Navigating the New Frontier: The Rise of Private Investments in Corporate Retirement Plans
In the world of corporate retirement plans, a significant shift is underway. For decades, the investment options available to participants in defined contribution plans such as 401(k)s have largely been confined to publicly traded securities like mutual funds, ETFs, stocks, and bonds. These assets offer daily liquidity and transparent pricing, which have long been considered essential for the administrative and regulatory frameworks of retirement plans.
However, a new wave of interest is challenging these long-standing limitations, driven by the desire to "democratize" access to investment opportunities that have historically been reserved for institutional and high-net-worth investors. Recent regulatory guidance from the Department of Labor (DOL) has paved the way for plan fiduciaries to consider including private investments in their plan lineups. This is a game-changer, but it's one that requires careful consideration, due diligence, and expert guidance.
What's Changing? An Overview of New Investment Opportunities
The push to include private investments in retirement plans is rooted in the belief that these asset classes can offer enhanced diversification and the potential for higher long-term returns. Private investments typically have a lower correlation to public markets, which can help to mitigate volatility and smooth returns over time.
The types of private investments being considered are varied and complex. They are generally not offered as standalone options on a plan's investment menu. Instead, they are typically integrated as a "sleeve" within professionally managed, multi-asset class vehicles like collective investment trusts (CITs) or target-date funds (TDFs). These vehicles wrap the private investments in a structure that aims to address the unique liquidity and valuation challenges of a defined contribution plan. The specific asset classes you may see include:
Private Equity: Investments in companies that are not publicly traded. This can include venture capital, growth equity, and leveraged buyouts.
Private Credit: Lending to private companies, often in the form of debt instruments.
Real Estate: Direct or indirect interests in real estate projects, often providing steady income streams and capital appreciation.
Infrastructure: Long-term investments in public assets like toll roads, energy grids, and airports.
Potential Benefits and Concerns for Participants
For plan participants, the potential benefits of this new access are clear:
Enhanced Diversification: Exposure to asset classes with low correlation to public markets can help portfolios weather market downturns.
Higher Return Potential: Historically, private investments, such as private equity, have delivered strong long-term performance, potentially leading to greater retirement savings.
Access to Growth Sectors: Many firms are choosing to stay private for longer, meaning that a significant portion of market growth is happening outside of public exchanges. Private investments allow participants to tap into this growth.
However, these benefits come with important considerations:
Complexity and Lack of Transparency: Private investments are often less transparent and more difficult to value than public securities. Their pricing is not based on a daily market close, which can make it challenging for participants to track performance.
Higher Fees: Private investment funds typically have higher management fees and complex performance-based fees, which can erode returns if not carefully managed.
Potential for Loss: Like all investments, private markets carry risk, including the possibility of capital loss. The concentrated nature of some funds can also increase exposure to specific sector risks.
The Critical Issue of Liquidity
One of the most significant challenges with private investments is their lack of liquidity. Unlike mutual funds, which can be bought and sold daily, private investments often have multi-year lock-up periods. This creates a potential "liquidity mismatch" with a 401(k) plan, where participants expect daily valuation and the ability to take out loans or make hardship withdrawals.
This is why these investments are typically structured within larger, professionally managed funds (like TDFs). The fund manager is responsible for maintaining a sufficient liquidity buffer—often by holding a portion of the fund in public, liquid assets—to ensure the fund can meet participant redemption requests without being forced to sell illiquid assets at a loss.
Who is a Good Candidate, and Who is Not?
The suitability of private investments depends heavily on an individual's financial situation and investment horizon.
Good Candidates:
Younger participants: Individuals with a long time horizon before retirement can better tolerate the illiquidity and complexity of these assets. They have more time for the investments to mature and to recover from potential losses.
Participants with a low need for liquidity: Those who are unlikely to need to access their funds for a loan or hardship withdrawal are a better fit.
Not Good Candidates:
Participants nearing retirement without other adequate liquidate assets: Individuals who are close to retirement age may need more liquidity and less volatility in their portfolios, so they should make sure that they do have other adequate sources of liquidity before investing.
Participants with a high need for liquidity: Individuals who may need to access their funds for financial emergencies are generally not well-suited for these investments.
Increased Scrutiny and Potential Fiduciary Issues
The inclusion of private investments in a retirement plan significantly increases the due diligence and oversight responsibilities of plan fiduciaries. Under the Employee Retirement Income Security Act (ERISA), fiduciaries must act with the skill, care, and prudence of a reasonable expert. While the DOL has provided some guidance, it has not provided a blanket endorsement. This means fiduciaries must be able to demonstrate a meticulous and well-documented process for:
Prudent Selection: Evaluating the private investment vehicle, its underlying managers, its fee structure, and its liquidity management strategy.
Ongoing Monitoring: Continuously monitoring the performance, fees, and operational efficiency of the investment.
Participant Education: Ensuring participants understand the risks and rewards of these complex investments.
A misstep in any of these areas could expose the plan's fiduciaries to significant legal liability.
The Importance of a Professional Investment Fiduciary
Given the heightened complexity and liability, the role of a professional investment fiduciary becomes more critical than ever. The distinction between a 3(21) and a 3(38) fiduciary is particularly important here.
A 3(21) fiduciary acts as a co-fiduciary, providing recommendations and expert advice. The plan sponsor, however, retains the ultimate responsibility for making and implementing investment decisions.
A 3(38) fiduciary, on the other hand, is an investment manager who assumes full discretionary control over the plan's investment lineup. This transfers the liability for the selection, monitoring, and replacement of investments to the professional. While the plan sponsor is still responsible for prudently selecting and monitoring the 3(38) fiduciary, the day-to-day management burden and liability are outsourced.
For plan sponsors considering private investments, partnering with a 3(38) investment manager is often the most prudent course of action. It allows them to leverage the expertise of a specialist while significantly mitigating their own fiduciary risk. This ensures that the plan's investment strategy is managed with the highest level of professional care and expertise, giving both the fiduciaries and participants confidence in the plan's ability to achieve long-term success.
At Emerald Asset Management, we see value in private investments as an asset class for the right investor. We will be paying close attention to the evolution of this proposal and continue to serve our clients with the highest fiduciary standard.
Emerald Asset Management is an independent, boutique Registered Investment Advisory firm based in Rocky Mount, NC, serving successful executives, business owners, and high-net-worth individuals across Raleigh, Durham, and Chapel Hill. As a fiduciary-led firm with over 30 years of experience, Emerald provides research-driven investment management and strategic financial planning. The firm specializes in individually managed stock and bond portfolios, alternative investments, and risk management strategies. With a disciplined approach and a commitment to clarity, Emerald helps clients navigate complex financial decisions with confidence. They can be reached at (252) 443-7616 or on the web at www.emeraldam.com.
The information presented is based on sources believed to be reliable and accurate at the time of publication. This material is for educational purposes only and does not necessarily reflect the views of the author, presenter, or affiliated organizations. It should not be construed as investment, tax, legal, or other professional advice. Always consult a qualified professional regarding your specific situation before making any decisions.
Emerald Asset Management is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Emerald Asset Management's investment advisory services can be found in its Form ADV Part 2 and/or Form CRS, which is available upon request.
