President Trump has fired the starting gun on encouraging America’s 401(k) plans to invest in private assets but corporate plans remain concerned about fees, structures and litigation. Meanwhile, many defined benefits funds are voicing their concerns about how it might impact access to investments, and alpha, and change the asset class.
President Trump’s latest executive order, the snappily titled “Democratizing Access to Alternative Assets for 401(k) Investors”, is widely viewed as firing the starting gun on increasing sophistication and diversification in the vast $8.9 trillion asset pool held by the country’s defined contribution corporate pension plans.
It is expected to provide a boon for private asset providers who have lobbied long and hard for regulatory support to market their wares to DC funds which overwhelmingly still invest in low-cost, passive strategies.
Moving into private markets brings a multitude of complications for DC funds in the US, not the least because 401(k) funds have seen healthy returns off the back of their existing strategies thanks to record-breaking US equity markets.
Investment executives at DB funds, which increasingly rely on private assets for alpha, are also voicing their concerns about how the private markets landscape could change with the advent of DC investors.
It leaves experts Top1000funds.com spoke to for this story questioning if America’s 715,000 corporate plans will rush to abandon index-tracking stocks and bonds and follow DC investors like Australia’s superannuation funds into global private equity, real estate and infrastructure any time soon.
Most importantly, one reason progress could stall is the executive order doesn’t allay fears among US companies of being hauled in front of the courts for how they manage their corporate pension schemes.
Over the last decade, particularly as dollars in the corporate DC system have swelled to dwarf the $3-4 trillion DB industry, companies like Walmart, Boeing and GE, to name a few, have been tied up in costly and time-consuming class action litigation, sued on matters like fiduciary duty, misusing funds or excessive fees. In part, this litigation has resulted in these funds being more risk-averse in their investment allocations.
In 2024, law firms estimate 60 new 401(k)-related lawsuits were filed (there were 100 in 2020) so that although corporate DC funds are already permitted to invest in private assets, most stick to investing in low-fee public markets and steer clear of alternatives or any kind of innovation lest they invite more litigation.
Trump’s executive order pledges to reduce the regulatory burden and litigation risks that have blocked up the system, and commentators believe new guidance will raise the pleading standards for bringing lawsuits and encourage 401(k) plans to consider the investment merits of alternatives.
But the president’s edict doesn’t explicitly resolve the litigation issue that has evolved into ever-changing lines of attack. As it stands, for most 401(k) fiduciaries, the thought of offering private investments simply creates greater liability risk and raises the spectre of more fee-focused litigation given the higher cost of alternatives.
“If I can invest in alternatives in my DB plan, why can’t I invest in the DC plan?” asks the CIO of a $35 billion corporate plan split between a $15 billion DC allocation with “zero exposure” to alternatives and a $20 billion DB asset pool with 20 per cent in alts, speaking on the condition of anonymity. “This democratizes access and that is good, and I have sympathy for this line of thinking.”
However, the risk of litigation and the absence of a track record of investing in private markets among peer DC funds, means he has no plans to change strategy yet.
“There is no upside to do this first. We will wait and watch and see what happens; let others stumble and stub their toe, and then we might do something.”
America’s largest DC plan the $1 trillion Thrift Savings Plan (TSP) doesn’t intend to alter course either. It runs five funds invested in large-cap and small-cap US stocks, government and corporate bonds, and international developed markets in an investment strategy prescribed by law.
“The TSP will not change how it invests based on recent policy changes,” confirms spokesperson James Kaplan.
“Unless the litigation question gets answered I don’t see a lot of up take from 401(k) fiduciaries,” says Dennis Simmons, executive director of CIEBA, which represents around 118 large corporates collectively managing $2.2 trillion across DB and DC plans. “The cost of alternative investments compared to a passive index fund and the litigation environment the way it is, means the pros and cons of alternative investments just won’t get talked about at investment committee meetings.”
Why state-run DC plans might be more enthusiastic
State-run plans hold much less (estimated at $1.5-2 trillion) of America’s total DC asset pool, but they are more likely to dip a toe first. States like Michigan and Alaska have fully transitioned to DC systems for new employees. Elsewhere, public retirement systems like Florida and Oregon have DC plans alongside their larger DB plans, which already have chunky allocations to private markets. These funds could use their scale and capability in alternatives to port over to their DC participants.
