President Donald Trump signed an executive order instructing the Securities and Exchange Commission, Department of Labor, and the Treasury to work on a framework that would allow for the inclusion of private market investments in defined-contribution plans, which could be a good step for these plans’ investors. The executive order also paved the way for the inclusion of alternative assets like cryptocurrency.
The executive order sets in motion the likely formalization of the 2020 Pantheon Ventures/Partners Group opinion letter from the DOL that stated private markets could be included in a qualified plan as part of either a target-date fund or some other managed solution. The letter made clear that such investments should not be directly accessible to plan participants.
The DOL letter was issued during the first Trump administration, so it’s not surprising that this issue reemerged in the form of a Trump favorite: the executive order.
The order also has support from a new raft of government officials, such as SEC Chairman Paul Atkins and recently appointed head of the SEC’s investment management unit, Brian Daly, who have made it clear that they favor the push toward the “democratization” of private markets.
This executive order will likely act as a mild accelerant to getting private markets into the hands of managed solutions providers and, ultimately, into the portfolios of individual investors. However, the path forward isn’t without risks and uncertainties.
What the Executive Order Means for Plan Sponsors
While the DOL opinion letter had no specific legal standing, the executive order shows that forces are afoot to create a well-defined legal framework that should help plan sponsors to feel comfortable with private markets.
However, fiduciary risk remains, as do significant operational hurdles. This is a largely untrodden area of the market.
Plan sponsors, who have been told for years that fees are critical to building plan menus, will now need to get their heads around complex fee structures and double-digit expense ratios. Asset managers and plan advisors will need to contend with frequent contributions and withdrawals, as well as the sometimes unpredictable cash flow needs of defined-contribution plans.
With effort, we believe these hurdles can be cleared.
While private market investments come with higher expenses, there are typically good reasons for these costs, and it is reasonable to assume that fees will be forced down further with time. Asset managers, recordkeepers, and advisors should be able to jointly solve the cash flow problems.
For example, private asset managers would like to know the appropriate liquidity buffer for a given strategy to ensure that it is as close as possible to a private market “pure play.” (There are private/public funds that are primarily public, thus solving—or at least minimizing—liquidity risk. But such vehicles should probably be viewed more as multi-asset-class plays and not a true private market fund. This lack of purity can present challenges for advisors with specific private market targets in mind.)
To this end, the managers, recordkeepers, plan sponsors, and the defined-contribution plan advisor (target-date or managed account advisor) could estimate expected cash flows to a private market vehicle by building a model that simulates participant behavior, the advisor’s allocation model, and extreme market events in an effort to determine the smallest feasible liquidity buffer for a given fund in a given plan or recordkeeper platform.
If, for example, a recordkeeper expects high attrition for a given participant population, the private market fund could hold a significant portion of assets in a vehicle like exchange-traded funds. If low participant turnover is expected, that portion of assets may be less than 15%.
Ultimately, we believe the key players are all keenly sensitive to the significant known and unknown risks of having private investments in 401(k)s. It seems clear that one material hiccup on a plan sponsor’s private market journey could tank the entire proposition for the foreseeable future.
Beyond the executive order, there’s little demand-side pull at this point. Neither the plan sponsor community nor the investing public appear to be crying out for private market exposure.
The push is almost entirely coming from asset managers, who see an untapped $12.5 trillion defined-contribution market on one side and decreasing funding rates on the institutional side. It’s fair to say that the push toward defined-contribution plans would happen regardless of the institutional market, but current events lend some urgency to the effort.
What Private Market Access in 401(k)s Could Offer Investors
If demand is not quite there, will all the effort even be worth it? We think so.
Private markets now account for a substantial part of the overall capital market. There are approximately 25 times the number of individual firms in the private equity space as in the public space. Firms are staying private for longer and coming to the IPO market larger and more mature. Therefore, the growth opportunities available to public market investors have become more limited.
Plus, the public market has become extremely concentrated, with just a handful of stocks driving performance.
And according to the World Federation of Exchanges, the number of IPOs has fallen by 22% over the past five years. Over the same period, global private credit has grown by 60% and is expanding rapidly. With spread compression in the public corporate credit space, the higher payouts of private debt can be particularly attractive for retirement-oriented investors.
The representative asset-allocation model works off of the assumption that an investor has access to the “global market portfolio.” Adding private market investments to portfolios gets us closer to this ideal.
Since their inception nearly 50 years ago, defined-contribution plans have come to resemble the defined-benefit plans they replaced. We’ve seen menus consisting of just a few basic (and often not very good) funds grow to large, diversified lineups and ultimately the entrance of target-date and managed account solutions. The inclusion of private markets is another step along this path.
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