ERISA

The Employee Retirement Income Security Act of 1974, commonly known as ERISA, is one of the most important federal laws affecting hedge funds that work with pension fundsRetirement benefit plans established by employers to provide income to employees after retirement, typically qualifying as tax-exempt organizations. and retirement money. Congress created ERISA to replace a patchwork of different state laws with one national standard for how employee benefit plansRetirement, pension, or other benefit plans established by employers for their employees, often subject to ERISA regulations. should be managed. The law was designed to protect workers' retirement savings by establishing strict rules about fiduciary dutyLegal obligation to act in the best interests of another party, requiring utmost good faith and loyalty. and what types of transactions are forbidden.

For hedge funds, the key issue is simple but consequential: Will the fund's money be considered "plan assetsAssets held in employee benefit plans subject to ERISA fiduciary obligations and regulatory protections." under ERISA? If the answer is yes, the fund must follow much stricter rules that can completely change how it operates. This determination hinges on a critical threshold test that we'll explore next.

The most important rule in ERISA for hedge funds is the "25% test." This test determines whether a hedge fund must follow ERISA's strict "plan asset" rules. Here's how it works: If pension fundsRetirement benefit plans established by employers to provide income to employees after retirement, typically qualifying as tax-exempt organizations. and other benefit plansRetirement, pension, or other benefit plans established by employers for their employees, often subject to ERISA regulations. own 25% or more of any class of ownership interests in a hedge fund, then all of the fund's assets are treated as "plan assets" under ERISA.

This test must be applied to each separate class of ownership interests in the fund. For example, if a fund has both Class A and Class B shares, each class must be tested independently. The fund manager must conduct this test every time someone new invests in the fund.

The law isn't entirely clear about what happens when investors withdraw money or when ownership transfers within families. However, the Department of Labor has indicated that when some investors withdraw and this increases the percentage ownership of remaining partners, this counts as a new "acquisition" that triggers retesting. The same rule applies when ownership transfers through inheritance or family gifts.

When a hedge fund crosses the 25% threshold and becomes subject to ERISA's plan asset rules, the regulatory burden becomes enormous. The impact touches nearly every aspect of how the fund operates.

First, the investment manager automatically becomes what's called an "ERISA fiduciaryAn individual or entity that exercises discretionary control over the management of an ERISA plan or its assets, subject to strict legal standards of care and loyalty.." This means the manager must follow strict legal standards. The manager must act only in the best interests of the retirement plan participantsEmployees or former employees who are entitled to benefits under an employee benefit plan covered by ERISA. (not the fund investors generally). The manager must also exercise the care that a prudent expertERISA requirement that fiduciaries exercise the care, skill, prudence, and diligence that a prudent person acting in a similar capacity would use. would use, diversify investments to reduce risk, and follow the plan documents as long as they comply with ERISA.

Second, ERISA's "prohibited transaction" rules create major operational headaches. These rules forbid many types of business dealings between the plan asset hedge fund and "parties in interestUnder ERISA, persons or entities with specified relationships to employee benefit plans who are subject to prohibited transaction restrictions.." Prohibited activities include buying or selling property to these parties, lending money to or borrowing from them, providing goods or services, and transferring fund assets to them. The definition of "party in interest" is extremely broad, covering essentially anyone who provides services to the fund or has business relationships with its affiliates.

ERISA creates serious problems for the performance fee Performance fee A performance fee is compensation paid to a hedge fund manager based on the fund's investment profits, typically calculated as a percentage (commonly 20%) of returns above a specified threshold, subject to high-water marks and potentially hurdle rates. structures that are essential to how hedge funds make money. Under ERISA's fiduciary rules, investment managers generally cannot cause the fund to pay them performance fees if the manager can influence the fee amount through their own actions. This restriction exists because ERISA prohibits fiduciaries from dealing with plan assets for their own benefit or acting on behalf of parties with conflicting interests.

When performance fees are allowed in plan asset fundsInvestment funds where 25% or more ownership by benefit plans triggers ERISA's plan asset rules and regulatory requirements., they typically require independent third-party valuations of hard-to-value investments. The fees must also be calculated based on both realized profits (from actual sales) and unrealized gains and losses (from increases or decreases in asset values), rather than only when investments are actually sold. This compensation structure must comply with ERISA's general prohibition against transactions between a plan and its fiduciary, which adds significant complexity and cost to fund operations.

