DOL's benchmark rule puts private markets to the test

Benchmarking a private equity fund is approximate by nature: holdings don't trade daily, reporting is sparse, and the gap between the best and worst performers is wide. The Department of Labor now wants fiduciaries to attempt the comparison anyway, as the price of a safe harbor for putting private assets into 401(k) plans.

The proposed rule, reported by PLANADVISER, would give defined contribution plan fiduciaries a process-based standard for prudence under ERISA. To qualify, a fiduciary would evaluate each investment on six factors: performance, fees, liquidity, valuation, complexity, and benchmarking. The last factor is the hard one. The fiduciary must find a 'meaningful benchmark' — an investment, strategy, index, or other comparator with similar mandates, strategies, objectives, and risks — and compare the investment's risk-adjusted expected returns, net of fees, against it.

"Benchmarking is exceptionally difficult with private assets," Ken Wiles, executive director of the Hick, Muse, Tate & Furst Center for Private Equity Finance at the University of Texas, told PLANADVISER. "It's hard with public assets, but even worse with private assets."

The proposal is designed to open DC plans to private assets, PLANADVISER reports. But benchmarking already recurs in ERISA litigation, where courts must decide whether a plaintiff's chosen comparison is close enough to support a claim of imprudence. Private assets resist clean comparisons. Their data are thin, their returns are widely dispersed, and no index carries general acceptance. A public equity fund can be checked against a recognized benchmark. A private equity fund may have no obvious one. The six-factor checklist does not close that gap; it merely forces the fiduciary to acknowledge it in writing.

The standard tools do not get the fiduciary much further. Internal rate of return, private equity's most-used measure, relies on estimated asset values until investments are sold. Public market equivalents try to put private portfolios next to public ones, but locating genuinely comparable public companies is itself a judgment call. The inputs are estimates, not observed prices.

"There is no standard benchmark," Wiles said. "There's no standard, industry-accepted way to specifically measure the performance on a risk-adjusted basis."

Gregory Brown, a finance professor at the University of North Carolina's Kenan-Flagler Business School, sees another problem: the benchmarks themselves are unstable. Private-market indexes, he told PLANADVISER, can carry different return and risk characteristics depending on how they are built, and some rely on proprietary data.

The DOL's definition of meaningful benchmark is broad enough to allow a range of comparators, and that is both the rule's strength and its weakness. A fiduciary can defend a benchmark that is reasonable on its own terms. A plaintiff can argue that the chosen benchmark misses the mandate, strategy, or risk of the private asset. The court is left to judge whether the comparison is close enough. Because the safe harbor turns on process rather than outcome, the fiduciary's written account of the benchmark search may matter more than the benchmark's actual fit. In a market without an accepted standard, that written account is the real protection.

For plan sponsors, the effect is direct. The rule is meant to make private markets more accessible to DC plans, but the benchmarking requirement imposes an obligation the asset class has not yet learned to satisfy. A sponsor evaluating a private equity fund will have to document why a particular index or comparator is meaningful, knowing that a plaintiff in a later lawsuit can challenge the same choice. That exposure is likely to slow adoption, not speed it, at least until a private-market benchmark standard emerges. For many sponsors, the added diligence alone may be enough to rule private assets out.

None of this makes the safe harbor unworkable. It makes it depend on a comparison that private markets have not yet produced in any agreed form. Public assets come with a benchmark already in place; private assets do not. For private assets, the fiduciary has to supply the yardstick and then defend its meaning. That is a heavier burden than the six-factor test suggests.