Much debate remains about whether private equity is an appropriate option for members of capital accumulation plans.

Canada’s neighbours to the south have been examining the potential legal pitfalls of these allocations. A recent information letter from the U.S. department of labor set forth a framework plan sponsors can use to consider the prudence of private equity within their plans.

The letter from the department of labor noted that U.S. legislation does allow for plan sponsors to explore the idea of adding a private equity element to a diversified management fund, be it a custom target-date, target-risk or balanced fund. These allocations have the potential to be managed in numerous ways, it said, such as through an account managed separately by a plan investment committee, under the supervision of a delegated asset manager or as part of a pre-packaged fund-of-funds product or some other pooled vehicle. However, the department of labor noted that direct and separate private equity investments don’t fall under this set of guidance and would require separate analysis.

In response, the Defined Contribution Institutional Investment Association wrote a paper on the matter. Overall, the DCIIA noted the guidance from the department of labour “creates an opportunity for DC fiduciaries to provide their plan participants with access and diversification, while retaining confidence that they are fulfilling their fiduciary obligations.”

The association identified three core potential benefits from the inclusion of private equity. First, these assets can offer plan members longer investment horizons, with the potential to outperform public equities. Second, it provides CAP members with access to assets typically only available to those within defined benefit pension plans. And third, private equity provides increased diversification, with the potential to hedge a member’s portfolio in the event of a public equity market downturn.

For plan sponsors looking at adding private equity to the mix, the department of labor pointed out several considerations. They must understand the long-term impact of adding private equity as it relates to the diversification of investment products and the potential for return, including considerations of management and performance fees. It also suggested they consider whether the fiduciaries in charge of plan investment decisions have the appropriate level of expertise to take on private equity.

Plan sponsors should also be aware of whether the private equity investment option includes liquidity and valuation features that allow members to take distributions and exchange into other plan investment options in a manner consistent with plan terms, noted the department of labor. And they should consider whether the liquidity constraints inherent to private equity investments align with the needs of a particular plan member population, taking things like age, employee turnover and contribution and withdrawal patterns into account.

Finally, the department of labor suggested that plan sponsors ensure disclosures about the risks of investing in private equity are made to plan members, enabling them to make as informed a decision as possible.