Investments & Wealth Review — The Last Mile: Alternatives in Defined Contribution Plans

In the latest issue of Investments & Wealth Review (May/June 2025), authors Chip Castille and Nate Palmer, CFA®, examine how private market investments represent the “last mile” in the evolution of 401(k) plans. By tracing the shift from defined benefit pensions to defined contribution plans, they highlight how participants have largely missed out on the diversification and higher returns that private equity, credit, real estate, and infrastructure can provide. Their analysis explores the legal, operational, and fiduciary hurdles limiting adoption, while pointing to evergreen funds and target-date solutions as practical avenues for integrating private markets into retirement portfolios .

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The 401(K) plan, now the cornerstone of retirement savings for most Americans, has an unexpected origin. Introduced in 1978 as an obscure provision in the U.S. tax code, it was designed to supplement traditional defined benefit (DB) pension plans. Over time, however, 401(k) plans largely supplanted DB plans, leading to defined contribution (DC) becoming the dominant vehicle for U.S. retirement savings. This unintended shift has profoundly shaped retirement security.

DB plans, fully funded by employers, feature professional asset allocation and manager selection, provide life-contingent income for guaranteed lifetime security, and include private market investments for attractive returns and portfolio diversification. In contrast, early 401(k) plans, managed by individual employees, had none of these attributes, leaving participants vulnerable to inadequate savings, suboptimal investment choices, and the risk of outliving their assets. Recognizing these shortcomings, policymakers and the retirement industry have worked to retrofit 401(k) plans with DB-like features. The Pension Protection Act of 2006 addressed funding and investment management by promoting automatic enrollment and establishing safe harbors for qualified default investment alternatives, such as target-date funds (TDFs) and managed accounts, which provide professional asset allocation, portfolio construction, and manager selection. The SECURE Act of 2019 advanced life-contingent income by facilitating the inclusion of annuities, offering participants guaranteed income streams.

Despite this progress, one critical gap remains: access to private market investments. These investments, encompassing private equity, private credit, real estate, and infrastructure, historically have shown the ability to deliver higher returns and provide diversification opportunities. In addition, the illiquidity associated with these exposures may be particularly apt here, given the long investment horizons of 401(k) participants. However, the adoption of private market investments in 401(k) plans has been slow, hindered by a narrow focus on fees, lack of off-the-shelf product, and the risk of litigation for plan sponsors.

Integrating private markets into 401(k) plans and TDFs is the next step in the evolution of the 401(k) plan, and it could be an important means to enhance retirement security for millions of Americans.

The Problem of Safe Harbor and Misaligned Incentives

Unfortunately, introducing DB-like features into 401(k) plans faces significant structural challenges. One key barrier is the legal environment surrounding plan sponsors’ fiduciary responsibilities. Under current regulations, if a plan sponsor adopts an innovative investment option and it performs well, participants benefit. However, if the investment underperforms, plan sponsors face significant legal risks from potential lawsuits, even when acting in participants’ best interests. This dynamic encourages plan sponsors to prioritize options that minimize litigation risk, such as "safe harbor" investments, as a prudent measure to protect participants.

This challenge is particularly pronounced for private market investments, which typically carry higher fees than their traditional public market counterparts.

Despite the potential for superior net-of-fee returns and improved portfolio diversity, plan sponsors must carefully weigh the risk of potential lawsuits alleging excessive fees or imprudent selections. To safeguard participants, many plan sponsors historically have opted for more conventional investment options that align with established safe harbor guidelines. Addressing these legal risks is essential to encourage broader adoption of innovative investments like private markets.

The Narrow Focus on Fees

One significant barrier to including private markets in 401(k) plans is the industry’s narrow focus on fees. In the 401(k) world, there is a widespread emphasis on minimizing fees, driven by a history of hidden costs and conflicts of interest. This focus is understandable, because plan sponsors strive to protect participants from excessive expenses and ensure transparency.

However, an overemphasis on fees can overlook the value of net-of-fee returns and the diversification benefits of certain investments. Private market investments, despite often carrying higher fees, historically have the potential to deliver superior returns that can enhance retirement outcomes. Plan sponsors, acting prudently to avoid frivolous lawsuits, may hesitate to include these options due to the risk of litigation over fee structures. According to a 2022 analysis by Bloomberg Law, more than 200 lawsuits were filed in 2020, many alleging excessive fees, with settlements so far reaching more than $150 on just 33 settled cases, underscoring the financial stakes. (1)

Case Study: How Plans Will Incorporate Private Market Exposures

We expect DC plans will incorporate private market investments through both custom, bespoke implementations and through the use of more pre-packaged, target-date and managed account portfolio solutions.

