Allow 401(k) plans to invest in alternative assets

In May of this year, the House of Representatives passed retirement legislation known as the the SECURE Act, by a vote of 417 to 3. If political stars and impeachment schedules align, that legislation may pass the Senate before the end of the year. It would achieve important goals, such as encouraging lifetime income solutions and allowing the creation of groups of small businesses that can offer 401(k)s together. But this legislation fails to address a simple aspect of fairness, which Congress or the Department of Labor should also address.

Wealthy individuals and institutional investors such as pension plans have access to an important kind of investing that most middle-class Americans are denied. This is inequitable, and it leads to worse outcomes for retirement security. Plan sponsors know this, and are trying to change it. They need some help in Washington.

Imagine you work for a company that has a pension plan, but the pension plan was already closed to new employees when you were hired. The good news is your company offers a 401(k) and you are enrolled. You bear some mild resentment for the fact that other employees still have pensions, but you know the world of retirement has changed.

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But then you find out that there is a set of asset classes that the pension plan invests in, but you cannot. Your employer makes investments in the defined benefit plan that include “alternative investments,” such as real estate, hedge funds, and private equity, but you can’t.

Now your resentment is anything but mild, because you see the rank unfairness of this system.

The vast majority of 401(k) plans offer no opportunity to invest in alternative assets, even though they improve investment performance. One of the keys to long-term investment performance is diversification, often called the only "free lunch" in investing. By creating different, uncorrelated returns, investors create healthier portfolios that outperform undiversified portfolios quite handily over time. Alternative investments help investors achieve that kind of diversification.

CEM, an institutional benchmarking firm, concluded that, without alternative investments, DC plan returns underperformed DB plan returns by approximately 110 from 1997 to 2014.

The importance of these different outcomes is enormous. Remember that the person with a defined benefit pension will receive his or her pension whether the pension plan’s investments perform well or poorly. Either way, the employer is still obligated to make good on the pension promise. So, the benefit of these good investments goes entirely to the employer, which then makes smoother or lower contributions into the pension plan. On the other hand, the person with a 401(k) is entirely dependent upon the outcome and performance of the investments in the 401(k) plan.

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One more thing to make your blood boil: wealthy investors have access to these classes whenever they wish, because they are “qualified” or “accredited” and can therefore reap the diversification benefits these investments provide.

So why can’t you have these investments in your 401(k)? It is because your employer is afraid of litigation. The Investment Company Institute (ICI) estimates that there is over $5 trillion in 401(k)s plans. Amounts of money like that attract trial lawyers the way honey attracts bees.

Alternative investments often have higher fees. And it is easy for a lawyer to make it look as if a particular investment has “underperformed.” For example, if an investor chooses a hedge fund for diversification, and the hedge fund generates a 7 percent diversifying return while the S&P returns 10 percent, did the hedge fund underperform? That’s like saying the field goal kicker underperformed the running back, because the kicker scored three points for a field goal and the running back scored six points for a touchdown.

This is an example of trial lawyers' having made the fear of litigation so powerful that you cannot gain the benefits of diversification that is the true mark of a responsible investment portfolio. Without some protection for plan sponsors, trial lawyers will have a field day with this kind of litigation.

There is a solution here, and it is pretty simple. The vast majority of 401(k) funds now go into Target Date Funds (TDFs).TDFs decrease the risk in a 401(k) plan as the participant gets closer to the target date of retirement. And they are run by institutions within parameters and processes that protect individual DC participants from over-allocating to alternatives.

The Department of Labor should issue guidance that makes it clear that alternatives can (and should) be used in TDFs. This guidance would not be a complete safe harbor: employers must still meet a high standard of fiduciary oversight and prudent process, but guidance would keep trial lawyers at bay and offer sensible ways to diversify retirement investments.

If employers, defined benefit pensions, and wealthy individuals can invest in these important, diversifying asset classes, then middle class investors should be allowed to do so too.

Charles E.F. Millard is the former Director of the U.S. Pension Benefit Guaranty Corp.