U.S. defined contribution plans are missing out on potential returns of $35 billion a year by not incorporating private equity and real estate investments like defined benefit plans do, according to a recent report from Georgetown University’s Center for Retirement Initiatives.
The study, notably funded by the private equity lobbying group American Investment Council, poses the question, “Should DC plan sponsors emulate DB plans by increasing (or, in most cases, introducing) allocations to illiquid assets within target date fund options?”
The conclusion? For the most part, yes, as the report finds the lack of asset diversification in DC retirement plans has been a potential missed opportunity.
Thanks in part to investments in illiquid assets, the report found defined benefit plans outperformed the average return in defined contribution plans by “an enormous gap” of 1.8% annually from 1998 to 2005. When CEM Benchmarking, which co-authored the June 2023 research report along with Georgetown CRI, updated the statistic in 2017, it found that in the 2007-2016 period DC plans had narrowed the gap to 0.46%. The narrowing was attributed to an improved average asset mix held by DC participants, an improvement driven by assets flowing into target date fund options that are professionally managed.
The report says it will be increasingly important moving forward for plan sponsors to diversify and optimize the asset allocation of their TDFs.
“Large providers of TDFs can use their scale and buying power to deliver above-average value in these asset classes via their offerings to plan sponsors and their participants,” the report’s conclusion states. “Plan sponsors should continue to further demand that their service providers, specifically their investment managers, TDF providers, and investment consultants, create, find, and deliver compelling real asset and private equity investment vehicles that can deliver successes like those achieved by DB plans.”
The conclusion goes on to say the success of DB plan sponsors as investors in private equity and real assets encourages plan sponsors and their investment fiduciaries to closely consider and examine opportunities to adopt real assets and/or private equity for their TDFs and/or further increase their current investment policy asset allocations to such asset classes.
The study modeled three different DC target date scenarios:
• Scenario 1: Add a 10% private equity sleeve
• Scenario 2: Add a 10% real asset sleeve
• Scenario 3: 50/50 of Scenarios 1 and 2
Under Scenario 3, the research found the improved returns—where the private equity would replace a mix of listed stocks and the real assets would displace some U.S. large-cap funds and core bond funds—would represent about $5 billion per year in additional net return if applied to all U.S. TDF options.
A 0.15% return improvement to the entire U.S. DC market would represent $35 billion per year in additional net return.
“Plan sponsors and their investment fiduciaries should challenge themselves and their industry partners to efficiently adopt private equity and real assets for their target date funds. The potential annual lost return for participants is measured in the billions of dollars per year,” the report says.
“Using reasonable assumptions for an individual DC participant who saves for 40 years and then draws down for 20, the return improvement might represent an additional $2,400 per year ($200 per month) in spending power in retirement for a retiree already drawing $4,000 per month or $48,000 per year in retirement income,” the conclusion continues.
It ends by saying the consideration of private equity and real assets in glide paths for TDFs is a “natural next step in their evolution, as they continue to be drivers of outcome success for all investors who are saving for a healthy and strong financial retirement.”
Not everyone on board
The idea of opening 401(k) plans to private equity investment is not without controversy. One argument is 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.
Another is that participants won’t understand it.
“Most participants still don’t understand basic stock and bond mutual funds. How are we going to educate them on private equity and real estate investment options?”
Integrated Retirement Solutions President Scott Pooch
“I am 100% opposed to this in most 401(k)s,” said Integrated Retirement Solutions President Scott Pooch. “Most participants still don’t understand basic stock and bond mutual funds. How are we going to educate them on private equity and real estate investment options?”
Pooch, who agreed to share comments made on LinkedIn with 401(k) Specialist for this article, added that while private equity in 401(k)s may be good in theory with the possibility of slightly higher returns, “But it would add a whole new level of complexity and would confuse participants.”
In 2020 President Donald Trump’s Labor Secretary Eugene Scalia handed private equity a major victory when he issued an information letter saying PE funds can be responsibly included in retirement plans as long as managers considered fees and risks.
Under the Biden Administration, the Department of Labor issued an updated information letter in late 2021 cautioning plan fiduciaries against the perception that private equity is generally appropriate as a component of a designated investment alternative in a typical 401(k) plan but did not prohibit it.
Despite the relative green light from the DOL on the issue, the threat of ERISA lawsuits or additional federal guidance has largely prevented 401(k) fiduciaries thus far from allowing PE into their plans.
SEE ALSO:
• Department of Labor Clarifies Its Private Equity 401k Stance
• Do Equity Investments Make Sense in Social Security?
Veteran financial services industry journalist Brian Anderson joined 401(k) Specialist as Managing Editor in January 2019. He has led editorial content for a variety of well-known properties including Insurance Forums, Life Insurance Selling, National Underwriter Life & Health, and Senior Market Advisor. He has always maintained a focus on providing readers with timely, useful information intended to help them build their business.
