Private equity and other private market investments may provide greater returns and greater diversification to defined contribution plan investment lineups, but questions of cost, transparency and portability present challenges to acceptance by sponsors and participants, according to Morningstar.
"While the nature of private-market investments, such as private equity, are aligned with the long horizons of many participants in principle, the cash flow flexibility with which the typical DC-plan sponsor is comfortable and that of a private-market fund manager are not naturally aligned," said a Morningstar report outlining the pros and cons of private market investments in DC plans.
"Additionally, the very nature of private markets with their high fees, limited liquidity, complicated cost structure, and often opaque reporting could prove a tough hurdle for plan sponsors even with the allure of increased diversification and potentially attractive returns," said the report released Nov. 13 by the Morningstar Center for Retirement & Policy Studies.
One key issue is measuring how assorted private market assets such as real estate, farmland, nontraded debt and commodities could be evaluated alongside publicly traded investments, Morningstar said.
"Unfortunately, analyzing and modeling private-market investments is particularly challenging because the pricing mechanism is completely different than that of public markets," the report said. "The defining feature of private markets is that they are thinly, if ever, traded. They trade among a tiny number of participants under cover of light regulation. Price discovery, to the extent it really exists here, is minimal."
If there is no effective way to measure the correlation between private market assets and publicly traded ones, then "there is no meaningful comparison" with portfolio construction models for DC plans, the report said.
Liquidity "may be less of a challenge," the report added, if there is cooperation among advisers, record keepers and plan sponsors to make sure participants are aware of this issue.
"One clear challenge is addressing a plan lineup change," the report said. "If a plan sponsor leaves a platform, how and when do investors get their money back? What sort of agreements between the parties are needed prior to investing to ensure a smooth, litigation-free process?"
Morningstar said plans' experience with guaranteed income contracts could provide a template for dealing with these issues affecting private market investments.
The market for private market investments in DC plans "is at its launch point," Morningstar concluded. "Making plan sponsors comfortable with the higher pricing, lower liquidity, and less-straightforward reporting will be a hurdle, but hardly insurmountable."
