Benefit plan investor

A benefit plan investor includes virtually every type of tax-advantaged retirement account and employee benefit program in the United States. Section 3(42) creates three main categories:

1. Employee benefit plans under ERISA Title I (like private company pension and health plans)
2. Plans subject to Internal Revenue Code prohibited transaction rules (including ERISA plans, individual retirement accounts, and Keogh plans)
3. Entities treated as holding plan assets in proportion to benefit plan investor ownership

This broad definition reflects ERISA's goal to protect American workers' retirement security. It applies strict oversight to any investment vehicle that handles retirement money. The wide scope ensures hedge funds cannot avoid ERISA requirements by investing through complex structures when retirement plan assets are ultimately at risk.

Benefit plan investors include the retirement and employee benefit arrangements most Americans use for future financial security. The most common types are:

• Private company pension plans
• 401(k) and profit-sharing plans
• Health and welfare benefit plans
• Keogh plan for self-employed individuals
• Individual Retirement Accounts, including Traditional, Roth, SEP-IRAs, and SIMPLE IRAs
• Entities treated under ERISA as holding plan assets, such as funds of funds that primarily invest in other investment vehicles

This extensive coverage prevents hedge funds from avoiding ERISA requirements through complex fund structures when retirement plan money remains exposed to investment risks.

The 25% test represents the most important concept for understanding benefit plan investors in hedge fund contexts. This rule determines when a hedge fund becomes subject to ERISA's comprehensive requirements.

Here's how it works: When benefit plan investors purchase ownership interests in an entity that is neither a publicly traded security nor a registered investment company, their assets normally include only their ownership stake in that entity.

However, if benefit plan investors collectively own 25% or more of the value of any class of ownership interests in the entity, that entity becomes a plan asset look-through entity. This 25% test creates a clear rule that fundamentally changes how hedge funds must operate. Fund managers must evaluate each separate class of ownership interests to determine whether benefit plan investors exceed the threshold in any individual class.

When benefit plan investors exceed the 25% threshold, the regulatory consequences completely transform the hedge fund's operational framework. The benefit plan investor's assets expand beyond their ownership stake to include an undivided interest in every underlying asset the fund owns. For ERISA purposes, regulators treat the fund as if it does not exist.

This look-through treatment means the investment manager has a direct relationship with each investing benefit plan. Benefit plans are treated as if they directly participated in every action the fund takes. This extends beyond investment decisions to include hiring service providers like accountants or administrators. When the fund enters into transactions, each investing benefit plan investor is treated as though it directly engaged in that transaction on a pooled basis.

When a fund exceeds the 25% threshold and becomes subject to ERISA, the investment manager becomes a fiduciary with respect to each benefit plan investor's assets in the fund. ERISA fiduciaries cannot deal with plan assets for their own benefit. They must follow strict standards of care, acting solely in the interest of plan participants and beneficiaries.

This fiduciary status creates severe operational restrictions. The investment manager or general partner cannot cause the fund to pay performance-based compensation like incentive fees if they can control the compensation amount. This happens when they can assign values to the fund's assets or time when they receive payment based on investment sales. This prohibition stems from ERISA's anti-self-dealing provisions that prevent fiduciaries from using their authority over plan assets for personal benefit.

The most significant operational impact occurs in asset valuation and performance fee calculations. In non-ERISA funds, investment managers typically retain discretionary authority to value fund assets, particularly illiquid securities without readily available market prices. ERISA plan asset funds prohibit this authority entirely.

To comply with ERISA's prohibited transaction rules, investment managers of plan asset funds cannot set their compensation by valuing the fund's securities. Assets without readily available market prices must be independently valued. An entity chosen by the independent plan fiduciary—rather than the investment adviser—must handle this valuation.

The investment manager must establish and fully disclose in advance how pricing will be determined from external sources. The fund's administrator or valuation agent must handle asset valuation according to the predetermined policy.

Additionally, Department of Labor advisory opinions require that incentive compensation be based on both realized and unrealized gains and losses. Taking incentive allocations on realized gains only creates conflicts of interest. This approach provides managers with incentives to sell winning positions and retain losing investments to generate fees.

The Plan Assets Regulation requires conducting the 25% test after each new acquisition of ownership interests in the fund. The Department of Labor has determined that partner withdrawals constitute acquisitions triggering retesting. This happens because withdrawal increases the ownership percentages of remaining partners.

This requirement means hedge funds must establish ongoing monitoring systems. They need to track benefit plan investor participation levels and conduct the 25% test whenever investor compositions change.

Fund managers must be particularly vigilant during redemption periods. Large redemptions by non-ERISA investors can push benefit plan investor ownership above the 25% threshold even without new benefit plan investments.

The determination of whether an entity qualifies as a plan assets vehicle excludes certain ownership interests from the calculation. The fund disregards ownership interests held by persons (other than benefit plan investors) who:

• Have discretionary authority or control over fund assets
• Provide investment advice for fees
• Are affiliates of such persons

This exclusion means when hedge fund managers, owners, and employees invest in their own fund, the fund ignores these investments when conducting the 25% test. However, if these same individuals invest through individual retirement accounts, those IRAs count as benefit plan investors. They count in both the numerator and denominator of the 25% calculation because IRAs qualify as benefit plan investors under the regulatory framework.

When hedge funds use for illiquid or distressed investments, the Plan Assets Regulation treats each side pocket as held by its own separate entity with its own 25% test. If a hedge fund maintains multiple side pockets, regulators treat the fund as multiple separate entities.

The main fund operates as one entity tested on a class-by-class basis. Each side pocket operates as its own distinct entity.

This treatment requires careful monitoring of benefit plan investor participation in each segregated pool of assets. This ensures ERISA compliance across all fund compartments. Once a side pocket is established, the benefit plan investor percentage typically remains fixed unless the investment manager allows early withdrawal from that specific side pocket.

Given ERISA compliance's significant regulatory burden and operational constraints, most hedge funds implement strategies to remain below the 25% threshold. They prefer this approach rather than accepting the requirements of becoming a plan asset fund.

Common approaches include:

• Continuous monitoring of benefit plan investor participation levels
• Provisions in subscription agreements requiring investors to disclose their ERISA status
• Reserving rights to restrict or force redemptions of benefit plan investors when necessary to maintain compliance

Some funds create separate share classes or parallel fund structures specifically designed for benefit plan investors. This approach allows funds to accommodate these investors while preserving operational flexibility for the main fund serving non-ERISA investors. Alternative structures include hardwired arrangements that can help manage the 25% test across multiple investment vehicles while maintaining compliance with plan asset regulations.