The ERISA 25 Percent Test Hedge Fund Managers Must Run Before Taking US Pension Money

The ERISA 25 percent test hedge fund managers apply to US pension money is set by section 3(42) of the Employee Retirement Income Security Act of 1974 and the Department of Labor's plan asset regulation at 29 CFR 2510.3-101. If benefit plan investors hold 25 percent or more of the value of any class of equity interest in a Cayman fund, the fund's assets become plan assets. The test is measured immediately after the most recent acquisition, ignoring interests held by the manager and its affiliates. The investment manager then becomes an ERISA fiduciary of every investing plan, and the prohibited transaction, bonding and indicia of ownership rules attach to the portfolio. The test is continual and class by class, and a redemption by an ordinary investor can trip it without any new pension subscription. A Cayman fund expecting US retirement capital needs the representations, the register and the monitoring in place from the first closing.

"We treat the 25 percent test as an operating control rather than a legal footnote. The subscription document asks the right questions, the administrator's register carries the answer against every holder, and the calculation is re-run before each subscription and each redemption is processed. Managers sometimes assume the test only matters when a pension plan subscribes. In practice the closest calls we see come from the other direction: a large non-plan investor redeems, the denominator shrinks, and a fund that was comfortably below the line is suddenly on it. The mechanics have to be in place before that happens, not after." David Lloyd, Chief Executive Officer at CV5 Capital

Executive Summary

US retirement capital is available to Cayman hedge funds and digital asset funds, on conditions the fund must be built to observe. The consequences of getting them wrong fall on the manager.

• Section 3(42) of ERISA excludes a fund's assets from plan asset treatment only if benefit plan investors hold less than 25 percent of the value of each class of equity interest, tested after every acquisition.
• Benefit plan investors are ERISA Title I plans, plans subject to Internal Revenue Code section 4975 such as IRAs, and entities holding plan assets, the last counted pro rata.
• Interests held by the manager, other persons with discretionary control over the fund's assets, and their affiliates are disregarded, which shrinks the denominator.
• The Department of Labor treats a redemption as an acquisition, so the test must be re-run when investors leave as well as when they arrive.
• Breach makes the manager an ERISA fiduciary and brings the prohibited transaction rules, the section 4975 excise tax, statutory bonding and the indicia of ownership rules into the fund.
• A Cayman fund controls the exposure through subscription representations, a flagged register, dealing powers tied to the calculation and, where appropriate, a dedicated ERISA class or feeder.

What the Test Is and Where It Sits

Section 3(42) of ERISA, added by section 611(f) of the Pension Protection Act of 2006, defines plan assets by reference to regulations made by the Secretary of Labor. The operative regulation is 29 CFR 2510.3-101, issued in 1986. Under paragraph (a)(2), a plan that acquires an equity interest in an entity that is neither a publicly offered security nor a registered investment company is treated as holding an undivided interest in each of the entity's underlying assets. That is the look-through rule, and a privately offered Cayman fund is squarely within it.

The look-through has two exceptions: the entity is an operating company, a category that includes the venture capital and real estate operating companies in paragraphs (d) and (e), or equity participation by benefit plan investors is not significant. Section 3(42) states the second in its current form. An entity's assets are not plan assets if, immediately after the most recent acquisition of any equity interest, less than 25 percent of the total value of each class of equity interest is held by benefit plan investors. A hedge fund invests capital and cannot be an operating company, so the 25 percent test is the exception it relies on.

The consequence of failing it is stated in the regulation. Any person who exercises authority or control over the management or disposition of plan assets, or who provides investment advice about them for a fee, is a fiduciary of each investing plan. That is the investment manager. The regulation's own definition of benefit plan investor at paragraph (f)(2) predates the 2006 Act and is wider than the statute; where they differ, section 3(42) governs.

Who Counts as a Benefit Plan Investor

Section 3(42) defines a benefit plan investor in three limbs. The first is an employee benefit plan subject to part 4 of Title I of ERISA. The second is any plan to which section 4975 of the Internal Revenue Code applies. The third is any entity whose underlying assets include plan assets by reason of a plan's investment in it.

The first limb is the corporate pension fund, the 401(k) plan and the union multi-employer plan. Section 4(b) of ERISA takes governmental plans, church plans that have not elected in, and plans maintained outside the United States primarily for non-resident aliens out of Title I altogether. Before 2006 the regulation counted those plans anyway; the Pension Protection Act removed them.

The second limb is where hedge funds most often miscount. Section 4975(e)(1) lists qualified trusts under section 401(a), individual retirement accounts and annuities under section 408, Archer medical savings accounts, health savings accounts and Coverdell education savings accounts. A self-directed IRA subscribing through a custodian is a benefit plan investor in full, and so is a solo 401(k) plan. Neither looks like pension capital on a subscription form.

The third limb is the fund of funds or other pooled vehicle that itself holds plan assets, counted only to the extent of the percentage of its own equity held by benefit plan investors. A fund of funds that is 40 percent plan assets counts 40 percent of its subscription, so the subscriber must state its percentage and update it as its composition moves.

