Should You Invest Your 401(k) in Private Equity?

The federal government wants to make it easier for ordinary Americans to use their 401(k) money to invest in private equity, an asset class historically limited to institutional investors.

And while several hurdles remain before middle-class Americans are able to invest like Wall Street bigwigs, the move raises a thorny question: Is it safe for regular people to sink their hard-earned nest eggs into these notoriously complex and risky investments?

President Donald Trump signed an executive order earlier this month giving the Department of Labor, in conjunction with the Treasury and the Securities and Exchange Commission, 180 days to develop guidance on how to incorporate alternative assets (including cryptocurrency, real estate and private equity) into retirement plans by reevaluating fiduciary guidelines.

Fiduciaries — in this case, employers and plan administrators — are legally required to operate in investors’ best financial interest. If they fail to do so, they risk being sued by their customers and sanctioned by regulators. As a result, any wide-ranging changes to 401(k) investing and management tend to be slow and incremental.

This push is no exception. Experts say it could take months, if not longer, before workers could see private equity funds in their 401(k)s, given how risk-averse plan administrators and sponsors tend to be. In addition, since executive orders don’t carry the weight of legislation, it’s possible that this initiative could be unwound by the next administration.

In the meantime, here's what you need to know.

Is more choice in 401(k)s better?

An especially vocal proponent of adding private equity to 401(k)s is the industry itself. (Of note: Private equity contributed heavily to Trump's reelection campaign, collectively donating more than $200 million, records show.)

A recent survey from Empower Retirement, one of the biggest retirement plan providers in the country, found that slightly more than 4 in 10 financial advisors are in favor of letting workers put their retirement savings into private equity.

Workers would still have the choice of where to put their 401(k) contributions. But giving ordinary people access to the same kinds of investments as pension funds, university endowments and other big institutions can help level the playing field, according to Empower president and CEO Edmund F. Murphy III.

"Expanding access to these markets through defined contribution plans presents a significant opportunity to enhance long-term retirement outcomes," he said in a news release.

Last week, the White House Council of Economic Advisors published research asserting that retirement savers who add private equity to their 401(k)s could see increases of 0.5% to 2.5% in value, depending on their age. It also said including private equity in retirement plans would contribute a total of $35 billion to the U.S. economy.

Investors today don’t have as many choices today as they did 30 years ago because the number of public companies in the U.S. has fallen by about 3,000 in that time frame, a drop some blame on the reporting requirements imposed on big companies. In addition, "firms are staying private longer, meaning much of the growth happens before an IPO," Michael Barczak, vice president of retirement plans at the Carson Group, noted in a recent blog post.

Cons of private equity in your 401(k): more risk, higher fees

Transparency requirements are the primary way the government protects investors and equips them with the knowledge they need to make smart decisions. Private equity isn't held to those standards. "There's not the transparency of a publicly traded company or a fund that's going to give you quarterly reports," says Bryan Kuderna, founder of the Kuderna Financial Team.

In theory, fewer regulatory requirements are supposed to make private equity faster and more flexible, so companies can deliver outsized returns to investors. But it doesn't always work out like that.

"A lot of these funds don’t outperform the stock market," says Jeffrey Hooke, a senior lecturer at the Johns Hopkins Carey Business School. In a research paper published earlier this year examining the performance of roughly five dozen funds from big private equity firms, Hooke found that fewer than half managed to beat the market returns by one metric — not exactly a windfall.

Hooke and other experts say private equity's weak performance of late stems from a few factors: the rapid growth of the industry and increased borrowing costs, as well as management fees that are much, much higher than typical 401(k) fees.

While mutual funds or exchange-traded funds in a large employer’s 401(k) plan might have fees of around 0.1% to 0.5%, private equity funds often charge north of 2% — "like a 200% increase in fees," he says. Investors in those funds are on the hook for those fees regardless of the fund's performance, an arrangement that has led to a phenomenon one recent CNBC article dubbed "zombie funds."

Skeptics of this push also are quick to point out that institutional investors who formerly snapped up private offerings are now offloading those holdings at a rapid rate. This is largely because private equity companies can’t find anyone willing to buy their investments without slashing prices.

What's more, at least some of the assets made available to retail investors would likely be the “leftovers” from pension funds and other big institutional investors. In other words, private equity firms want to sell to ordinary Americans the same assets that sophisticated investors are actively trying to get rid of.

"That raises questions about alignment, transparency and product integrity," ratings agency Moody’s Ratings warned, according to a report in the Wall Street Journal.

Even a small chunk of the $12.2 trillion stashed in 401(k)s would be a big infusion of capital, which could prove tempting for bad actors. As reported by the Journal, Moody's warned that "some managers may be tempted to compromise" their standards and throw money at dicey companies just so they have investments they can bundle and sell to unwitting 401(k) investors.

"I assume this will all be worked out in the industry’s favor, and perhaps to the detriment of those with 401(k) plans," Hooke says.

Against this backdrop, experts say that even if the White House's vision for private equity in 401(k)s comes to fruition, retirement savers would be wise to tread carefully.

"It's a cool talking point at a cocktail party, but I don't see the reason for taking that added risk," Kuderna says. "It's kind of sexy because it has this exclusive appeal… but in reality, I think there's a reason why that divide was already there. The average joe doesn't have any business investing in private equity."

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