August brought news of a potential change on the horizon for investors in 401(k) and 403(b) retirement plans who want more investment options – think diversification and a broader menu to select from – to potentially grow a retirement nest egg.
The White House’s Aug. 7 executive order is designed to open 401(k) and 403(b) plans to the possibility of investing in “alternative investments.” These strategies were previously reserved for sophisticated institutional investors such as the managers of pension plans and university endowments, and high-net-worth individuals. The order aims to help everyday workers attain stronger and more financially secure retirement outcomes and build wealth.
Officially titled “Democratizing Access to Alternative Assets for Retirement Savers,” the order instructs the U.S. Department of Labor and the Securities and Exchange Commission to take action within 180 days of Aug. 7 to enhance access to alternative assets for participants in 401(k) and other defined contribution retirement plans. The order also attempts to clear the way for two other hot-topic areas for retirement plans: cryptocurrency and retirement income (annuities).
While big pension plans, endowments and foundations, wealthy individuals and families have benefited from the return and diversification profile of the alternative investments category – private equity, private credit and private real estate, to name a few – these investment options have not been allowed or widely available in 401(k) and 403(b) plans for a number of reasons. These reasons include the employers’ fear of the risk of litigation, as well as factors of complexity, lack of transparency, high fees, minimum investment thresholds and illiquidity.
Critics argue that while it’s tempting to jump into the alternative investment marketplace for potentially higher returns and greater diversification, the risks associated with these alternative investments might expose the everyday investor to less-favorable outcomes and might even damage trust in the financial system.
The questions are plentiful:
• Will these alternative investments be available for 401(k)s immediately? No, while the SEC is mandated to implement the plan on a timeline, even if your plan wants to offer them, new investment options will require months to build and then roll out because of product development, regulatory updates and adjustments by plan and investment providers.
• What form will this investment selection take? It is likely the first-generation investors will see a target-date fund with a small allocation to alternatives. Target-date funds use a mix of asset classes such as stocks, bonds and cash to facilitate retirement planning by systematically modifying their asset allocation as the designated retirement year nears, shifting toward a more conservative investment approach.
• Should plan sponsors add alternative investment options for individual investors to access? As usual, the answer depends on several factors: the range from fees involved, transparency of the holdings, liquidity of the investment, volatility, the makeup of the employer’s workforce and more. Just like with cryptocurrency, it is prudent to undertake a diligent review process of alternative assets. When adding something as volatile, new or opaque as these options, it may be prudent to consider limiting participants’ exposure. (For example: limit exposure to 5%-10% of their balance).
Both investors and plan sponsors must evaluate this significant shift in the retirement landscape, including all options and repercussions. Individuals who are part of their organization’s 401(k) or 403(b) plan are well advised to watch for new products coming to market from retirement plan investment providers, to understand what they are investing in, and to learn how it may differ from the type of alternatives available to institutional investors.
Based in Providence, Jamie Worrell is a co-founder and the managing director of the Northeast office of Strategic Retirement Partners, an independent retirement plan advisory firm. He may be reached at jworrell@srpretire.com.
