Opening defined-contribution plans to private equity is a mistake

Opening defined-contribution plans to private equity is a mistake
U.S. regulators dropped the ball in a recent letter clarifying that regulations do not prohibit the use of private equity funds in 401(k) plans
JUN 21, 2020

U.S. workers increasingly rely on defined-contribution plans like 401(k)s, rather than defined-benefit pension plans, for a portion of their retirement income. That reliance puts the burden on regulators and plan sponsors to safeguard employees’ retirement savings.  

But U.S. regulators dropped the ball recently when the Department of Labor issued a letter clarifying that its regulations do not prohibit the use of private equity funds in 401(k) plans. The DOL’s move was applauded by Securities and Exchange Commission Chairman Jay Clayton, who has been working to change SEC rules that currently limit investing in private equity funds to accredited investors — those with a net worth of $1 million, excluding the value of their home — to allow retail investors to access private equity. 

The DOL letter didn’t suggest giving employees direct access to private equity in their 401(k) accounts, but it said that private equity could be included among the holdings of a target-date or balanced fund offered by the plan. Even given that approach, though, using PE funds in 401(k)s is a bad idea. 

COMPLICATIONS ARISE

Private equity funds traditionally have been the province of high-net-worth and institutional investors because of features like the high minimum investment required, the high fees that PE funds charge and the funds’ limited liquidity.  

Since PE funds use investors’ money to take long-term stakes in businesses, they typically require a commitment of anywhere from three to 10 years. Such lockups would seem to pose a complication for 401(k) plans that need to cash out participants who are retiring or leaving the company. 

And PE funds traditionally charge their investors 2 and 20: a 2% annual fee on assets under management and a 20% performance fee on the fund’s profits. In contrast, as of 2016, participants in large 401(k) plans were paying an average of 45 basis points for domestic equity funds and 35 basis points for domestic bond funds, according to data gathered by the Investment Company Institute and Brightscope. Research in recent years has emphasized the extent to which high fees can eat into investment returns over long time spans. Surely that applies to PE investments as well as mutual funds.

The big argument in favor of PE funds is that they will outperform other investments. In fact, in the Labor Department press release, Secretary of Labor Eugene Scalia cited the “strong returns” that alternative investments such as private equity funds can provide.

But recent research by Ludovic Phalippou, an economist at Oxford Saïd Business School, found that private equity funds’ returns since 2006 have averaged 11%, in line with what investors could have gotten from the stock market over that time frame. Meanwhile, from 2006 to 2015, the funds earned $230 billion in fees, Phalippou calculated. 

A CHALLENGING TASK

PE funds are also opaque. Assessing a target-date fund’s PE component and monitoring its performance would seem to be a challenging task for the committees overseeing the 401(k) plans of small and midsize companies.  

Of course, InvestmentNews reporter Emile Hallez has noted that despite the DOL letter, companies sponsoring retirement plans probably aren’t going to rush to add private equity to their DC plans. Plan sponsors are likely to be discouraged by the cost and complexity of private equity investments, and the slew of 401(k) lawsuits has left them wary. 

But it seems clear that PE funds are interested in accessing some of the $7.9 trillion held in U.S. defined-contribution plans. The Labor Department should not be lending them a helping hand. 

Latest News

Northern Trust names new West Region president for wealth
Northern Trust names new West Region president for wealth

The new regional leader brings nearly 25 years of experience as the firm seeks to tap a complex and evolving market.

Capital Group extends retirement plan services further with a focus on advisors
Capital Group extends retirement plan services further with a focus on advisors

The latest updates to its recordkeeping platform, including a solution originally developed for one large 20,000-advisor client, take aim at the small to medium-sized business space.

Why RIAs are the next growth frontier for annuities
Why RIAs are the next growth frontier for annuities

David Lau, founder and CEO of DPL Financial Partners, explains how the RIA boom and product innovation has fueled a slow-burn growth story in annuities.

Supreme Court slaps down challenge to IRS summons for Coinbase user data
Supreme Court slaps down challenge to IRS summons for Coinbase user data

Crypto investor argues the federal agency's probe, upheld by a federal appeals court, would "strip millions of Americans of meaningful privacy protections."

Houston-based RIA Americana Partners adds $1B+ with former Morgan Stanley director
Houston-based RIA Americana Partners adds $1B+ with former Morgan Stanley director

Meanwhile in Chicago, the wirehouse also lost another $454 million team as a group of defectors moved to Wells Fargo.

SPONSORED How advisors can build for high-net-worth complexity

Orion's Tom Wilson on delivering coordinated, high-touch service in a world where returns alone no longer set you apart.

SPONSORED RILAs bring stability, growth during volatile markets

Barely a decade old, registered index-linked annuities have quickly surged in popularity, thanks to their unique blend of protection and growth potential—an appealing option for investors looking to chart a steadier course through today's choppy market waters, says Myles Lambert, Brighthouse Financial.