A new bucket for the retirement portfolio.
© tsuguliev, ILYA AKINSHIN/stock.adobe.com; Photo illustration Encyclopædia Britannica, Inc.
Everybody wants something exclusive. To find out what’s beyond the velvet rope. What perks and privileges await in the VIP room, and more importantly, how do I get access? It’s a human story as old as time: Access is the prize, whether or not what’s behind the gilded door is actually good for us.
For investors, one such prize has traditionally been alternative investments (“alts”)—the kind that have long been reserved for pension funds, endowments, and the ultra-wealthy. Alts include private equity, private credit, real estate, hedge funds, and cryptocurrency.
Key Points
- Plan sponsors have avoided offering alternative investments for decades due to litigation risk.
- A Department of Labor proposal moves toward a safe harbor framework for plan sponsors, although meaningful change may still be years away.
- Large institutions use alternative investments to their advantage, but individual investors are unlikely to get the same benefit.
Thanks to a U.S. Department of Labor (DOL) proposal, everyday investors may soon find these once out-of-reach alternative investments available as options in their 401(k) plans. Whether that’s a win for the typical investor or a windfall for Wall Street is a very different question.
Why 401(k) plans have avoided alternative investments
Technically, alts have never been banned from 401(k) plans. Beginning with the Employee Retirement Income Security Act of 1974 (ERISA), the DOL has given retirement plan sponsors the ability to consider any investment. So why have they been virtually absent from retirement menus for decades? It’s simple: lawsuits.
Plan sponsors have a strict fiduciary duty to act prudently on behalf of plan participants. In practice, that means adhering a set of core duties, including:
- Duty of loyalty. A fiduciary must act in the participants’ best interests at all times.
- Duty of prudence. Decisions must be made with care, skill, and diligence.
- Duty to avoid and/or manage conflicts of interest. A fiduciary must fully disclose fees and other forms of compensation, and ensure they don’t conflict with the duty of loyalty.
Alternative investments—with their often complex fee structures, lockup periods, and lack of transparency and liquidity—have traditionally made such fiduciary duties harder to demonstrate. One bad investment outcome—or one disgruntled employee—could land a plan sponsor in an expensive lawsuit. From a business standpoint, the risk wasn’t worth the reward.
The DOL’s proposed rule establishes a process-based safe harbor, a framework of sorts that gives plan sponsors legal cover. The rule identifies several factors they must “objectively, thoroughly, and analytically consider” when selecting alternative investments:
- Performance
- Fees
- Liquidity
- Valuation
- Performance benchmarks
- Complexity
If they follow the framework, a plan sponsor is presumed to have met their fiduciary duty.
What institutions know that most individual investors don’t
Institutional investors have known for years that public markets are shrinking, as the number of publicly traded companies in the U.S. has declined dramatically over the past two decades. Not only does this mean fewer choices for traditional stock and bond investors, but much of the early-stage wealth creation that used to happen in public markets now occurs long before a company ever lists on a stock exchange.
Investing for beginners
From stocks and bonds to real estate, alternative investments, and income-generating assets, today’s investors have more choices than ever. You don’t need to become an expert overnight, but understanding the basic building blocks—and how to assess them—can help you feel more confident making your first move. Visit our Learning Journey for beginning investors (and take the quiz).
So by the time the average investor can buy in, the biggest gains may already be gone.
Large institutional investors—think the Harvard endowment, the California Public Employees’ Retirement System (CalPERS), or major sovereign wealth funds—have adapted to this reality by allocating meaningful portions of their portfolios to alternative investments. One reason they can make these investments work is simple: They can afford to wait. Long, illiquid lockup periods that might last a decade or more are manageable when you’re overseeing a portfolio worth billions.
Scale also matters. Big institutions have the leverage to negotiate access to the best fund managers and the best fee structures. They can afford the due diligence, the specialized staff, and the patience that alternative investing demands. For the typical individual investor, none of those advantages come with the package.
The case for skepticism: What’s really driving the push for alternatives
With this push to offer alternative investments to the masses, there’s one question worth asking: Who really benefits?
(Hint: It’s probably not the individual investor.)
It’s more likely that Wall Street, always on the lookout for new ways to generate revenue, has its eyes set on the more than $10 trillion currently sitting in 401(k) plans—and the new fees alternative investments could generate.
Fee layers, explained
Buying a mutual fund already means paying fees behind the scenes. Add alternative investments to the mix, and you’re stacking another layer—or two—on top. You may not see them, but over time, they can quietly eat into returns. Learn more about fund fees and expense ratios.
And that wouldn’t be entirely unreasonable. If individual investors were likely to get the same benefits from alternative investments that large institutions do, it might make sense. But will they?
Probably not. The advantages institutions enjoy come down largely to scale. They negotiate directly with fund managers, securing lower fees and access to top-performing funds. Individual 401(k) investors don’t have that leverage. They’ll pay more—and likely get less.
Just as important, they won’t be investing in alternatives directly. You won’t open your 401(k) dashboard one day and find a private equity fund sitting next to your S&P 500 index fund. Instead, alternative investments will be wrapped inside familiar fund structures, like target-date funds.
That packaging adds another layer of fees and management, which dilutes the very returns that made alternative investments attractive in the first place. You get the complexity and the cost, but potentially not the return.
The bottom line
Although the exclusivity may seem alluring, the typical investor may not see a meaningful benefit from alternative investments—especially after accounting for the added fees and complexity. For most long-term investment objectives, more efficient, lower-cost, and more liquid strategies like dollar cost averaging and allocating to index funds will get the job done.
Experts suggest it may still be years before alternatives make their way into your 401(k). If they do, approach them the way you would any VIP room: with curiosity, a healthy dose of skepticism, and a clear sense of what you’re getting into before you walk through the door.