offering hedge funds in a 401k

[Guest xerty]

Client would like to offer hedge funds in their 401k plan (along with existing selection mutual funds). If you can suggest resources for further reading on this topic I'd be most appreciative.

Here are my questions -

1) If offered, would the plan need to insure the employees who wish to invest in the hedge fund option(s) meet the "accredited investor" requirements (typically $1M in assets or $200K in annual income)? If so, does that raise discrimination issues since many employees, esp NHCEs, will not be eligible for this investment option? I was told that this "look through" to individual plan participants was required for self-directed plans under Reg D of the Securities Act of 1933, but I am not sure if that applies in this case.

2) Can the client offer one of their own hedge funds as an investment option? Is there an issue with the company charging performance or other fees to the plan under ERISA rules? Would it matter whether the fees charged were lower than the "standard" fees charged to outside investors?

Thank you for any help or advice you can offer.

[BeckyMiller]

I can't speak to the registration issue, but with respect to the company's own hedge funds, you need to look at the prohibited transaction rules. The concept of a qualifying employer security is limited to stock, bonds or certain publicly traded partnership units. See ERISA Section 407(d)(5). I am pretty sure that few, if any, of today's hedge funds meet the definition of a publicly traded partnership unit included at © of the regulation. So, it is likely that their own hedge funds would be not be a qualifying employer security and could not be held by the plan absent an individual exemption request.

If I am reading this too narrowly, I would like to hear back from the group.

As to the question that you did not ask - realize that many hedge funds will spin off unrelated business income, potentially subject to income tax. So, that needs to be taken into account when evaluating the investment.

Further, hedge funds frequently do not have a readily ascertainable fair market value. So, whether you are simply valuing participant accounts or having to deal with the auditor of the plan, there may be additional costs incurred to measure value.

Finally, if more than 25 percent of the hedge funds units are held by benefit plan investors, the ERISA plan asset rules will apply to the underlying assets, rather than the equity instrument. At a minimum, someone needs to monitor this and if the rule is violated, significant additional costs are likely to be incurred. See ERISA Section 42 and reg. 2510.3-101.

[Guest xerty]

Hi Becky - thank you for your reply. I have done some additional research on this since I first posted and would be happy to hear your (and others') thoughts. For example, I'd found that the 401k plans of several prominent companies in the investment or financial services fields do offer hedge fund options apparently to all employees (not just "accredited" ones), although I don't have the details of how these plans or funds are structured to comply with the relevant regulations. I have not found an example of a hedge fund being offered in its own 401k plan, although this is not the easiest thing to research.

if more than 25 percent of the hedge funds units are held by benefit plan investors, the ERISA plan asset rules will apply to the underlying assets, rather than the equity instrument. At a minimum, someone needs to monitor this and if the rule is violated, significant additional costs are likely to be incurred. See ERISA Section 42 and reg. 2510.3-101.

I have read about the 25% rule for determining whether the hedge fund is deemed to have "plan assets" for ERISA purposes, and it seems that this is the most common exception used to avoid the ERISA rules about prohibited transactions, charging incentive fees, etc. The other main alternative being registering the fund, but that requires additional administration and compliance costs. In this case, I believe that both the 401k investment and any associated benefit plans (such as IRAs) would be well below the 25% threshold for all relevant share classes. Ongoing monitoring would be required of course, but should be feasible.

I can't speak to the registration issue, but with respect to the company's own hedge funds, you need to look at the prohibited transaction rules. The concept of a qualifying employer security is limited to stock, bonds or certain publicly traded partnership units. See ERISA Section 407(d)(5). I am pretty sure that few, if any, of today's hedge funds meet the definition of a publicly traded partnership unit included at © of the regulation. So, it is likely that their own hedge funds would be not be a qualifying employer security and could not be held by the plan absent an individual exemption request.

If I am reading this too narrowly, I would like to hear back from the group.

I agree the hedge fund is not likely to fall under the security types you mention, typically being a private (not traded) limited partnership. Would the prohibited transaction rules still apply to the fund if it passes (under) the 25% significance test? Is there a distinction between ERISA prohibited transactions and the similar Code rules on such?

As to the question that you did not ask - realize that many hedge funds will spin off unrelated business income, potentially subject to income tax. So, that needs to be taken into account when evaluating the investment.

Good point, thanks for the reminder . Proper structuring of the offshore investment entities can avoid UBTI, but this may not be the case for this fund. The UBTI tax liability seems unlikely to exceed the $1000 threshold for taxation as long as relatively small amounts are invested per plan participant, although of course this depends on the nature of the fund's investment activities.

[austin3515]

Does anyone have anything to add to this? I have a prospect asking questions about this exact thing. They would not draw any fees on the account, however, there does of course appear to be an inherent conflict of interest. Would this always be a prohibited transaction, or are there ways around this?

[MoJo]

Resurfacing this.... I have a money manager client wanting to include it's own hedge fund in the investment mix. My sense is that it is a PT, unless a PTE exists (for which I am aware of those for a bank's own investments (collective trusts) and mutual fund purveyors' own investments in their 401(k) plans - but not for hedge funds).

Any insight?

[austin3515]

I have had an ERISA attorney conclude that this situation was not a PT. I don't have a copy of the legal analysis, but it went so far as to be indirectly discussed in a DOL submission about an unrelated matter. That's how sure he was it was not a PT. So anyway, there is a way.

[MoJo]

Thanks Austin. I'll be doing some research on the issue (I'm a "recovering" ERISA attorney myself, but don't like recreating the wheel, if I don't have to). Evenif it isn't a PT (and I won't be convinced that it isn't unless I see some authority to that effect), I have major problems with teh fee structure of the hedge fund (flat wrap percentage PLUS a share of the profits of the fund) which raises my sense of smell on several levels.

[jpod]

MoJo: In my opinion, the only way it could possibly not be a pt (and note I say "possibly"), is to eliminate all fees payable to the fiduciary making the decision to put the fund on the menu, or payable to an affiliate of that fiduciary, or payable to someone in which the fiduciary "has an interest" that may affect its judgment on the matter. Even then there still could be a pt lurking (e.g., seed money for the fund, or being able to tout the fact that "we make the fund available to our own employees through our DC Plan!).

[austin3515]

In my scenario, the plan was invested in a share class that had zero management fees going to the sponsor. Clearly, the sponsor cannot earn a profit from plan assets.