Q: What is meant by a 401(k) and direct contribution (DC) plan?

A 401(k) is a tax-advantaged retirement savings plan offered by employers in the United States, allowing employees to save and invest a portion of their paycheck before taxes are deducted. It is one of the most common forms of Defined Contribution (DC) pension plans. According to the US Bureau of Labor Statistics, 67% of private industry workers have access to a DC plan. As of 2022, there were 754,862 DC pension plans in the US with 121.3 million participants. The total assets amount to USD8.1tn.

Q: How could those already invested respond to new investment opportunities under the recent executive order?

Since retired participants are unlikely to allocate to PMs, given their need of recurring income and their relatively unpredictable time horizon, it is the active participants who are likely to be primarily affected by this executive order. In 2022, there were 92.6 million active DC plan participants. While the exact value of their assets is unknown, if they represent 76% of the total participant base, their assets could amount to USD6.2tn. It is difficult to forecast how much active participants in a DC pension plan would allocate to PMs. By comparison, US defined benefit pension funds allocate between 2%–16% to private equity. 

Q: What factors could influence the extent to which active DC plan participants allocate capital to private markets, and what could be the potential impact on private market assets under management?

Three dimensions must be considered when it comes to the behaviour of active DC participants:

1. The age of the participants. The younger they are, the higher they can allocate to an asset class that requires significant patience. Whether they will effectively do so remains an open question.
2. The amount they can effectively invest. The younger they are, the lower the accumulated amounts are too. For Baby Boomers, the average 401(k) balance is circa USD 250,000. For Generation X, it is circa USD 192,000, while for Millennials it is circa USD 67,000, and for Generation Z it is circa USD 14,000.
3. The proportion of the savings allocated to PMs to effectively have an impact on the overall results, and to be able to reach the minimum threshold to invest in PM funds. Assuming that the latter would be set at USD 10,000, and to ‘move the needle’ on returns would probably require an allocation of at least 5%–10%, then a 5% allocation would add USD310bn to assets under management in the PMs, while a 10% allocation would double that amount. This high estimate assumes that all participants would invest in PM. Some industry surveys point to a potential participation rate of 50%. This would lead to an addition of USD150bn to USD310bn.

Q: What type of investment structure is best suited for enabling DC plan participants to access private markets?

The most adapted vehicle for participants in a DC plan is probably an evergreen (open-ended) structure. It is operationally simple as it only requires a single cash transfer upon subscription and provides an immediate and continuous exposure to PMs. It also offers redemption features necessary for the portability of such accounts. Moreover, an evergreen fund is usually accessible with relatively modest amounts.

Q: What could be the systemic impact of allocating DC pension capital to private markets?

The assets under management of PM evergreen funds are estimated to be USD300bn to USD400bn. The high estimates based on the 5%–10% allocation mentioned above would effectively double or triple this amount. It is unclear if PM evergreen funds can absorb such an influx. Best practices imply that closed-end and evergreen funds invest pro rata in given PM transactions. If the latter were suddenly to collect significant additional capital, it would be more difficult to maintain such discipline and alignment of interests.

The dynamics of fundraising would also be altered, favouring the brands and large institutions able to address the intricacies of the DC pension market. This might channel the capital into larger PM transactions, which are already competitive and thus might yield even lower returns. The overall assets under management in PM funds would increase by 1.8%–3.5% from USD17.5tn to USD17.8tn to USD18.1tn. Although this increase seems manageable and somehow innocuous, it could have a significant impact on private markets. 

The USD310bn to USD620bn potentially coming from DC pension plans would thus increase this total by a high estimate of 8.2%–16.5%. If this fresh capital flows into PMs over a short period of time, it will significantly alter the landscape. Notably, the performance of PM investments could be adversely impacted, as valuations would rise purely due to increased demand, regardless of underlying fundamentals. 

Q: What are the key regulatory and governance challenges that need to be addressed before private market funds can be integrated into pension plans?

So far, many questions remain unanswered when it comes to the inclusion of PM funds into DC pension plans. Regulations and rules have yet to be drafted, and the devil is in the details, notably when it comes to fiduciary responsibilities.

Clear guidelines and safeguards would be welcome, notably when it comes to the commercialisation of PM products to DC pension plans. It would be important to ensure equal treatment of investors in PM products regardless of the structure chosen, and to safeguard the discipline and alignment of interests provided by the joint investment of closed-end and evergreen structures.

Q: What does this new reality mean for private investors?

Assuming that this executive order leads to a significant influx of capital into private markets over a short period of time, private investors are advised to exercise caution. They should prioritise strategies less vulnerable to these capital flows - particularly those that are difficult to replicate through evergreen funds. Additionally, they should consider working with specialised managers who employ differentiated investment strategies and demonstrate strict discipline in asset pricing and capital deployment.