Episode 28 – Should your 401(k) Invest in Private Equity and Crypto?

[MUSIC PLAYING]

Welcome to Market Perspectives, a Mercer Advisors podcast. Today’s episode is the executive order on 401(k). I’m Josh Zumbrun. I’m the Director of External Communications here at Mercer Advisors, and I’m joined today by Don Calcagni, our Chief Investment Officer. Don, thanks so much for being here today.

Great to be here, Josh. Thank you.

So earlier this month, President Trump signed an executive order that has the potential to add really surprising new offerings to people’s 401(k)s.

And the two options that have gotten the most attention are private market investments, private equity, private credit. We’ve talked about those a lot on the podcast. Investments that aren’t traded on public markets, they’re going to be able to be available in people’s 401(k)s.

And the second one that’s getting a lot of attention is crypto. People will be able to make some crypto type investments in 401(k)s.

Correct.

So, it’s going to take some time before, these options actually show up in most people’s 401(k). There’s a lot of rules and regulations that need to be sorted out, and we’ll dig into that. The upshot here is that at some point, people might have these as options in their retirement accounts, their workplace retirement plans. So, Don, start us off. Give us an overview of what exactly was announced here last week.

Yeah, so the president’s order specifically is really under this banner of democratizing access for 401(k) investors to alternative investments like private equity, like you referenced and cryptocurrencies, but also a range of other things like direct real estate and things like that. So that’s really the headline of this new executive order is to really democratize access and provide different investment choices or new investment choices to 401(k) plan participants.

Now, let’s take these asset classes one at a time, that are going to be showing up in people’s 401(k). Let’s start with private equity. And let’s talk about this like just in general. We’ll get to whether they belong in for 401(k) in a second. But like we’ve talked before on the podcast about the risks and potential opportunities in private markets. So, let’s walk through that again a little bit for our listeners.

Sure. And Josh, I think you’re right. I think we have to first disentangle for a moment, what is the investment case for private investments, for example. And then it’s a separate question around whether or not they belong in a qualified 401(k) plan environment. So I mean, the investment case for private investments, at least in our view, remains quite strong.

Over very long periods of time, private investments have delivered higher returns to investors than public investments like mutual funds and ETFs. And we expect that to continue going forward. We think the expected returns on private investments, whether that be private equity, venture capital, or private credit, we think those expected returns going forward are going to be higher in private markets than in public markets. That’s number one.

And that’s not just your view right. I mean JP Morgan’s long-term capital market assumptions. I think this is very likely to be the case. This is a widely held idea.

Correct. This is not unique to me or to Mercer Advisors in any way, shape, or form. I think most capital market experts expect that for good reasons, that private investments should have higher expected returns than the returns on public investments. And you and I have discussed that before on prior podcasts, and I know we’ve written articles on that in the past.

Number two would be that the diversification ability. So, diversifying beyond just public markets, the economy is broader. President Daniel Gourvitch talks about investing in the full economy. And I like that concept, because there’s so much more available to investors than what is just available through public markets. And so, I mean, the real idea here, Josh, is higher returns, better risk management through better diversification. Those are good reasons to consider private assets.

There’s a host of other reasons, but at the end of the day, it all really comes down to that higher returns, better diversification. In theory, that’s a really good thing for investors, regardless of who they are and how they would access those particular types of investments.

Something for people to think about. And then what’s the case on cryptocurrency. You wrote a piece earlier this year titled is Bitcoin an investable asset. And your conclusion was not yet.

What’s your latest thinking. What do you mean by investable asset and why is this not quite there yet in your view?

Yeah, no, it’s a great question. And the one thing, even before I start to answer that particular question, is that I think it’s important for listeners to understand that we will always continue to keep an open mind on these things. There are millions of investors around the planet who have invested their life savings into digital assets. And so, as we continue to learn more and monitor developments, we will continue to revisit our views.

But let’s answer your question, what is an investable asset? And at least in my view, an investable asset has an asset pricing model. What do I mean by that? What I mean by that is with an investable asset, you should be able to clearly make a defensible case around at what price you would buy the investment. And alternatively, on the other side, at what price would you sell the investment.

So if you’re looking at McDonald’s or the S&P 500, or a bond issued by Ford Motor company, we can clearly look at that and say, OK, there’s a certain price at which it makes sense to buy. And then there’s also a certain price at which it would make sense to sell those investments, right? Things like valuations price to earnings. Earnings are a cash flow, right?

