The Risky Business of Alternative Investments in 401(k)s

The Biden administration’s recent executive order aiming to expand retirement savings options could open the door to alternative investments like private equity, venture capital – even potentially investments in companies like Elon musk’s SpaceX – within 401(k) plans. While proponents tout the potential for higher returns, financial experts warn these investments are significantly riskier, less obvious, and come with substantially higher fees than traditional retirement plans.

Higher Fees and Hidden Costs

Currently, the vast majority of 401(k) assets are held in mutual funds with average fees of just 0.26%, according to the Investment Company Institute. Alternative investments, traditionally the domain of institutional investors and wealthy individuals, operate under a different model. Private equity, for example, often employs a “2 and 20” structure – a 2% annual management fee plus 20% of any profits generated.

“I don’t think people are talking enough about the potential for higher fees,” says Philitsa Hanson, head of product, equity and fund administration at Allvue Systems. The executive order, she adds, “raises more questions than answers. Someone will need to be very thoughtful about how these types of assets can be incorporated” into 401(k) plans.

Jason Kephart,an analyst at Morningstar,points out that these fees aren’t always straightforward. “They might be even underrepresenting the actual cost to the end investor, and I have a hard time seeing how plan sponsors are going to get agreeable with that.” He anticipates increased scrutiny and a demand for greater openness in fee disclosures.

Liquidity and Transparency Concerns

Beyond fees, a basic challenge lies in the illiquidity of these assets. Unlike publicly traded stocks and bonds, private equity and other private assets aren’t traded on open exchanges.This makes it arduous to assess performance on a daily basis and understand the factors driving those results.

“It’s been all about cutting fees, doing no harm,” notes Dmitriy Katsnelson, deputy chief investment officer at Wealthspire advisors. “It’s going to take a while for people to come up with a framework to make this work and think about the risks.”

Hanson highlights a technical mismatch: “You’re asking systems designed for daily trades to support illiquid and sometimes manually priced assets. There’s a fundamental mismatch there.” This lack of liquidity also complicates portfolio adjustments and could pose challenges for investors nearing retirement who may need access to their funds.

Investor Education and Suitability

The shift towards alternative investments necessitates a significant increase in investor education. According to Cerulli’s Bailey, the typical retirement fund investor “is not sitting there thinking about optimizing their portfolio” and considering the impact of adding private assets to the mix on their risk or potential return.

Blackstone President and Chief Operating Officer Jon Gray recently emphasized that private assets are generally more suitable for younger investors with a longer time horizon. This raises questions about the appropriateness of offering these investments to those closer to retirement.

The Path Forward: New Products and Increased scrutiny

For alternative asset managers to successfully tap into the vast pool of 90 million investors and trillions of dollars in employer-sponsored retirement plans, they will likely need to adapt. This means developing new products with lower fees, greater liquidity, and increased transparency.

Plan sponsors will also need to carefully evaluate the risks and benefits of incorporating these assets, ensuring they align with the best interests of their participants. Increased regulatory oversight and a focus on clear, concise disclosures will be crucial to protecting investors and fostering confidence in the evolving landscape of retirement savings.