President Trump has issued an executive order to permit investors to hold alternative assets in their 401(k) accounts. Among other things, Trump directed the Securities Exchange Commission to amend its regulations to support this order. The intent is to provide an array of investment possibilities, diversification, and more upside for American workers. Those favoring this action believe it democratizes Wall Street, since alternative assets have previously been in the domain of high-net-worth individuals. Pension funds invest in private equity for both diversification and yield.
The announcement from the White House advised that excessive regulation has prevented fiduciaries that manage ERISA-directed plans from offering alternative investments. Alternative assets would presumably include private equity and private credit, real estate, and cryptocurrencies. Today, most 401(k) offerings comprise publicly traded stocks and corporate bonds, Exchange Traded Funds (ETFs), and mutual funds. Typically, they are conservatively developed financial products, unlike the potentially higher-yielding alternative investments.
The spirit of this executive order supporting deregulation of financial services is clear: Over 90 million Americans have employer-sponsored retirement plans. However, there is one word missing from the White House announcement: risk.
Deregulation Risks
First, alternative investments tend to be opaque. Unlike publicly held companies, private equity companies are not required to issue 10-K annual and 10-Q quarterly reports to the SEC, as well as 8-Ks that advise material events. In general, there is less regulatory oversight for private equity. Not only that, private equity tends to be an aggressive, entrepreneurial culture, as opposed to a more staid institutional one.
Second, there is considerable risk in holding publicly traded securities, particularly due to event risk, also called Black Swans. In the week following the 9/11 attacks, the S&P Index lost 14 percent of its value, and the major exchanges remained closed for over two weeks out of fear of panic selling.
From the mid-September 2008 collapse of Lehman Brothers to early March 2009, the Dow Jones Industrial Average lost over 50 percent of its value. During about five weeks in March and April of 2020, the Dow lost 37 percent of its value, and in a two-week period, 30 percent of retirement assets were wiped out. Mark-to-market accounting practices and a lack of counterparties caused assets to be sold at “fire sale” prices.
During financial meltdowns, even high-quality bonds may be sold at a loss, given limited interest in credit instruments. Alternative investments could fare even worse.
Third, most alternative investments are not listed on stock exchanges; hence, they have no liquidity, and there is also no way to determine market value. The intent of a 401(k) is a savings vehicle for later in life when the monies are needed in retirement. But if you cannot exit various alternative investments when you need the cash, what is the point of having them? A possible exception would be cryptocurrencies listed on exchanges; however, even the most well-known of them, such as Bitcoin, is subject to major fluctuations.
Further, as I have written in The American Spectator, monetary authorities have warned that cryptocurrencies are used by criminal organizations to support money laundering, terrorism, and other illicit activities. (RELATED: Facebook’s Cryptofantasy Is a Cryptosetback)
Alternative investments are not for everyone, even though their higher yields have much allure, and they offer diversification. The average 401(k) balances for those between 50 and 70+ years of age are $200,000 to $250,000. Event risk, corporate performance, and general market fluctuations can inflict major damage, and substantially higher holdings are needed to offset this type of investment exposure, particularly due to the potential need for liquidity.
Another factor is that at age 73, one must take a required minimum distribution RMD. One is therefore at risk when trying to sell alternative investments into a thin or virtually non-existent market. This means selling other assets to raise cash, increasing the concentration of alternative investments.
At the end of March, 401(k) balances totaled $8.7 trillion, which is over five times auto loan debt and about the same magnitude as student loan debt, according to the Investment Company Institute of Washington, D.C. The United States does not need a few trillion dollars rapidly migrating into alternative investments. Such an allocation of resources conjures up images of the crash of 2008, which had various contributing causes that are still being debated. But it is safe to say that the expansion of the mortgage industry with rising housing prices, combined with some origination of subprime mortgages, was among the elements of an excessive allocation of capital.
We should hope that guardrails will be established to monitor the shift of capital from “ordinary” investments to alternative ones. Some investment firms periodically monitor their clients’ expressed risk tolerances with respect to time horizon, income versus growth, and liquidity. They also review the experience of their clients with equities, fixed income, options, derivatives, gold, and other investments.
Alternative investments sound peppy and certainly may yield more than traditional ones. But there is something called risk, and the streets — Main Street and Wall Street — are not paved with precious metals.
We must remember this adage: “All that coruscates is not aurific.”
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Frank Schell is a business strategy consultant and former senior vice president of the First National Bank of Chicago. He was a Lecturer at the Harris School of Public Policy, University of Chicago, and is a contributor of opinion pieces to various journals.