Retirement Options Based on Merits, Not Politics

In the last couple of months, we have seen reversals of the prior Administration’s positions regarding retirement plan options. Most recently, the DOL walked back their position on including private equity in 401(k) plans. The DOL cautions plan fiduciaries that, “Except in this minority of situations, plan-level fiduciaries of small, individual account plans are not likely suited to evaluate the use of PE investments in designated investment alternatives in individual account plans.”

This is a departure from the June 2020 Letter that encouraged the inclusion of private equity in retirement plans. The original letter recognized the value of private equity and was motivated to provide retirees with access to the best investment options. The DOL acknowledged that many large institutions, including Defined Benefit Plans (DB Plans), have historically allocated significant portions of their portfolios to private equity based on their return potential.     

The revised positioning isn’t debating the investment merits of private equity, but rather challenging the ability of plan fiduciaries to properly evaluate the options. Therefore, we should be solving for the right issue – and not penalizing retirees by restricting their options. We should double down on the need for more education, better transparency, and comprehensive due diligence. Plan Sponsors may need to engage outside experts to properly vet options.

In fact, the appropriate remedy for private equity is similar to the remedy for another position reversal by the current Administration. The Trump Administration originally imposed restrictions on the use of ESG funds in retirement plans and imposed a higher fiduciary burden on plan sponsors; the Biden Administration subsequently removed the barriers and encouraged better education. Read US Department of Labor proposes rule to remove barriers to considering environmental, social, governance factors in plan management.

Evaluating the Options

The DOL should provide clear and consistent guidance to plan sponsors. Investment options should be based on their investment merits. Plan fiduciaries should consider the role of each investment in a retiree’s portfolio, individually and as part of the overall portfolio. Investment options may be designed to increase return, increase income, decrease volatility, and/or hedge the impact of inflation.

The Role of Various Asset Classes

DB Plans have historically used an expanded slate of investment options to achieve the plans desired outcomes (see below). As the data shows, many institutions, including private and public pension plans, had significant allocations to hedge funds, private equity, private debt, and real assets (real estate and infrastructure). To accomplish the plans goals, they leveraged internal and external experts, to evaluate investment options, conduct due diligence, and determine the appropriate amount of capital to allocate to each investment. They carefully monitor the results of the various options, and periodically make adjustments based on the prevailing market conditions, forward-looking capital market assumptions, and the funds performance.

Asset Allocation by Institutional Segment

Defined Contribution Plans (DC) have typically used less sophisticated investment options. DC plans are typically structured as 401(k) plans, or 403(b) plans, where employees and employers contribute money. In DC plans, retirees can select pre-designed solutions (Target-Date Funds) or make their own selections from a pre-determined menu of options. Depending on the size and sophistication of the Plan Sponsor, the menu of options, and underlying asset classes, can vary a great deal.

Investor Education

In the DOL’s guidance regarding the inclusion of ESG and Private Equity, they cited the need for better education, so investors can make better-informed decisions. I agree with the need for better education -and not just for retirement plans. As an industry, we need to do a much better job in educating investors about the merits of complex strategies – private markets and sustainable investing among others.

Private markets include private equity, private credit, and real assets. Private markets are becoming more of a Main Street investment option (Innovations in Private Markets Blog). Sustainable investing includes Socially Responsible Investing (SRI), Environmental, Social, and Governance (ESG), and Impact investing (Sustainable Investing Blog).

Advisors, asset managers, and plan sponsors should take the lead in educating investors. They should explain the merits of the strategies, and how to distinguish amongst the myriad of options. They should discuss the risk and return characteristics of a particular strategy or asset class – and discuss the performance during different market regimes.

As an industry, we should double down on our educational efforts, to help investors achieve their long-term goals and objectives. Plan sponsors should provide transparency regarding investment options, including:

• The historical risk and return of underlying investments.
• The related experience of the investment professionals responsible for managing the funds.
• For private markets, key structural considerations, including fees, use of leverage, cash drag, and liquidity among others.
• For private markets, the underlying fund composition, including the percentages of liquid and illiquid securities (including secondaries).
• For ESG funds, the screening and weighting methodologies used for selecting securities, and the benchmark used for comparisons.
• For ESG funds, the weighting methodologies across E, S, & G pillars.

 A well-educated investor will make better investment decisions and likely have a higher probability of achieving their goals. A well-educated investor won’t panic when we experience market volatility and will be more disciplined in sticking to their plan. We should focus our efforts on addressing the need for investor education – not on restricting access to options because of the lack of education.

(1) Godbout, Ted, “DOL Clarifies Guidance on Private Equity in 401(k) Plans”, American Society of Pension Professionals & Actuaries, December 21, 2021

(2) US Department of Labor proposes rule to remove barriers to considering environmental, social, governance factors in plan management | U.S. Department of Labor (dol.gov)