Democratized 401(k) Plans Warrant Caution

Wall Street firms and others are ramping up to offer a slate of alternative investments­—such as private equity, cryptocurrency, and other nontraditional assets—for inclusion in participant-directed 401(k) and other defined-contribution retirement plans.

In August, President Trump gave the Department of Labor 180 days to begin “democratizing” access to alternative assets for 401(k) plans. It sounds great, but investors should be cautious when deciding whether alternative investments are suitable for their retirement plans.

Alternatives are a large asset category and can be an attractive part of a diversified portfolio, providing the opportunity to mitigate risk, generate enhanced returns or provide attractive streams of income. For instance, hedge funds seek to control risk exposures through hedging strategies. Private equity and venture capital represent the potential for enhanced returns through the long-term growth of businesses. Other “alts” provide opportunities for income, such as private credit, commercial real estate or energy royalties.

Alts provide many opportunities, but its sectors do business in closed markets that can be difficult to navigate for newcomers or naïve players. Closed markets also mean less liquidity, often with an unknown time horizon to realize value. Because of these intricacies, fees for management groups can be high. It is critical that those high fees are paid to skilled managers who can justify and earn those fees.

Unlike a pension fund, which operates in perpetuity and usually has a sophisticated investment team, a 401(k) is a unique investment plan with a finite life and required distributions based on set formulas. Configuring a long term, illiquid asset into such a structure creates challenges. Solving for those problems may dilute an alternative asset’s benefits. Further, creating a structure appropriate for these strategies may require higher fees. Finally, top performing managers are often capacity constrained and have ample access to capital and therefore may likely remain closed to 401(k) investors.

Bottom line: As with any investment, be sure to understand the risks, do your due diligence on the managers and assess fees carefully relative to the opportunity.

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