USA – DISTRICT OF COLUMBIA Trends and Developments Contributed by: Sanford Heisler Sharp McKnight, Sanford Heisler Sharp McKnight
A participant’s access to their retirement savings may be limited by the fund’s redemption policies. Redemp - tion policies for these funds may permit monthly, quarterly or annual redemptions. Others may allow redemptions only when the fund’s manager, in their sole discretion, allows it. Often, alternative investment funds may honour redemptions not with cash but with the securities in the portfolio which, themselves, may be illiquid. Under this backdrop, fiduciaries must give consideration to the liquidity needs of participants who experience a financial crisis, retire or change employment, and to beneficiaries of a participant who passes away. It remains unclear whether illiquid investment alter - natives will be asked to prepare liquidity risk man - agement programmes that mirror those of registered funds, or whether fiduciaries will instead draw on bar - gaining power to negotiate certain key provisions from Rule 22e-4 of the Investment Company Act of 1940, such as limiting investment in illiquid assets to 15% or less, or to enter into separate agreements with a fund’s manager (also known as side letters) that allow plan participants special redemption rights. This requirement creates a substantial practical chal - lenge for many committees. Liquidity risk manage - ment involves highly technical concepts that many fiduciaries lack the expertise to evaluate. As a result, one anticipated outcome of the proposal is greater fiduciary reliance on outside investment profession - als with specialised expertise. Even then, fiduciaries retain oversight obligations and must document both the process and rationale for their conclusion. Valuation Risk Creates Significant Exposure “The fiduciary must appropriately consider and deter - mine that the designated investment alternative has adopted adequate measures to ensure that the desig - nated investment alternative is capable of being timely and accurately valued in accordance with the needs of the plan.” Defined contribution plan fiduciaries should expect regular account valuation, daily transactions and transparent, conflict-free pricing. Because real estate funds, hedge funds and private equity funds hold hard-to-price assets, plan fiduciaries will need to
familiarise themselves with and periodically monitor a fund’s valuation process to ensure a timely and fair valuation of the portfolio. The DOL’s proposal reflects growing regulatory con - cern regarding conflicts in private market valuation practices. Fiduciaries, then, must engage in rigorous scrutiny to ensure an independent, conflict-free valu - ation process. How does a plan assign a fair value to an asset that is not traded on a recognised exchange or whose trading has been suspended? How does a plan assign a fair value to a bond that is in default? What steps are the plan’s fiduciaries taking to ensure that the private fund manager has adequate proce - dures in place that fairly value the assets in the fund? Fiduciaries must be able to answer these, and more, questions regarding the valuation of plan investments. Failure to do so evidences an imprudent fiduciary process. For example, under the DOL’s proposal, funds managed by an entity that can purchase pri - vate assets from an affiliate using proprietary valu - ation methods would not meet the requirements of the proposed “safe harbour”. A fiduciary committee that cannot explain how illiquid assets are valued may struggle to defend the prudence of selecting those investments. Performance Benchmarking “The fiduciary must appropriately consider and deter - mine that each designated investment alternative has a meaningful benchmark and compare the risk-adjust - ed expected returns, net of fees, of the designated investment alternative to the meaningful benchmark. The proposal defines ‘meaningful benchmark’ for this purpose as ‘an investment, strategy, index, or other comparator that has similar mandates, strategies, objectives, and risks to the designated investment alternative.’” The investment adviser of an investment fund charges an investment advisory fee on the premise that it will beat an identified benchmark (eg, S&P 500, FTSE Narieit, LIBOR). If a plan intends to pay these fees, fiduciaries should select and retain an asset that beats its benchmark; otherwise, the plan is not getting val - ue for its money. Prudent selection and evaluation of investment benchmarks are critical to evaluating fund
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