401(k)s need private equity and real estate, study says

If plans can address liquidity and valuation concerns, they could benefit from higher returns, Georgetown CRI found.

401(k) plans are missing out on $35 billion a year in returns they could see if they incorporated private equity and real estate, a recent report from Georgetown University’s Center for Retirement Initiatives found.

That result would be possible if defined-contribution plans such as 401(k)s allocated up to 10% of their assets to illiquid assets — half of that being private equity and half real estate, according to the study. In that scenario, the private equity would replace a mix of listed stocks, while the real assets would displace some U.S. large-cap funds and core bond funds. Those changes would lead to better financial outcomes 82% of the time, with reduced volatility and a median boost in annual returns of 15 basis points.

If that added diversification were applied to all target-date funds within DC plans, it would result in excess annual returns of $5 billion, the study concluded.

But unlike traditional pension plans, which have long used less-liquid assets to their benefit, DC plans such as 401(k)s almost totally lack private equity and real estate. That difference in part reflects the higher liquidity and valuation requirements for DC plans, although some institutional-size DC plans, particularly outside of the U.S., have used their scale to work to address those concerns.

Public DC plans in Australia and the U.K. have successfully done so, said Chris Flynn, head of product development and research at CEM Benchmarking, which contributed to the report.

“Nine of the biggest DC funds in the U.K. just made a commitment to hit 5% private equity by 2030. So it can be done,” Flynn said. “The biggest opportunity is for those really big target-date providers who have the scale to offer something that’s really compelling to plan sponsors.”

The handful of plan sponsors in the U.S. that have considered the asset classes are often those that have experience with pension plans and thus are more familiar with illiquid assets and the asset managers that provide access to them, he noted.

“Using reasonable assumptions for an individual DC participant who saves for 40 years and then draws down for 20, the return improvement might represent an additional $2,400 per year ($200 per month) in spending power in retirement for a retiree already drawing $4,000 per month or $48,000 per year in retirement income,” the study concluded.

Aside from liquidity and valuation concerns, plan sponsors face another, perhaps more daunting hurdle, which is the threat of litigation. Although lawsuits against 401(k) sponsors involving target-date funds historically have focused on high fees, a string of recent cases have focused on alleged performance lags in the low-cost BlackRock LifePath Index funds.

While the illiquid asset classes, especially private equity, have high fees relative to other asset classes, the performance should be considered net of fees, the report noted.

Meanwhile, the Department of Labor gave guidance in 2020 via an informational letter, stating that plan fiduciaries would not be violating the Employee Retirement Income Security Act merely by including a professionally managed fund that included private equity.

Regardless, “the high fees set off alarms,” said Ron Surz, president of Target Date Solutions.

The lack of liquidity also raises potential issues for retirees in target-date funds, Surz said. “I’m not sure how that would work in a DC plan, especially for people who are in retirement, who need access to their assets.”