Last year, the Department of Labor paved the way for plan sponsors to add private equity (PE) investments as part of a professionally managed asset allocation fund offered as an option to investment to participants in defined contribution plans.

And a new report just might get there, not just on paper, but in reality.

Researchers at the Urban Institute found that average retirement savings would increase when 401 (k) plans included private equity investments held in professionally managed asset allocation funds, such as a target date or target risk funds, because private equity funds generate higher returns on average. , that public equities and the EP offer opportunities for diversification.

In fact, the researchers estimated, in the most optimistic scenario, that private equity investments could increase average account balances by as much as 10% over a full career. To be fair, the simulated impacts varied widely, with some savers doing significantly better than average and others doing significantly worse, according to the Urban Institute report.

And the authors of the report, which was funded by the American Investment Council, a lobbying, advocacy and research organization started by a consortium of private equity firms, said the increase in retirement savings would not happen overnight.

In fact, they said it would take time for any changes in returns to accumulate, so these effects on retirement savings would be negligible over the next decade as target date funds add up. gradually from PE to their portfolios.

“Progressive” could be an understatement. Right now, very few plan sponsors and plan providers jump at the opportunity to add private equity investments to their offerings, according to Mike Kane, managing director of Plan Sponsor Consultants. “We only saw one or two questions about them, periodically, from the investment committees,” he said. “We also don’t know of any target date investment families that might include PE investments in asset allocations for their different vintages.”

Choosing the right private equity fund

Professionally managed asset allocation funds, such as maturity funds, invest in a combination of stocks and bonds. Just over 51% of Fidelity’s 2050 Freedom Fund (FFFHX) is, for example, invested in US stocks, just over 41% in non-US stocks and around 7% in bonds. If and when fund companies start investing in equity within asset allocation funds, the allocated percentage is likely to be low, say less than 5%.

Tony Davidow, author of Goals-based Investing, is generally optimistic about adding PE to the asset allocation funds offered in 401 (k) plans, but said it needs to be done the right way.

On the plus side, Davidow said adding PE to maturity funds gives retirees access to an “elusive” asset class. Typically, PE investments are only open to accredited investors who understand that they are purchasing an illiquid asset that is typically held for more than 10 years.

And because of this illiquidity, private equity investments – as the Urban Institute noted – are expected to generate higher returns than public stocks. Other institutions say much the same thing. JP Morgan, for example, tells investors to look beyond traditional asset markets for higher yields. In its latest report, JP Morgan predicts that a 60/40 portfolio would only gain 4.3% per year over the next 10 to 15 years, compared to 8.10% per year for private equity.

There is a wide dispersion of returns when it comes to private equity investments, however, Davidow said. And there could be a big difference between the best, the worst, and the average.

“While private equity has historically generated a substantial liquidity premium – the excess return received for tying up capital for an extended period of time, not all private equity funds are created equally,” Davidow said. “In fact, one of the most important issues to focus on is selecting the right fund, because the dispersion of the returns from the high-performing private equity fund has been around 2,000 basis points. . Conversely, the dispersion of returns for the top-to-bottom global equity fund is less than 400 basis points. “

Therefore, there is a real premium in selecting the right private equity fund, he said.

Take into account the structure of the fund

Plan members should also consider the structure of the PE fund. The main fund structures available to accredited investors are either interval funds or take-over funds, Davidow said. “Although they offer better liquidity than traditional limited partnership funds, Qualified Buyer (QP) funds, they should be viewed as long-term investments, to allow managers sufficient time to execute their investment. strategy, ”he said. “To allow investors greater flexibility in modifying their investment options to include private equity, it may be necessary to put in place new product structures, or more evolved structures, to better align on maturing funds. “

These new product structures are also likely to have different fee structures, Davidow said.

Historically, PE investors have paid a high management fee of 2% as well as 20% of profits. But Davidow believes PE fees will need to come down for 401 (k) funds, a trend that is already underway with registered funds (interval and take-over funds).

Will adding PE really increase yields?

Other experts, meanwhile, said adding PE investments to a target date fund might reduce risk and volatility, but might not increase returns as much. That’s because only a small percentage of assets are likely to be allocated to PE investments in a target date fund, said Bryan Hodgens, a retirement expert. “Is the juice worth the squeeze?” ” He asked.

This is a question likely to be debated in the years to come. In a scenario that adopted the most favorable assumptions, the authors of the Urban Institute report said that adding PE to a target date fund would increase average account balances at age 65 by $ 39,500 (in 2020 inflation-adjusted dollars), or 9.5%, from the baseline that excludes PE investments from pension plan accounts.

In contrast, the scenario with the least favorable assumptions would reduce the average account balances at age 65 by $ 3,500, or 0.9% compared to the baseline scenario. And the scenario with more neutral assumptions would increase average account balances at age 65 by $ 27,600, or 6.6%.

Hodgens also believes that plans that offer funds with PE investments will struggle to educate plan participants. “Private equity funds are not easy to understand, can lack liquidity and pricing the underlying investments can be difficult,” he said.

Your to-do list

So what should a 401 (k) plan member do?

Two items belong to the task list.

One, be vigilant. If you are investing in an asset allocation / target date fund within your 401 (k), don’t disregard notices in your 401 (k) plan that signal changes in your fund mix. Read the. It would be easy to miss an update that your fund is now investing in the PE.

Second, take the time to learn more about the benefits of diversification. Essentially, spreading your investment funds across different assets helps reduce the overall variability (i.e. risk) of your portfolio, according to Gary Sanger, a professor at Louisiana State University. And it’s a good thing.