Here’s why Trump’s proposed 401k executive order may be very bad news for your retirement

Amidst the other recent headlines about his signature, you may have missed the news that Donald Trump plans to sign an executive order in the coming days that will allow defined-contribution plans like your 401k to include private market investments.

If you’re not the sort of person who views a mutual fund prospectus as light beach reading, this may sound like the kind of boring story that only your crypto-obsessed brother-in-law might care about. But this is serious business that could have repercussions on your retirement—especially if you’re not paying attention.

This proposed policy could be sending us down the same bumpy road that knocked the tires off of company-sponsored pension plans, dramatically increasing retirement insecurity for most American workers. Here’s what you need to know.

What’s in the executive order?

The specific details of the forthcoming executive order (EO) remain hazy. But most experts agree that the president will probably use the EO as an opportunity to formalize the 2020 Pantheon Ventures/Partners Group opinion letter from the Department of Labor.

This letter, issued during Trump’s first administration, suggests that private equity investment options could be included in defined-benefit plans (i.e., 401k and 403b plans and the like) as part of a target-dated fund or other managed fund. The letter also emphasizes that plan participants should not be able to directly access private equity investments.

It’s likely this letter may serve as a blueprint for the EO that crosses Trump’s desk in the near future.

What’s private equity?

Private equity is an investment in a privately traded company by an accredited investor or group of investors who take on a controlling interest in the organization. Though typically lucrative, private equity investing is often characterized by a long time horizon and a lack of liquidity. Private equity firms often charge high fees and expenses, and they may not disclose conflicts of interest.

Let’s look at these specific characteristics:

Private trading

Private equity is an investment class that is not available to the general public. This is unlike shares in publicly traded companies that anyone can purchase on the open market.

Accredited investors

An individual may be considered an accredited investor if they have earned $200,000 (or $300,000 with a spouse) for each of the past two years, or if they have a net worth of over $1 million excluding their primary residence. This means you’re only allowed to invest in private equity if you can be relatively sure you won’t be completely wiped out if you make a single bad investment.

Controlling interest

Typically, private equity investors take a controlling interest in the company and work to actively manage the business in order to increase its value.

Illiquidity

Private equity investment requires a long time horizon and most private equity funds will impose limits on when an investor can withdraw their funds. These limits will often last years.

Fee structure

Private equity funds come with fees and expenses that can be confusing, opaque, or just plain undisclosed.

Conflicts of interest

Private equity firms can and do have interests that conflict with those of their investors and the funds they manage. Though the SEC has proposed stronger rules for Private Fund advisers, and the commission does enforce what it can, investors must remain vigilant for the possibility of conflicts of interest.

So what’s the problem with private equity?

There are some very good reasons why defined-benefit plans have always been closed to private equity. At its best, private equity is an effective tool that can help companies restructure and position themselves for future growth. This is what Dell did in 2013.

But too often, private equity functions more like the “Bust Out” episode of The Sopranos, where Tony drives his friend Davey’s sporting goods store into bankruptcy by maxing out debt to purchase inventory the mobsters peddle for a profit. Sears and Toys “R” Us are two examples of companies that didn’t survive their private equity adventures. Those two bankruptcies eliminated 70,000 jobs, and company pension plans were eventually frozen or terminated.

Why add private equity to 401k plans?

There are $12.2 trillion worth of assets in U.S. defined contribution retirement plans. Private equity would appreciate getting a foothold in an investment sector that has traditionally been cut off from non-accredited investors.

Proponents of the idea claim that allowing 401k investors to include private equity in their defined contribution plans will give them the opportunity to enjoy the higher returns that are typically restricted to accredited investors. But detractors worry that private equity is too risky and illiquid an investment class to have in a workplace retirement plan—which is where an employee would take a hardship withdrawal during a tough economic time.

Critics like Elizabeth Warren have called private equity predatory and demanded stronger regulations.

Why not just ignore it?

If investing in private equity isn’t your cup of tea, it may seem reasonable to simply put the matter out of your mind. You just won’t invest in any of the private equity target-dated funds and your 401k will continue chugging along.

The only issue with this plan is the fact that opening the door to private equity in our defined contribution plans will also make the employers sponsoring those plans more vulnerable. Under the Employment Retirement Income Security Act (ERISA), employers have a fiduciary responsibility to make sure the investment options in your 401k are prudent and that any fees are not onerous.

Plan sponsors have traditionally been leery of private equity in 401k retirement plans because of their illiquidity, complexity, opacity, and high fees, which leaves them open to ERISA lawsuits. Considering the fact that ERISA lawsuits against excessive 401k fees have risen to a near record high in the past year, employers have good reason to be worried.

Yes, this does mean that everything is working as planned. Employers are supposed to take fiduciary responsibility for their employees’ retirement plans, and when they don’t, the workers can file ERISA lawsuits against them–and win. So far, so good.

But the creation of ERISA 50 years ago, including the much-vaunted litigation portion of the law, may have contributed to the decline of pension plans.

If it ain’t broke . . .

Placing even more complex fiduciary responsibility on the shoulders of employers could have similar unintended consequences that we can’t yet see. Average 401k savings rates and balances have recently been at record highs. As pensions have declined, and more Americans are feeling nervous about the future of Social Security, do we really want to open up defined contribution retirement plans to a new class of under-regulated, risky investments?

The average retirement investor simply has no need of private equity in their 401k.

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