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Employer-sponsored defined-contribution pension plans, or 401(k) accounts, feature mainly low-cost and highly liquid investment products. 

However, guidance issued this year by the US Department of Labor allows providers of higher-cost and less-liquid private equity investments to offer the products to 401(k) plan sponsors. In June, the DoL clarified that private equity investments are allowed in 401(k) plans if they are within professionally managed asset allocation funds and are evaluated for risks and benefits by the responsible plan fiduciary.

The guidance was issued at the request of Partners Group and Pantheon Ventures, companies that offer private equity funds designed to be included in retirement plans. Pantheon believes that more than 100m US citizens covered by defined contribution plans, with more than $8.8tn in assets, will benefit from the diversity and potential returns of private equity investments.

“Many people understand the dynamics of the shrinking public markets, and that exposure to small and mid-sized companies — especially technology companies experiencing significant growth — is often only available through private investments,” Susan Long McAndrews, a partner and member of Pantheon’s partnership board, said in a statement.

George Michael Gerstein, co-chair of the fiduciary governance practice at law firm Stradley Ronon, said in September that the DoL’s guidance is a recognition that diversification in 401(k) plans is essential. He stresses that the DoL guidance merely provides a framework and not a safe harbour from liability. “While we can expect plan sponsors to follow the letter closely, there may be some reluctance . . . primarily out of concern that including alternatives further exposes them to litigation,” he said.

 Litigation is a perennial risk for plan sponsors and many of the lawsuits faced by 401(k) plan sponsors involve claims of excessive fees. Mutual of Omaha, an insurance and financial services company, as well as consultancy firm McKinsey, are among the most recent plan sponsors to agree to pay millions of dollars to settle lawsuits. Mutual agreed to settle for $6.7m in September, while in August, McKinsey agreed to settle for $39.5m.

Shawn O’Brien, a senior analyst for retirement at research company Cerulli Associates, says plan sponsors will need the help of advisers to understand how private equity products work at a fundamental level and within 401(k) plans. Since the DoL says the private equity investments in 401(k) plans must be within professionally managed funds, where portfolios rebalance automatically according to the investor’s age and target retirement date, Mr O’Brien expects them to be part of target-date funds, at least initially.

In the second quarter of this year, Cerulli surveyed 24 managers of target-date funds, which had a combined $2.4tn in assets. None had private equity allocations in their target-date funds and only 8 per cent of those surveyed were considering including private equity allocations within the next 12 months. “When you look at innovations and trends that take place in the defined contribution market, they tend to occur at a very slow pace,” Mr O’Brien says.

Francesca Federico, co-founder and principal at Twelve Points Wealth Management and among this year’s FT 401 advisers, says educating plan sponsors would be the first hurdle when including private equity investments in 401(k) plans. Advisers who do not have a deep understanding of private markets should not recommend private equity to plan sponsors, Ms Federico says. If the adviser does not work with private equity in their wealth management business, they likely should not do so in the retirement space,” she says.

Advisers acting as fiduciaries will have the same liability and communication risk as plan sponsors when recommending private equity investments, says John Cunningham, the executive vice-president at Alliant Retirement Consulting and among this years’ FT 401 advisers. “If employees do not understand the risk and have losses, they will have attorneys seeking recoveries from fiduciaries, which could likely be the advisers themselves,” he says.

Nevertheless, anything that expands investment opportunities is generally a positive development, according to Mr O’Brien. Among the advantages of including private equity investments in 401(k) plans is the potential for superior long-term, risk-adjusted returns net of fees, he says.

However, Mr O’Brien says the higher cost of private equity investments for the “incredibly price-sensitive” retirement market and the complexity of the investment are among the factors plan sponsors must consider when evaluating them.

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