The private equity industry is lobbying the incoming Trump administration to allow 401(k)s – and, presumably, IRAs and other tax-deferred accounts – to include private equity funds. Americans have $11 trillion sitting in their retirement accounts, so it’s understandable that the private equity industry wants to get its hands on some of that money.
I’m torn on the idea.
On one hand, I believe in the free market and the idea that consenting adults have the right to make their own decisions as long as they don’t infringe on the rights of anyone else.
On the other hand, despite their strong track records, these funds will probably not turn out to be good investments for most people.
Let me explain.
Private equity invests in startups, real estate deals, loans, and other esoteric investments that typically need to be held for years to see a payoff. They’re often reserved for wealthy, sophisticated investors who have the time and resources to wait for these investments to run their course.
The investments are usually higher-risk, but private equity investors generally have enough money to shrug off any deals that don’t work out.
These investments can also be complex, and the average investor likely will not understand what they’re investing in. Think of how many people buy annuities without grasping all the intricacies of how they work. Private equity is just as much of a mystery to most investors.
Now, private equity actually has a very good long-term track record. It has beaten the S&P 500 over the past five, 10, 15, and 20 years. Over the last decade, the Pitchbook North American Private Equity Index returned 17.3% annually, versus 11.9% for the S&P 500.
However, private equity is illiquid. At a certain point, investments in 401(k)s and IRAs have to start being liquidated due to mandatory withdrawal requirements, and some investors may withdraw additional money as they need it. But private equity investments usually don’t pay off based on a specific timeline, so they would limit investors’ flexibility in their retirement accounts.
Furthermore, private equity funds often charge high fees – normally around 2% of the assets managed plus 20% of the profits if they’re above a certain level. Most mutual funds in a retirement account charge around 1%. Index funds usually charge around 0.2% or even less.
Lastly, private equity is hard to value. If you own a mutual fund, you know exactly what that fund is worth at the end of each day. Individual stocks, bonds, and ETFs’ values are calculated in real time.
A private equity fund’s value is much harder to figure out. How do you know if you’re getting a fair price when you buy or sell the fund? Or even what it’s worth on any given day? It makes planning for retirement more difficult if you don’t even know how much your account is worth.
I believe it’s likely we’ll see private equity funds become available in retirement accounts in the next couple of years. But unless you have experience with these funds or can tolerate significantly higher risk, I suggest you avoid them.