Due to the lacklustre performance in the equity and debt markets in recent years, investments in hedge funds and other alternative investment vehicles are becoming increasingly attractive to retirement plan trustees and investment committees.
At the same time, fund managers are eager to manage retirement fund assets since:
1) there are a vast amount of assets being held in pension plans (USD11 trillion dollars of plan money as of 30 September, 20111) and;
2) there is typically a long investment horizon for such assets.
However, the Employee Retirement Income and Security Act of 1974, as amended (ERISA), the Internal Revenue Code of 1986 (IRC) and the Pension Protection Act of 2006 (PPA) create special issues for fund managers who manage ERISA plan assets.
Under ERISA, each fund is subject to additional requirements and obligations once more than 25 percent of the fund’s assets under management (AUM) are subject to ERISA (the 25 percent threshold). Moreover, the “prohibited transaction” rules of Section 4975 of the IRC raise additional issues for fund managers who manage ERISA assets.
Once the 25 percent threshold is met, the fund is subject to the following significant requirements and obligations. There are others, but we’ve chosen to highlight these key items:
• The fund manager becomes an ERISA fund manager creating co–fiduciary liability. Fund managers and plan trustees are thus liable for each other’s actions.
• There are certain limitations with respect to block trades and cross trades. For example, the interests of the plan should not exceed ten percent of the block trade.
• Fund documents need to be reviewed for compliance with ERISA laws. Of significance, the typical indemnity clause in a partnership agreement for gross negligence of the investment manager is not permitted under ERISA.
• An ERISA fund manager must acknowledge its fiduciary responsibility under ERISA rules and need to be in compliance with ERISA requirements at all times.
The 25 percent threshold is calculated each time there is a change in ownership of equity interest of the fund.
The denominator of this calculation should exclude controlling equity interest of the fund. Therefore, only limited partners’ capital is used in the calculation and certain limited partners’ capital under the control of the general partner would also be excluded. Under the PPA, only ERISA Plans and IRAs count towards the determination of the 25 percent threshold. Foreign plans and government plans are excluded from the numerator of this calculation but are included in the denominator.
Further, the 25 percent threshold is calculated on each class of partners’ capital. Thus, if there are multiple classes of capital, any one of which has more than 25 percent ERISA investors, then the whole fund is considered a plan asset fund and ERISA compliance rules will need to be met.
Similarly, fund the adviser should look at their investors to determine if any are pooled investment vehicles. In those instances, the beneficial ownership by ERISA investors is the key. For example, Fund A has a limited partner (“Fund of Funds B”) which owns 50 percent of Fund A. Sixty percent of Fund of Fund B’s limited partners are ERISA plans, therefore 30 percent of Fund A is deemed to manage plan assets (50% Fund of Fund B’s ownership of Fund A * 60% ERISA plan ownership of Fund of Fund B). Therefore, Fund A needs to be in compliance with ERISA rules as more than 25% of the beneficial ownership is the hands of ERISA plans.
ERISA fund managers must also consider prohibited transactions and parties in interest transactions as defined under Section 4975 of the IRC. For example, performance fees may be considered self dealing prohibited transactions. However, performance fees would be allowed if:
• the fee arrangement is approved by the plan fiduciary;
• most investments are readily marketable; and
• all other investments (not readily marketable) are appraised by an independent appraiser chosen by
the plan fiduciary.
Another potential pitfall is the use of soft dollars. NASD Rule 2080 provides a safe harbour that governs how investment managers can use soft dollars. If Investment managers are not availing themselves of the safe harbour, their soft dollar expenses may be considered prohibited transactions resulting in a failure to comply with the ERISA rules.
Finally, there are additional required disclosures at the plan level. ERISA compliance requires the fund to file Form 5500 in addition to its income tax return. Further, Schedule C of the Form 5500 requires disclosure of direct compensation paid by the plan. This includes management fees and performance fees paid by the ERISA plan to the fund manager, as well as other fees which might be paid in connection with certain investments.
