Can private equity narrow clients’ retirement savings gap?
In June, the Department of Labor issued an information letter giving the green light to defined contribution plans’ use of private equity within asset allocation funds, such as target date funds.
This opens the door for plan sponsors seeking to offer more pension-like investment options to plan participants, who have until now largely been limited to funds that invest in publicly listed stocks and bonds.
This could also offer a path forward for clients caught up in a disturbing national trend: The shift from defined benefit to defined contribution plans in the U.S. has contributed to a significant and growing retirement savings gap – the difference between the savings workers will require to support their living expenses in retirement and what they are on track to save.
In 2017, the World Economic Forum estimated the U.S. retirement savings gap at $28 trillion, representing a 40% share of the global total.
There are myriad and complex factors underlying the retirement savings shortfall. Factors in favor of pensions over DC plans include more complete and comprehensive investment menus — particularly access to the private markets — and private equity as a component of a target date fund held within a DC plan, which may provide retail investors with a safe, responsible way to access the benefits of the asset class.
Fortunately, private market strategies like private equity and private credit may soon become integrated into DC plan investments.
Pensions and other institutional investors have traditionally held meaningful allocations to private market strategies. In 2018, state and local pensions allocated an average of 12.5% to alternative investments, including private equity, according to a study of public retirement systems by NCPERS.
Such allocations seem destined to rise. According to a 2019 survey of global pensions by BlackRock, which found that more than half planned to increase private equity allocations in 2020.
Other institutional investors also hold substantial private equity allocations. The top-performing foundations and endowments allocate more than 40% to private markets — including private equity and venture capital, according to a study by Cambridge Associates.
Including private equity as a component of a target date fund held within a DC plan may provide retail investors with a safe, responsible way to access the benefits of the asset class.
The attractiveness of private equity lies in its long-term performance versus public equities. Over a 15-year period, the Cambridge U.S. Private Equity Index has outperformed the S&P 500 Index, after fees, by more than 400 basis points a year on average, with less volatility. Astudy by research firm Cliffwaterfound that private equity delivered state pensions their strongest asset class returns — 10.05% and 9.31%, respectively — over the study’s 10- and 18-year periods. As such, a private equity allocation offers the potential to both enhance portfolio performance while lowering risk.
Proceed with care
It should be noted that there are good reasons access to private equity funds have historically been restricted to large, sophisticated investors like pensions, foundations, endowments and family offices. The funds are illiquid, the investment minimums are high and the strategies, fee structures and administrative requirements can be complex.
Including private equity as a component of a target date fund held within a DC plan, however, may provide retail investors with a safe, responsible way to access the benefits of the asset class.
Because they are managed by experienced investment professionals at larger firms, target date funds should have the ability to source and conduct due diligence on private equity funds and determine an appropriate allocation that will balance return and risk goals alongside illiquidity and fee considerations.
To be clear, adding private market exposure to DC plans will pose challenges. DC plan fund flows are less predictable than they are in pensions and participants can freely switch between funds. As a result, target date fund managers must find ways to balance liquidity with the performance enhancement potential of private markets.
Even more important, however, will be educating plan sponsors about the important characteristics, benefits and considerations of investing in private markets and the importance of performing due diligence on any fund making a foray into private markets.
The move to defined contribution from defined benefit plans shifted the burden of saving and investing from employers to employees without giving workers the robust tools needed to assume that important responsibility.
Given that the objective of target date funds is to help provide investors with adequate retirement savings, any appropriate investments that can help achieve this goal should be accessible to them.
Enabling target date and other diversified asset allocation fund managers to access the same investments that have long been available to pensions could help these managers deliver returns for participants that are stronger and steadier than those that can be achieved in the public markets alone.
Over time, this move may help workers close the retirement savings gap and mitigate the risk of outliving their savings.