Ways the Private Equity Industry Could Make or Break Your 401k

Make an informed decision about how to invest your 401k.

Pensions used to be major retirement plans that invested in private equity. Because pensions have been disappearing and 401ks are taking over, private equity companies now want to tap into your 401k funds.

Investing your 401k funds in private equity might benefit you — and might not. Keep reading to find out how and why private equity companies are trying to make it happen — and explore the roadblocks they’re encountering. When you’re allocating your 401k, make sure you look long-term as you find the best investments for your portfolio.

401ks Could Open Private Equity to Average Investors

Private equity firms typically cater to companies, institutions and high-net-worth individuals. The average American investor doesn’t really have much of an option to invest in this asset class.

“Many advisors build into their client portfolios an allocation for alternative investments, which would include private equity and venture capital,” said Sean McComber, president and CIO of Divergent Private Wealth Advisors LLC. “But these investments have traditionally been reserved for high net worth individuals because, as they say, it takes money to make money — and it’s the wealthy who are most likely to have extra money to put at risk in these types of investments.”

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Private Equity Offers Higher Returns

Defined benefit plans — like pensions — usually have better returns than 401k plans in the long-term, according to a study by the Center for Retirement Research at Boston College. Unfortunately, pensions and similar defined benefit plans are going away and defined contribution plans are replacing them.

Private equity’s pitch focuses on the fact that it offers greater returns than traditional 401k allocations such as mutual funds. In fact, the private equity industry has experienced 13 percent annualized returns — after fees — over the last 25 years, according to advisory firm Cambridge Associates’ U.S. private equity index. Standard & Poor’s 500 index had annualized returns of just more than 9 percent over the same period.

“There are private equity companies that are successfully diversifying away some of the inherent risks in this space, and Bain Capital, Greenspring Associates and Evercore are three that immediately come to mind,” said McComber. “Companies like these have excellent due diligence processes, develop extraordinary expertise in certain fields and leverage world-class professionals to manage their processes and portfolios.

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Higher Returns Might Come at a Higher Cost

A private equity investment has its drawbacks; for instance, it typically charges higher fees than those associated with traditional mutual funds that comprise 401ks. Also, because more investors are getting into the private equity market, fees are going up.

Hedge funds have had to reduce their fees, but the new interest in private equity has enabled it to maintain fees at around 2 percent, which is what hedge funds typically used to charge. Higher fees could raise the cost of your 401k investment, but there’s another downside to investing in private equity: You’ll be taking on greater risk than you would with typical 401k allocations.

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“The biggest challenge I’ve seen with these investments is an addiction to the projected returns,” said McComber. “I’ve seen it from investors and company principals alike, and it’s the mindset where they say, ‘Why would I put my savings into traditional investments like stocks and bonds when I can put it into — or keep it in — this company and make two to five times more what I would get from a traditional portfolio?'”

Allocating part of your 401k in private equity investments might present a dilemma. “There’s nothing wrong with this strategy in my opinion, and I do think that average Americans should have access to these types of opportunities to grow wealth,” said McComber.

“As advisors, we strive to counsel our clients that above-average returns means above-average risk and only a small portion of the portfolio should go into this high-risk allocation. I would be fearful of the average investor having access to private equity and venture capital in his retirement plans on a DIY basis, without the guidance of an advisor to temper their exuberance in this space,” McComber said.

Time Horizons Could Hinder 401k Private Equity Investing

Private equity investments pose another obstacle to 401k allocations in terms of “time horizons,” or the amount of time you plan to hold your investment before you cash out. When it comes to defined benefit plans like pensions, time horizons are fairly lengthy, to the tune of 10 or 20 years. That time horizon complements a private equity fund well, which has an upfront investment and a long-term payout.

But a 401k plan is not designed with the same expectations. Instead, a 401k plan enables investors to switch where they allocate their money much more frequently.

Private equity could produce high returns for your 401k investments. The question of risk, however, is more pertinent than ever because this is not merely an allocation in your portfolio, it’s the foundation of your retirement funds.

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