Every time a presidential administration changes between parties, a series of regulations are inevitably changed to favor the positions of the new leaders in power. Retirement and pension policy are no exception, with recent rounds of “policy ping pong” focused on issues including fiduciary duties, investment options, and environmental, social, and governance (ESG) investing. One area where we hope regulators can help dial down this game of ping pong is with private investments in defined contribution (DC) retirement plans.
Studies from organizations across the political spectrum, including the Urban Institute and the R Street Institute, have noted that the inclusion of alternative assets (asset classes outside of stocks, bonds, and cash, including private equity, real estate, private credit, infrastructure, and hedge funds) can substantially increase fund performance. Research by Vanguard suggests that the inclusion of private assets in plans can increase post-fee retirement wealth by at least 10% over time. A recent Georgetown study noted that a typical 401(k) participant may receive an extra $200 per month in retirement income if alternative investments were included. In fact, public pension funds have successfully invested in these asset classes for many years. Even the occasional paper that is less supportive of alternative investments has noted that their inclusion in larger funds can reduce volatility risk.
In an era when the number of publicly traded companies have been shrinking (down by almost 50% to just 5,000 companies in 2020), it seems prudent for wisely managed funds to invest where more opportunity lies. Over 80% of large U.S. firms are privately owned, and not available to investment by 401(k) participants. With one-third of the S&P 500’s value held by just seven companies (the “Magnificent 7” tech firms), there are increasing risks for funds that are limited to investments in publicly traded companies. Investing in private investments can help mitigate these risks, and possibly even provide a hedge against cyclical or sectoral investment declines.
However, alternative investments do include more risk to investors. Fees are traditionally higher than public equity investments, and litigation risk is also higher. Investments are more fixed in nature, with some having fixed investment periods. Information on certain investments is more limited, and the structure of these investments can be complex. Investors who are not able to work with the long-term nature of some of these investments may also become subject to volatility risk.
This is why the industry rightly understands that the best way to incorporate private market investments in DC plans is as just a part of the overall plan mix. Current proposals from key stakeholders would make participation in these alternative investments voluntary, generally a part of an overall professionally managed portfolio. They plan to create investment vehicles that allow for funds to remain accessible for 401(k) participants, while also taking advantage of the diversification benefits of these funds. Keeping DC participation in private market funds as a small portion of overall fund investment may also provide benefits on the fund side, allowing funds to stay under typical Employee Retirement Income Security Act (ERISA) management thresholds that could significantly increase management costs.
The DOL regulations in response to President Trump’s August executive order to “democratize access to alternative assets” may have more staying power than usual as long as they provide safe harbors for stakeholders to provide products that reflect the needs of, as well as the limitations facing, individual DC participants. The new regulations should favor plan design that encourages longer holding periods, increases liquidity pooling, and helps mitigate individual participant risk. Those making investments that include private investments should have a clear understanding of the risks involved, and should be encouraged to be appropriately cautious. These new regulations, for example, should not cause investors to go crazy on the newest crypto investment.
We are hopeful that both the alternative investment industry and the Department of Labor both understand the importance of appropriately designed regulations and investment choices to ensure stable and successful inclusion of alternative assets in the retirement plans of Americans. If designed properly, taxpayers will realize greater plan gains and will receive higher and more stable returns in retirement. Smaller investors will gain the use of an important savings tool that until now was only available to wealthier Americans. However, if the regulations encourage a “wild west” atmosphere that does not adequately protect investors from the inherent risks of alternative investments, then we should expect the ping pong game to resume the next time a Democrat is in the White House. Investigations will take place into cases where participants were “wronged”, and resulting regulations will reverse the “democratization of alternative assets.” Better to pursue practical and appropriate regulations now than risk another round of ERISA ping pong.