Wall Street notched a big win last month as the government moved to allow riskier investments with higher fees into Americans’ 401(k) plans. The U.S. Department of Labor released a proposed rule that would open defined contribution plans to alternative investments typically available only to more experienced investors with sufficient capital to absorb losses.
The announcement signaled the impending realization of a long sought after goal of large asset managers like Blackrock and Apollo Global: greater access to the $14 trillion retirement plan market along with the enticing potential for notably juicier fees generated by alternatives.
Proponents argue that adding assets other than traditional stocks and bonds can improve long term returns and reduce volatility, a proposition that is true in principle if not necessarily in practice. But these nontraditional assets are not well understood by most individual investors, come with their own unique risks and can be significantly more costly, raising the question of whether they are appropriate for the typical American saving for retirement.
The term “alternative investments” is generally understood as a broad classification encompassing asset classes other than the familiar stocks, bonds and funds. Alternatives include investments in private companies that do not trade on public markets, like private equity (ownership of nonpublic companies) and private credit (pools of private nonbank loans). Unlike listed securities, these private investments are relatively illiquid, meaning you cannot necessarily get your money back at will. They are also generally more opaque since they are often not required to file public financial statements or register with the Securities and Exchange Commission.
Other alternatives contemplated in the Labor Department’s rule include private real estate holdings and commodities as well as digital assets like cryptocurrencies. The action was taken in response to an executive order signed in August by the president.
Most investments in 401(k) plans are funds comprised of publicly traded equities and bonds that are typically highly liquid, readily bought or sold on public markets. Alternative assets like private equity are often illiquid, subject to time and quantity limits on redemptions, and may only be valued periodically compared with stock prices that reflect real time supply and demand.
One argument frequently advanced in support of alternatives is that participants in defined contribution plans like 401(k)s are deprived of access to asset classes that are common in pension plans. It is certainly true that most defined benefit plans (traditional pensions) utilize non publicly traded investments like hedge funds, private equity and private credit. According to the Labor Department, 34% of all holdings in state and local government pension funds are in some type of alternative asset class.
However, the comparison is somewhat specious owing to the structural differences of the two types of retirement plans. Defined benefit plans, by definition, provide a known and stable payment stream to retirees based typically on their previous earnings history. It is the responsibility of the employer to sufficiently capitalize the plan, and if its investment selections underperform, the company must inject sufficient additional funds into the plan to meet its obligations. Defined contribution plans are funded primarily by employee deferrals, often partially matched by employer contributions, so the participant’s income in retirement is entirely dependent upon their own saving and investment decisions.
Furthermore, a traditional pension plan has a much greater life span (at least theoretically) and better access to professional managers, so it is more appropriate to allocate some of its capital to less liquid and possibly riskier investments with a longer return horizon.
Advocates for allowing alternatives in retirement accounts also argue that adding so-called non-correlated assets improves returns and reduces volatility. This is certainly true in principle and forms the basis diversification. However, it is not clear that private investments outperform public markets after adjusting for illiquidity and the use of leverage. Furthermore, it is probable that small investors in 401(k) plans will not have access to the best performing private asset managers. Returns in alternatives vary widely depending on manager skill.
As to reducing volatility, much of the lower apparent variability of private investments is illusory, due to the fact that their values are estimated infrequently, sometimes only quarterly, disguising the true daily volatility that would be reflected if the security traded on public markets. The renowned fund manager Cliff Asness has coined the term “volatility laundering” to describe the understatement of short term fluctuation. Prices don’t change much if you don’t update them.
Plan sponsors are not specifically barred from offering alternative asset classes in their defined contribution plans. However, most have been highly reticent to do so due to the legal standard to which sponsors are held in selecting appropriate investment options. Companies have a fiduciary duty under the Employee Retirement Income Security Act of 1974 to act solely in the best interest of the plan participants. That fiduciary duty (and legal liability) extends to vetting investment options.
The Labor Department guidance includes six specific criteria on which employers must evaluate potential investments for inclusion in a retirement plan, including risk, fees, complexity and liquidity. The intent is to provide a safe harbor for plan sponsors that adequately document their due diligence under the rule, presumably reducing the risk of lawsuits from participants.
Yet the roadmap does not provide absolute immunity from legal challenges alleging that the employer’s diligence was insufficient, and court challenges will undoubtedly arise at the first sign of trouble. In fact, much of the substantial progress in reducing excessive fees over the past decade has been the result of litigation. It is therefore difficult to imagine employers embracing these complex and costly options in the near term.
Even if they do, are costly and complicated alternatives really in the best interest of average workers in their 401(k)s? For a typical long term retirement investor, a diversified portfolio of low-cost funds containing highly liquid publicly traded stocks and bonds across broad sectors remains the most appropriate approach. In your 401(k), complexity and costs are not your friends.
Christopher A. Hopkins, CFA, is a co-founder of Apogee Wealth Partners in Chattanooga.