Could private equity be a benefit for DC plans?

While defined contribution plans represent the next logical market for private equity funds to tap, that doesn't mean DC plan sponsors should be excited for the opportunity necessarily.

That's the upshot of a new report from the Morningstar Center for Retirement & Policy Studies, which unpacks the pros and cons of including private market funds in defined contribution plans.

While private equity has long been a key component of institutional portfolios, its introduction into defined-contribution plans like 401(k)s remains relatively new. The case for such alternative funds appears strong on paper, with managers boasting a history of material outperformance over the public markets. But recent headwinds – including increased borrowing costs from higher interest rates, a crunch in available capital, and an apparently strictiral decline in the number of PE funds relative to those seeking capital – have "made the environment less favorable," according to the report.

Based on 2020 guidance from the Department of Labor, the report said DC plans can include private equity investments without violating ERISA provisions if they live within diversified managed solutions, such as target-date funds, and it's otherwise walled off to participants.

"[T]he fund within which the illiquid investment resides must have a 'sufficient' level of liquidity—that is, investment in public-market vehicles to meet likely participant demands," the report said, emphasizing the DOL's advice is just guidance.

Even though private market fund exposure could help participants diversify their retirement portfolios more broadly into alternatives such as real estate, private credit, and farmland, the report emphasized "sponsors will likely be wary of constraints on liquidity unless the end investor is unambiguously aware of such constraints." To get around those challenges, the authors highlighted several structures have been developed including interval funds, which offer periodic redemption options, and tender offer funds, which allow redemptions at the discretion of the fund’s board.

Muddying the picture further, private equity valuations rely on on appraisal-based models. These valuations, while often less volatile than public market prices, may lack transparency and comparability, making it challenging to bolt private assets into DC plans alongside traditional options such as index funds. 

"The market is at its launch point and such funds are likely to take hold slowly," the report read. "Making plan sponsors comfortable with the higher pricing, lower liquidity, and less-straightforward reporting will be a hurdle, but hardly insurmountable."