What You Need To Know Regarding Private Equity And How It Will Impact Your 401k

With public stock and bond markets declining in 2022, investment experts have clamored to include more private options in employee retirement plans.

Compared to previously defined benefit pension plans, defined contribution plans such as 401(k)s have a minimal allocation to private alternatives. According to research published in September by Cerulli Associates, less than one percent of defined-contribution plans offer private equity, private credit, or hedge funds. Only 10% of plans feature private real estate, which is atypical.

In 2021, 11.9% of the average state and municipal defined benefit pension plan’s assets were allocated to private equity (PE). This allocation has more than quadrupled since 2011 when it was 5.6%. Pension plans have attempted to make up financing shortages for an aging senior population by investing in higher-performing, riskier assets. Analysts at Cerulli believe 401(k) participants should be permitted to do the same.

In the latest 401(k) participant research, 50% of retirees reported Social Security as their primary source of income, while only 7% of current workers believe they will continue to depend on Social Security, says Cerulli senior analyst David Kennedy. Individual retirement accounts have a financing gap, and riskier tactics may be required to attempt to close it, just as pensions are doing the same.

Private equity is not expressly prohibited by Erisa, also known as the Employee Retirement Income Security Act (1974), which governs 401(k)s. However, the incorporation of private funds, which often demand more significant fees than public ones and are illiquid, makes them more difficult to evaluate and exit. Not being able to easily convert these assets presents challenges and significant legal penalties for retirement plan sponsors. This partially explains the hesitation.

In June of 2020, however, the Department of Labor issued a letter that stated: As a designated investment alternative for an Erisa-covered individual account plan, a fiduciary’s duty under Erisa sections 403 and 404 is not violated by a private equity component within a professionally managed asset allocation fund.

This may appear as a green light for private equity, but caution is advised. The Securities and Exchange Commission issued a “risk alert” about private equity funds and potential conflicts of interest. Following that, the Biden DOL (Department of Labor) issued a less favorable response letter to that Trump-era one, where it reiterated the SEC’s concerns and stated that the previous letter from the Department of Labor reflected the private equity industry’s perspective; it did not include counterarguments and independent research data to balance out the representations.

The new DOL letter also noted that investors would require greater disclosure and education regarding the additional liquidity risks of private equity, as retirement savers may need to liquidate or transfer these assets earlier than many long-term investors, particularly workers who frequently change jobs.

There was widespread fear that plan sponsors were incapable of picking and supervising private equity (PE) funds in their capacity as fiduciaries. This was especially true for small plans whose trustees are probably not qualified to evaluate the utilization of private equity investments.

However, the DOL made an interesting exception: Plan-level fiduciaries with experience evaluating PE investments for defined benefit pension plans to diversify investment risk may be qualified to analyze these investments for participant-directed individual account plans, especially if supervised by a qualified fiduciary investment adviser.

Consequently, some of the largest and most established companies offer defined benefit pension plans to their older employees and 401(k) plans to their younger employees. They may have the experience necessary to earn the DOL’s approval in picking private equity funds for their pensions. It also indicates that they may seek to recruit experts or advisors to aid in the selection process.

Given this guideline, it is anticipated that the usage of private equity (PE) investments in 401(k)s will increase in certain types of plans and funds. Private wealth co-head Robert Collins of Partners Group, a $131 billion private alt-asset manager, says there is a great lot of renewed impetus behind this topic, which was started with [the DOL’s 2020] information letter and is now increasing.

Pooled plans. 

The Secure Act of 2019 is mainly responsible for the expansion that Collins is referring to. It permitted the establishment of Pooled Employer Plans or PEPs. These plan structures allow many employers’ employees to participate in a single retirement plan. The purpose of outsourcing to a PEP provider is to decrease employer compliance requirements and fiduciary liability.

Outsourcing to a PEP would enable smaller firms to have a professional outside fiduciary to locate and qualify the most qualified PE managers and adhere to the DOL’s demanding criteria. Collins says he knows many plan sponsors who will offer pooled employer plans that include private equity; however, he cannot disclose the names of these plan sponsors.

Private equity is illiquid and requires additional attention. Therefore most experts anticipate that it will not be a stand-alone choice in plans but rather an allocation or element of a target date asset allocation fund. This removes a significant portion of the liquidity problem, as PE represents a small portion of a much more liquid pie. It also addresses concerns that individual investors need more sophistication to examine a private equity fund and choose how much they should participate. The target date manager performs the necessary analysis and allocation.

Similar private real estate allocations already exist in target-

date funds within 401(k) plans. Real estate is ahead of other private assets, notes Tripp Braillard, head of Clarion Partners’ Defined Contribution Distribution, which manages 401(k) target-date funds’ private real estate sleeves. Before the 2008 financial crisis, property management companies like Clarion were already managing money for large employers’ defined benefit pension plans and developing 401(k) products.

The global financial crisis drove the demand for the asset class significantly, adds Braillard. During public market panic selling, private real estate and other securities tend to hold their value better (partly due to the difficulty of selling). Sponsors of pension plans with experience in real estate wanted to transfer volatility-reducing measures from the 401(k) side to the pension plan side.

Given that the public markets are experiencing a bad market, the largest corporations may again consider private alternatives for similar reasons, namely to boost returns and reduce overall volatility. The DOL appears to be okay with this, at least for now.