United States

401(k) plans now offer investments in private equity, but should they?

INSIGHT ARTICLE  | 

It wasn’t too long ago that investing in a 401(k) plan seemed simple enough: Choose a mutual fund—stocks, bonds or maybe a target date fund—and keep working until you retire. Private equity funds seemed a world away, the domain of high net worth investors with the sophistication to understand the risk they were taking on.

And indeed, lack of regulatory guidance prevented private equity funds from gaining access to 401(k) plans, even though there was technically no specific ban on them. The fiduciary responsibilities by plan sponsors and the liability surrounding the investments held by private companies made it impossible.

But all the while, some in the private equity industry have searched for a way to tap into the vast pools of capital available in 401(k) plans—something that could offer plan participants more options for investing while setting up guardrails that would provide some measure of protection.

Now they have a way.

On June 3, 2020, the Employee Benefits Security Administration, a division within the Department of Labor, issued an information letter giving the green light for 401(k) plans to include private equity investments.

Will this guidance letter unleash retirement funds into the private equity market?

A possible path toward democratizing wealth

Proponents of the information letter hail the opportunity that this new guidance will bring to the average American saving for retirement. Some even go as far as to say that it will democratize wealth by providing access to an asset class that has been available only to institutional and accredited investors. The number of publicly traded companies in the United States, for example, has plunged in recent decades, effectively limiting the choices for investors saving for retirement.

According to the U.S. Bureau of Labor Statistics, 71% of all workers had access to either a defined benefit plan—the traditional pension—or a defined contribution plan like the 401(k). The potential prize invested in 401(k) plans is enormous—about $6.2 trillion, according to the Investment Company Institute.

To the proponents of including private equity funds in 401(k) plans, investing in such an alternative asset class can provide strong returns, allow for greater diversification of investment options and potentially hedge against public market risks. Supporters point out that traditional pension plans and some IRAs have for years been allowed to invest in private equity funds.

Or is there a bumpy road ahead?

Opponents, though, have misgivings about the appropriateness of making such sophisticated investments available to unsophisticated investors. They also point to the operational challenges of making the funds available, and to the related costs that lie ahead.

There is little disagreement that employers and plan sponsors will need to put guardrails in place to ensure that private equity investments are ready for these types of investors. For example, plan sponsors will need to ensure that private equity investments meet all of the following criteria:

  • Are structured as a custom target-date, target-risk or balanced fund
  • Have the necessary liquidity component to allow for plan participant deposits and withdrawals
  • Not offer the private equity component as a vehicle for direct investment by plan participants and beneficiaries on a stand-alone basis

The letter refrained from considering whether a particular fund or investment alternative satisfied the fiduciary rules under the Employee Retirement Income Security Act of 1974 (ERISA), which might result in additional legal expenses.

The valuation of private equity investments will also pose another roadblock because it is inherently more complex with the lack of observable inputs that go into the valuation models. This will mean increased operational expenses in the form of additional staff, fair value disclosures and annual financial statement audits.

The proposal will also be fighting the increasing preference of 401(k) plan participants to put their investments in lower-cost index funds. Private equity investments, by contrast, are not known for their low cost structure.

The takeaway

It’s not clear whether 401(k) plans will race toward offering the option to invest in private equity funds. According to PitchBook, total dry powder in the United States as of Sept. 30, 2019, exceeded $680 billion. Deploying this capital in light of the pandemic has been increasingly difficult for private equity funds. Will they welcome a large pool of 401(k) dollars after weighing all considerations?

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