Are alternative assets a fit for a 401(k)?

The U.S. Department of Labor (DOL) recently proposed regulations that would make it easier for individuals with defined contribution plans such as 401(k)s to diversify a portion of their portfolio into investments not traditionally available to plan participants.

Often called alternative assets, these investments include private equity, private credit, hedge funds, digital assets, real estate, and commodities, among others.

The DOL issued the proposed regulations in March in response to President Donald Trump’s executive order last August seeking to remove barriers that have discouraged plan sponsors from offering alternative assets as investment choices in 401(k)s and other defined contribution plans. The regulations seek to ease sponsors’ concern that offering these kinds of investment choices could expose them to fiduciary liability under the Employee Retirement Income Security Act (ERISA).

In view of the proposed regulatory changes, the JofA asked two CPA financial planners whether they would recommend that clients invest some portion of their 401(k) funds in alternative assets if they were offered the opportunity to do so. They highlighted the risks and benefits.

Risks to investors

“To evaluate whether a client should consider alternative investments,” said Robert Westley, CPA/PFS, CFP, regional wealth adviser at Northern Trust in the New York City area, “the starting point for advisers is to understand their client’s balance sheet, cash flows, and their portfolio, including their time horizon — the ability to withstand more complicated investments with greater risk and a longer number of years to liquidity.”

“These are private investments, so they have less oversight than public investments, and there is a higher risk of them not performing as well,” said Kim Clark, CPA/PFS, CFP, principal and wealth adviser at Cerity Partners in Raleigh, N.C.

Less liquidity and longer holding periods

“Many of the funds have longer time horizons, as high as 10-plus years in some cases, compared with public equities that next day settle for cash,” Westley said. “Underlying investments in private equity and venture capital are also illiquid, so there is the risk of a mismatch of the investor’s time horizons.” The lack of liquidity can make it impossible to rebalance a portfolio in response to market changes or take a necessary withdrawal.

Higher and more complex fees

“These fees tend to be higher than investing in passive index funds that track public markets,” Westley said.

Clark agreed. “While today ETFs [exchange-traded funds] generally charge management fees of less than 1%, alternative assets are more likely at 2%, and private-equity fees can be a 2% annual management fee plus 20% of carried interest.”

Valuation risk

Overall, there is less transparency about the value of alternative investments because they do not have daily market pricing and there are less-frequent valuations.

“Unlike public companies that have to do quarterly reporting, it is hard to track the performance of alternative assets compared with the stock market and to look at trends to assess their performance at a point in time,” Clark said. “There is the risk of whether the company is worth what the manager says it is worth, because we do not know.”

“Valuation is not mark to market like public equities,” Westley said. “This can be important for required minimum distributions because distributions are calculated based on fair market value and, therefore, being able to value the retirement account is very important for investors.”

Lack of transparency

“When you invest in an index fund, you know exactly what you are investing in, what index it is tracking, and the proportions of what the fund holds,” Westley said. “For some of these alternative investments, you do not know exactly what is going on within the fund.”

Rewards for investors

More investment options and diversification and hedging

“Alternative investments are a way to provide some diversity from the stock market to a portfolio,” Clark said. “They can be less volatile than the stock market and offer some stable baseline returns that are better when the stock market is in a declining period, but you need to be in the right investment.”

Westley agreed. “These assets can be used as a component of a portfolio because they have a reduced correlation to public markets,” he said. “They move differently than investments in public markets. When public equities are experiencing some hardship and volatilities, private investments have different characteristics that may result in them being flat or up, which offsets some of the volatility in the overall portfolio.”

Enhanced return potential

“Alternative assets can offer enhanced return potential,” Westley said. “For example, venture capital investments in early-stage startup companies with a lot of growth potential offer potentially higher returns compared to large and more mature public companies in public equity markets. Another example is that private credit has potentially higher yields or interest rates than publicly traded bonds and Treasury bills.”

Clark pointed out that certain alternative assets provide good inflation hedging qualities — for example, exposure to real estate. “In times of high inflation, public market equities could decline, but real estate can do well,” she said. “Real estate funds that trade in public markets don’t tend to do that well, but private funds tend to be less risky and perform better.” She also noted that commodities have done very well in the last couple of years.

Cryptocurrencies and digital assets have gotten a lot of attention because of their high rewards and high risks. Westley indicated these investments are an emerging space. “I do think there is a push to have broader access to these in retirement accounts,” he said.

“In my opinion, on a risk scale, crypto is at the bottom of the barrel and should not be more than 1% of a portfolio in a retirement account,” Clark said.

Clark recommends that investors do their own research before investing in alternative assets if they become available in their 401(k) or other defined contribution plans and talk to their advisers to get a second opinion.

Westley observed that alternative assets may be appropriate in certain retirement account portfolios. “Advisers that have high-net-worth clients with access to, or who are already familiar with, alternative investments outside of retirement accounts may assess the pros and cons of holding alternative assets inside their retirement accounts,” he said.

“For someone who only has $100,000, it’s not worth investing it in something that does not have as much visibility as the stock market,” Clark said. “For high-net-worth individuals with millions of dollars, it can be a great option. I encourage my clients not to be the guinea pigs. I have faith in the markets because there are hundreds of years of data about them, which we do not yet have on the private sector.”

— Maria L. Murphy, CPA, is a freelance writer based in North Carolina. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at David.Strausfeld@aicpa-cima.com.