In the US, a primary way to save for retirement is via employer-sponsored retirement plans. The primary type of these plans is the 401(k) – named after the tax code that established these plans. 401(k)s are in the news these days and a client reached out asking what I thought about the latest hot topic – adding alternative investments into these plans

Current Investment Options in 401(k)s

As noted above, 401(k) plans are the primary savings vehicle for working Americans. They are funded via a combination of employee savings (via salary deferral) and employer contributions (matching or direct funding). Each 401(k) plan offers a menu of investment options. Given the fiduciary responsibility placed on the plan sponsors (ie: employers), there is a meaningful amount of controls and safeguards surrounding the investment selection for the plans. Larger plans will hire advisors and consultants to help them select the investment options (often mutual funds) and those parties will assess the funds for items such as performance, risk, transparency, fees, and liquidity. Most plans will offer 10-20 fund choices, featuring relatively straightforward options that will provide broad based market exposure. Common options including stable value/money market fund, aggregate bond fund, broad equity index fund, international equity index funds, and target retirement funds.

Recent Events

Last week, President Trump signed an executive order directing regulators to issue guidance that would allow employers and plan sponsors to include alternative assets in their retirement-plan offerings.

Alternative Investment Recap

What are alternative investments? As the name implies, they are “alternatives” to the publicly available/liquid investments most of us are familiar which include cash, bonds, and stock. Alternative investments include private equity, private credit, hedge funds, REITs, and more. The argument is these “alternative” options will provide returns and risk that is uncorrelated from public markets, providing investors with diversification and the ability to achieve outsized returns.

Alternative investments are not publicly traded so they do not have daily pricing (or daily liquidity – ie: ability to sell at any minute). They tend to have a longer time horizon but also have a longer “lock up” of funds that corresponds to that time horizon. Take private equity as an example. These investments involve allocating capital to a manager/private equity fund that will take the cash and invest in private businesses. It can take 5-10 years (if not longer) for the underlying investments in these businesses to be monetized, at which point the fund can distribute proceeds back to the the investors.

As Always…It Depends

So what do I think of this proposal? I’ll defer to my favorite answer – “it depends!”

For a select group of investors who have the requisite understanding of alternative investments and their overall risk and return profile, alternative investments in their employer plan might make sense. These securities can produce returns that are uncorrelated to other public investments (providing needed diversification). Further, given the long time horizon of these investments (and challenges in redeeming early without taking a meaningful haircut), alternatives force investors’ hands to stay the course. Said another way, even if you wanted to sell out during a downturn, you likely can’t (where you can always sell your equity mutual fund, even if it is the worse possible time to do so). This can be a helpful governor for certain nervous investors. Lastly, concerns over illiquidity and costs associated with these investments can be muted for investors that have meaningful funds outside their employer plans and/or opt to only allocate a small portion of their 401(k) plans to these investments.

However, for most investors, I would argue this is not a great idea. Why? Investing is complicated. Assessing investment options is complicated. Understanding and evaluating public investment options in a 401(k) plan is complicated. Understanding and evaluating alternative investment options in a 401(k) plan is really complicated. My fear is that most 401(k) plan participants, no matter how many disclosures are provided, may not fully understand what they are buying and may quickly become offsides with their desired risk and return objectives. Further, the illiquid nature of these investments may prevent investors from getting their money out when they need to (unexpected withdrawal or a planned or required withdrawal in retirement). Lastly, these investments are complex and cumbersome to execute, and as a result tend to carry very high fee loads. In some cases, they can outperform public markets net of those fees but that is far from a certainty based on historical results. Given how important 401(k)s are to many savers’, ‘ retirement picture, keeping an eye on fees and net returns is essential. For many, the simplest and most transparent option (ie: public mutual funds) is likely to remain the right answer.

Changes are coming for 401(k) plans and while these plans have employer sponsors selecting the fund options, it remains the responsibility of the end investor to know why they own and why they own it. If alternatives appear in your plan investment menu in the near future, proceed with caution and work closely with your advisor to assess you own situation.