In 2020, the Trump administration announced that 401(k)s and other defined contribution retirement plans were not explicitly barred from offering private equity investments to participants. These alternative investments, which historically have been limited to wealthy and institutional investors, aren’t available as standalone options, but they could potentially be bundled with other investments in, for example, target-date funds, according to Trump’s Department of Labor.
This announcement marked a potential change from the traditional rules of defined contribution plans, which had been limited to publicly traded investments like market-listed securities. Here’s what you need to know about the potential benefits and pitfalls of this change.
If you need help deciding whether private equity belongs in your 401(k) or have other investment-related questions, consider talking to a financial advisor.
What Is Private Equity?
Private equity is a form of investment in privately held companies that are not publicly traded on stock exchanges. These investments are typically made through funds pooled from institutional investors or high-net-worth individuals, aiming to acquire ownership stakes in businesses with growth potential. Private equity firms often buy companies outright, restructure them and eventually sell them for profit, generating returns for investors.
Investing in private equity typically requires significant capital, as it is generally restricted to accredited investors – those who meet specific income or net worth thresholds set by regulators. Institutional investors, such as pension funds or endowments, are common participants due to the high entry requirements and longer investment horizons. Investments in private equity are often held for several years, as firms aim to enhance the company’s value through strategic changes and operational improvements before an exit, such as a sale or initial public offering (IPO).
Unlike public stocks, private equity investments generally involve higher risks due to their illiquidity and reliance on the operational success of the companies. However, they also offer opportunities for significant returns that can outpace more traditional assets. Private equity serves as an alternative way to gain exposure to companies before they potentially go public, providing diversification beyond public markets, but it requires careful consideration due to its complexity and risks.
How Private Equity Could Affect Retirement Accounts
In a June 2020 letter responding to two private equity firms, Trump’s DOL stated that a plan fiduciary would not violate their fiduciary duties by offering a “professionally managed asset allocation fund with a private equity component” within an ERISA plan.
“In making such a selection for an individual account plan, the fiduciary must engage in an objective, thorough, and analytical process that compares the asset allocation fund with appropriate alternative funds that do not include a private equity component anticipated opportunities for investment diversification and enhanced investment returns, as well as the complexities associated with the private equity component,” the letter concluded.
However, in December 2021, the Biden administration clarified that it did not endorse the inclusion of private equity investments in defined contribution plans. “Except in this 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.”
While the two administrations have differed in their views, leading to some ambiguity, Trump’s election in November 2024 could see his new administration return to this topic of private equity within ERISA plans.
Private equity is risky. It can be enormously profitable, offering the opportunity to invest in billion-dollar startups while they’re still scrounging for cash, but just as often these investments crash and burn, leaving the investors with nothing. Major private equity and venture capital firms build their business models around the success stories, with profitable investments providing returns that offset the losses.
Individuals have none of these protections. Someone who winds up with “PE” in their retirement account will be invested in a field of assets whose rules are set for sophisticated investors, not individuals dabbling with their 401(k). This investor won’t likely have the resources to offset big losses with lottery ticket wins, creating retirement accounts exposed to high-risk high-reward investments without the business model to cover for when those risks go south.
What Are the Opportunities?
Advocates point to studies that show that the private equity market generally returns 4% more than public equity markets such as the S&P 500. This, they argue, is reason enough on its own to incorporate private equity into tax-advantaged retirement accounts.
As the American Investment Council, a private equity lobbying organization, wrote, this will allow individuals “to diversify their portfolios and benefit from private-equity’s outsized returns.” A series of private equity investments can possibly help boost the value of retirement accounts, as successful private companies sometimes return significant profits to their shareholders.
Retirement accounts such as 401(k)s do tend to suffer from a speculation and liquidity problem. Investors often prioritize safeguarding their assets over growing their investments, and as a result their savings don’t grow fast enough to secure their retirements. In the best case scenario a series of private equity investments could give someone access to a Google or Facebook before it goes public, building real value and helping to secure a safer retirement in the long run.
Advocates point out that defined benefit plans have long included private equity components in their portfolios. Others argue that private equity investments would give defined contribution participants diversity and a hedge against broad public market downturns.
What Are the Risks?
There are many risks to incorporating private equity into retirement accounts.
First, claims about private equity successes are unreliable. As the Wharton School notes on its website, ultimately the claims about outsize gains in private equity are unreliable “because the industry is secretive, and findings of academic studies vary.” Such unreliability accounts for estimates of actual returns varying wildly.
Insiders have also dismissed claims of private equity success. “Since 2009, when the global economy limped out of the worst recession in generations, U.S. public equity returns have essentially matched returns from U.S. buyouts at around 15%,” according to Bain Capital, itself a private equity firm.
The Financial Times has pointed out that what little data the private equity industry does release often cannot possibly be true: “Taking oft-cited claims that Yale University had delivered a 30 per cent [internal rate of return] from its buyout investments since inception, [a finance researcher] showed how this could not be reconciled with reality. Had Yale staked just $1m on private equity in 1973, Phalippou pointed out, an investment compounding at 30 per cent would have turned into $24bn by 2011. That sum was more than Yale’s entire endowment at the time.”
Even if details of investments in private equity are disclosed in a technically legal fashion, understanding what is disclosed – and being aware of what is not being disclosed – requires a sophistication on the part of its investors. Individuals may consent to incorporating private equity into their defined contribution plan without understanding the risks involved.
One of the reasons private equity is risky is because of the extraordinary amounts of debt often incurred to buy up businesses and other financial assets, creating situations where private equity firms and the companies they own are heavily leveraged. This is one reason many financial professionals have responded to the 401(k) change with a single word: “Yikes.”
Bottom Line
Private equity investments in 401(k) plans are an intriguing but complex addition that may bring both opportunities and risks. While they offer the possibility of higher returns and diversification, they also come with higher levels of risk, long holding periods, and complexities not always suited for typical retirement savers. Regulatory perspectives on the inclusion of private equity in retirement accounts have varied, reflecting the debate over whether the potential gains justify the significant challenges.
Tips for Investing in Private Equity
- Consider talking to a financial advisor about private equity investments. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Understanding your risk tolerance and investing goals is a key part of any long-term financial strategy. A free investment calculator can help you better visualize your goals and preferences.
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