Of course, “alternative” means different things to different people.
But, loosely defined, alternative investments are those that are not quoted on an exchange or other public market. This could include anything from hedge funds and private equity funds to real estate, timber, oil & gas, LBOs and commodities.
To be sure, these instruments can be complex and often come with unique investment and fiduciary risks. Especially within a defined contribution plan, where the risk-return profiles are being placed upon the participants, alternative investments are generally not appropriate as a core investment.
But employee benefit plans are increasingly focusing their attention on alternative investments for at least a portion of their overall investment portfolio.
“What has happened is that as plans have chased returns, they’ve gotten more esoteric, and alternative investments have crept in,” notes CPA Mike McNamara, a partner at Greer & Walker, LLP in Charlotte, NC. “That’s not necessarily a bad thing. Alternative investments can help with plan diversification and reduce the volatility of investment performance. The key is that alternative investments should always be subject to the specific financial and actuarial condition of each plan and the risk tolerance of the plan fiduciaries.”
Alternative investments often come under limited regulatory oversight, making it critical for plan fiduciaries to perform thorough due diligence and ongoing monitoring. “Investments in unregulated or less-regulated markets do pose some risks that might not be understood by plan fiduciaries in the same way that the risks of diversified stock and bond portfolios are understood,” notes McNamara.
Hedge funds, in particular, pose some unique challenges. They typically employ leverage (options, futures, swaps and short selling) and offer limited liquidity. Then, there is the issue of transparency. “There is a lack of transparency in the hedge fund industry as a whole,” says McNamara. “However, a hedge fund that provides access to information about underlying investments would certainly allow fiduciaries to execute their responsibilities.”
The Valuation Challenge
Perhaps the biggest challenge of alternative investments lies in establishing an accurate value. “By their very nature, these are investments for which a readily determinable fair value does not exist,” explains McNamara. “A hedge fund is not listed on NASDAQ, and you can’t pick up The Wall Street Journal and get a share price for a private equity fund.”
McNamara notes that it is actually quite easy to land in the murky waters of alternative investment valuation. “It doesn’t have to be some exotic fund. Plenty of plans offer investments that are outside of the traditional stocks, bonds and mutual funds. For example, maybe participants can direct their investments into real estate holding companies. Well, how do you establish a fair value on the real estate?”
What A Fiduciary Needs to Know
While generally accepted accounting principles require alternative investments to be valued at fair value, these values can be hard to come by. “Typically, the outside investment manager, the custodian or the issuer of the alternative investment ends up determining a value, and no one at the plan looks at it,” McNamara explains. “There is no requirement for the sponsor to have an independent valuation performed.”
So, that means that fiduciaries must have a sufficient understanding of :
- The underlying investments.
- The portfolio strategy of the alternative investment.
- The method and significant assumptions used by the fund manager to value the underlying investments.
“Basically, the Department of Labor holds plan management responsible for the proper reporting of plan investments. You have to have sufficient information to evaluate and independently challenge the valuation. Therefore, it is important that you become familiar with the assets your plan invests in and the methods and significant assumptions used to value them, especially for investments for which readily determinable market values do not exist.”
What You Can Do
But what if a detailed listing of the underlying investments is not available? Here, you may gain sufficient understanding of a fund through other activities:
- Periodically interview fund managers so that you understand a fund’s strategy, positions and valuation methodologies.
- Compare data obtained from the fund manager with other available information, such as sector data, indexes and cash distributions.
- Corroborate this information through the annual audited financial statements of the alternative investment.
The Limited Scope Audit Trap
Additional valuation challenges occur in situations where an audit of plan assets is required. In a “limited scope” audit, the Department of Labor allows the auditor to accept the fair value that a plan custodian assigns to an alternative investment. (By comparison, in a full scope audit, the auditor is required to test the model used for determining the alternative investment’s fair value.)
The danger arises when plan administrators simply rely on that certification with no further understanding of the investment or the valuation methods used. “They receive certification stating that the investments are valued at fair value and think that they don’t ever have to look any deeper at these investments,” McNamara explains.
Ultimately, a plan fiduciary is responsible for complete and accurate financial reporting of all plan investments. To that end, you’ll need to:
- Establish processes for determining fair value measurements and disclosures
- Select appropriate valuation methods
- Identify and adequately support any significant assumptions used in preparing the valuation
- Ensure that the presentation and disclosure of the fair value measurements are in accordance with Form 5500 reporting requirements and GAAP.