The risk of private equity in your 401(k)

0:01NPR

0:11This is The Indicator from Planet Money. I'm Darian Woods. And I'm Paddy Hirsch. Private equity. To some people, private equity funds are sober agents of efficiency and corporate optimization. To others, they're a horde of asset-stripping barbarians, intent on draining every penny of value out of vulnerable enterprises like, I don't know, local newspapers and Little League. Yeah, the phrase private equity brings a lot of emotion. And whichever side of the fence you're on, the point is they are private. They're mysterious, risky and expensive. Not the kind of thing your average investor should be sticking their nose into, you might think.

0:48Except that's not what the president thinks. It appears Mr. Trump thinks we can handle private equity. Which is why he's reportedly on the point of issuing an executive order that could allow investment plans like your 401k, Darian, to include a private equity option. On today's show, we'll look at the potential risks and benefits of 401k investments in private equity, why the president might be issuing an executive order to make it happen, and whether he even really needs to. That's all coming up after the break.

1:28a suite of over 80 institutional quality bond funds, actively managed by a 200-person global team of sector specialists, analysts, and traders. They're designed for financial advisors looking to give their clients consistent results year in and year out. See the record at Vanguard.com slash audio. That's Vanguard.com slash audio. All investing is subject to risk. Vanguard Marketing Corporation distributor. Support for this podcast and the following message come from Mint Mobile. At Mint Mobile, their favorite word is no. No contracts, no monthly bills, no hidden fees. Plans start at$15 a month.

2:08Make the switch at mintmobile.com slash indicator. That's mintmobile.com slash indicator. Upfront payment of$45 required, equivalent to$15 a month. Limited time new customer offer for first three months only. Speeds may slow above 35 gigabytes on a limited plan. Taxes and fees extra. See Mint Mobile for details. Investment plans offered by companies to workers, like 401ks, typically only invest in highly regulated, publicly traded securities. Stock traded on a public exchange like the New York Stock Exchange or the NASDAQ, or bonds regulated by the Securities and Exchange Commission. The reason?

2:48ERISA. So it stands for the Employee Retirement Income Security Act. This is Anita Mukherjee. She's an associate professor in the Department of Risk and Insurance at the Wisconsin School of Business. ERISA is really important. It's the foundation of a lot of what protects our 401k investments for workers today. ERISA doesn't say investment plan providers can't invest in the racier end of the market. If it wanted to, NPR could give you, Darian, the option to put your money into private equity. If you can't beat them, join them. That's what I would say. They could even give you an option to invest in venture capital, even crypto, but only if it met certain conditions.

3:25Employers and plan administrators must act solely in the interest of participants and manage plans prudently. Ah, yes, the prudent man rule. Indicator listeners know this one. We've got the episode in the show notes. Yeah, so prudence, really it's about, it's a difficult one, right? Because it's just doing what's right for the employee. Doing what's right for the employee. Hmm. Could that include letting me roll the dice on private equity? Well, come on, Darian. There could be value there for certain types of investors. This might be more appropriate for young people. Anna Maria Lussardi is a senior fellow at the Stanford Institute for Economic Policy Research.

4:06She says younger workers who might wish to be more aggressive with their investments, perhaps you, Darian, might welcome the chance to have a wee flutter in the private market. You know, to own a piece of a fund that's invested not in Google or Apple or whatever, but the next Google or the next Apple to indirectly hold a stake in those companies before they go public and before they go to the moon. And this is why also the private equity has offered, by the way, this higher return. We are always going after the higher return, but this higher return comes with a higher risk. And I think something that the investor has to be aware of.

4:43Right, some cold water on my dreams of higher returns with no risk. Anna Maria says private equity funds are inherently risky because of the kinds of companies these funds invest in. We are talking about firms that are not public, are not traded in the markets. And these can be smaller firms and they could also be firms that are more likely potentially to fail. Private companies aren't subject to the same kind of regulation as public firms. They're less transparent. So investors don't have the same ability to assess what their prospects are compared to public companies. And then there are all of the risks associated with the private equity funds themselves.

5:26These are not like your friendly, easy-to-trade, open-book mutual funds. No, sir. It's not as liquid as other mutual funds. Normally, private equity, you know, require investment to stay from 7 to 10 years. Yes, you heard that right. Private equity firms lock up your money for years. And most importantly, the fees are much higher. 2 % for the management fee and 20 % of the profit. It's these risks and restrictions and fees, not any laws against private equity, that have kept employers and plan managers from offering private equity as an investment option to their workers. It just hasn't been prudent in their eyes.

