ICYMI – Why Private Equity Belongs in Your 401(k)

Retirement plan fiduciaries recognize this, and it is one of the reasons why target date funds (TDFs) have become the most popular investment offered by plan sponsors. Experienced professionals use their expertise and knowledge to arrange a mix of assets in TDFs to provide the best possible outcome for retirees. We need to ensure that these experienced fiduciaries have all the tools at their disposal to invest people’s retirement savings prudently, and that means giving them the latitude to look to asset classes other than the traditional stocks and bonds.

An advantage offered by TDFs is that the underlying investments can be broadened to include asset classes that have traditionally benefited other types of long-term investment pools, such as defined benefit (DB) plans, without increasing complexity for the participant. Asset classes such as private equity, real estate, and hedge funds can be used to create a “diversified TDF” that improves retirement income outcomes by diversifying the investment portfolio with these alternative asset classes and improving returns when compared with a portfolio solely composed of equities and fixed income.

A study by the Georgetown University Center for Retirement Initiatives (CRI) in partnership with Willis Towers Watson found that the strategic use of alternative assets, such as private equity, real estate, and hedge funds, can improve the performance of TDFs. The data show that a well-diversified fund that includes these types of assets can improve the stream of income at retirement by an estimated 17% in the best-case scenario and 11% in a worst-case scenario.

Other research found similar benefits of incorporating private investments into diversified portfolios.  In June 2021, Willis Towers Watson published a private markets paper highlighting the compelling proposition of private markets including that “Private markets investments have outperformed public equities by 5.9% per annum since 2000.”

Some critics suggest that allowing professional fund managers to incorporate private equity, for example, means throwing open the doors to standalone private equity funds. The reality is, as the Georgetown CRI study illustrates, the approach would be to incorporate private equity as a relatively small sliver within a target date fund.

In addition, the investment in private equity actually decreases the risk to retirement plans and their participants. Between 1996 and 2016, there was a 50% drop in the number of public companies, indicating that the stock market represents a shrinking portion of the U.S. economy. Investors need greater diversified exposure to the broader economy to reduce risks and capture real economic value.

Critics question the performance of funds that include private equity, but they typically and conveniently rely on analyses based on short-term horizons of only five or 10 years. A long-term lens is needed to make intelligent investment decisions and would show that private equity outperforms the stock market and all other asset classes.

Another argument made against using alternative assets in 401(k) investment plans is that doing so is “too confusing” for the average individual to understand. By that standard, most traditional stocks and bonds would also have to be excluded. The whole reason that TDFs and other funds exist reflects the fact that many retirement plan participants do not have the skills or desire to make complex investment decisions on their own.

Some question the fees charged and suggest that the only prudent investments for 401(k) plans are simple, low-cost solutions. That represents penny-wise, pound-foolish thinking. There is no fiduciary requirement for sponsors to implement the lowest cost option available, and it is not particularly controversial to state that participant outcomes are improved as long as the net-of-fee value proposition is positive.

The fact is that the United States is not alone in working to expand the investment choices for fund managers. For example, Australia’s system of superannuation funds provides for default funds, some of which are permitted to operate in a manner like TDFs. The superannuation funds commonly invest in alternative assets, and AustralianSuper, the largest Australian Superannuation defined contribution (DC) fund provider, offers funds with an allocation of more than 20% of their assets to real estate, private equity, and other asset classes.

Not only are professional investment managers trained to understand how to use private equity and other alternative assets classes effectively in their funds, but they also have a legal obligation to make decisions in the best interest of their investors. This includes addressing any concerns such as liquidity and pricing, benchmarking, fees, and governance related to incorporating alternative investments into TDFs. This fiduciary responsibility means that they can be held personally liable for breaches, with consequences from both government overseers and the ever-present threat of litigation.

The U.S. Department of Labor (DOL) appropriately recognized that fiduciaries need all the tools at their disposal to improve retirement outcomes, and the agency established limits and guardrails designed to help fiduciaries make prudent decisions and protect participants. Undoing that work would only serve to make fiduciaries’ jobs more difficult and undermine retirement security for working Americans.

Now is not the time to reverse course and make it more difficult for plan fiduciaries to consider options that help to achieve the best risk-adjusted returns and deliver the best retirement income outcomes for their employees.