Is Private Equity Better Than Crypto in Your 401(k)?
Contributor: Jasmin Sethi
Probably!!!
All of this recent talk about crypto being introduced into 401(k) plans makes me wonder if there is an area of alternative assets that might satisfy investors better. I’ve been hearing a lot of news recently about investors looking for ways to make their 401(k) investments more exciting. Though cautionary on PE, the Department of Labor, or DOL, has used less stringent language about PE than crypto. Specifically, they caution that small plan fiduciaries may not have the expertise required to evaluate complex investments like private equity funds. They also caution that participant-directed plans would not be a good fit for the same reason. By contrast, regarding crypto, DOL has warned, “At this early stage in the history of cryptocurrencies, the Department has serious concerns about the prudence of a fiduciary's decision to expose a 401(k) plan's participants to direct investments in cryptocurrencies, or other products whose value is tied to cryptocurrencies.” Yikes! Commentators have been trying to figure out what that means.
A recent study conducted by the Urban Institute analyzed the impact that private equity investment would have on 401(k) accounts. They simulated scenarios by varying multiple factors, such as investment returns relative to the market, volatility, and the percentage of 401(k) plan assets being invested in PE. They simulated 16 different scenarios that PE investment would have on the returns of a 401(k) plan. When they compared these 16 scenarios against a benchmark scenario without any PE investment, they found that 14 of the 16 scenarios would increase average account balances in 401(k) plans over the benchmark.
The most favorable outcome of the scenarios showed average account balances increasing by $39,500 (9.5% increase) by the time the participant turned 65. The worst performing scenario would reduce average account balances by $3,500 (0.9% decrease) by age 65. The scenario that they considered to have neutral assumptions still returned $27,600 (a 6.6% increase) above the benchmark. Another notable point from the study is that lower income 401(k) plan holders would see increases to their retirement savings – not just those with larger account balances.
I have long thought that private equity could be valuable in 401(k) plans and unlike crypto, it benefits from established valuation methodologies. With this in mind, remember that alternative assets should likely compose no more than a total of 10% of your portfolio, probably only 5% for most people, and it should be diversified. The DOL specifically emphasizes that most 401(k) plan fiduciaries don’t have the expertise required to fully analyze private equity models, meaning it’s almost certainly impossible for participant-directed plans to responsibly invest in private equity. The Urban Institute study also noted that a large influx of retirement funds into PE will make it harder for PE funds to continue to achieve the same level of returns they historically have. Lastly, the time horizon for PE investments is much longer than most other asset classes, making it more difficult for plan fiduciaries to forecast returns and liquidity.
Thus, like any alternative asset, upsides to this asset class exist, but plan sponsors and participants need to be comfortable with the various trade-offs before choosing to invest retirement funds in PE.
Jasmin Sethi is the CEO of SCA. She educates investors on the topic of building a secure retirement through a variety of asset classes. She assesses the implications of various policy and industry changes on individual opportunities for building a retirement portfolio and helps financial firms and plan sponsors facilitate better outcomes for individual financial security.