Don’t Get All Excited by the Green Light for PE in 401(k)s

Private equity isn’t always a market beater and charges high fees. Besides, it’ll be confined to larger investment pools, like target-date funds, which limits its impact.

So now private equity can be included in 401(k) accounts, eh? That’s the latest US Department of Labor guidance for sponsors of defined contribution plans, such as 401(k)s.

Trouble is, for one thing, there’s still concern that PE may not be an apt investment for regular investors, namely the folks who entrust their investments to DC plans. That means litigation risk. A Supreme Court decision in February allowed workers to sue Intel for placing risky and costly PE investments into its retirement accounts.

Certainly, the Labor Department is not opening the floodgates for PE ownership by average investors. The guidance restricts the strategy to target-date and balanced funds, meaning any negative impact from PE would be diluted by more conventional investments in stocks and bonds. But any great returns will be thinned out, too. Right now, hardy retail investors can invest in PE operations by simply buying shares in the handful of publicly traded private equity firms, such as BlackRock and Pershing Square.

The current Labor Department and Securities and Exchange Commission have been pushing to let average folks into alternative investments, like PE, and to permit more financial services to access the $6.2 trillion 401(k) market. The new guidance “helps level the playing field for ordinary investors,” said US Labor Secretary Eugene Scalia in a news release.

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SEC Chairman Jay Clayton applauded Labor’s new policy, saying in a statement that the announcement “will provide our long-term Main Street investors with a choice of professionally managed funds that more closely match the diversified public and private market asset allocation strategies.”

Indeed, the SEC is examining ways to widen the definition of who is an “accredited investor,” able to directly buy into PE funds. Currently, you must have $1 million in assets outside of a home and $200,000 in minimum yearly income.

Sure, PE can be very lucrative, sometimes. The top quarter of PE funds by performance were up 16.2% annually over the 10 years ending in September, according to Pitchbook researchers.

But PE funds in general have not outpaced the S&P 500, a report from the Bain & Company consultancy last year found. For the 10 years ending last June, they rose 15.3%, a couple of hairs behind the S&P 500’s 15.5%. Meanwhile, investing in an S&P 500 index fund is a helluva lot cheaper than in a PE fund.

For PE, fees are quite high, with the classic 2 and 20 in place for many (although a number now charge less). That means a 2% yearly management fee and 20% of the profits.

And given the recent surge of cash into PE funds, from institutions and wealthy people, a fear persists that too much of it will be ill-spent on dubious investments. The Bain study also noted that these funds “are paying prices they swore they would never pay and looking to capture value that may prove elusive.”

At present, though, amid an onrushing recession and the virus pandemic, PE deals are slowing down. So are public offerings. Likely result: fewer exits for PE portfolio companies as other buy them, hence less boodle for PE investors.

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Tags: 401(k), Private Equity, S&P 500, SEC, target-date funds, United States Department of Labor (DOL), US Supreme Court

Pensions would have fared better during the financial crisis of 2008 and the COVID-19 pandemic market downturn if they had been allowed to use a proposed flexible system called a composite retirement plan, according to a study issued by several construction and contractors associations.

That’s as opposed to a traditional defined benefit multiemployer plan, where benefit levels are locked in. Many multiemployer plans today are underfunded. Under the composite variety, the plan first becomes overfunded early on. And if a recession or some other calamity hits, this cushion—20% over what’s needed—see it through and avoids brutal benefit reduction. As a last resort, if things get even worse, the plan has the ability to trim benefits.

Composite plans are a proposed new type of multiemployer retirement plan that has not yet been authorized for use in the US. They are “a voluntary approach with built-in guardrails to keep plans on track,” Josh Shapiro, the white paper’s author and a senior actuarial advisor with Washington, DC-based Groom Law Group, said in a release. The firm wrote a report based on the group’s findings.

The concept of the composite plans is relatively simple and has two main features that differ from defined benefit plans. The first is an asset cushion created when establishing benefit and contribution levels intended to protect against market downturns.

This would require plan contributions to be calibrated to reach a funding level of 120% instead of the 100% traditional plans aim for. And the second is to allow trustees to make benefits cuts before the situation gets out of control, but only as a last resort.

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“While reducing past benefits is never easy,” said the report, “taking this step at the first sign of a long-term imbalance will prevent plans from ever facing the dire funding crisis that currently plagues the multiemployer pension system.”

As many as 117 multiemployer pension plans covering 1.4 million participants are underfunded by $56.5 billion, and could become insolvent within the next 20 years, according to actuarial consulting firm Cheiron.

The report includes a case study intended to evaluate how a composite plan would have performed during the financial crisis of 2008 compared with a traditional pension plan.

“Our case study illustrates how the key composite plan features can provide greater long-term benefit security than current pension plans,” said Shapiro.

The hypothetical case study focuses on a defined-benefit pension plan that was 75% funded immediately prior to the 2008 market crash. The plan assets are assumed to have declined by approximately 26% from the 2008 market crash, and the plan also experienced an immediate 10% reduction in its level of covered work.

The case study assumes that following the 2008 downturn, the trustees of the plan took several actions to improve funding levels, include cutting the rate of benefit accrual earned by active participants by 40%, and scaling back early retirement subsidies applicable to non-retired participants, which resulted in a 5% reduction in overall plan liabilities.

Additionally, a series of mandatory contribution rate increases were implemented that resulted in 4.5% annual increases in rates for 2009 through 2012, 3.5% annual increases for 2013 through 2016, and 2.5% annual increases after that.

Despite the steps taken, the study says the funding level of the plan would have continued to trend downward, and even the generally favorable investment returns that occurred between 2009 and 2020 would not have been sufficient to stabilize the plan, which would have entered critical and declining status due to its projected insolvency.

However, if the plan had been subject to the 20% funding cushion that applies to composite plans at the beginning of 2008, its assets would have been 15% higher than they were under the current funding rules. However, even with the additional 15% of assets held by the plan, these measures would have been insufficient to return the plan to financial health. The case study therefore also assumes that the trustees would have reduced accrued benefits by implementing an across-the-board benefit reduction of 5%. The benefits could be restored later if the plan recovers sufficiently.

According to the case study, the higher funding target and ability of the trustees to proactively reduce benefit levels would have produced a 2020 funded ratio of 84%, opposed to a 48% funded ratio in the baseline scenario. The baseline traditional pension plan was projected to fully exhaust its assets in less than 15 years following the 2020 plan year, while the composite plan was projected to be fully funded over a 10-year timeframe.

Additionally, the baseline traditional pension plan would have needed to cut benefits by more than 40% in 2020 to be in approximately the same funded position as the composite plan.

“By providing employers with the cost predictability they need to be successful in their businesses,” said the study, “composite plans will achieve greater long-term employer participation than traditional pension plans.”