The challenge with digital assets like Bitcoin is they don’t own anything. There’s no balance sheet. There’s no factories. There’s no real estate. And importantly, they do not generate cash. Cash flows. We live our lives with cash. Good old greenbacks. And the problem is these investments do not generate cash.

I do attend a number of crypto conferences. I was at one in Miami earlier this year, and I asked the sponsor of that conference, I asked him, I said, “At what price would you buy Bitcoin?” He said, at any price.

So I said, OK. And then I said, “At what price would you sell it?” Oh, I would never sell it. That’s not an investment. That’s an ideology.

Yeah.

Right? And so that’s my concern. Now that said, let’s back up. I usually have folks saying, well Don, this is about investing in the blockchain.

Well the blockchain and Bitcoin are not the same thing. Bitcoin uses the blockchain, right? But they are not the same thing. And so I think, from an investment perspective, one, we have to be very precise. We have to be very diligent.

We are fiduciaries. We have a very high standard of evidence before we allocate any of our investors’ capital to any investment. And so, at least in my view, that lack of cash flows, that lack of balance sheet assets, I have no claim on any asset when I own Bitcoin. And so for those reasons, to quote Mark Cuban, “I’m out.”

And so until those things change, or until our view of the world somehow materially shifts for good reasons, I just don’t think it’s our role as fiduciaries to be allocating our client’s capital to cryptocurrencies. Now, whether they do so on their own, I think is entirely up to them. But I don’t think that that’s really our mandate as fiduciaries.

So, you wouldn’t recommend cryptocurrency investments as a core part of anyone’s portfolio, 401(k) or otherwise. But private investments, it’s a little more interesting. You do think there’s a use case for private investments. So walk us through how you would think about, OK, what are the challenges of doing private investments in a 401(k)? Because it seems like this is going to be the option that eventually shows up in people’s accounts, is there’s going to be a private equity fund as one of the options they could select in their 401(k). What kind of needs to happen before we get there, and how would people evaluate it once that option starts to pop up?

So I think the investment case for private assets remains very strong. So for example, with a buyout private equity fund, you own a company. Or rather the fund that you’ve invested in owns a company. And that company is generating cash flows and trying to increase its profits. And therefore the private equity fund manager, the general partner, the GP they’re ultimately hoping to sell that firm either to a public company or to another, larger, perhaps bigger private equity investor at a premium over what they bought the company for. So that’s very, very strong investment case.

Now, the question is now would you take that type of investment and put it inside of a 401(k) plan. Well, that’s a very different conversation. A 401(k) plan in theory, is a very long-term account. It’s not really an investment. A 401(k) plan is an account type. It’s an account through which you own investments that has certain IRS preferential treatment. You’re making this you’re deferring money out of your paycheck, for example, into the 401(k) plan.

Industry leaders. And by industry I mean of the private equity industry have argued and there’s some legitimacy to this argument. They’ve argued that, hey, 401(k) plans are long-term investments. And, hey, so are these private equity funds that we manage. I mean, typically, a private equity fund lasts for anywhere from 10 to 15 years.

And in theory, you could argue, well, a long-term investment inside of a long term retirement plan savings vehicle. OK, logically, that sounds like it makes sense.

I can’t tap that money for until I’m 59 and 1/2 anyways.

Correct in theory. And there’s always exceptions to these things and the exceptions matter. And that’s where I think there are some hard questions that need to be ironed out. Now, to be fair, the president’s order, his executive order directed the commissioners of the Department of Labor, which oversees ERISA plans. ERISA stands for the Employee Retirement Income Security Act of 1974. The Department of Labor is responsible for regulations pertaining to ERISA, but he also directed the Securities and Exchange Commission, which governs investor eligibility requirements, to invest in private investments.

Yeah.

Typically you have to be a qualified purchaser. You have to have $5 million or more in investable assets. I mean, these are SEC requirements generally before you can invest in private investment funds like a private equity fund.

So there’s a lot of questions here that need to be ironed out. The president’s order is directing those two agencies to over the next 180 days to work together to answer these questions and make it easier for 401(k) investors to invest in these assets.

So the devil is going to be in the details. It’s going to take a little bit of time to play out, walk us through at a high level what some of the difficult questions are here that we just don’t know the answer to yet, which for now makes it very hard to say yes, this would be a good idea for some 401(k). Or like, no, everyone should avoid this.