Public pension funds are also governed by different laws from corporate plans which means litigation is less of an issue, says David O’Meara, senior director at WTW, head of DC investment strategy. “There is a question of conflict of interest for corporate sponsors that government investment officers just don’t have when it comes to providing benefits for employees,” he says.
It leads him to flag another potential impediment to corporate 401 (k) flows entering private markets: sponsor enthusiasm. Corporate plans are motivated to use alternatives in their DB plans because strong returns directly impact the balance sheet in an explicit benefit. The company is also on the hook for any pension shortfall but in corporate DC plans, the employer isn’t liable for returns.
“In theory, investments in a DB scheme are solely for the purpose of members, but in reality the better the DB plan investments perform, the lower the cash cost and lower the cost of managing the plan for the sponsor,” he says.
Other factors limiting enthusiasm
Even if President Trump’s order sees off class action attorneys, corporate pension funds need to navigate other barriers to entry that will also test their enthusiasm for change. Alternative assets are harder to value and sell than traditional stocks and bonds and will introduce illiquidity, leverage and opacity, demanding a risk tolerance and ability to withstand losses.
It would be wise for 401 (k) fiduciaries to begin by investing in other assets outside stocks and bonds before jumping straight into alternatives, suggests the anonymous CIO.
“Some plan designers don’t even provide access to emerging markets as an asset class. How many understand the risk of illiquidity?” they ask, pointing to the fact that many sophisticated investors were wrong-footed by liquidity gates during the pandemic. “They were qualified investors. My question is, will people really know the risks they are signing up to?”
Investment teams at DB public sector funds that view 401(k) investors in a similar bucket to retail investors, even though 401(k) plans have an employer-based structure, also flag concerns that they will flock to private assets without fully understanding what they are investing in.
“With so many 401(k) plans in the US, there’s a risk of capital chasing the trend without fully appreciating the asset class or its liquidity constraints,” reflects Anne-Marie Fink, CIO of private markets and funds alpha at the $171 billion State of Wisconsin Investment Board which targets a 35 per cent allocation to private markets in the core trust fund over the long term.
Fees are another potential barrier. Few 401(k) plans have any experience of being charged performance fees. The sector’s hyper-focus on fees and a mentality that lower fees are always better, will make alternatives a hard sell. It requires education and endorsement of new concepts like fees also equating to a higher return or protection on the downside, and net-of-fees value for end savers.
Are fees the problem?
Commentators also flag the risk of additional layers of fees being levied on 401(k) plans, similar to retail products where more intermediaries take a cut and the net return for the final customer is degraded.
CEIBA’s Simmons counters that participants will come to understand the pay-off between returns and fees in alternatives.
“Those that have defaulted will say you ‘go ahead and do it for me’, but those that are engaged and want more diversification and the potential for higher returns understand that comes with a cost,” he reasons.
Moreover, DC funds in Australia and the UK are comfortable with the risk-return trade-off, putting in place the right governance frameworks that include professional boards and skilful investment teams.
In Australia, a 30-year old defined contribution system, funds have seen the benefits of investing in private assets. According to industry body the Association of Superannuation Funds of Australia, the average MySuper fund has a 24 per cent allocation to private assets.
Similarly in the UK, NEST, the country’s largest DC fund, has around 20 per cent allocated to private markets and hopes to increase this to 30 per cent by 2030. It has pioneered an investment approach that includes calling its own tune on the fees it is prepared to pay, including refusing to pay performance fees.
“We wouldn’t work with a manager not willing to offer products at a fee the team feels is justified,” says Rachel Farrell, NEST’s director of public and private markets.
Although 401(k) plan participants may not be sophisticated, the idea that plan fiduciaries, skilled CFOs, directors and treasurers of sophisticated organisations, aren’t up to the job is plain wrong, surmises WTW’s O’Meara. It’s as much of a red herring as the notion that 401(k) plans will suddenly plough into crypto assets, specifically identified as an alternative asset in Trump’s executive order.
