The Labor Department last year paved the way for plan sponsors to add private equity (PE) investments as a component of a professionally managed asset allocation fund offered as an investment option for participants in defined-contribution plans.
And a new report just might make it happen—not just on paper, but in reality.
Researchers at the Urban Institute found that average retirement savings would increase when 401(k) plans include PE investments held within professionally managed asset allocation funds—such as a target-date or target-risk fund — because PE funds earn higher returns, on average, than public stocks and PE provides diversification opportunities.
In fact, the researchers estimated—under the most optimistic scenario—that PE investments could boost average account balances by nearly 10% over a full career. To be fair, the simulated impacts did vary widely, with some savers doing substantially better than the average and others doing substantially worse, according to the Urban Institute report.
And the authors of the report, which was funded by the American Investment Council, a lobbying, advocacy, and research organization that was launched by a consortium of private-equity firms, did say the increase in retirement savings would not happen overnight.
In fact, they said it would take time for any changes in returns to accumulate, so these effects on retirement savings would be negligible over the next decade, as target-date funds gradually add PE to their portfolios.
“Gradual” might be an understatement. At present, very few plan sponsors and plan providers are jumping on the chance to add PE investments to their offerings, according to Mike Kane, a managing director with Plan Sponsor Consultants. “We have seen only a question or two about them, periodically, from investment committees,” he said. “We are also not aware of any target-date investment families that may be including PE investments in the asset allocations for their various vintages.”
Picking the right PE fund
Professionally managed asset allocation funds, such as target-date funds, invest in a mix of stocks and bonds. Slightly more than 51% of Fidelity’s 2050 Freedom fund (FFFHX) is, for instance, invested in U.S. equities, slightly more than 41% in non-U.S. equities and about 7% in bonds. If and when fund firms start investing in PE inside asset allocation funds, the percent allocated is likely to be small, say less than 5%.
Tony Davidow, author of Goals-based Investing, is generally bullish on the concept of adding PE to asset allocation funds offered within 401(k) plans but he said it must be done in the right way.
Among the positives, Davidow said adding PE to target-date funds provides retirees with access to an “elusive” asset class. Typically, PE investments are open only to accredited investors who understand they are buying an illiquid asset that is usually held for 10-plus years.
And because of that illiquidity, PE investments—as the Urban Institute noted—are expected to earn higher returns than public stocks. Other institutions are saying much the same. J.P. Morgan, for instance, is telling investors to look beyond traditional asset markets to find higher returns. In its latest report, J.P. Morgan is projecting a 60/40 portfolio to earn just 4.3% per year over the next 10-15 years versus 8.10% per year for private equity.
There is, however, a wide dispersion of returns when it comes to PE investments, said Davidow. And there could be a big difference between the best, worst and average returns.
“While private equity has historically delivered a substantial illiquidity premium—the excess return received for tying-up capital for an extended period of time, not all private-equity funds are created equally,” said Davidow. “In fact, one of the most important issues to focus on is selecting the right fund, because the dispersion of returns from the top-to-bottom performing private-equity fund has been roughly 2,000 basis points. Conversely, the dispersion of returns from the top-to-bottom global equity fund is less than 400 basis points.”
Therefore, there is a real premium for selecting the right private-equity fund, he said.
Consider the fund structure
Plan participants also need to consider the PE’s fund structure. The primary fund structures available to accredited investors are either interval funds or tender offer funds, said Davidow. “While they provide better liquidity than the traditional funds structured as limited partnerships, qualified purchaser (QP) funds, they should be deemed long-term investments, to allow the managers ample time to execute their strategy,” he said. “To allow investors greater flexibility in changing their investment options to include private equity, there may be a need for new product structures, or more evolved structures, to better align with target-date funds.”
Those new product structures are also likely to have different fee structures as well, said Davidow.
Historically, PE investors paid a hefty 2% management fee as well as 20% of profits. But Davidow thinks PE fees will need to come down for 401(k) funds, a trend that is already under way with registered funds (interval and tender offer funds).
Will adding PE really boost returns?
Other experts, meanwhile, said adding PE investments to a target-date fund could reduce risk and volatility but might not boost returns all that much. That’s because only a small percentage of assets is likely to be allocated to PE investments in a target-date fund, said Bryan Hodgens, a retirement expert. “Is the juice worth the squeeze?” he asked.
That’s a question likely to be debated in the years to come. In a scenario that adopted the most favorable assumptions, the authors of the Urban Institute report said adding PE to a target-date fund would increase average account balances at age 65 by $39,500 (in 2020 inflation-adjusted dollars), or 9.5%, relative to the baseline that excludes PE investments from retirement plan accounts.
By contrast, the scenario with the least favorable assumptions would reduce average account balances at age 65 by $3,500, or 0.9% relative to the baseline. And the scenario with more neutral assumptions, would increase average accounts balances at age 65 by $27,600, or 6.6%.
Hodgens also thinks plans that offer funds with PE investments will have a tough time educating plan participants. “Private-equity funds are not easy to understand, could lack liquidity, and pricing the underlying investments can be difficult,” he said.
Your to-do list
So, what’s a 401(k) plan participant to do?
Two items belong on the to-do list.
One, be vigilant. If you invest in an asset allocation/target-date fund inside your 401(k) don’t disregard the notices from your 401(k) plan that report changes in the composition of your fund. Read them. It would be easy to miss an update reporting that your fund is now investing in PE.
Two, take the time to learn more about the benefits of diversification. In essence, the act of spreading your investible funds across different assets helps reduce the overall variability (i.e. risk) of your portfolio, according to Gary Sanger, a professor at Louisiana State University. And that’s a good thing.