The SEC issued 138 questions to stakeholders. One explores the potential for wider utilization of private equity in 401(k) plans.

"This release is very wide open," said Jasmin Sethi, associate director of policy research at Morningstar and co-author of the firm's comment letter to the SEC.

"It's important to note that when the SEC issues a concept release, it's not issuing a proposed rule," explained Sethi, an attorney who previously served in the SEC's Division of Trading and Markets Division. "They're brainstorming."

Of the approximately 50 comment letters received by the SEC, most were focused on the existing definition of accredited investor, which individuals must meet to invest in exempted private equity funds.

But a couple of poignant letters, including Morningstar's, dialed in on one question from the SEC: If a target-date retirement fund were to seek a limited amount of exposure to exempt offerings in its portfolio, what measures, if any, should we consider taking to enable this?

"The SEC is asking if they should make it easier for TDFs to invest in private equity. And what we are saying is that will be pretty difficult to do," said Sethi.

Morningstar's letter addresses several challenges to incorporating private equity into TDFs.

Measuring and verifying returns on private equity funds before assets are sold is difficult, according to Morningstar.

"Managers do not report returns consistently, and valuations are not computed in a rigorous way," write Sethi and Aaron Szapiro, Morningstar's director of policy research.

"This inconsistency makes it very difficult for a target-date fund considering investment into a private equity fund or a retirement plan sponsor choosing a target-date fund to engage in a prudent process to evaluate whether a private pooled investment is in the best interests of their plan participants, including the private funds that might be offered as part of a target-date fund," they say.

PitchBook, a Morningstar subsidiary, tracks data on nearly 14,000 private equity funds. Accounting practices vary among fund managers, and involve more subjectivity than reporting returns on mutual funds registered with the SEC, according to Morningstar's letter.

Another challenge is the infrequency of pricing and the illiquid nature of private equity investments.

"Although retirement investors are theoretically long-term savers, almost all investments inside employer-sponsored plans feature daily liquidity for good reason," write Sethi and Szapiro.

"The labor force in the U.S. is very dynamic; people leave their jobs and find new ones all the time. Further, participants may need their money for hardship withdrawals or loans. Simply because a worker has a long-term investment time horizon vis-à-vis their retirement does not mean they can give up liquidity," according to the comment letter.

Furthermore, PitchBook's data shows significant variance between the best-performing and worst-performing private equity funds.

Between 2008 and 2018, funds in the top quartile returned 16.23 percent, while those in the bottom quartile averaged 5.19 percent. Those in the bottom decile produced negative returns.

The "idiosyncratic" risk of private equity funds is higher than with other pooled investments, which have a narrower spread in returns. That will spook plan sponsors, already leery of their fiduciary risk, says Morningstar.

"There are real operational challenges, which is why this has not been done," explained Sethi in an interview. "In one sense, private equity is appealing to retirement investors that have a long-term investment horizon. And of course we would all love to get higher returns. If there is a way to do it, we want to do it. But it will require significant infrastructure changes in retirement plans."

The arguments for PE

The Committee on Capital Markets Regulation, a non-profit, nonpartisan think tank that advocates for competitive and stable capital markets, thinks there are ways to address the concerns raised in Morningstar's comment letter.

"In our view, offering exposure to private equity funds is consistent with ERISA's fiduciary duties," the Committee writes in its comment letter.

The Committee argues that volatility in private equity returns has been lower than volatility of returns in public markets, and that including private equity in 401(k) plans can reduce overall risk. The letter also claims private equity has consistently outperformed public markets.

The illiquid nature of private equity could be countered with a "liquidity buffer," which would assure limited allocations to private investments in a pooled fund like a TDF, and rely on cash allocations when participants sell the fund to move to another investment menu option.

Moreover, massive redemptions are not the habit of 401(k) investors, argues the Committee, which is jointly chaired by John Thornton, Chair of the Brookings Institution, Glenn Hubbard, Dean of the Columbia Business School, and Hal Scott, a Harvard Law School professor.

Their letter cites data from Alight Solutions showing that average monthly transfers of 401(k) assets represented only 0.18 percent of savings between April 2017 and June 2018. Trading during 2008 did not exceed historical norms, according to data from the Investment Company Institute.

"By keeping an investment option's allocation to private equity investments modest, plan fiduciaries can be highly confident that short-term flows into or out of an investment option will not result in excessive exposure to illiquid private equity funds," the letter says.

The need for daily valuations on private equity can be met by reporting a daily net asset value of the funds that relies on the most recent valuation, which is typically reported quarterly, the Committee argues.

Clarification from the Labor Department would be needed to make sure investments satisfied ERISA's employer protections in allowing participants to self-direct their investments.

"Without such guidance, the lack of clarity regarding the current ERISA liability framework will continue to unnecessarily force 401(k) participants—most of which are long-term investors—into foregoing returns from illiquid assets, such as private equity funds," the Committee's letter says.

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