Retirement savings plans have included alternative investments for more than 30 years. Plan sponsors view alternatives as complementary to traditional stock investments and annuities — but most plan participants don’t even know their 401(k) savings include these asset classes.
A study released in February 2022 aims to shed light on these under-the-radar investments. Is it time to review your plan’s asset allocation?
A financial advisor could help you plan for retirement and help you select investments that align with your financial goals. Find a qualified advisor today.
How Alternatives Affect Your Retirement Savings
The Defined Contribution Institutional Investment Association (DCIIA) has released a new study evaluating how alternative investments affect 401(k) and other retirement savings plans. DCIIA contributors weighed the pros and cons of including private real estate, hedge funds and private equity in multi-asset portfolios and found that there may be benefits despite the risks.
U.S. private real estate encompasses nearly $16 trillion in market size, making it the third largest asset class in the U.S, and many target-date and mutual funds include it as a source of stable income. Real Estate Investment Trusts (REITs), which manage and develop that real estate, have grown rapidly in popularity, averaging a 7% annual return over the past 15 years.
On the other hand, plan sponsors employ hedge funds for flexibility. They utilize investment tools such as derivatives, leverage and short selling that potentially allow them to return streams uncorrelated to traditional stocks and bonds. For example, 10-year-performance averages indicate that hedge funds perform similarly to the Bloomberg Aggregate Bond Index with half the volatility of the S&P 500 Index.
The study also evaluated the inclusion of private equity as asset alternatives. The Department of Labor issued a guidance letter in June 2020 that permits retirement savings plans to include private equity in managed-asset portfolios but only in certain circumstances. Fiduciary responsibilities require plan sponsors to calculate if private equity can realistically provide better outcomes net of their fees to plan participants, and if they can, the alternative may be included.
Given that private equity comprises equity investments not listed or traded on any public exchange, details regarding these investments can be difficult for retail investors to source. However, on average, the study estimated that private equity returns 8% to 10% annually net of fees over a 30-year simulation.
Opportunities and Challenges of Alternative Investments
The DCIIA evaluated these three alternative investments and determined that the potential for returns was high. Yet all three asset classes carry inherent risks that can negatively affect your 401(k) and retirement savings.
Importantly, the three asset classes are often not publicly traded on any exchange. This means that much of the financial data about these firms is not easily sourced by the average investor.
A mere 7% of private real estate is listed on the stock exchange, but defined contribution plans like your target-date retirement fund can include private companies. According to the DCIIA findings, private real estate may only provide moderate returns compared to traditional stock investments. Nevertheless, allocating some of your savings to this alternative could benefit you as a source of diversified and stable income.
Hedge funds, too, offer only a moderate potential for returns compared to stocks and bonds. They do not offer stable income yields either. But despite this, hedge funds can benefit your portfolio by offering high protection against stock market plunges, potentially saving your funds from down markets.
The last asset class, private equity, is a little murkier. Private equity investments are only available to institutional investors and often have complicated organizational structures, which make it difficult to clearly trace their cash flows. The DCIIA found that only 1% of retirement savings plans currently include private equity as an alternative, and yet these investments carry a potentially high return compared to traditional market choices. The downside, though, is low stability and diversification.
Bottom Line
Many investors may not know that their retirement savings also include alternative investments such as private real estate, hedge funds and private equity. These asset classes help to further diversify investment portfolios but also carry inherent risks to which investors may not know they are being exposed.
Retirement Planning Tips
- Not sure if alternative investments will help you grow your retirement savings? For a financial plan tailored to your needs, consider speaking with a qualified financial advisor. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use SmartAsset’s free retirement calculator to get a good estimate of how much money you’ll need to retire.
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