Private Equity in 401(k)s: Are the Rewards Really Worth the Risk?

Historically, the realm of private equity has been dominated by extremely wealthy investors, endowments, and pension funds. However, this landscape may be on the verge of transformation.

Individuals saving for retirement through 401(k) accounts are beginning to gain entry into the private investment sector, which primarily focuses on privately owned companies instead of publicly traded ones.

In June, BlackRock, the largest asset management firm globally, revealed plans to introduce a 401(k) target-date retirement fund that will incorporate private investments, set to launch in 2026. Similarly, Empower, another major player in the retirement sector, announced in May that it will include private investments in certain workplace accounts later this year. Other retirement plan providers are also following suit.

According to the Wall Street Journal, the Trump Administration is anticipated to issue an executive order soon, which will seek federal guidance on integrating private investments into 401(k) plans.

Companies that invest in private assets are actively seeking to access 401(k)s and other “defined-contribution” workplace retirement plans, a market valued at $12 trillion.

Private equity firms gather funds to acquire, manage, and sell companies for profit. Typically, their investors are affluent individuals or institutions. The private credit market provides loans to businesses or individuals outside traditional banking and fixed-income sectors.

In the past, ordinary retirement savers have had limited opportunities to invest in private assets. The entry point for a private equity fund often starts in the millions, or at least in the hundreds of thousands, as noted by Investopedia. Additionally, investments may be locked in for several years.

Why wealthy investors prefer private equity

However, endowment managers and affluent investors like private equity funds for a reason.

According to Robert Brokamp, a senior adviser at The Motley Fool, “they actually have done better than the stock market by 1 to 2 percentage points” in recent decades.

According to Investopedia, private equity produced average yearly profits of 10.5% between 2000 and 2020. Other estimates are higher. The stock market, of course, has its own risks, but private equity is seen as a high-risk, high-return alternative.

Why is it appealing to the wealthy? According to Boca Raton, Florida-based certified financial planner Keith Singer, “because it has the highest upside.”

With the benefits come significant drawbacks

Private firms encounter fewer regulations and reporting obligations compared to their public counterparts. It can be challenging to ascertain the earnings of a private firm.

“These are private entities, and that entails reduced transparency,” Brokamp noted. “This is partly why companies choose to remain private: they wish to avoid the extensive regulatory paperwork associated with going public.”

According to Brokamp, the number of public companies has decreased “by about half” since the mid-1990s. Private firms generally remain private for a longer duration and tend to initiate public stock offerings at a later stage.

Investing in stocks carries inherent risks. However, private equity can pose even greater risks.

While stocks are risky, a retirement investor who allocates funds to an S&P 500 index fund is “putting money into some quite established companies,” Brokamp explained.

In contrast, private equity often deals with distressed companies, leading to higher bankruptcy rates.

“Private equity is riskier than public equity,” stated Caleb Silver, editor in chief of Investopedia. “It’s inherently more speculative, as you are investing in companies that, in some instances, lack a proven history.”

Considering the associated risks, Silver advises that a typical retirement saver should limit their investment in private assets to no more than 10% of their portfolio: “It’s simply too risky.”

Some of the new 401(k) options appear to be designed to mitigate that risk. For instance, BlackRock intends to include private investments within a more comprehensive target-date retirement fund.

Target-date funds usually provide a combination of stocks, bonds, and other assets, with the allocation becoming more conservative as retirement approaches. The upcoming BlackRock fund would dedicate only 5% to 20% of its assets to private investments, with that percentage decreasing as the investor ages.

Private equity is often illiquid: Investors typically find their funds locked up for extended periods, sometimes for months or years. In contrast, a 401(k) allows for daily buying or selling of investments.

However, this concern is less significant when private equity is part of a target-date fund, which contains publicly traded assets that can be liquidated if an investor wishes to exit.

In 2020, the Trump Administration released an “Information Letter” stating that 401(k)-style retirement plans could include private equity without breaching federal laws. The legislation mandates that 401(k) managers must prioritize the interests of investors, safeguarding them from substantial losses and high fees.

Is private equity too risky for those saving for retirement?

Some experts worry that the risks associated with private investments might be too high for the average retirement saver.

Recently, Sen. Elizabeth Warren (D-Massachusetts) wrote a letter to the CEO of Empower regarding its initiative to include private investments in 401(k) accounts.

“Given the sector’s weak investor protections, its lack of transparency, expensive management fees, and unsubstantiated claims of high returns, we are seeking information on how your company will ensure the safety of the billions of dollars of retirement savings it safeguards as it implements this program,” Warren wrote.

Empower’s response essentially argued that retirement savers should have the opportunity to access the profitable private investment market after being excluded for so long.

“Empower believes in the democratization of private investing,” wrote Edmund F. Murphy III, the CEO of Empower.

Nevertheless, leaders in the 401(k) sector would ‘feel more comfortable’ with private investments if Congress passes legislation that clearly permits it, according to Thomas Gahan, managing director of Procyon Partners, a financial advisory firm based in Shelton, Connecticut.

Gahan anticipates that more 401(k) providers will start to include private investments as an option within target-date funds, similar to what BlackRock intends to do. “I think it’s a stepping stone,” he remarked.

The 401(k) industry might eventually permit any retirement saver to invest in funds composed entirely of private investments, Gahan noted, but likely not without legislation that specifically authorizes these investments—or an executive order from Trump.

“This will happen over time,” he said, “not overnight.”