Why Private Investments Don't Belong in 401(k) Accounts
A new executive order by President Trump may allow alternative investments like private equity, real estate, and digital assets in 401(k) plans.
An executive order released by President Donald Trump last week opened the door for alternative investments to be offered in defined-contribution plans such as 401(k)s. The order instructs the U.S. Department of Labor and other federal agencies to review the regulatory rules that fiduciaries of such plans must follow.
The types of investments listed in the order are:
Private market investments [e.g., private equity, debt (private credit) and other nonpublic instruments];
Real estate (including debt secured by real estate interests);
Digital assets (via actively managed vehicles);
Commodities;
Infrastructure financing projects; and
Lifetime income strategies, including longevity risk-sharing pools (i.e., potentially tontines).
Most of these investments are available to investors through individual retirement accounts (IRAs), Roth IRAs and taxable brokerage accounts. Depending on how exposure is desired, a self-directed IRA may be necessary for some. Private market investments generally require investors to be accredited, which means having a certain level of income or wealth.
While there has been some demand from workers for the ability to invest in cryptocurrencies in their 401(k)s and similar types of plans, there has been little demand for adding private investments. Rather, the desire to include private investments in retirement plans seems to be coming from the industry itself.
The arguments for incorporating private investments are diversification and returns. Private equity ownership, private debt, direct lending and venture capital have historically been used as sources of return and income. These assets improve the diversification of portfolios holding publicly traded securities because they are infrequently bought and sold.
Having started my career valuing privately owned businesses and partnerships, I can tell you that determining the price of a privately owned entity is a matter of estimation. Their values are based on prices from transactions of similar entities.
However, other transactions don’t tell you the actual market value. Consider the price that real estate platform Zillow estimates a house is worth. It does not account for the home’s unique features and shortcomings. Similarly, past transaction prices may not reflect the true value of the private companies held in your portfolio.
Cost and liquidity are also issues that must be considered. All the investment categories listed in the executive order come with higher investment fees. Higher costs diminish returns. Furthermore, private investments have historically come with restrictions regarding the timing and frequency of transactions, including limits on how much can be withdrawn at any given time. This could be a mismatch with retirement plans that have constant inflows and erratic withdrawals. Plus, what safeguards will there be to prevent someone from not being able to access their money if they need to take a hardship loan or move to another job?
Then there is suitability. Many participants in 401(k) and 403(b) plans already do not fully understand what they currently own. Workers who do not understand what a target-date fund is certainly will not understand the risks of direct lending or investing in an infrastructure financing project.