New Study Supports Private Equity in 401(k)s

What You Need to Know

Pension plans have benefited in recent years from their use of private equity and other illiquid investments, according to a new report.
The success raises the question of whether 401(k) plans should follow suit now that many investors utilize target date funds.
The report suggests 401(k) investors would likely benefit from such a development.

Illiquid asset classes such as private equity and real estate investments represent a missed opportunity for retirement plan investors to improve total-return performance, increase diversification and reduce volatility of asset values, according to an analysis from the Center for Retirement Initiatives at Georgetown University.

The report suggests workplace defined contribution retirement plans could (and probably should) take a page out of the modern pension plan playbook by utilizing such asset classes, arguing many pensions have benefited in recent years by redeploying a modest portion of their assets away from traditional stock and bond investments.

According to the report, U.S. pension plans outperformed the average return of defined contribution plans by 1.80% per year from 1998 to 2005, which the authors call “an enormous gap.” From the 2007 to 2016 period, however, DC plans had narrowed the gap to 0.46%, with most of the narrowing attributed to an improved average asset mix held by DC participants thanks to the widespread adoption of professionally managed target-date funds.

Now, as pensions embrace more progressive investment approaches that feature private equity, real estate and infrastructure investments, it is possible that gap could widen again — unless DC plans themselves find ways to offer these potentially attractive investments.

Ultimately, the authors suggest, the widespread utilization of target-date funds, which automatically mix and manage investors’ retirement savings, presents a great opportunity for private equity investments to be offered to the mass market without requiring individuals to gain any specialized expertise.

Contents

The Rise of Target-Date Funds

As the CRI report spells out, the widespread adoption of target-date funds as a default investment in 401(k)s and other defined contribution style plans has been a great benefit to individual investors.

Before the rise of TDFs, the report recalls, participants were largely left on their own to construct portfolios, and they often did a poor job, either taking excessive risk or leaving all of their money parked in safe but low-returning default investments.

After the Pension Protection Act of 2006 allowed plan sponsors to use fully diversified and return-seeking TDFs as a default, this rapidly began to change. As noted, the CRI report finds the adoption of TDFs has helped to meaningfully close the performance gap between pensions and DC plans.

The report suggests the success of TDFs raises the prospect of additional reforms based around the popular investment vehicle, namely, the potential to add more illiquid asset classes to the mix in an effort to reduce volatility and boost long-term returns.

About the Analysis

To test whether this is a good idea, the CRI report utilizes data from CEM Benchmarking’s U.S. database of reported DC plan TDF allocations and returns in combination with reported DB plan allocations and return data.

With these datasets, the authors assess how DC plan participants’ experiences would have changed had their TDFs made higher allocations to illiquid assets during the 2011 to 2020 time period. The report considers three distinct approaches to implementing these allocations, each with a different level of illiquid investments being used.

For the sake of accuracy, the analysis uses the actual range of reported annual real asset and private equity portfolio return series of the pension plans, net of all costs to implement the portfolios. The report uses this to calculate a range of adjusted outcomes assuming the adoption of investment alternatives under a set of DC target-date scenarios.

The range of outcomes for the adjusted DC target-date scenarios was then compared against unadjusted DC target-date options to assess the net impact of illiquid asset allocations on TDF performance.