Is Private Equity Coming to Defined Contribution Retirement Plans?
The Department of Labor (DOL) recently issued guidance explaining how defined contribution retirement plan sponsors can offer private equity investments. The key point of this guidance is that plans including private equity investments must offer them as part of an asset allocation fund, and not a stand-alone fund. In other words, plan menus are unable to offer private equity as an individual offering. Instead, the private equity investments need to be embedded in something like a target date fund or balanced fund, which is primarily a mix of traditional stocks and bonds.
Private Equity Primer
Private equity consists of capital that is not listed on a public exchange and is categorized as an “alternative investment.” Specifically, private equity consists of money and investors that directly invest in private companies or in the “buy out” of public companies to bring them private. Institutional investors, such as pension plans, and high-net-worth individuals typically provide the capital for private equity investments.
A private equity fund consists of Limited Partners (LPs), who generally own 99% of the fund’s shares and have limited liability. The remaining 1% of shares are owned by the General Partners (GPs), who have full liability. The GPs are also responsible for managing the investment. Private equity investments range from complex leveraged buyouts to venture capital investments.
Private Equity in Defined Contribution Plans
Private equity has come into consideration for defined contribution retirement plans because it may offer a stream of returns that could enhance the returns of a typical stock and bond portfolio. Fixed income returns are under pressure, with low interest rates becoming a long-running theme in capital markets. Both prior and during the Coronavirus pandemic, the Federal Reserve cut rates. Thus, the lower-risk fixed income portion of target date funds and asset allocation funds have seen much lower returns than in prior periods. Strong private equity funds may potentially deliver better investment results than traditional equity funds.
Defined benefit pension plans have access to private equity investments, so it is logical that defined contribution (DC) participants be included as well. The large minimum investment, typically in the several million dollar range, has traditionally prevented all but massive institutional entities and high-net-worth individuals from investing in private equity funds. These investment minimums effectively shut out many everyday retirement plan participants. With the recent DOL guidance, this access may now be easier for the average investor.
Plan Sponsor Considerations
While access to potentially higher-returning funds may benefit retirement plan participants, there are other considerations that retirement plan fiduciaries should take into account regarding private equity investments.
Private equity investments are often more complicated than publicly traded securities, entail longer time horizons and have greater ongoing fees. The typical fee is 2% of assets under management plus 20% of profits above a certain return threshold. These fees are markedly higher than the typical mutual fund offered in defined contribution plan lineups, especially index funds. Longer time horizons for private equity investments can lead to liquidity issues. This may present issues in DC plan accounts that are participant-directed, as people are accustomed to making investment changes when they please. There is also the issue of valuation. Publicly traded securities, like stocks and bonds, have readily available valuations based on transactional data. However, private equity investments are not as easily valued and are not beholden to the same disclosure requirements and governance controls as public companies. The SEC prohibits mutual funds from holding over 15% of fund assets in illiquid investments. It is likely that the DOL will suggest private equity investments not exceed 15% of assets in whatever vehicle holds it, such as a target date or balanced fund.
There is also the question of returns when it comes to investing in private equity. Will future returns exceed that of ordinary equity investments? Will the inclusion of private equity in target date funds provide plan participants an increased return without excessive risk? The answers are unclear. Whether or not private equity investments are adopted by target date asset managers is uncertain. In either case, it will remain the duty of retirement plan fiduciaries to evaluate the fit of the target date suites offered and conduct due diligence surrounding risk, cost, and asset allocation. However, any allocation to private equity investments will require an even closer review.
Those who are skeptical of private equity investments argue that the firms that are bought out or taken over are stretched thin and squeezed financially to generate unrealistic growth, in order to cover the fees associated with private equity managers. This could make consistent performance difficult to attain in the future. Like ordinary mutual funds, the performance of private equity funds varies. In evaluating private equity funds, looking at the overall outperformance over the last four decades is insufficient and many top performing funds are not even open to new investors. The quality and availability of private equity funds for retirement plans will require careful examination.
There is a dramatic spread between the private equity funds that are highly successful and those that underperform or fail outright. In fact, the 2010 decade proved to be an exceptionally challenging time for private equity funds, relative to the public equity market. For the 10-year period ending June 2019, the average return for private equity funds measured 15.3%, while the S&P 500 returned 15.5% (Bain & Company). While this is a decent absolute return for private equity investors, investors are not looking to pay higher fees to attain performance on par with public markets. However, looking back at two or more decades, private equity returns are more favorable compared to equity markets.
While expanding the investable opportunity set for retirement plan participants is positive on the surface, it will reinforce the importance and significance of ongoing due diligence. It is important to remember that there is no “silver bullet” when it comes to investing. Simply assuming private equity allocations will improve returns in a target date suite is not a prudent approach. Most target date asset managers will likely be slow to include private equity in their glide paths, if they do so at all. Retirement plan sponsors and fiduciaries need to carefully consider the positives and negatives to determine whether the inclusion of private equity makes sense for their participants.
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Opinions expressed are those of the author, and do not necessarily represent the opinions of Cammack Retirement Group.
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