Private Equity 401(k): Why Private Equity Means More Risk

Highflying tech startups and billion-dollar “unicorns” generate a lot of buzz, but since most are private companies, the average U.S. worker can’t invest in them. That’s largely due to accredited investor rules which stipulate that in order to invest in a private company, you need an annual income of at least $200,000 or a net worth of $1 million — excluding the value of your home. In other words, the average U.S. worker doesn’t make the cut.

The Department of Labor (DOL) is looking to change that, starting with your retirement portfolio. Earlier this month, the DOL published new guidance explaining how, effective immediately, retirement plan sponsors could start offering private equity funds.

Notably, the agency argued that doing so didn’t require any changes to existing rules and that the investments were completely permissible under the Employee Retirement Income Security Act of 1974 (ERISA). As long as sponsors carefully weighed the risks, they wouldn’t be violating their fiduciary duty to employees.

Risk and illiquidity

With fewer companies going public today, the prospect of investing in private equity is likely alluring. After all, it’s flush with cash: as of this writing, U.S. private equity managers held an estimated $914 billion in capital. But there are several reasons why we at Guideline are concerned about this policy change.

First, if you thought public stocks were unpredictable, private equity’s volatility may lead you to reconsider. For every spectacular success (Facebook), there are dozens of other spectacular flameouts (Theranos or WeWork). But unlike their public counterparts, private companies aren’t required to disclose their numbers to everyday investors.

That means when things go south, 401(k) plan sponsors will have little to no warning. Further, in a climate where account holders want greater visibility into the purpose and social impact of their investments, that opacity won’t fly.

That unpredictability is only made worse when you consider that private equity is “illiquid,” meaning investors can’t do anything with it in the short-term. Most private equity funds have an investment horizon of four to seven years, though some can last as long as a decade. That makes it hard to adjust your strategy and risk levels over time. That’s particularly troubling for older employees, as it’s advisable to invest more conservatively as you near retirement age.

Cost and performance

There’s another reason why 401(k) plans don’t usually include private equity investments — they are prohibitively expensive. In addition to a typical 2% assets under management (AUM) charge, private equity managers also charge around 20% of any resulting profits. With fiduciary investment litigation being what it is, this might not be the best investment for participant money.

Even the most expensive, conventional 401(k) offerings fall well below this price point. And when you consider the value of compound interest over time, those extra costs can add up to the tune of hundreds of thousands of dollars in missed savings. You can learn more about how your 401(k) plan’s fees impact long-term savings here.

Keep in mind that this isn’t simply a matter of getting what you pay for. In general, private equity funds aren’t any more successful than conventional index funds. A report published earlier this year found that private equity returns fell below S&P 500 returns over the last decade.

To be fair to private equity’s proponents, the difference wasn’t much — 15.3% versus 15.5%. But considering the high price of admission just to participate, private equity’s risks aren’t necessarily worth its rewards for most investors.

In times of public market volatility, it can be tempting to view private equity as a promising alternative. But there are reasons why successful retirement portfolios are instead built around more reliable domestic and international stocks and bonds. When it comes to something as important as your retirement savings, you can’t simply throw caution to the wind.

The Guideline team will continue to monitor legislative and regulatory changes impacting your company’s retirement plan.

The information above is provided for educational purposes only and should not be construed as personal investment advice or a guarantee of performance. All investments involve risk and your investments could lose value. You are advised to consult a qualified financial adviser before relying on the information provided herein.