Private equity and your 401k
Can you put private equity investments in your 401(k)?
On June 3rd, 2020 the Department of Labor (DOL) issued an information letter that provided guidance on the DOL’s framework to allow 401k fiduciaries to allow private equity investments in their qualified retirement plans:
“For decades, institutional investors like traditional pension plans and endowments have invested in private equity, but 401(k) plan fiduciaries have been reluctant to add the asset class to their plans in the absence of specific guidance from DOL," said Jon Breyfogle. "The Information Letter released today is important because it gives fiduciaries more legal certainty if they want to consider additional asset classes as part of a diversified 401(k) investment option."
In the past, 401k plans have not included these types of investments because there was a specific lack of guidance by the Department of Labor, which controls the rules and regulations surrounding qualified retirement plans (“ERISA”, as defined by the Employee Retirement Income Security Act of 1974). The DOL suggests in the letter that private equity be made available as part of a balanced suite of investment options, that also includes, stock, bond, and target retirement funds. At first glance, this probably sounds beneficial, because having more options for your retirement accounts can only be a good thing, right? The reality is that there are far more private companies than public ones in the U.S. but investing in them isn’t always a good idea. Private equity is extraordinarily risky, with massively high fees, and funds that tend to completely disappear and/or go out of business at an alarming pace.
Private equity funds allow private investors to invest in privately held companies, many of which are struggling or looking for buyers to restructure or liquidate their assets. The funds charge massively high fees and are extremely high risk. Direct investing into private equity is generally restricted to “accredited investors”. An accredited investor is an individual or married couple that has an income greater than $200,000 or $300,000 respectively, or a net worth of $1,000,000 excluding their primary residence. The general idea is that accredited investors can afford to lose money if a risky investment goes badly.
Retirement and private equity are incompatible
The benefits of a normal retirement plan like a 401k or IRA are immense. Many employers provide a match of essentially free money, and there are huge tax benefits to deferring taxes later in life. Most middle-class Americans are dependent on their retirement savings, and in the past ERISA guidelines have ensured the protection of those assets. The federal government and the DOL play a big role in making sure these plans run properly and protect investors from funds that don’t have their best interest in mind. This “fiduciary duty,” is crucial, as it allows investment managers to provide unbiased advice that is in the best interest of your average retiree. Private equity is designed for extremely wealthy investors, because often, the funds will suffer massive losses. But if you’re wealthy, you can really spread out your private equity investments, and eventually make good money, even if some investments suffer large losses.
Secretary of Labor Eugene Scalia said that the guidelines “level the playing field” and provide options for investors, but numerous studies have shown that private equity doesn’t outperform the stock market, and in reality under-performs after fees, with significantly more risk.
What does Arrow recommend?
We have two suggestions for 401k investors in response to these new guidelines. First, make sure to check your default 401k allocations to make sure that a percentage of your funds wasn’t defaulted to a private equity fund. Secondly, if you are considering a risker allocation of private equity in your 401k, consider making it a small one. We recommend limiting your allocation to 2% of your overall portfolio for each $100,000 of your total net worth. In other words, an investor with a net worth of $1,000,000 should limit their private equity exposure to a maximum of 10%.