“The 401(k) system is using fewer asset classes and has less diversification and less sophistication than any other asset pool in the world not because fiduciaries are incapable but as a consequence of how 401(k) has evolved,” he argues.
Cue another headwind.
In contrast to DB pension funds, the 401(k) system comprises asset allocation structures like target date funds and managed account solutions that are rooted in a mutual fund world. They require investments in the fund are marked to market at the end of each trading day ensuring daily liquidity to rebalance or support plan participants who might leave the company or take a distribution and for this reason are incompatible with private markets.
But proponents argue these structures can still support illiquidity. Cashflows going into 401(k)s are typically positive for the first 40 years and only turn neutral and then negative as people retire. Participants in these funds are unlikely to trade their portfolios and shouldn’t be compared to hot money that moves in and out of asset classes quickly.
Alternatives won’t be offered as separate, designated options in the plan. Instead, participants can wrap illiquid exposures within target date funds selected to match their age, or as part of another co-mingled, balanced fund in a blended and balanced approach.
“401(k) plan participants are as able as any other investors to withstand illiquidity. The idea that funds need to liquidate the entire portfolio in any given day is not a reality and puts an unnecessary constraint on the portfolio,” says O’Meara.
Once again, the UK’s NEST provides a case study in how it could be done. It boldly shaped evergreen investment structures with the UK’s asset management industry to create the type of products that allow it to invest in private markets with the transparency, liquidity and ongoing investment opportunity, it requires.
“In evergreen structures, NEST can constantly monitor deployment, see their pipeline and see money being put to work. In many cases, NEST was the first evergreen fund [a] manager had done, so the structures were really designed in consultation with us,” explains NEST’s Farrell.
Moreover, managers soon realised the cost-saving benefits of not having to raise capital all the time. A saving, she says, which is now accrued to the LP.
Why DB investors are worried
Still, the concept that target date funds resemble institutional asset pools raises eyebrows among DB investment teams, concerned that their ability to access and continue to source some of their most prized returns from private markets will be impacted by a new type of investor that doesn’t have the same long-term horizon.
Like $367 billion CalSTRS’ CIO Scott Chan who oversees a 35 per cent allocation to private markets of which private equity boasts a 10-year return of nearly 13 per cent. Chan says the pension fund will lean into its experience, partnerships and ability to create sophisticated investment vehicles to navigate the next wave of investment into private markets which he predicts will “significantly dwarf” previous flows.
“Whenever the flow of capital starts to happen, it could drive the ability to find excess returns lower,” he says.
It’s a similar story at SWIB where Fink particularly seeks more clarity on how 401 (k) plans will access private equity where SWIB targets a 20 per cent allocation (including private debt).
“We’re cautious about how retail flows might affect institutions so we’re engaging GPs early. The focus is governance, co-investment access and fair fee structures,” she says. “We will continue to advocate for structures that preserve fairness and protect long term returns.”
Texas Retirement System is also concerned about asset managers rolling out new products that will put semi-liquid private market products into the hands of retail investors.
“We are above our allocation to private equity, so we are slowing the pace, but at the same time the largest asset managers are creating products for retail and distribution to deploy products that are coming to market as we speak,” said Neil Randall who oversees TRS’ (overweight) 12 per cent private equity allocation. “Private equity firms with the largest platforms and strongest brands are expected to be the early winners.”
Randall’s main concern involves transparency regarding the amount of retail capital raised alongside institutional capital in a particular fund.
He says the investor aims to work with GPs to devise a cap on the amount of retail money in the same fund they also invest in. Other potential impacts could also be felt in LPs’ valuable co-investment pipeline if retail investors eat into this deal flow.
“Differing time frames could reduce co-investment opportunities,” acknowledges Fink.
As long-term investors do their best to ready for what lies ahead, another concern looms large. They can’t hide their alarm that the policy shift is a result of an executive order.
“An executive order has made this available, but what happens if another executive order makes it unavailable? How do you unwind it? Nobody knows the future,” says the CIO of the corporate plan.
Whatever the future holds, the genie is out of the bottle.
