applied to DC plans,” the report’s authors concluded.

PitchBook developed a quantitative framework for assessing the history of private-market managers called the PitchBook Manager Performance Score. Scores range from a low of 0 to a high of 100, and fund families—funds from a manager following the same strategy, potentially across multiple vintage years and unique funds—are distributed across the spectrum in roughly a bell curve, with a center around 50.

“The score allows for more accurate comparisons between managers, as it accounts for variation in vintage years and benchmarks performance against a reasonable peer group,” according to Mitchell.

Examining the fund families found in the 20 pension funds, Morningstar’s data analysis, showed clustering around the middle, with more than 72% of the fund families scoring between 45 and 65.  

Although data show pensions are not clustering below the mean with poor performers, “they are also not consistently selecting the best strategies,” Mitchell wrote. ”While this is not a particularly surprising finding, it does not bode well when contemplating how private equity could show up in defined contribution plans like 401(k)s,” she says.

Notwithstanding the operational challenges involved with incorporating PE into DC plans, Mitchells says examining the potential risk-reward benefits of private equity and how such assets could be incorporated into DC plans did reveal “pension plans were not better than average at identifying the best performing PE fund families; and plans generally did not concentrate their positions with specific PE managers,” she wrote in the report.

Meanwhile, swapping target-date-fund equity allocations for private equity investments in DC retirement plans resulted in more participants being able to retire at age 65 without running short of money in retirement, found Employee Benefit Research Institute research published in 2022.

Research and Methods

The Morningstar research was authored by Jasmin Sethi, associate director of policy research and government affairs at Morningstar, and Mitchell.

Researchers identified the largest 20 pension plans with PE exposure, as measured by AUM reported under Schedule H on the Department of Labor’s Form 5500 in 2020 and used other fields on the Form 5500 to capture investments in private equity, Mitchell explains.

“We took the largest plans by assets from those that passed this filter,” she says. “Then, to calculate the specific private equity allocation for each plan, we reviewed the financial statements attached to each year’s filings to avoid overestimating by using solely the data available in the structured Form 5500.”

Compliance February 15, 2024

Congressional Hearing Highlights Arguments for, Against Retirement Security Proposal

The House of Representatives hosted a second hearing on the retirement security proposal, during which witnesses disagreed on the adequacy of existing rules and the proposal’s potential to restrict access to financial products.

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Opponents of the Department of Labor’s retirement security proposal testified at a Congressional hearing Thursday that the proposal would dramatically decrease access to advice for smaller account holders, while proponents argued it is a necessary regulation to reduce and mitigate investor abuses.

The U.S. House of Representatives Committee on Education and the Workforce Subcommittee on Health, Education, Labor and Pensions hosted the hearing, in which witnesses testified to the DOL’s retirement security proposal, often called the fiduciary proposal. The changes to regulation, currently under review by the DOL’s Employee Benefits Security Administration, would expand fiduciary duties under the Employee Retirement Income Security Act to a wider range of recommendations and would include rollovers, investment menu design and annuity sales.

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Support for the Proposal

Joseph Peiffer, president of the Public Investors Advocate Bar Association, was called to testify by Democrats on the committee to represent victims of conflicted advice. He testified that “none of the people that I have ever represented realized that their adviser might be held to a standard below that of a doctor or an attorney” and added that some financial “firms advertise like they have the duties of doctors but litigate like they owe more duty than a used car salesman.”

The proposal will ensure retirement savers get the advice “they deserve and that they believe they are already getting,” Peiffer told committee members.

Current regulatory frameworks do not adequately protect retirement savers, Peiffer argued. Regulation Best Interest, a rule enforced by the Securities and Exchange Commission that requires advisers to mitigate conflicts and provide tailored advice, “does not cover advice to plans,” because it only applies to retail investors. He noted that retirement plan sponsors are not considered retail investors regardless of their actual size or financial sophistication, referring to an element of the proposal that would make investment menu design sales, often a one-time transaction, fiduciary advice. According to a comment letter from Morningstar, this part of the proposal could save small businesses up to $55 billion in excessive fees.

Peiffer was also sharply critical of the notion that the proposal would limit access to financial products to lower-income savers. He noted that small accounts “can least afford to have conflicted advice,” and evidence to the contrary comes solely from “industry-funded studies.” He noted that smaller accounts still have access to advice outside the retirement context after SEC’s Reg BI was enacted, despite it being very similar in substance to the DOL’s proposal.

Representative Susan Wild, D-Pennsylvania, concurred, saying that studies showing a large decline in access were “done by trade associations, and that’s what’s being relied upon.”

Lastly, Peiffer argued that the National Association of Insurance Commissioners’ model regulation, which governs annuity sales in 42 states, is inadequate because it does not require insurance agents to “even count compensation as a conflict.” He added that “if compensation isn’t a conflict, then what is it?”

Opposition to the Proposal

Though it is true that the NAIC regulation does exempt compensation from material conflicts of interest, Thomas Roberts, a principal in Groom Law Group, testified that insurance producers “are duty bound to consider the cost” of a product when making a recommendation. He added that “the mere fact that a professional salesperson receives some compensation, in and of itself, is not a conflict with their best interest obligation.”

Supporters of the proposal have long argued that the SEC’s Reg BI and the NAIC model regulation are adequate to address the abuses the DOL is concerned about and that the proposal, at best redundant, at its worst would sharply reduce access to financial products for lower-income savers.

Doug Ommen, the insurance commissioner for Iowa, testified in opposition to the proposal, noting that the NAIC regulation, like Reg BI, prohibits product-specific sales quotas and contests due to the obvious conflicts they can create.

Roberts explained that the proposal would impose a greater regulatory burden, and large segments of the population would either be “unserved altogether or underserved.” Since imposing ERISA duties and obligations would increase costs and limit the compensation advisers could collect, he argued that it would become uneconomical to serve smaller accounts.

Jason Berkowitz, the chief legal and regulatory affairs officer at the Insured Retirement Institute, testified that since commission-based professionals “get paid only if they complete a transaction, they have a vested interest in completing the transaction. That vested interest doesn’t prevent them from acting in the client’s best interest, but it does mean they can’t realistically meet a sole interest standard.” As a consequence, they would be forced to increase minimum balances for the accounts they service.

The hearing came as the DOL’s EBSA considers potential adjustments to the proposal before moving it forward. The proposal, first made in October 2023, has already gone through a 60-day public comment period, with EBSA taking that feedback into consideration in its final rulemaking.

Tim Hauser, EBSA’s deputy assistant secretary for program operations, said in a recent interview that if adviser present themselves as acting in investors’ best interest, they “should be held to that standard.”

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