The Trump administration has cracked open the door for private equity funds to get into 401(k) workplace retirement plans. There’s roughly $5.6 trillion in such accounts, and the prospect of capturing even a sliver of it has the industry abuzz. A more complicated question is whether ordinary investors will really want their money going into buyout funds.
Private equity is a different beast from the mutual funds retirement savers are familiar with. PE managers often buy companies whole, financing the purchase with debt that ends up on the books of the companies themselves. That adds to potential profits but also to risk and complexity. Funds tend to have long lockup periods, during which investors can’t get their money out, and charge high management fees as well as take a share of profits off the top.
The U.S. Department of Labor, which oversees retirement plan rules, on June 3 issued guidance that’s been taken as a green light to include PE funds in some plans. It doesn’t say that workers should suddenly get an option to pick one by themselves. Rather a PE fund might be included as part of the portfolio of another diversified fund.
“This really sets the stage,” says Jonathan Epstein, founder of the Defined Contribution Alternatives Association, a trade group that’s pushed for allowing more kinds of investments, including PE, in 401(k) plans. One possibility is making PE part of a target-date fund, a popular option that mixes investments in stocks and bonds and gradually reduces exposure to risky assets as investors reach their retirement date. Such funds are often the default investment option in their plan and are chosen by plan sponsors who are obliged to look out for employees’ interest. But this may mean that savers will have to read the fine print to know whether some of their money is in a private equity fund.
The complexity and illiquidity of PE funds may be a roadblock for some employers. “It is like a square peg in a round hole,” says James Veneruso, who advises on retirement plans at consulting firm Callan. But that doesn’t mean such challenges can’t be overcome if funds can make some changes, including lower fees, he says.
A group of unions and consumer and investor advocacy organizations, including the Consumer Federation of America and Public Citizen, sent a letter to Secretary of Labor Eugene Scalia urging him to pull the guidance because of “gaping holes in investor protections.” The organizations questioned not only whether small-time savers have the sophistication to make decisions on the asset class, but also whether employers and others who are in charge of choosing plan options do.
Proponents of private equity argue that PE funds, which have long been used in traditional pension plans, have outperformed public stocks. The industry also cites private equity’s diversification benefits, as well as the opportunities in the private markets as the universe of public companies shrinks.
Not everyone agrees that private equity offers such impressive returns, especially after the mangers’ fees. A recent paper by Ludovic Phalippou, a professor of financial economics at University of Oxford’s business school, found that private equity has performed in line with comparable public stocks. Large private equity managers have disputed his findings.
One issue is that it’s difficult to agree on the right benchmark for PE investments—should they be compared to the S&P 500 index or small companies or global equities? And the way their performance is commonly cited, as an internal rate of return, can be confusing and hard to compare to returns reported by mutual funds. IRR factors in the speed at which private equity hands back capital to investors after it’s put to work. “The problem is these numbers are not what you think they are,” says Phalippou. “These are not rates of returns that somebody earned on their capital year after year,” he says.
Lurking behind all this is a broader policy fight. Regulators in the Trump era have argued that retail investors should have broader access to a lot of investments previously limited to wealthy individuals and institutions. Democrats have generally sought more regulation of financial products, and some have been critical of private equity, blaming it for loading up companies with debt and causing layoffs and bankruptcies. The government’s approach could soon change with the presidential election less than five months away. As a harbinger, six Democratic senators and Bernie Sanders, the independent from Vermont, sent a letter to Scalia urging him to reconsider his decision.
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