[CHUCKLES]

There are so many questions here, Josh that need to be answered. First and foremost, at a very basic level, private investments are very complex. Knowing a good one from a bad one, from a mediocre one is not easy. We have a full time, dedicated team of experts with MBAs and CFA charter holders analyzing private investment funds to determine which ones are good and worthy of investment, and which ones are we going to pass on.

When you think of the typical 401(k) participant, when you think of the typical human resources department that’s tasked with providing investors education on these things. That’s a tall order. That’s a tall task.

Many planned participants even struggle with understanding what is a mutual fund. What is an index fund like an S&P 500 index fund.

And so legitimately, there’s this big hurdle that needs to be overcome in terms of investor education. Selecting good private equity investments is painfully difficult, even for the very best firms with lots of experience in investing in private asset classes.

And you and I have touched on previous podcasts that there is a very real concern that these smaller investors in plans like 401(k) plans could end up only investing in the things that are left over. Not the very best assets that are typically going to be gobbled up by ultra high net worth and institutional investors. And so that’s the first is that there’s this investor education hurdle that needs to be overcome.

And then secondly, which I think is one of the biggest issues, Josh, is there’s a bit of a liquidity mismatch here. While in theory, a 401(k) plan is a long-term savings vehicle, the average US worker has somewhere between 12 to 15 career changes in their lifetime. So they’re changing jobs 12 to 15 times. And generally an advisor would counsel that, hey, don’t forget to take your 401(k) with you. Maybe roll that to an IRA or roll it into your new employer plan.

So while in theory these are long-term vehicles, the truth is that many, many times investors are only in their 401(k) plan for what, two to four years before they have to liquidate the investments. Because you don’t do an in-kind transfer of your 401(k) assets to an IRA rollover, that there’s a few exceptions to that, but this is not one of them.

And so if you only have really a 2 to 4 year horizon on average, and that’s the average. Some folks it’s even shorter.

That’s not a very long-term time horizon. Remember the typical private equity fund invests capital for 10 to 12 to sometimes 15 years. That’s much longer than the traditional tenure of a US worker at their employer.

So there’s a liquidity mismatch here. There’s also situations where employees are taking loans from their plan. Maybe they’re in the process of a divorce. And there’s a qualified domestic relations order where they have to divide the pension plan, the 401(k) plan with an ex spouse.

So there are many, many situations where participants need access. They need liquidity in their plan.

And I think that runs counter to really what these investments are designed to do. These are long-term investments. So those are just some of the concerns.

I think the last one that I’ll touch on, Josh, is that plan sponsors and advisors to qualified plans are held to an exceptionally high fiduciary standard when it comes to the prudent management of other people’s life savings. And this has been an area where there’s been a lot of litigation over the years where attorneys have gone after inappropriate fees or inappropriate investment choices inside 401(k) plans.

And so part of the order and the president even mentioned this in the order, part of this order is going to have to address liability protections, I would argue, for plan sponsors and for advisors and investment managers to these types of plans. Because if you look at the trend of litigation over the past 20 or 30 years, it has been squarely focused on fees and inappropriate investments.

And so someone could easily argue that these private investments, with their high fees, perhaps could be inappropriate for the planned participants. I already mentioned the investor education challenge that we’re going to have to overcome. So there are some really big issues here that need to first be addressed to our satisfaction before we can seriously consider whether or not it makes sense to include private investments inside of a 401(k) plan.

One of the things that stands out about that right is there’s a pretty big philosophical shift that could be underway here, because for decades of 401(k) industry had been moving towards very simple options with very low fees is the most common standard. And here, you’re talking about introducing an asset class that’s traditionally been quite complicated, had in some cases very, very high fees. And so it’ll be quite a shift for the way these plan sponsors have to think about what they’re doing.

It is a dramatic shift, Josh. Like you cannot overstate how much of a shift this is for the ERISA space, specifically for 401(k) plans. You’re right. In 1980, when the first 401(k) plan was launched, most of those plans originally just owned employer stock. Remember the Old Enron debacle where so many of the employees, unfortunately had their life savings in Enron stock.

