President Trump says he wants to democratize retirement by allowing 401(k)s to invest in so-called alternative investments, or strategies outside stocks and other traditional investments, such as private equity and cryptocurrencies.
The executive order signed by Mr. Trump on Thursday would open the door to higher-risk investments landing in your 401(k). It could also potentially serve as a game changer for the $5 trillion private equity industry, which for years has wanted to gain access to America’s retirement plans.
The move has the potential to shake up the typically staid menu of investment choices provided to workers through their employer-sponsored defined-contribution plans, which include 401(k)s and 403(b)s, with the latter aimed at teachers. The change might appeal to some savers, given that alternative investments can provide protection from market swings while also providing the potential for outsized returns. But there are several catches to be aware of, experts say.
Alternative investments such as private equity and cryptocurrencies “have matured into a strong-performing asset class delivering excellent long-term returns, so this is good news for Americans,” Simon Tang, head of U.S. at Accelex, a private markets specialist, said in an email.
But there are caveats, experts say. For one, some alternative investments carry higher risk profiles than traditional asset classes, and offer less transparency about their performance on a day-to-day basis. It’s also unclear whether or not employers will want to offer such investments given the risks.
Here’s what to know.
What does the executive order change about 401(k)s?
The president’s order directs the Labor Department and other agencies to redefine what would be considered a qualified asset under 401(k) retirement rules.
Americans’ retirement plans are governed by the Employee Retirement Income Security Act of 1974, a law better known as ERISA. Under that regulation, employers are required to offer retirement options that are in the best interest of their employees, not Wall Street.
Most retirement plans for Americans are made up of stock and bond investments, and to a much lesser extent, cash and heavily traded commodities such as gold.
Workers would still be able to limit their investments to traditional assets like stocks and bonds, and would also be able to opt out of adding new alternative strategies to their portfolios.
When could those changes become effective?
It’s unclear, but it’s likely going to take months or even longer given the complexity of ERISA.
After the Labor Department provides its new guidance, it will take time for major retirement plan companies such as Fidelity and Vanguard to develop appropriate funds for employers to use.
Employers will also likely need time to revise their retirement plan options, so it may take several years before crypto and private equity become mainstream investments in individual retirement plans. Whether employers and their workers will opt to invest in these asset classes is another question, experts added.
“While asset managers are salivating over the idea of tapping in to a portion of the $12.5 trillion in defined contribution assets, we believe adoption will be slow due to cost, transparency and complexity,” said Pitchbook analysts in a report written to provide an analysis of some aspects of Mr. Trump’s order.
How risky are these investments?
All investments carry risks, but alternative asset classes come with additional pitfalls that heighten their potential for volatility. For instance, private equity invests in companies that are not publicly traded, which makes it difficult to know on a day-to-day basis whether the investment is up, down or sideways.
“When it comes to investing in stocks, retail investors are used to instant pricing, clean data and daily performance updates,” Tang said. “Private markets are a different ballgame. There’s no real-time information, no ticker and no standardization, just fragmented documents and unstructured formats.”
Cryptocurrencies, for their part, may have more transparency on pricing, but they can also be extremely volatile, with major shifts in valuation from day to day. That said, cryptocurrencies have grown increasingly popular, with about 1 in 4 people investing in crypto, according to Security.org.
Do alternative investments outperform stocks and bonds?
Alternative investments can outperform stocks and bonds, but there’s no guarantee.
For instance, bitcoin last year jumped 135% in value, compared with a 24% increase in the S&P 500. But in 2022, it was another story, with bitcoin dropping 65% while the S&P 500 lost 19%, one analysis shows.
Private equity investments, meanwhile, returned 13.5% over a 10-year period, outpacing the 9.7% return for stocks and a 1.9% for bonds over the same period, according to a recent study.
While the potential for outsized gains may appeal to some investors, alternative investments also tend to carry higher costs, such as pricier fees for fund managers, which can eat into returns.
“Higher costs come from the fact that while you can trade a stock for pennies, it requires travel, negotiations, legal work, and much more, to buy and operate a private company. These costs are typically passed along to fund investors,” Pitchbook said.
