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.

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.

What the Calculations Show

According to the authors, each of the three scenarios considered would have led to better performance for TDF investors.

Conclusions and Considerations

According to the report, the 15 basis point per year return improvement in the blended scenario, which had the highest proportion of improved outcomes, would represent about $5 billion per year in additional net return if applied to all U.S. target-date options.

At the same time, a 0.15% return improvement to the entire U.S. defined contribution plan market would represent $35 billion per year in additional net return, according to the authors.

Using what the report calls “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 for a retiree already drawing $4,000 per month or $48,000 per year in retirement income.

“The results of the analysis show there can be significant benefits to adding private equity and real assets to TDFs,” the authors conclude. “Private equity has provided return enhancement while offering greater diversification among equity sub-asset classes and improved outcomes for investors. Real assets have served as a diversifier alongside stocks and bonds, with an additional benefit of offering inflation sensitivity.”

As the authors acknowledge, just as DB plans with private assets have higher costs, so would DC plans, but what is more meaningful to plan participants is the value of the strategy being pursued in terms of expected impact on total return and risk.

“The strong performance shown by all three scenarios is calculated after the impact of higher costs, since the net (after cost) returns of DB pension plan portfolios are used,” the authors emphasize. “These returns are net of not only manager fees, commitment fees, and performance fees, but also of asset class-specific consulting costs, and the internal staff costs at the DB plans required to oversee these portfolios.”