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Management firms like Vanguard and Fidelity will now be permitted to invest retirement funds in private equity products.
On June 3, under the cover of viral chaos and civil unrest, the Department of Labor announced that it would allow private equity firms to sell products to individual retirement accounts, including 401(k)s. The impetus was President Trump’s vague, blustery, and deregulatory executive order to “remove barriers” to the “innovation, initiative, and drive of the American people.” But the Labor Department’s rule will do the opposite, exacerbating wealth inequality by sucking a huge pile of money out of the pockets of workers saving for retirement and shepherding it to the few fabulously wealthy owners of private equity firms.
By opening the floodgates to private equity, the Department of Labor will subject individual retirement accounts to private equity’s exorbitantly high fees, while providing roughly the same returns as low- and no-fee mutual funds. Experts suggest that this pointless payout to private equity from these fees––borne entirely by workers––might be in the ballpark of $13.7 billion per year.
Worker money already props up the private equity business model. CalPERS, one of the largest pension funds in the world, has been investing heavily in private equity firms that buy and sell distressed assets for years. Now, Trump’s Labor Department has given the green light for even more worker money to flow into an industry that frequently harms workers, by loading companies with debt, forcing them to cut labor costs to the bone, and frequently bankrupting them, while extracting the last bits of value.
By opening the floodgates to private equity, the Department of Labor will subject individual retirement accounts to private equity’s exorbitantly high fees.
The Department’s rationale for allowing retirement savers to buy products from private equity firms was that these funds perform well. Secretary of Labor Eugene Scalia said in a press statement that letting private equity funds develop products for retirement savers was to allow them to “gain access to alternative investments that often provide strong returns.” But experts disagree. Professor Ludovic Phalippou at the University of Oxford analyzed private equity funds from 2006 to 2015, and found that they don’t earn back the legendary sky-high returns. Rather, the “funds have returned about the same as public equity indices since at least 2006.” One main problem is that the high fees that private equity firms charge, which can range anywhere from 7 percent on the low end to 20 percent for private clients, diminish the returns to investors. These performance fees totaled about $230 billion over the period studied.
If private equity was to sell products to individual investors, their fees would likely be in the range that they charge California’s public-employee pension fund CalPERS, which Phalippou notes is about 7 percent. Eileen Appelbaum, co-director at the Center for Economic and Policy Research and an expert on private equity, told me she thinks 7 percent is at best a conservative estimate. The investments allowed by the government in 401(k) plans would be a “fund of funds,” or an investment fund composed of other private equity funds. This would likely tack on an extra percentage point. Then you add in the standard fee that a brokerage like Fidelity or Vanguard takes for managing the overall 401(k) (which are small and range from 0.21 percent to 0.6 percent, according to Investopedia), and the fees for a private equity product would be in the range of 8.2 to 8.6 percent. Compare this to the more standard index fund, which would have only a minuscule 0.21 to 0.6 percent fee.
The 401(k) market is currently a massive $6.2 trillion, and Appelbaum notes that only a little more than half of that market is invested in the kind of target-date funds and balance funds that the Labor Department made private equity firms currently eligible to sell into. (Target-date funds are often the default option for workers, making that a big potential prize for private equity.) She thinks that for the time being, most financial advisers will not feel comfortable selling private equity products to their clients. Sources indicate that Vanguard and Fidelity, two of the biggest advisers, have thus far declined to move retirement funds into private equity.
But even a small stake in such a giant market would be a windfall for private equity managers. Even if the market settles in at around 5 percent of all 401(k) funds, that would represent a still-giant pool of $171 billion. If 8 percent of this goes to private equity firm fees (less the broker fees), private equity will have charged workers $13.7 billion to deliver returns equal to or less than public equity markets. As Appelbaum notes, retirement savers will suffer from “having all this money taken out that they didn’t have taken out before.”
There are other disadvantages, says Appelbaum. Private equity investments are notoriously risky, lack the financial transparency of public firms, and typically force investors to commit their money for a decade. “There are a lot of downsides,” Appelbaum said. “For the extra risk you’re supposed to get extra reward. But here there is no extra reward.”
Private equity investments are notoriously risky, lack the financial transparency of public firms, and typically force investors to commit their money for a decade.
Another problem is that, even if the top quartile of glitzy private equity firms perform well (which Appelbaum suggests they often do), any retirement product would feature a blend of private equity funds, which likely would include the middling and loser funds, bringing down the prospective return without bringing down the industry-standard, sky-high fees. And as Barbara Roper of the Consumer Federation of America indicated to me, without strong protections for workers from being ripped off by financial advisers, they could easily be talked into these hazardous investments.
Appelbaum stresses that the creation and implementation of the private equity products is likely a little ways off. Financial firms aren’t likely to feel confident selling them right away. Private equity funds also need upfront investments of $5 million to $10 million, which will require asset managers to somehow pool 401(k)s into big investments; this is especially difficult given the speed with which workers change jobs and will need to withdraw funds that private equity firms want to lock up. “Frequent turnover in retirement plan investments makes private equity a particularly poor choice for most retirement savers,” Roper said. And currently, the economic shutdown has distracted private equity with a perverse problem: They have over $1.4 trillion in undeployed capital (known as “dry powder”) that they need to spend.
Nonetheless, private equity firms have been drooling over the tantalizing 401(k) market since at least 2013, Appelbaum says. (She wrote an oracular article in 2014 called “Private Equity Is Coming for Your Nest Egg.”) The Trump Labor Department rule is the fulfillment of a long-deferred dream.
The Labor Department did not return a request for comment on the $13.7 billion annual fee estimate.
Democrats are starting to speak out about the Labor Department’s decision. Michael Gwin, spokesperson for Democratic presidential nominee Joe Biden, gave the Prospect this statement: “While Joe Biden steadfastly supports more equal access to retirement saving incentives and opportunities for wealth building, he staunchly opposes regulatory changes that will lead to skyrocketing fees and diminished retirement security for savers. This regulatory action is another example of President Trump putting the interests of Wall Street ahead of American workers and families.”
If private equity products won’t bring in extra returns for workers, what is the Trump administration after? It looks like they want to use workers’ money to pamper and fashion a new class of billionaires. Many of them, after all, are friends and donors of the administration.
This model has already been proven. Phalippou finds that as they got increasingly involved with pension funds, the number of private equity multibillionaires rose from three in 2005 to 22 in 2020. From studying the private equity industry, he suggests that the use of private equity is a wealth transfer that “might be one of the largest in the history of modern finance: from a few hundred million pension scheme members … to a few thousand people working in private equity.” Under the guidance of the Trump administration, it seems it can only get worse.
