Analysis: Private equity isn't what retirement savers need

  • Secretary of Labor nominee Eugene Scalia speaks during his nomination hearing on Capitol Hill, in Washington, Thursday, Sept. 19, 2019.

    Secretary of Labor nominee Eugene Scalia speaks during his nomination hearing on Capitol Hill, in Washington, Thursday, Sept. 19, 2019. (AP Photo/Cliff Owen)

 
 
Posted6/21/2020 6:00 AM

At a time of considerable financial turbulence, the Trump administration is edging ever closer toward allowing individual investors access to private equity funds through their retirement accounts. The aim, Labor Secretary Eugene Scalia said last week, is to "ensure that ordinary people investing for retirement have the opportunities they need for a secure retirement."

Historically, private equity -- or investments in private companies -- has been off limits except for wealthy individual investors or big institutional ones. Hedge funds, which typically use more complicated strategies than mutual funds, are still off limits.

                                                                                                                                                                                                                       
 

For now, the main way retail investors will be able to tap the private equity alternatives is through a 401(k) target date fund, which tends to shift to more conservative investments as beneficiaries get older. Plan sponsors will be responsible for making the calls on whether to include private equity funds in participants' 401(k)s, which ones and to what extent.

Having the plan sponsor act as a gatekeeper may provide some level of protection for Americans' retirement savings. But there are no clear signs yet that sufficient safeguards will be in place or that the rewards will outweigh the risks.

A lot of money is potentially at stake. A 2019 report from Fidelity shows that more than half of individuals had all of their 401(k) savings in a target date fund compared with just 16% a decade earlier.

The industry argument for opening up retirement accounts to private equity is that pension plans and sophisticated investors have been allowed to do so for years, often enjoying better returns -- so why shouldn't retail investors have a shot, too? And, they say, more and more highly valued companies such as Airbnb are staying private for longer, so it's harder for the average investor to get a piece of the action.

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The problem with that reasoning is that there's a wide disparity when it comes to private equity fund performance. It's true that top performers have outperformed the market, but those funds are often restricted to the biggest institutional investors or repeat clients.

An analysis of recent economic literature by Eileen Appelbaum and Rosemary Batt shows that the median private equity buyout fund has basically matched the stock market's performance since 2006. They predict that the future of private equity fund performance isn't so rosy. With more funds and firms, and more cash on hand at corporations, there's likely to be competition and overpaying for prized companies -- therefore making it more difficult to provide outsized returns.

Then there are the fees. Private equity funds tend to charge an annual management fee of 2% and a performance fee of 20%. Added to the generally higher fees already paid for target date funds, the returns will really have to be supersized to justify the cost of the alternative investments.

In addition, private equity funds typically come with lock-up periods, often at least several years, when investors can't access their capital. Some argue that since target date funds are supposed to be retirement vehicles for buying and then forgetting (because the allocations change automatically as a worker ages), they're well suited to private equity's illiquidity.

                                                                                                                                                                                                                       
 

But it's unclear what will happen if a plan sponsor wants to switch to a new target date fund with different private equity offerings, or if employees change jobs and want to transfer their 401(k)s, or simply need to access their cash, as some are doing now.

Batt also points out that investors would have to earn at least 3 basis points more than the stock market to justify the illiquidity risk of their private equity exposure.

Finally, the Labor Department is putting the responsibility of vetting the private equity funds squarely on the shoulders of 401(k) plan sponsors. I spoke to several investment management professionals who stressed that many plan sponsors don't have the sophistication or background in alternatives to fully understand the complicated structures of many private equity funds.

They pointed out the difficulties posed by the lack of performance consistency even among funds offered by the same providers and how hard it can be to value the underlying assets in funds invested in private companies. They also emphasized how private equity funds are more lightly regulated than mutual funds so don't have to be as transparent about their holdings.

Whatever the consequences for people's 401(k)s, investor advocates say it's only a matter of time before other alternative investments like hedge funds line up to tap retirement accounts. And they have no doubt that private equity will eventually make a play for retirement assets directly, not just those in target date funds. That could be the riskiest proposition of all.

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners. Leonids is a Bloomberg Opinion columnist covering personal finance.

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