Outside the Box: Private equity in your 401(k) — is this a good idea?

Previously, defined-benefit plans, such as pensions, have been able to include private-equity investments as part of their portfolios, as have many retirement plans globally, but defined contribution (DC) plans in the U.S., such as a 401(k) accounts have not. The benefit? Accessing investment options that have exposure to more asset classes, like private equity, can provide diversification benefits for long-term retirement savers if fiduciaries use this opportunity to take a fresh look at alternative investments.

With the right framework and investment vehicles, access to alternative solutions within workplace savings plans could provide an ample opportunity to help Americans achieve their long-term retirement goals. However, across the industry there has generally been a lack of education for many plan sponsors and advisers as it pertains to the types of investments and overall benefits that access to private equity could offer. Given this lack of requisite knowledge, there are both opportunities and challenges that savers should know when it comes to these types of investments.

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Opportunities for savers

Let’s start with what this means for individuals. Private-equity funds, which fall into the broader category of alternative investments, include a range of investments covering various asset classes, risk levels and other characteristics that could benefit defined contribution participants. Previously these types of investments have only been available to more affluent and institutional investors, but now, this is no longer the case.

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Why would this be a good thing for retirement savers? For long-term savers, access to different types of alternatives (including private equity or infrastructure, commodities, hedge funds and venture capital) can be an important part of one’s portfolio. Research has found that private equity investing in particular reduces the risk of an investment portfolio through diversification.

Providing greater access to alternative investments can be of particular importance given the significant decrease in investment options in the public markets. Over the past 20-plus years, the roughly 50% decline in the number of public companies in the U.S. has limited the investment opportunities for long-term savers who, in the past, have relied on public equity markets to generate returns to help them achieve their retirement goals. To put this into context, private companies account for approximately 99% of the corporate investment opportunities in the U.S.

Studies have shown private-equity investment have also historically exhibited less downside performance than traditional investments during periods of market stress, when retirement savings are most vulnerable. For example, according to industry data, buyout and venture capitalist funds outperformed the S&P 500 SPX, +0.35% by an average of more than 3% annually between 1987 and 2010. Given the markets today, this can be an especially important consideration.

For individuals with the right balance of risk tolerance, private equity may be an optimal investment for a portion of one’s portfolio. However, it’s important to know that the guidance does not relate to direct investment in private equity by retirement savers. It does not, for example, allow fiduciaries to add a private-equity fund as an investment option alongside registered mutual funds, CITs, and other more traditional defined-contribution plan investments. Instead, the guidance relates to an “in between” structure in which fiduciaries give individuals a careful amount of exposure to private equity by creating a managed fund in which retirement savers can choose to invest, and then directing a modest portion of that managed fund to underlying private-equity funds.

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Mitigating risk

Over the years alternative investments have gained popularity due to their history of strong returns. Despite the high returns, private equity also carries unique risks that may make direct investment inappropriate for some retirement savers, including liquidity concerns, particularly in times of market stress, as well as structural complexity.

That said, given the return opportunities and diversification benefits that these funds offer, and the significant loss of market access for individuals as capital has shifted to private vehicles, it is entirely appropriate for fiduciaries to use this opportunity to take a fresh look at allocating a responsible portion of managed funds to private vehicles. It’s also possible for fiduciaries to prudently manage the risks of private funds while offering plan participants enhanced diversification benefits.

Ultimately, it comes down to satisfying the appropriate due diligence, monitoring, and general education. Providing an ample opportunity set of investments is pertinent for sound investment decision-making and plan fiduciaries need access to diversified investments when constructing plan menus, making allocation decisions and selecting plan default investment options.

Sharing access to education and starting the conversation can help create greater outcomes for retirement savers. While it’s exciting to see this step in the direction stemming from the DOL guidance proposed, there is still work to be done.

Charlie Nelson is chief executive of retirement and employee benefits at Voya Financial.