The Department of Labor’s Office of Inspector General recently issued a report detailing concerns with the valuation of alternative investments (such as private equity funds, hedge funds, and real estate) held by ERISA plans. ERISA requires plan sponsors and fiduciaries to value investments for several purposes, including to determine funding obligations, select investments, monitor investment performance, and file accurate financial statements. The report notes that many plan fiduciaries rely on valuations provided by managers of alternative investments without analyzing the basis for the valuation or seeking independent review. The report suggests that this practice poses substantial risks to the retirement system and urges the Labor Department to require more rigorous valuation methodology.
Here are some of the highlights of the report and the response by the Labor Department’s Employee Benefits Security Administration (EBSA):
Concerns Regarding Valuation. The Office of Inspector General (OIG) expresses concern that, absent rigorous valuation procedures, ERISA plans could become victims of Ponzi schemes and other fraudulent investments, or could make imprudent investments. OIG notes that improper valuations may affect a plan’s funded status and the assets available to pay benefits. From a sample of plans reviewed, OIG found that 90 percent did not obtain independent valuations of alternative investments or demonstrate an analytical process to determine their fair market value.
Focus on Limited Scope Audit Rules. Although most funded ERISA plans must be audited annually, ERISA permits plan fiduciaries to elect “limited scope audits.” In a limited scope audit, auditors may rely on statements regarding plan assets provided by a bank, insurance company, or other regulated financial institution if the institution certifies that its records are complete and accurate. According to OIG, “For hard-to-value investments, records of the certifying institution could be nothing more than a pass through of estimated values directly from the alternative investment entity.” The OIG report asserts that the plan administrator must determine whether the financial institution’s certification is sufficient to establish the fair value of the plan’s assets: if not, the administrator “must perform sufficient due diligence to determine the fair value of the assets in question.”
Increased Enforcement Activity by EBSA. The OIG reviewed enforcement cases involving hard-to-value investments and found weaknesses in EBSA’s enforcement review procedures. In response, EBSA described several current enforcement initiatives that focus on the valuation of alternative investments. Three EBSA regional offices have ongoing projects on alternative investments, according to EBSA, and all of its regional offices conduct investigations of these investments. For example, the Cincinnati Regional Office “specifically reviews alternative investments to ensure that valuations of a fund and/or of underlying funds are performed regularly, using standard valuation practices, and that the fund is audited by an independent, reputable third party.” EBSA also noted that it provided training to its investigators earlier this year regarding alternative investments.
Limited Reporting to Labor Department. The OIG report also focuses on EBSA’s limited ability to identify potential valuation problems. OIG observes that plans often include information regarding alternative investments in financial statements attached to the Form 5500, but the Labor Department cannot access this information electronically as it can data that is entered directly on a Form 5500.
OIG Recommendations. The OIG report recommends that EBSA take several steps to increase the accuracy of valuations of alternative investments, including:
- provide guidance to plan administrators to analyze and support the valuation of alternative investments held by ERISA plans;
- establish procedures for EBSA investigators to (a) ensure that plan administrators obtain independent valuations or have a process to analyze the value of alternative investments, and (b) evaluate the quality of plans’ audits; and
- improve Form 5500 data collection and analysis regarding alternative investments.
EBSA Response. EBSA disagreed with many of the report’s conclusions and resisted dedicating substantial resources to increase its focus on valuation of alternative investments. EBSA observed that many plans that invest in alternative investments rely on professional managers who have a duty to monitor plan investments and the advisors they retain. EBSA noted that alternative investments “may represent a non-material percentage of plans’ overall investment portfolio,” and that it might be appropriate in some cases for plan fiduciaries to rely on values reported by managers of alternative investments. Nonetheless, EBSA stated that it plans to consult with other federal agencies on “whether and how to develop useful investor guidance regarding hard to value, alternative investments and investment strategies.”
The OIG report is one of several in recent years to recommend that the Labor Department increase its scrutiny of alternative investments held by ERISA plans. The ERISA Advisory Council and the General Accountability Office each issued multiple reports on the topic. While EBSA’s response indicates a reluctance to devote substantial additional resources to the topic, it also describes ongoing efforts to evaluate plan fiduciaries’ valuation of alternative investments. Pension plans investing in private equity and other alternative investments might therefore be subject to EBSA investigations focusing on the valuation of these investments.