Fortunately, there's an important safety valve called the Qualified Professional Asset ManagerAn investment manager meeting specific qualification requirements who can rely on ERISA exemptions for certain prohibited transactions. (QPAM) exemption. This exemption allows plan asset hedge funds to engage in many transactions with parties in interest that would otherwise be prohibited under ERISA.

To qualify as a QPAM, an investment manager must meet certain requirements. The manager must be registered as an investment adviser Registered investment adviser (RIA) A registered investment adviser (RIA) is a hedge fund manager or other investment adviser that has registered with the SEC or state securities regulators. These advisers must follow comprehensive rules including fiduciary duties, compliance requirements, and regular examinations. with at least $135.87 million in assets under management. Alternatively, the manager can qualify by having shareholder or partner equity exceeding $1 million, along with affiliate guaranteesAssurances provided by related entities to cover potential liabilities or obligations of the primary entity. covering potential liabilities.

The QPAM exemption permits most typical investment activities that hedge funds need to operate effectively. These include securities transactions with broker-dealersA person or firm engaged in the business of buying and selling securities for the account of others or for its own account., margin trading and short selling, swap transactions, foreign exchange trading, and establishing credit lines. This relief is essential because it would be practically impossible to require each retirement plan investor to provide daily updates about their business relationships, which can change frequently.

Recent changes to the QPAM exemption, which took effect in June 2024, have added new procedural requirements. These include mandatory notifications to the Department of Labor for entities using the exemption, enhanced record-keeping obligations, and expanded rules about when entities can be disqualified from using the exemption. These changes reflect the Department of Labor's increased focus on oversight and compliance monitoring for investment managers who rely on this critical exemption.

Many hedge funds use sophisticated legal structures called "master-feeder" arrangements with "hardwiredLegal arrangements where feeder funds are contractually required to invest only in a specified master fund, creating a pass-through mechanism." feeder funds Feeder fund A feeder fund is a type of investment fund that collects money from investors and then invests nearly all of that money into a larger "master fund." This structure allows different types of investors—such as U.S. taxpayers, tax-exempt organizations, and foreign investors—to all participate in the same investment strategy while using the fund structure that works best for their specific tax and regulatory needs. to manage ERISA compliance while still accepting significant pension plan investments. In a hardwired structure, the feeder fund's legal documents specify that the feeder will make no investments other than putting money into the master fund. This makes the feeder essentially a pass-through entityA business structure that does not pay taxes at the entity level, instead passing income and tax attributes through to its owners. rather than one that makes independent investment decisions.

This structure allows the master fund to apply the 25% test in a more favorable way. A feeder fund with less than 25% benefit plan participation counts as having 0% benefit plan investors when the master fund does its calculation. A feeder fund that exceeds 25% benefit plan participation counts as a benefit plan investor only in proportion to its actual benefit plan ownership. This mechanism allows assets from a "clean" feeder (one that stays under 25%) to dilute or "wash out" assets from a plan asset feeder, enabling the offshore feeder to accept unlimited pension plan money while keeping the overall master fund in compliance.

Given the substantial operational burden that comes with ERISA compliance, most hedge funds try to avoid plan asset status rather than embrace it. Common strategies include carefully monitoring the percentage of benefit plan investor participation, requiring investors to disclose their ERISA status in subscription documents, reserving the right to limit or force withdrawals by benefit plan investors, and creating separate share classesDifferent categories of fund shares with varying fee structures, rights, or redemption terms offered to different investor types. or entirely separate funds specifically for benefit plan investors.

The complexity of ERISA compliance extends far beyond just passing the 25% test. Once a fund becomes subject to ERISA, it faces ongoing operational requirements including special reporting obligations, bonding requirementsERISA mandates that fiduciaries obtain fidelity bonds to protect plan assets from losses due to fraud or dishonesty. for fiduciaries, and potential legal liability if other fiduciaries breach their duties. These requirements create substantial administrative burdens and potential legal exposure, making the strategy of staying under the 25% threshold attractive for many fund managers, even though it limits how much pension plan money they can accept.