As time went on, actively managed mutual funds really became the workhorse of most 401(k) plans. But as the industry matured and financial science began to really document that these actively managed funds really weren’t adding any value, they were just helping fund managers buy new boats that in reality it made sense to shift towards lower cost passive choices like index funds and things like that. So you’re right, that has really been the trend for close to 50 years now.

We are now looking at adding investment choices to 401(k) plans that many times could have fees upwards of 3, 4, 5, 6% annually. When you start to look at the total cost of ownership of a private equity fund. It can be quite high. And again, this isn’t our listeners should be careful. I want to be clear. I’m not arguing against the merits of investing in private investments. That’s why we started our conversation where we did.

We think private investments do have a role to play in a diversified portfolio. But again, manager selection is critical, and you have to be aware of the fact that the fees are exceptionally higher than what they are when you’re investing in public stocks and bonds, for example, through an S&P 500 index fund.

It seems like there’s a real possibility that it’s going to be, very much a case by case, fund by fund sort of decision for people that maybe some people will have their 401(k) plan offer something that’s quite sensible. But some people might end up with options in their 401(k) that are pretty mediocre.

And I’m wondering I mean, it’s going to be pretty hard for individuals to assess which ones they have. They’re not going to see the full universe. They’re just going to see the options in their particular plan. And how equipped are people to assess if they’ve got good options or bad ones?

I would argue they’re not well equipped at all. And this is one been one of the perennial, pervasive challenges in the 401(k) plan space is that plan participants, employees, they’re doctors, they’re accountants, they work in an Amazon warehouse or something like that. They’re not experts in financial markets. They’re not experts in all of these different financial products that are available to them.

And, unfortunately, one of the things we observe across the retirement plan space is that many investors make what are arguably suboptimal choices with respect to their long-term retirement savings. They’re often sitting in cash or maybe a target date fund that’s maybe really not really appropriate given their age or given their risk tolerances. And that’s just with the options that are available today Josh.

Even with simple options, people are making–

Absolutely. Now you start adding a buyout private equity fund. Maybe you’re adding different crypto solutions, different crypto investment choices. These things get insanely complex very quickly. Even financial advisors aren’t really up to speed on average when it comes to private investments.

It’s one of the things we’ve done at Mercer’s is we’ve invested a lot of time and energy in educating our advisors around the use case and the nomenclature, the different financial metrics that are used within private investments versus public market securities. It’s a big hurdle. So even these financial advisors across the industry that 401(k) plan participants are relying on for counsel, oftentimes they are ill equipped to help them navigate the private investment space.

So Don, where are you landing on this overall?

Yeah, at the moment, I’m neither for nor against it, Josh. I don’t know maybe that’s a non-answer. But here’s how I think about it is, first and foremost, I’m always very excited about democratizing access to high-quality investments for investors. Just as a core principle. I strongly support that.

Now with that, though, comes lots of responsibility. With that comes lots of requirements. I mentioned education, I mentioned being careful of fees. I’ve mentioned the liquidity matching and making sure that we have the right investors investing in the right products.

And so I’m excited about this development. I actually do see a world at some point. It’s probably a year or two from now where it could make sense, where maybe there’s some product innovation, where it makes sense to perhaps include that in a very small diversified way in a 401(k) plan. But at the moment, I’m really taking a wait and see approach.

This is an issue where details matter and also understanding incentives. What are the incentives for including these into 401(k) plans and making sure that whatever we’re doing, that it is always in our investor’s best interests.

Well, it’s going to be an interesting road ahead. It’s obviously, something that we’ll have to continue following and seeing how it evolves. It’s going to be a recurring theme, I think.

Don, thank you so much for joining us today to start this conversation. And like I said, I’m sure this is one we’re going to be talking about in the future.

No doubt, no doubt. I think it’s an exciting development, Josh. And it all comes down to the execution. How do we do it. Do we do it in a way that is in the best interests of retirement savers? And so thank you for inviting me on the podcast. I appreciate it.

So if you’re already a Mercer Advisors client, stay in touch with your advisor about this. If you see these options are starting to show up in your 401(k), like we said, it’s probably going to be a while, but don’t hesitate to reach out and evaluate. If you’re not a Mercer Advisors client but you’re interested in more information, don’t hesitate to get in touch. Go to our website, merceradvisors.com.

It starts with a phone call. This is definitely an issue we’ll be continuing to follow. But until next time. This has been Market Perspectives.

[MUSIC PLAYING]

PLAYING]