Although private equity has long been recognized for its appealing risk/return characteristics and a means to diversify away from traditional asset classes, inclusion in defined contribution plans has often been limited by structural considerations such as regulation and liquidity. Recent product innovations have reduced those barriers, reinforcing the value for DC plan sponsors of taking a fresh look at the asset class.
To help with this process, we recently published a white paper, Unlocked Potential: Enhancing DC Outcomes With Private Equity, seeking to illustrate the potential impact of including private equity in a target date fund (TDF). The idea was to concretely highlight some of the benefits that sponsors may have heard about, but did not fully consider previously, given the more formidable barriers to inclusion in DC plans.
In the paper, we provide an analysis considering the hypothetical effect of moderate private equity allocations to TDF portfolio outcomes, and then to income streams potentially provided to retired participants through annuity payouts. Some highlights include the following:
- Our return assumptions were based on forward-looking estimates of index results, while fees were roughly in line with industry averages.
- We modeled two hypothetical TDF portfolios with a 40-year glide path.
- Over that period, a hypothetical employee contributed 10% of annual salary (which grew from an initial $26,600 by 3.2% per year thereafter).
- One portfolio included only traditional equities, while the other substituted a 10% sleeve of private equity within the traditional equity allocation.
- The higher return profile and lower volatility of private equity investments improved not only mean return, but also, in a Monte Carlo simulation, the range of hypothetical portfolio returns.
- Private equity boosted the overall wealth accumulation in the TDF, with potential returns increasing anywhere from 63 to 93 basis points (bps).
- An initial 10% allocation to private equity increased portfolio fees slightly (by 14bps), but boosted the net annualized returns by up to 93bps.
- The resulting higher level of wealth accumulation allowed for the purchase of a larger annuity stream, increasing potential monthly retirement income by 19% in a median performance scenario.
Scenario Analysis: Enhanced Asset Accumulation and Maximized Retirement Income
Source: Neuberger Berman. For Illustrative Purposes Only. Inflation-adjusted value is discounted by a 2.12% 30-year breakeven inflation rate. It is assumed the investor purchased a 10-year guaranteed annuity with all account assets at retirement, with a $1 million up-front payment buying a $5,946 monthly payment over 10 years (Fidelity’s average quoted annuity rate as of October 15, 2024). Income replacement ratio is an annuity’s monthly payment divided by pre-retirement monthly salary. The projections or other information generated by this analysis regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. These hypothetical returns are used for discussion purposes only and are not intended to represent, and should not be construed to represent, predictions of future rates of return. Actual returns may vary significantly. Our assumptions are subject to change without notice. Please refer to the additional disclosures and index definitions found in the paper described.
Takeaways
We believe the case for adding private equity remains compelling, extending from the large and growing universe of privately owned companies available for investment, enhanced performance potential and diversification. For many investors who may not qualify for traditional private markets vehicles or may be uncomfortable choosing among more retail-oriented products in the segment, their DC plan may provide an opportunity to gain private equity exposure.
Clearly, the inclusion of private equity in DC plan target-date funds requires due diligence, the navigation of regulatory hurdles and satisfaction of liability concerns tied to introducing new or innovative asset classes. However, as we have noted in previous publications, we believe such issues are surmountable, and ultimately less consequential than the potential advantages that private equity may offer for plan participants seeking more favorable retirement outcomes.
