The 401(k) Shake-Up: Private Equity's Role and Risks

On August 7, President Donald Trump signed an Executive Order allowing 401(k) savers to access alternative assets in their retirement plans.

That means that you could invest in companies that aren't publicly traded, in some private real estate ventures and even in cryptocurrency.

The move was applauded by the Labor Department as a means of expanding investment choices for savers and giving them more autonomy over their money. Many big names in the financial world support the change.

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BlackRock, for example, thinks private equity in 401(k)s could help millions of Americans enjoy better returns in their retirement plans. Introducing this option, the giant says, could generate about 15% more money in the typical participant's 401(k) plan over a 40-year period.

However, some lawmakers are sounding alarms about the change. Not only are private assets harder to sell, they warn, but they might not be subject to the same disclosure rules and scrutiny as those that are publicly traded.

Put another way, savers might not know just how much risk they're taking on.

Private equity in 401(k)s — leveling the playing field?

On a basic level, allowing private equity in 401(k)s gives savers more choices. Josh Tolley, CEO at Kingsbridge Brokers, says the change could be a positive one as long as savers know what they’re getting into.

“It could have a major positive impact on investors if they are willing to face the risks. … At the moment, it seems as if the major investment companies are looking at it as a harvesting opportunity, though, which could signal trouble 10 years down the road.”

All told, says Tolley, 401(k) investors need more options than those they typically have today.

“Gone are the days when people thought a 7% to 10% return over a 30-year investment horizon was worth it as inflation and taxation destroy the compounding effect,” he says. The opportunity to generate higher returns is unquestionably appealing, particularly for savers with long investment horizons.

Tolley also says that allowing private equity in 401(k)s helps to level the playing field.

“The fact that the wealthy people have access to private placement vehicles, which 98% of these vehicles are not accessible by non-accredited investors, is forcing a growing wealth gap that can never be fixed with taxes, regulations or social programs,” he says.

“Education and equal access are the only way to bring financial equality and equity. Done right, this could be a great opportunity for more people.”

Better diversification and protection from inflation

A big risk that retirement savers face today is, as Tolley mentions, having inflation erode the value of their nest eggs.

Henry Yoshida, CEO, CFP and co-founder of Rocket Dollar, a fintech platform built for helping investors tap alternative assets as a vehicle for retirement, thinks this change could help protect savers in that regard.

“Private-equity investments that focus on real assets such as real estate, commodities and infrastructure can serve as potential hedges against inflation, since the value of these assets often increases in rising interest rate environments,” he says.

Keep in mind, however, that your 401(k) might be able to offset much of inflation if you have a 401(k) match, depending on how generous your employer is.

Yoshida also feels that private equity could lend to better diversification in 401(k)s.

“With the right guardrails in place, this type of access could help Americans achieve better diversification and better overall risk-adjusted returns,” he explains.

Don't overlook the risks and pitfalls

Though Yoshida thinks expanding investment opportunities to 401(k) savers could yield positive results, there are some risks and pitfalls of which to be mindful.

For one thing, the typical investor might not have the knowledge to assess their risk properly.

Steep learning curve

“Millions of Americans are not knowledgeable enough about complex private and alternative investments and, thus, could make poor decisions with their retirement savings,” he says.

“The introduction of private investments in 401(k)s would also have to be coupled with providing education on the risks and potential pitfalls of private equity and alternative investments.”

Higher fees

Yoshida also warns that savers could face higher investment fees if they opt to dabble in private equity.

"By virtue of being complex, private equity and alternative investments carry higher fees than large-cap stock mutual funds or index funds, which make up a large portion of current 401(k) dollars,” he says.

There’s a twofold concern here. One is that savers will be subjected to higher fees than they’re comfortable with. The second is that investors will run from higher fees without recognizing the potential for higher returns.

Lack of liquidity and transparency

Furthermore, says Yoshida, one of the biggest drawbacks of private equity and alternative investments is that they are illiquid.

“In many cases, investors may not sell their shares as easily as public market securities, and this could pose problems when investors need to liquidate holdings in situations like job transfers or retirement,” he explains.

There's also a lack of transparency to worry about. Financial Advisor quoted Phyllis Borzi, former assistant secretary of the Department of Labor’s Employee Benefits Security Administration, as saying, “You often have no idea exactly what you’re investing in — what funds are inside the fund-of-funds, how they’re valued, and what the underlying risks are."

Your 401(k) could be used as a bailout for lackluster funds

Lastly, as The Lever reports, there’s also the concern that struggling funds could use everyday savers’ money as a bailout of sorts when things get rocky.

Not only could 401(k) dollars help keep flailing funds alive, but there might be nothing to stop fund managers from using 401(k) investors’ money to pay back other investors looking to make an exit.

All told, it’s pretty clear that allowing private equity in 401(k)s is a mixed bag. Savers should recognize that while they might now have more choices for investing their money, it’s important to know what they’re getting into.

Read More

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