Identifying Exceptions to the ERISA Plan Asset Rules | Practical Law

Identifying Exceptions to the ERISA Plan Asset Rules | Practical Law

A resource that assists in determining whether an employee benefit plan's investment in an entity, such as a private equity fund or hedge fund, satisfies one of the exceptions from the plan asset rules under the Employee Retirement Income Security Act of 1974 (ERISA).

Identifying Exceptions to the ERISA Plan Asset Rules

Practical Law Legal Update 0-533-6035 (Approx. 5 pages)

Identifying Exceptions to the ERISA Plan Asset Rules

by Practical Law Employee Benefits & Executive Compensation
Published on 16 Jul 2013 • USA (National/Federal)
A resource that assists in determining whether an employee benefit plan's investment in an entity, such as a private equity fund or hedge fund, satisfies one of the exceptions from the plan asset rules under the Employee Retirement Income Security Act of 1974 (ERISA).

Defining Plan Assets under ERISA

When a certain type of employee benefit plan invests in an equity interest of an entity, the plan must look-through that interest and treat its investment as an investment in the underlying assets of the entity, unless an exception applies. An entity, such as a hedge fund or private equity fund or other collective investment vehicle or issuer that is not itself a plan subject to ERISA, is treated as holding assets of the investing employee benefit plans if it appears that its primary purpose is to invest retirement plan assets. This is known as the "look-through rule."
The determination of whether a entity is treated as holding ERISA plan assets is made based on the final regulations issued by the DOL, as modified by ERISA Section 3(42), a statutory provision added under the Pension Protection Act of 2006 (together, the Plan Asset Rules).
For more information on the Plan Asset Rules, including a description of the types of employee benefit plans subject to these rules, see Practice Note, ERISA Plan Asset Rules.

Exceptions to the Plan Asset Rules

There are several exceptions from the Plan Asset Rules that are described below. In addition, see Determining If Entity Holds ERISA Plan Assets Flowchart.

Exceptions for Debt Investments

The Plan Asset Rules only apply to a plan's investment of an "equity interest" in an entity. The term equity interest under the Plan Asset Rules means any interest in an entity other than an instrument that is treated as indebtedness under applicable local law and which has no substantial equity features. For example, a profits interest in a partnership, an undivided ownership interest in property and a beneficial interest in a trust are equity interests.
Complications may arise regarding whether a plan's investment in mortgage-backed securities (MBS) and asset-backed securities (ABS) is considered an "equity interest" or a debt investment for purposes of the Plan Asset Rules. The DOL declined to specify what factors should be considered in determining whether a debt instrument has "substantial equity features" under the Plan Asset Rules, but instead indicated that the determination is inherently a facts and circumstances test to be determined on a case-by-case basis. To complicate matters, the characterization of an instrument as debt or equity must be made on a continuing basis.
To determine whether an ERISA plan's investment in MBS or ABS should be considered an investment of an "equity interest" or a debt investment, see Practice Note, Guide to ERISA Issues in Mortgage-backed Securities and Asset-backed Securities Transactions: Identifying Debt Under the Plan Asset Rules.

Exceptions that Apply to All Plan Investments

The Plan Asset Rules specifically provide that an entity is not considered to be holding plan assets when a plan invests in:
For more information on these exceptions, see Practice Note, ERISA Plan Asset Rules: Statutory Exceptions.

Additional Exceptions to the Look-Through Rule

The Plan Asset Rules provide additional exceptions to the look-through rule, including three well-known exceptions. An entity is not treated as a look-through vehicle under the Plan Asset Rules if it is established that:
There are benefits to using one of these exceptions instead of the other, depending on timing, among other concerns. For example, the VCOC exception may only be used if certain requirements are met before the plan's initial investment in the entity, and must be tested on an annual basis, while the 25% Test may be used at any time during a plan's investment, but the value of a plan's investment in the entity must be continually monitored. For more information on choosing what exception may work best for a client's particular facts and circumstances, see Practice Note, ERISA Plan Asset Rules: Comparing the VCOC and 25% Test Exceptions.
For a flowchart summarizing all of the potential exceptions from the plan asset rules, see Determining If Entity Holds ERISA Plan Assets Flowchart.

Effect of Plan Asset Rules on Plan Investments

If none of these exceptions to the Plan Asset Rules apply, the entity is considered to be holding plan assets subject to ERISA and:
  • Individuals or entities with discretion to manage and control the entity's assets, or who provide investment advice for those assets, such as an investment manager for a private equity fund, are considered ERISA fiduciaries to each of the plans investing in the entity (see Practice Note, ERISA Fiduciary Duties: Overview: Pooled Investment Vehicles).
  • The transactions entered into by the entity and the compensation arrangements of the investment manager or general partner, or both, of the entity are subject to the prohibited transaction provisions of ERISA and Internal Revenue Code Section 4975 (see Practice Note, Prohibited Transactions and Exemptions under ERISA and the IRC).
  • The entity is treated as a benefit plan investor when it invests in a second entity, such as in a feeder fund arrangement.
  • The indicia of ownership of the entity's assets must be held in the US, subject to exceptions.
  • The investment manager must disclose in advance of the plan's investment the compensation it will receive and provide certain investment information to the plan.
For more information, see Practice Notes, ERISA Plan Asset Rules: Effect of Look-Through Rule on Plan Investments and Prohibited Transactions and Exemptions under ERISA and the IRC.