Including private equity funds in 401k plan portfolios would improve performance and lower overall portfolio risk, according to a new study titled, “Why Defined Contribution Plans Need Private Investments.”
The study, recently published by investment management firm Neuberger Berman, the Defined Contribution Alternatives Association (DCALTA) and the Institute for Private Capital (IPC), finds that investing in private funds increases average portfolio returns and reliably increases Sharpe ratios (return per unit of risk).
The results are “robust” when accounting for the inclusion of higher fees for the private portfolio and randomly selecting a few funds from each vintage year (e.g., 10), suggesting that the results are feasible in practice for many investor types, the study’s abstract states.
“We have found that the best-performing institutional investors have broadly diversified portfolios and significant exposure to illiquid assets,” said Hayden Gallary, Investing Managing Director with Cambridge Associates, a contributor to the study. “The ability to extend this strategy to DC plan participants in a professionally managed and risk-controlled way could improve performance, and in turn result in better outcomes.”
The analysis includes a sample of 2,515 U.S. private equity funds to create simulated portfolios for 1987-2017 that invest part of their overall equity allocation in these funds.
The collaboration is based on an alignment of views that DC plans and ultimately, participants, should benefit from the same private investment opportunity utilized by defined benefit plans, endowments and other pools of capital.
The call for private equity funds to be added to retirement plans comes after the Securities and Exchange Commission’s June 18 concept release on harmonization included the idea and solicited comments.
“Our research confirmed our hypothesis that the U.S. defined contribution plan space was operationally capable of including illiquid investments in DC plans but lagged in actual implementation relative to other countries (i.e., Australia, Mexico),” the study says. “DCALTA believes this to be attributed to litigation concerns due to a lack of regulatory and/or legislative clarity, product liquidity limitations and a lack of knowledge on the opportunity set of available investments.”
The idea of opening retirement plans to private equity funds is not without controversy, as some believe that because private equity funds are unregistered and therefore don’t have to submit public filings, the top-performing funds are more likely to report results than struggling funds.
That can skew totals, and the performance calculations for private equity funds that do report are inconsistent.
The study noted this factor, saying researchers were “paying careful attention to the fact that returns of the portfolio are artificially smoothed by the lack of observed price data.”
As DC plans replace DB plans across the globe, the study says it has become evident that it is difficult to replace one with the other without improved infrastructure and the inclusion of a long term, broad-based asset allocation investment model.
“We must transition from a supplemental DC savings mindset to a long term, compensation replacement mindset which includes institutionalizing DC investments to be more like DB investments. The research presented in this paper makes it clear that including private assets as an option in DC plans is crucial to this transition,” the study says.
“As DC plans look to provide more of a ‘DB experience’ to their participants, we believe including alternative exposure within their asset allocation offerings is a natural progression,” said Michelle Rappa, managing director at Neuberger Berman.
At this point, the SEC has not indicated what may come out of the input it receives during the public comment period.