Implications Of Erisa Exemption For Alternative Investments

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Describes ERISA implications for Pension Plans investing in Alternative Investments

Describes ERISA implications for Pension Plans investing in Alternative Investments

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  • 1. Implication of ERISA Exemption Alternative Investments for US Pension Plans February 2009
  • 2. Pension Plan Investment Options
    • Pension Plan Sponsors have two broad choices in investing plan assets:
      • Invest in funds with managers subject to ERISA regulations
        • Institutional Commingled Funds
        • Separate Accounts offered by insurance companies
        • Investment Funds (Limited Partnerships, Limited Liability Companies) with more than 25% assets from ERISA plans
      • Invest in funds with managers exempt from ERISA regulations
        • Publicly traded stocks or mutual funds
        • Investment Funds (Limited Partnerships, Limited Liability Companies) with less than 25% assets from ERISA plans
        • Venture Capital Operating Companies
        • Real Estate Operating Companies
    1
  • 3. Investment Managers Subject to ERISA
      • Allows Plan Sponsor to delegate responsibility for investments to qualified investment managers who accept ERISA fiduciary status.
      • Plan Sponsor shielded from liability due to acts and omissions of investment manager.
      • Plan Sponsor retains fiduciary responsibility for:
        • Investment Strategy and Asset Allocation (if not delegated)
        • Selection of investment manager
        • Monitoring the investment manager
        • Decision to retain or terminate investment manager
      • If Plan Sponsor is sued for poor investment performance:
        • Plan sponsor shielded by investment manager’s fiduciary responsibility for investment transactions.
        • Plan sponsor retains liability for investment strategy, asset allocation, selection and monitoring of investment manager.
    2
  • 4. Investment Managers Exempt from ERISA
      • Fund manager not subject to ERISA fiduciary rules.
      • Plan Sponsor not able to delegate fiduciary responsibility for investments.
      • Plan Sponsor (Investment Committee) has fiduciary responsibility for:
        • Investment Strategy and Asset Allocation
        • Selection of investment
        • Monitoring the investment
        • Decision to retain or sell investment
      • If Plan Sponsor is sued for poor investment performance:
        • Plan Sponsor retains fiduciary liability for investment selection.
    3
  • 5. ERISA Fiduciary Responsibility
    • Investment Managers subject to ERISA have the following fiduciary responsibilities with respect to their specific investment mandate:
      • Duty of Loyalty
      • Act solely in the interest of participants.
      • Prudent Expert
      • Use due diligence and appropriate expertise.
      • Diversification
      • Diversify plan assets subject to specific mandate to minimize risk of large losses.
      • Pursuant to Plan Documents
      • Follow plan documents to the extent they are consistent with ERISA.
    4
  • 6. ERISA Restrictions
    • Investment Managers subject to ERISA are subject to following restrictions:
      • ERISA prohibits fiduciaries from engaging plan in transactions with a “party in interest” that includes:
        • Employer or employees participating in plan
        • Fiduciaries
        • Any person providing services to plan
        • 10% shareholders
        • Any entity of which 50% or more is owned by above parties
      • ERISA prohibits conflicts of interest transactions:
        • Dealing with plan assets in their own interest or for own account.
        • Representing a party whose interests are adverse to plan.
        • Receiving compensation for their own account from another party in transaction involving plan assets.
        • Payment of certain incentive fees to managers.
    5
  • 7. ERISA Exemption Investment Manager Rationale
    • For certain asset classes such as real estate, infrastructure, private equity, etc., ERISA restrictions make it difficult for the fund manager to carry out normal business activity of acquiring and managing assets.
    • When a fund manager is exempt from ERISA regulations
      • Fund can engage in complex transactions involving affiliates, such as:
        • Borrow money from affiliates to finance real estate transactions
        • Acquire investments made available to the fund by an affiliate in an off market transaction.
        • Use affiliates to manage underlying investment…common practice in real estate transactions.
      • Incentive fees can be paid to managers…common in real estate industry.
      • Fund can avoid unforeseen violations of ERISA regulations as well as administrative costs in determining whether or not every fund activity is permissible under ERISA.
    • ERISA exemption allows funds to be competitive in above asset classes and attract capital from pension plans as well as non-ERISA investors.
    6
  • 8.
    • Corporate pension plans have begun to increasingly invest in funds whose managers are exempt from ERISA fiduciary requirements because:
      • Certain asset classes such as Infrastructure, Private Equity, and to a large extent, Real Estate, are available to pension plans only through ERISA exempt funds.
      • These asset classes exhibit low correlation with traditional assets such as equity and debt and allows plans to further diversify their investments while assuming minimal additional risk.
    ERISA Exemption Corporate Pension Plan Rationale 7
  • 9.
    • Plan Sponsors investing in an ERISA exempt investment protect themselves as follows:
      • Prudent asset allocation to ERISA exempt investments
        • Plan Sponsor can limit the amount of assets to be allocated to such investments.
      • Building protections within Investment Manager Agreement
        • Investment Management Agreement can be negotiated and structured to provide adequate protection for Plan Sponsors.
        • ERISA like obligations may be included in agreement to the extent possible.
      • Monitoring of Investment Manager
        • Regular monitoring of investment manager portfolio and performance at specific intervals can minimize risk of large losses to plan.
    ERISA Exemption Protection for Corporate Pension Plans 8
  • 10. Type of ERISA Exemptions
    • Department of Labor provides the following exemptions from ERISA regulations to investment funds that accept assets from ERISA regulated plans:
      • Investments in publicly traded securities or mutual funds
      • Participation by benefit plans is less than 25% of total equity
      • Venture Capital Operating Companies (VCOC)
      • Real Estate Operating Companies (REOC)
    9
  • 11. Venture Capital Operating Company
    • Many real estate, infrastructure, private equity and hedge funds are structured to take advantage of the Venture Capital Operating Company (VCOC) exemption from ERISA rules.
    • A fund is considered a VCOC when:
      • At least 50% of its assets are invested in operating companies where it has management rights.
      • The fund manager regularly exercises management rights for at least one of its portfolio companies.
    10
  • 12. ERISA Exempt Investment Trends
    • Several large companies have a portion of their pension plan portfolio invested in ERISA exempt investments.
    • A survey of 75 corporations conducted by JPMorgan indicates that 63% of the companies (47 out of 75) have invested in alternative assets.
    • As per Greenwich Survey published in 2007:
      • 4.4% of corporate pension plans have invested in private equity and 2.2% of the plans had invested in hedge funds.
      • Among corporate pension plans, average allocation to private equity was 6.3% and to hedge funds was 5.4%.
    11
  • 13. Conclusion
    • ERISA does not prohibit plan sponsors from investing in funds whose managers are exempt from ERISA rules.
    • Recent industry trends indicate an increasing number of real estate, infrastructure and private equity funds adopting the VCOC structure to achieve greater flexibility in conducting fund operations.
    • If a benefit plan sponsor invests plan assets in a fund subject to ERISA:
      • Plan sponsor retains fiduciary responsibility for investment strategy, asset allocation, prudent selection and monitoring of the fund manager.
    • If a benefit plan sponsor invests plan assets in a fund exempt from ERISA:
      • Plan sponsor has fiduciary responsibility for all investment selection.
    • When investing in ERISA exempt investments, Plan Sponsors can protect themselves through prudent asset allocation decision, provisions in the Investment Manager Agreement and regular monitoring of manager performance.
    12