ERISA status and US tax status are separate questions. A private foundation is not a benefit plan investor, but its exposure to leverage inside the fund is governed by the unrelated business taxable income rules in how Cayman funds accommodate US tax-exempt investors through blocker structures.

How the 25 Percent Test Is Measured

Class by class, not fund by fund

The threshold applies to each class of equity interest, so a small class can fail on a modest pension subscription while the fund as a whole is far below the line. Neither the statute nor the regulation defines a class; practitioners generally look to differences in economic rights, voting rights and liquidation priority. The class architecture in the offering document is therefore also the architecture of the test.

The denominator excludes the manager

Section 3(42) disregards interests held by a person with discretionary authority or control over the entity's assets, or who provides investment advice about them for a fee, or any affiliate of such a person, with affiliate defined by control. The effect is asymmetric: manager and affiliate holdings leave the denominator while benefit plan holdings stay in the numerator, so seed capital cannot dilute the percentage. The regulation's example at paragraph (j)(4) shows 10 percent plan money becoming 28.6 percent once a large affiliate holding is stripped out.

Immediately after every acquisition

The test is run at every dealing day, not at year end. In Advisory Opinion 89-05A the Department of Labor confirmed that the term acquisition is construed broadly and that a redemption by an existing investor is an acquisition, because it increases the proportionate interests of the remaining holders. The opinion cites the regulation's preamble describing the testing as continual. Because the measure is value, the test should be computed on the valuation used to strike the dealing price.

Class A holds 16.0 of plan money against 100.0 of total value, a naive 16 percent, but the manager's 30.0 seed is disregarded and the true figure is 22.9 percent. A non-plan redemption of 10.0 would lift it to 26.7 percent with no new pension subscription.

What Happens If the Test Is Breached

Holding plan assets changes the legal character of the manager's relationship with every investing plan. For a Cayman fund with a non-US manager, or a US manager without a plan asset business, several of the consequences are difficult to satisfy at all.

First, fiduciary status. Under section 3(21)(A) the manager controls plan assets and is a fiduciary of each plan, so the duties of loyalty, prudence and diversification in section 404(a) apply to the portfolio, with personal liability under section 409. Second, the prohibited transaction rules. Section 406 of ERISA and section 4975 of the Code prohibit sales, loans, services and the use of plan assets between a plan and a party in interest or disqualified person. Those categories include the manager, the fund's service providers and their affiliates. Paying the manager's fee or using an affiliated broker then needs an exemption.

Section 4975 adds an excise tax of 15 percent of the amount involved for each year, rising to 100 percent if the transaction is not corrected. Plan asset funds commonly rely on the class exemption for qualified professional asset managers, PTE 84-14, amended by the Department of Labor in 2024.

Third, bonding. Section 412 requires every fiduciary of a plan, and every person who handles plan funds, to be bonded against fraud and dishonesty by a surety acceptable on US federal bonds. Fourth, the indicia of ownership rules. Section 404(b) prohibits a fiduciary from maintaining the indicia of ownership of plan assets outside the jurisdiction of the US district courts except as the Secretary permits by regulation. The permitting regulation, 29 CFR 2550.404b-1, allows offshore holdings only for securities of non-US issuers or governments, securities principally traded outside the United States and incidental non-US currency. Even then, those assets must be managed by a US-organised bank, insurer or registered investment adviser of stated size, or held by a US bank or US registered broker-dealer of stated size.

The Alternatives to Staying Below 25 Percent

A fund has three ways to deal with the plan asset rules. It can stay below the threshold in every class, which is what most hedge funds do. It can qualify as an operating company. Or it can accept plan asset status and run as a plan asset fund, which is a deliberate business model rather than an accident.

The operating company routes are narrower than managers sometimes assume. A venture capital operating company must have at least 50 percent of its assets at cost in operating companies over which it holds and exercises contractual management rights. A real estate operating company must have at least 50 percent at cost in real estate it actively manages or develops. Neither can be satisfied by listed securities, derivatives or digital assets. Running as a plan asset fund is a real choice for a US registered investment adviser with the capital, the US custody chain and the compliance function to meet the rules above. For a manager outside the United States, or one whose strategy depends on offshore venues, it is rarely practicable.

Building the Test into the Cayman Fund from Day One

The controls must exist before the first pension dollar arrives, because the test runs at every acquisition from inception. Four elements do the work.

The subscription document is the data source. It should require every subscriber to state whether it is a benefit plan investor within section 3(42) and under which limb. An entity holding plan assets should state its own plan asset percentage, and every subscriber should say whether it is the manager or an affiliate. Those representations sit alongside the investor status representations in how Cayman funds deal with US accredited investors and qualified purchasers, and carry a continuing duty to notify changes. They are collected through the process set out in how the hedge fund subscription process actually works.

The administrator's register is the calculation engine. Every holder carries a flag for its ERISA category and, for pro rata entities, its stated percentage, so the test can be computed per class on each dealing day and reported with the headroom remaining. How the regulation's reference to classes of equity interest in the entity maps onto shares of a single segregated portfolio within a segregated portfolio company should be settled with independent professional advice before launch.