6:07And of course, there is the risk that if workers lost a lot of money because a private equity investment went south, they might sue. And Anita says private equity funds have been lobbying for years to tweak ERISA and nudge the prudence calculation in their favor. Why? Well, because retirement accounts are where all of the money is. Retirement assets in general are just massive, right? Two-thirds of all employer-based savings are in 401k plans. And there's$8.7 trillion in 401k plans. And I think if some of that can be invested in private equity, certainly that would be good for private equity to be able to take on more risks and see if they can get those returns.

6:47Two funds in particular have led the charge to get their sticky digits on your 401k money. The US branches of Pantheon Ventures, based in the UK, and of Partners Group, based in Switzerland. Back during the first Trump administration, these two funds made their case to the Department of Labor, which oversees investment plans. And in 2020, the department wrote a letter back, effectively saying, sure, we don't see why a plan manager shouldn't invest in private equity, so long as they followed ERISA guidelines. Anita says this letter acted as an easing of the restrictions on what plan managers could offer.

7:22The Trump administration made it easier for plan sponsors and employers to invest in private equity without necessarily facing consequences if those investments didn't pan out. The letter gave plan managers some legal cover if something went wrong and an investor sued, in other words. But for the most part, 401k plans didn't take the bait. Especially once the Biden administration later clarified that it didn't think investing in private equity was generally appropriate for a 401k. And this was kind of a bummer for private equity. They had a pretty lean couple of years in 2022 and 23, and they really, really, really, really wanted that 401k money, which is where the Trump executive order comes in.

8:03The intention is to really encourage plans to take a step forward in this direction. We don't know what's in the expected executive order yet, but the general opinion seems to be that it will formalize what the Department of Labor said in that 2020 letter, a kind of presidential nod, if you will, that will give even more cover to companies that might want to offer a private equity investment option to workers. And it is true that some workers might appreciate the opportunity to diversify away from public markets. I mean, since 2000, the number of companies that are publicly traded on the main exchanges has shrunk by 35 percent.

8:40Meanwhile, the private equity market has grown 400 percent. What's more, says Ana Maria Lusardi, many 401k investors have gotten a lot more sophisticated as their retirement assets have grown. As you move along in your career, and if you contribute monthly and yearly, you're starting to get a sizable amount of wealth, right? So we all are becoming, in a sense, you know, potential good investor. Some of these investors may well want to take private equity risks. And private equity sure as heck wants their money. Oh my gosh, a match made in heaven. Well, maybe, but both Anna Maria and Anita agree that private equity isn't ever going to be a big part of the universe of 401k offerings.

9:24It just doesn't really fit that well with the core purpose of a retirement account. It feels like putting private equity in 401k plans might be like putting a Ferrari engine in like a minivan, right? It's sort of, it's not intended to be a way to grow your investments in a wild way to retirement. It's intended to be sort of a steady way to save a reasonable amount for retirement. In other words, even if you're one of the roughly 56 % of 401k investors that actually does check your 401k allocations, don't expect to see a private equity investment option in your plan the moment the executive order is signed.

10:05Both Anita and Anna Maria say it'll take time for plan managers and employers to figure out just what they can offer and to whom and how much legal protection an executive order might give them. The guidelines in ERISA may have been softened around the edges, but they haven't been eradicated. Prudence will still be required. This episode was produced by Cooper Gass McKim with engineering by Robert Rodriguez, who's fact-checked by Cyril Juarez. Kate Kocannon is our editor. The Indicator is a production of NPR. This message comes from EasyCater, committed to helping organizations order and manage food for all their business needs with online ordering from favorite restaurants, employee meal programs, and tools to see and control food spend at easycater.com.

10:53This message comes from Warby Parker. Prescription eyewear that's expertly crafted and unexpectedly affordable. Glasses designed in-house from premium materials starting at just$95, including prescription lenses. Stop by a Warby Parker store near you. This message comes from NPR sponsor, Capella University. With Capella's FlexPath learning format, you can set your own deadlines and learn on your schedule. A different future is closer than you think with Capella University. Learn more at capella.edu.