The DOL Now Allows Private Equity in 401(k) Plan's Investment Lineup
posted by Fisher 401(k) September 3, 2020
In early June 2020, the Department of Labor decided to allow private equity investments to be included in specific fund types offered in a 401(k). While pension plans have included these investments for decades, this is the first time employers sponsoring a 401(k) plan have been given the green light for private equity. Here’s what the DOL’s new guidance means for 401(k) plans, and what employers need to consider moving forward in order to protect their employees’ best interests.
What does private equity mean?
Private equity refers to investments in privately held companies, as opposed to investments in publicly traded companies represented by the stock market.
How is private equity different from investments in the stock market?
Assets invested in private companies are generally far less liquid than stock investments, as there is no market to quickly or easily sell an interest in a private firm.
Traditionally, the equity portion of the funds included in a 401(k) plan are made up of stock investments. The public nature of the stock market means investors can purchase shares in a company where information about the company’s performance, its historical growth, and its overall value tend to freely available through regulatory filings, investment data providers, and articles online. As the firm managing mutual funds decides which public companies to invest in, they have access to all of the publicly available information provided by those companies. For example, there’s a daily price for a given corporation’s stock, which makes it easier to buy and sell. Private equity, however, does not share the same level of transparency. There is no stock market determining the value of private companies, so more research is required to gauge what private equity investments are worth.
Why has private equity not been included in 401(k) plans historically?
Private equity has not been a part of 401(k) plans to this point because employers have been concerned or unsure of their fiduciary risk in including it without specific guidance from the DOL. A law suit brought forth by an Intel employee over the use of these alternative investments in 2015 did not help in assuaging any sponsor fears.
Part of this risk comes from the complex nature of private investment. Evaluating private investments and documenting the reasons for choosing to invest in any given private company is a greater challenge for 401(k) plan fiduciaries. And because these investments are more difficult to sell quickly than stocks, it can be difficult to rely upon the kind of liquidity 401(k) plans need to account for employees coming and going or retiring at different times.
What types of private equity is allowed in 401(k) funds?
Private equity cannot be offered as a standalone investment option in a 401(k), but it can be included as one of the investments that make up a fund. For example, a 401(k) plan may have a qualified default investment alternative (QDIA) for employees who don’t want to choose their own investments, and now it is possible for employers to include QDIAs that include private equity investments.
What are the pros of including private equity in my 401(k) plan’s diversified fund options?
Private equity provides new opportunities for diversification and increased returns, especially in contrast with the stock market:
- 401(k) Investment Fund Diversification: It’s important for any employee saving money in a 401(k) plan to diversify their investments to help create a higher overall return. For example, the stock market has many factors that influence its movement. An individual company’s stock price might go up or down. The stock market at large is subject to global economic forces that can lead to downturns and upswings. Private companies may not move according to those same forces, which creates an opportunity to balance out potential short-term losses in the stock market.
- Potential for Increased Returns: It is becoming increasingly commonplace for new companies to avoid going public for longer periods of time, opting instead to grow using private investment. Uber, for example, stayed private for a long time because of the regulatory burden of becoming a publicly traded company. Including private equity in a 401(k) fund option gives access to these kinds of high-growth companies while they’re young, which creates potential for higher returns as those companies grow.
What about the cons of private equity in 401(k)?
The nature of private equity creates some challenges in terms of liquidity, potentially high fees, and a lack of transparency:
- Private Equity Liquidity: Private equity investments are generally longer-term than an investment in stock. If, for example, you wanted to invest in Apple, it would be possible to effectively buy or sell that stock at will. That is not the case with an interest in a private company, which can make it difficult for fund managers when employees choose to withdraw their money from such a fund. This means fund managers who decide to include private equity need to have a plan to cover assets tied up in private equity with other liquid assets in the fund.
- Private Equity Fees: Private equity is historically a very expensive investment. As a direct investment outside of a retirement plan, private equity has only historically been available to accredited investors with a certain amount of assets. For these wealthy individuals, the high fees associated with private investment might be more tolerable than for the average employee in a company retirement plan.
- Private Equity Transparency: A big part of any employer’s fiduciary duty to a 401(k) plan is the ongoing monitoring of investments—are the investments available to your employees of good quality? Are the fees associated with them reasonable? It’s relatively easy to analyze a mutual fund made up of investments in companies like Netflix, Apple, and Google; these are large, public companies with years of history in the stock market. Using a benchmarking tool, employers and their 401(k) advisers can compare funds to other, similar investments and determine which ones to keep and which to drop. Private equity returns are self-reported, meaning there’s a big potential for a bias. That can make monitoring private equity a challenge even for many seasoned professionals.
How do I decide whether or not to include private equity in my 401(k) fund lineup?
The same principles apply to evaluating private equity as any other component of your 401(k) plan’s lineup. It’s critical to follow a defined process in choosing which investment options to offer employees. This includes a good-faith consideration of any one option’s risks, potential for returns, and costs.
The ultimate goal of any good 401(k) fund lineup is to serve the needs of the employees who use it. Maybe a medical practice with a plan full of doctors can afford the risks and higher costs of private equity, but a construction company’s blue-collar workers might be better served with more liquid, less expensive investments. Frame your process for including or not including private equity in your understanding of your employees’ unique needs and goals for their retirement.
This process can be made easier by partnering with a 3(38) investment manager who will monitor and select funds on your behalf. For more information about how Fisher Investments 401(k) Solutions helps employers offer high-quality 401(k) investment options, along with plenty of employee education to help them make the most of those options, contact us today.