The dealing procedures are the enforcement mechanism. The offering document should reserve the power to reject or scale back a subscription, and to compulsorily redeem or convert an interest, where a transaction would take any class to the threshold. Because a non-plan redemption is an acquisition, the redemption run is tested as well as the subscription run. A fund that lets large non-plan holders leave while its plan investors are locked can be pushed over the line by its own liquidity terms.

The offering document is the disclosure. It should state whether the fund intends to keep benefit plan investors below 25 percent of each class, describe the powers reserved to do so, and say that the manager does not intend to act as an ERISA fiduciary. This sits within the package described in accepting US investors in a Cayman fund under Regulation S and Regulation D. US taxable investors will separately need the information described in what the Cayman fund must provide on PFIC status.

ERISA Classes and Separate Feeders

Where meaningful pension participation is expected, two structures keep the arithmetic under control. The first is a dedicated ERISA class holding all benefit plan investors and no others. A class held entirely by plans is 100 percent plan money, so the class does not solve the problem by itself. It puts the plan capital where its percentage can be managed against a deliberate population of non-plan co-investors. It also keeps plan subscriptions from constraining classes meant to redeem freely. The design choices are set out in launching a hedge fund with multiple share classes; the ERISA class is one application of them.

The second is a separate feeder. A feeder that admits only benefit plan investors will itself hold plan assets, and its investment in the master fund counts in full towards the master's numerator. That is manageable so long as the master's own classes stay below 25 percent. A segregated portfolio on a platform offers an intermediate option: a separate portfolio with its own classes, register and test, inside a regulated structure whose administration, governance and reporting already exist. The CV5 hedge fund platform is built on that architecture.

Whichever route is chosen, the offering document should say what the fund will do if a class approaches the threshold, and the board should have authority to do it without an investor vote.

Key Takeaways

• Decide before drafting the offering document whether the fund will accept US retirement capital and, if so, through a monitored limit, an ERISA class or a separate feeder.
• Write the section 3(42) representations into the subscription document, including the pro rata percentage for entities holding plan assets and a duty to notify changes.
• Instruct the administrator to flag every holder by ERISA category and to compute the test for each class on each dealing day.
• Reserve and use the power to reject, scale back, convert or compulsorily redeem interests where a subscription or redemption would take any class to 25 percent.
• Exclude the manager's and affiliates' holdings from the denominator in every calculation and never treat seed capital as dilution.
• Map the consequences of a breach for the custody chain and counterparties before launch, so that a plan asset outcome is a choice and not a surprise.

Frequently Asked Questions

What is the ERISA 25 percent test for a hedge fund?

Under section 3(42) of ERISA and 29 CFR 2510.3-101, a privately offered fund's assets are treated as the assets of the plans that invest in it. The exception applies where benefit plan investors hold less than 25 percent of the value of each class of equity interest. The test is applied immediately after every acquisition of an interest, and holdings of the manager and its affiliates are disregarded. If the threshold is reached in any class, the manager becomes an ERISA fiduciary of each investing plan.

Who is a benefit plan investor?

Section 3(42) lists three categories. The first is an employee benefit plan subject to Title I of ERISA, such as a corporate pension or 401(k) plan. The second is any plan subject to section 4975 of the Internal Revenue Code, which includes IRAs, health savings accounts and Coverdell accounts. The third is any entity whose assets are plan assets because plans have invested in it, counted only in proportion to its own plan asset percentage. Governmental plans, non-electing church plans and non-US plans for non-resident aliens are outside Title I and do not count.

Does a redemption by a non-ERISA investor affect the 25 percent test?

Yes. In Advisory Opinion 89-05A the Department of Labor stated that the term acquisition is construed broadly and that a redemption by an existing investor triggers the test, because it increases the proportionate holdings of the remaining investors. A fund therefore has to run the calculation before processing redemptions as well as subscriptions, and should reserve the power to scale back or convert interests where a redemption would take a class to the threshold.

Can a Cayman fund accept ERISA money at all?

Yes. Nothing in ERISA prevents a US plan from investing in a Cayman fund. The fund either keeps benefit plan investors below 25 percent of each class, or it accepts plan asset status and satisfies the fiduciary, prohibited transaction, bonding and indicia of ownership rules that follow. The first route is the usual one for a hedge fund or digital asset fund, particularly where the manager or the custody chain is outside the United States.

What happens if a hedge fund exceeds 25 percent benefit plan investors?

The fund's underlying assets become plan assets. The manager is then a fiduciary of each investing plan under section 3(21)(A). The prohibited transaction rules in ERISA section 406 and Code section 4975 apply to dealings with the manager, service providers and their affiliates. A fidelity bond is required under section 412, and the indicia of ownership of the fund's assets must be held in accordance with section 404(b) and 29 CFR 2550.404b-1. Section 4975 imposes an excise tax of 15 percent of the amount involved on a disqualified person, rising to 100 percent if the transaction is not corrected.

Is a self-directed IRA a benefit plan investor?

Yes. An individual retirement account described in section 408(a) of the Code is a plan to which section 4975 applies, and section 3(42) of ERISA counts every such plan as a benefit plan investor in full. The subscription document should ask the question directly, because an IRA subscribing through a custodian can be mistaken for an ordinary individual account.