President Donald Trump’s recent executive order. This order is a significant step toward allowing alternative investment options, including private equity funds, to be used in workplace retirement plans, including 401(k)s. This major policy change expands the range of investment options available to average workers. Until now, their choices were largely restricted to traditional assets such as stocks and bonds. Financial experts warn against the premise behind those investments — that they should be directly impacting individuals’ retirement savings.
The goal of the executive order is to expand those opportunities for high returns, which were typically limited to accredited investors. These investors often make over $200,000 per year or hold assets over $1 million in net worth. Private equity funds tend to be riskier investments with a higher potential for return. They usually charge an up-front annual fee of 2% of funds raised and they take 20% of all profits above a threshold. Pension funds, particularly those that invest in private equity, have a history of outpacing typical 401(k) plans. Adding these funds to workplace retirement accounts can further complicate matters.
The Risks of Private Equity Investments
Private equity funds can pose special challenges, especially with respect to liquidity. Unlike publicly traded securities, these funds could face difficulties selling shares on short notice. This constraint may limit an issuer’s flexibility to raise liquidity or redirect capital to other priorities at critical junctures. Prominent investor Jerry Schlichter warns against sinking money into investments that you don’t understand.
“If you don’t understand the investment, you shouldn’t depend on it for your retirement assets.” – Jerry Schlichter
Sheltering from taxes can lead to significant investment gains, but as Schlichter’s statement highlights, education and understanding is key. He calls private equity, “a square peg in a round hole.” Although funny, this analogy goes to show just how poorly these investment vehicles align with the desired outcome and needs of the average 401(k) participant.
Investment professionals have long stressed the need to understand the underlying assets you’re investing in before putting retirement savings at risk. CFRA’s chief investment strategist, Sam Stovall, reminds us that keeping an ear close to the ground requires you to know what you own.
“There’s nothing wrong with [nontraditional 401(k) investments], but you have to know what you own.” – Sam Stovall
Potential Benefits and Concerns
Private equity should be an option in 401[k] plans. They argue that this reform would allow ordinary employees to partake in returns that have mostly accrued to richer Americans. Experts, including BlackRock CEO Larry Fink, are confident that this move will provide better financial returns for regular investors. Worries over the added risks and difficulties that come with private equity are still top of mind.
Financial professionals have cautioned that private equity funds typically hold back lots of cash for redemptions. This strategy leaves them at risk of under-spending their own capital. This pattern may depress aggregate returns and affect long-term growth prospects. There’s tremendous upside on these funds for big returns. The experts are split on whether they reliably beat out regular old market indexes over the long haul.
Alternative Investment Strategies
In light of these risks associated with private equity investments, many finance experts have praised a return to more conventional practices with regard to retirement savings. Schlichter recommends holding a permanent portfolio of uncorrelated assets that have proven track records of high returns spanning multiple decades. Investment professionals love to tout low-fee exchange-traded funds (ETFs) and mutual funds. They love these alternatives for their transparency and lower price tags.
Stovall further stresses the importance of investors defining expectations for what they’re investing in.
“What is it that you’re buying? What are your expectations for this investment? And if it goes through a slump, what are you going to do then?” – Sam Stovall
This unique piece of advice serves as a gentle reminder to readers to digest their own risk appetite when outlining their retirement plan. Equally important is to consider their investment horizon.