Everyday investors have long heeded the same practical advice: Buy a collection of cheap index funds because professional stock pickers generally don’t beat the broader market over the long haul.
But now, 401(k) investors may soon be pitched a new idea that aims to boost returns and further diversify their precious retirement dollars by incorporating private equity, private credit and other alternative investments. These assets are costly, opaque and not easy to unload — the polar opposite of the beloved index fund.
This type of investing requires well-seasoned asset managers who typically demand high fees to do the vetting and the picking, and who had long worked only with large institutions, pension funds and the wealthiest families.
That raises some logical questions for the indexing public: Are these investment managers any more successful than those in the public stock and bond markets? Is it worth taking on the extra risk and expense to find out?
More 401(k) plan overseers — and the employees whose dollars they are entrusted with — are likely to be contemplating these questions, now that the Trump administration’s Labor Department has proposed rules that intend to make it easier to include these alternatives in workplace retirement plans.
Proponents — namely in the private asset industry, which has aggressively lobbied for access to the $14.2 trillion pot of 401(k) money — argue that regular 401(k) investors are now restricted to the diminishing universe of roughly 4,000 publicly traded companies. Their ranks have thinned by nearly half since the late 1990s, as companies have stayed private longer, turned to private sources of funding or been absorbed by other companies.
The Trump administration has echoed this idea, saying it wants to “democratize access” while reducing the regulatory burden and minimizing the chance of lawsuits for plan sponsors that include them.
But not all of these risky investments are created equal, and they’re impossible for the average person to evaluate. Sponsors of 401(k) plans that decide to go down this road will need to lean heavily on the pros. The results could be serious — the gulf between the best-performing private investments and the poorest-performing ones may be far wider than for standard-issue mutual funds.
For instance, the top-performing private equity fund had a return of nearly 25 percent over the three years that ended on Jan. 31, compared with a loss of nearly 48 percent for the worst performer, according to Morningstar PitchBook’s US Evergreen Fund Indexes, which is used as a general proxy for the types of alternative investments that may show up in 401(k) plans.
Results for direct lending ranged from a gain of 3 percent to 14 percent over the same time period, whereas another private credit category ranged from a gain of nearly 28 percent to a loss of 3 percent.
“And there’s no saying that you’re getting the top fund in your 401(k),” said Hilary Wiek, a principal analyst in fund strategies at PitchBook, which provides data and analysis on private markets.
“The top-performing fund may not need 401(k) money,” she added. “They might just be happy with the investors they have. There’s an argument to be made that the ones who are struggling are the ones that are going to be looking for other sources of capital.”
Investors in 401(k) plans provide a consistent and constant stream of new funding, even if there aren’t enough new attractive investment opportunities to go around. Typically, large investment institutions might commit a certain amount of money that would be “drawn down” when new options arose. With the influx of 401(k) money, these bigger investors have concerns that their returns could be diluted, which sets up the industry for potential conflicts of interest, experts said.
Hal Ratner, head of research at Morningstar Investment Management, said investment vehicles in this class were riskier than their publicly traded counterparts but could serve to smooth volatility in a broadly diversified portfolio — they’re generally not subject to daily price fluctuations, which can eat into returns. (Less frequent pricing can have a downside, however, masking problems that don’t show up until later.)
But investment managers would need to show that private allocations were adding some value to an otherwise plain-vanilla portfolio of index funds.
“That is a hard bar to hit,” Mr. Ratner said. “If they don’t do that, they’re out of luck, and they’re out of money.”
There are several broad categories of private investments, and many variations within them. Private credit, which has grown rapidly in recent years, is essentially a shadow lending market outside big banks and public markets, but these players aren’t subject to the same rules and regulations that apply to traditional banks. In recent months, investors have become increasingly worried about the industry’s health, leading to a wave of redemption requests — and causing some firms, like Blue Owl Capital and BlackRock, to limit them.
Private equity firms buy stakes in companies that aren’t traded on public stock exchanges, enabling the companies to operate with less transparency, and often require people to lock up their money for even longer time periods.
That makes many of these investments ill suited for people who rebalance their portfolio holdings, change jobs, roll over their assets or retire. Investment managers have said they have come up with workarounds — the investments are likely to be wrapped inside target-date funds, which are a mix of stock and bond funds that automatically become more conservative as a worker’s target retirement date approaches. That structure provides more flexibility, but firms acknowledge that private assets are less liquid — and that certain risks will persist.
Many investment firms have already teamed up with private asset managers and are building products that dedicate up to 20 percent of their portfolios to private assets. Last year, State Street Investment Management introduced a target-date vehicle that includes index-based investments along with a bucket of alternatives like private credit and private equity, managed by Apollo Global Management. The alternatives are targeted to account for up to 10 percent of the portfolio.
(State Street declined to provide pricing information, saying fees for these trusts are not publicly available like those for mutual funds or exchange-traded funds but are disclosed to plan fiduciaries.)
BlackRock is working on a version that will incorporate alternative assets and that should become available this year, said Nick Nefouse, BlackRock’s global head of retirement solutions and head of LifePath, the firm’s target-date funds. The private market allocations will be actively managed within the target-date portfolio, he added.
“If we’re going to add the private markets, they have to improve on what they could currently buy or what they’re currently invested in,” Mr. Nefouse said. “Private markets are not a panacea on their own.”
T. Rowe Price has teamed up with Goldman Sachs Asset Management and Oak Hill Advisors for their expertise in private markets and direct credit, respectively, to offer a series of blended retirement portfolios. Younger investors start with roughly 20 percent of the portfolio dedicated to private assets, which are gradually reduced to 14 percent in retirement and then phased out entirely 20 years after investors retire. Pricing was not yet available.
Besides target-date funds, alternative investments are appearing inside managed 401(k) accounts. The professionals chosen by plan sponsors to oversee these portfolios might turn to alternatives that aren’t available to plan participants as stand-alone options.
“We are already seeing a lot of innovation in the managed-account space,” said Jason Roberts, founder of the Fiduciary Law Center, a firm for plan sponsors and financial services firms. “These products and strategies will be something that will eventually make their way to plan sponsors for consideration.”
When they do, plan sponsors and their professional helpers will have to decide whether to greenlight them.
Plan fiduciaries, or the employers or plan administrators entrusted with overseeing the plans, must adhere to a law known as ERISA, which requires them to act solely in the best interests of employees, including choosing prudent investment options.
The recently proposed rule, which is expected to be made final by the end of the year, would allow plan overseers to meet their fiduciary obligations as long as they adhered to a “process-based safe harbor.” This requires them to evaluate investments using six factors, including performance, fees, complexity and liquidity (meaning there’s enough cash on hand for participants’ withdrawals, for example).
“Workers aren’t saying, ‘This is what we want,’” said Renée M. Jones, a professor at Boston College Law School with a forthcoming book, “Untamed Unicorns: Why Startup Finance is Broken and How to Fix It.” “It’s more of the industry saying, ‘This is what you should have.’”