Usually, when people ask if they can get alternative investments in their 401(k) plans, they likely hear … crickets.
According to Cerulli Associates, less than 1% of defined contribution plans currently offer private credit, private equity or hedge funds. Most alternative assets in the DC place are private real estate, offered by 10% of the plans (of those that work with institutional consultants). “Only 4% of target-date managers allocate to [private equity] and private debt, and none allocates to hedge funds within their off-the-shelf target-date series,” said Cerulli in a September edition of its “Cerulli Edge” report.
There are many reasons alternatives have had a hard time cracking the DC world, from the complex to the banal. But it’s a fair question to ask: Why is it that a teacher in California has had access to alternatives investments in her pension for decades, but a worker at a small company that makes, say, glass or auto parts, can’t get into things like hedge funds or private equity or private credit in their 401(k) plan?
That question becomes more crucial for investors in a year of roller coaster volatility, when plan participants likely want stakes in something new that hasn’t lost 20% of its value, or who might want more hard assets on hand at a time of rampant inflation, something tied to gold or land or credit. Proponents of alternatives say these investments can offer diversification, downside protection and income.
Also, consider that the public markets are shrinking—the number of publicly listed companies dropped by half to 3,600 in the last quarter century, said Morgan Stanley in 2020, while the assets in private investments are increasing. Are employees at small companies going to not get a piece of this expanding pie?
Simple math offers one explanation for the drought: Private investments are often simply too expensive for little retirement plans. Also, the investment committees at most companies are often unsophisticated. Their memberships turn over a lot. One bad move—perhaps the collapse of an expensive, flashy hedge fund—and the plan sponsors or consultants fear they could get their heads handed to them in court.
Alternatives also pose logistical problems. They aren’t as liquid as other investments, for starters. They often demand multiyear lockups and capital calls. And since the pool of alternative funds created for DC plans is tiny, it’s extremely difficult to benchmark them against other funds in the universe. As Jennifer Doss of plan consultant CAPTRUST says, that means a lot of funds end up comparing themselves to the S&P 500.
If a fund can’t be benchmarked, managers have less ability to defend themselves in court if an investment goes south. That’s not good when investors have become more litigious in the DC plan space and there are plenty of plaintiff lawyers salivating in the wings.
Now consider that the alternative managers themselves may not be thrilled with the idea of asking small retirement plans for nickels and dimes, especially at small companies with high employee turnover. They’re looking for deeper pockets for their expansive deals in real estate, credit and infrastructure.
“The issue for alternatives in particular historically has been scale,” says David Kennedy, a senior analyst in retirement research at Cerulli. “A lot of times, asset managers want to be reasonably certain that a minimum amount of funds are going to be flowing into their particular strategy.”
“There’s some large sums of money out there that can really move the dial for an asset manager,” Doss says. “And DC is not necessarily the No. 1 on that list.”
Holly Verdeyen is the U.S. defined contribution segment leader at Mercer, another giant consultant that works with DC plans. She says the firm generally likes the idea of offering private assets in client plans, saying alts reduce risk and improve returns. But she adds that there are implementation problems. Besides the admin and record-keeping problems they pose, private assets generally lack daily liquidity and can’t be valued every day, which is not good when you’ve got participants cycling in and out of investments. Not to mention that the fees are out of whack for the DC space.
“What do you do when people are going to leave and they want the value of their account when you sever from service?” asks Marcia Wagner, an ERISA attorney in Boston. “What do you do with an illiquid asset? So I can see a lot of rationale for the minimized usage of this particular investment vehicle from both a legal and practical perspective.”
That doesn’t even address the legal and regulatory concerns. The Department of Labor has released letters saying that private equity could in some cases be used in DC plans, but the DOL’s messaging has been noncommittal; it says a fiduciary must make sure that the funds can be benchmarked and that managers have explained their fees and conflicts of interest.
“Except in [a] minority of situations, plan-level fiduciaries of small, individual account plans are not likely suited to evaluate the use of PE investments in designated investment alternatives in individual account plans,” said the DOL in a letter at the end of 2021.
Until the government issues more robust guidance for liquid alternatives, there will be less uptake in defined contribution plans, Wagner says.
Litigation is a different kind of threat, Verdeyen says. Performance among alternatives typically varies more widely than among public equities. These deviations from a benchmark median could prompt questions from both plan participants and class action attorneys.