Private Equity In Your 401(k)?

On August 7th, President Trump signed an executive order titled Democratizing Access to Alternative Assets for 401(k) Investors, directing the Department of Labor, in concert with other regulatory agencies, to reexamine and clarify fiduciary guidance regarding alternative investments (private equity/credit, cryptocurrency, real estate, etc...) in 401(k) plans in an attempt to boost access to these asset classes for American workers through their 401(k).

Before getting too excited, you shouldn't expect to see a Private Equity Fund pop up in your investment lineup anytime soon. What's far more likely is that a small slice of an existing plan investment could be invested in these assets. Many fund shops have already been working on this. With the risks and costs associated with these asset classes, it's reasonable to think the slice would be no more than a few percent of the total fund.

Why not directly? As with most things, the devil is in the details...

Pricing issues

Alternative assets are notoriously difficult to value. Unlike stocks and bonds that are traded daily, private assets are not actively traded on an exchange. Many asset managers have proprietary systems used to approximate the value of the investments, but these tend to be subjective in nature and could prove to be wildly off base from actual values since they generally extrapolate an index performance to the values of the underlying investments even though there is often little correlation between the actual value and the index used.

Limited (if any) liquidity

Many features of your standard 401(k) plan are premised on the ability to buy and sell investments. This includes the obvious features like rebalancing accounts and transferring money from one investment to another, but it also comes into play with participant loans and in-service distributions such as hardships. Recordkeeping systems aren't setup to accomodate illiquid investments. There are many interval funds (where you can sell up to a predetermined cap periodically) available that could help with this to a degree, but this complexity isn't suitable for many participants.

High costs

Private equity, in particular, is quite expensive. It's not unusual to see management fees of 2% plus a performance fee of around 20% of the profits on top of the fund operating costs, audit fees, legal fees and distribution/marketing charges. All this could easily add up to over 5% annually. This is a pretty high hurdle to clear when you can access publicly traded assets for well under 1% total expenses.

Final Thoughts

The combination of high costs, valuation risk, and a general lack of transparency have kept private investments on the sideline to date - they just haven't been able to clear the prudent investment bar. Loosening regulations likely won't change that without some significant changes in the private equity product space, which won't change overnight. With retirement plan litigation on the rise, why would a fiduciary take the risk on this when they don't have to?

We are starting to see some movement with private credit investments, which may prove to be much easier to justify adding to a plan (potentially even as a stand alone investment) since bond valuations are simpler and private credit investments are already available as publicly traded funds with much lower fee structures than their private equity counterparts.

Access to new markets can be good, but it has to be good for savers, not just the financial product manufacturers!