Custom Private Market Implementations

Custom implementations likely will be available only to the largest plan sponsors, typically those that sponsor multiple retirement plans representing several billion dollars or more in plan assets, all held within a master trust. This mega plan structure facilitates the grouping of similar investments together to create asset- class funds across both public and private markets, striking a daily net asset value or price (a process referred to as unitization). This allows large employers to unitize large, preexisting private market programs, typically within their DB pension pools, and make them available across custom TDFs within 401(k) plans. This, in turn, requires a custodial bank separate from the plan recordkeeper, third-party investment consultants, and an in-house investment team with the ability and comfort to pursue the best interest of participants.

The Evergreen Opportunity

We expect most all other DC plans will access private market exposures through investment in evergreen funds, such as U.S. Securities and Exchange Commission-registered interval and tender-offer funds, which feature daily pricing, daily/monthly subscriptions, and quarterly liquidity (typically defined as a proportion of fund assets, most often 5 percent). We believe the evergreen fund structure overcomes longstanding impediments that have largely prevented most DC retirement plans from investing in private market investments due to infrequent pricing, multi-year lockups, and capital calls associated with more traditional drawdown private market fund structures.

Moreover, as evergreen funds add new wealth management clients and assets and further improve underlying investment portfolio diversity, these benefits, namely improved vintage seasoning, scale, and liquidity, will accrue to DC plan investors as well. Financial advisors within the wealth management channel are accessing evergreen funds directly as a component of a broader investment portfolio for wealth management clients; however, we anticipate that DC retirement plans will access evergreen private market funds on a more indirect basis as detailed more fully below.

Target-Date Fund Investment in Private Markets

Although we believe private market investments make good investment sense when made available to plan participants indirectly as a component of a broadly diversified, professionally managed target-date or managed account portfolio, we do not advocate doing so as a stand-alone investment option within a participant- directed DC retirement plan lineup. With respect to both target-date and managed account portfolios, we expect both will attain private market exposure in a similar manner, generally through a collective investment trust (CIT) that invests in a private market evergreen fund along with a public market companion, e.g., public market fixed income or equities, to provide enhanced liquidity to support daily flows related to participant-directed activity.

For target-date solutions, we believe the liquidity companion within these private market CITs generally can be small, i.e., less than 5 percent, because the target- date manager can more actively manage daily flows into and out of other TDF- related investments until month-end subscriptions into and quarter-end redemptions out of the applicable evergreen fund(s). By investing in private market evergreen funds through a CIT, the TDF manager can access additional benefits including the netting of all inflows and outflows across all TDF portfolio vintages and streamlined purchase and redemption of the private markets evergreen fund.

Managed Account Investment in Private Markets

In contrast, given the greater variability surrounding discretionary managed account solutions where each plan participant theoretically could have a unique portfolio implementation, we expect the allocation to the liquidity companion within a private market CIT designed for managed accounts to be higher, likely in the 20–30 percent range. Whether or not a participant has exposure to private markets in a managed account will depend first on the plan recordkeeper, second on the managed account provider, and third on the plan sponsor all assenting to permit access. This likely will occur through a "sidecar" solution, in which investments separate from the plan sponsor lineup are made available to the managed account provider. We expect plan recordkeepers will launch private market CIT marketplaces to streamline and amplify access and uptake of private market CITs through model portfolio, managed account, and especially advisor managed account solutions provided by large retirement plan aggregators.

The Fee Impediment

Introducing private market investments within multi-asset solutions will create a variety of challenges for plan sponsors, from increased fees to notice provisions related to sponsor-directed redemptions; however, we expect all such issues to be readily addressable. Allocating 10 percent to a private market CIT with a 2- percent fee will increase overall portfolio fees by 0.20 percent, but we expect the improvement in risk-adjusted returns and both increased availability through off- the-shelf retirement products and overall use by other plan sponsors will merit their use.

Private market investments are designed for investors with longer investment horizons, arguably making them a perfect fit for DC plan participants who save for as many as four decades during their working years and then typically spend down their savings over the following two decades or more in retirement. DC retirement plans now universally offer participants daily liquidity but evergreenfund formats can readily accommodate liquidity for those plan participants who desire it and provide portfolio diversity and return enhancement for those participants who do not.

Policymakers and regulators can help by providing clearer guidance on evaluating net-of-fee returns and the benefits of alternative investments. Stronger safe harbors for private market investments, similar to those provided for annuities in the SECURE Act, would empower plan sponsors to confidently explore options that enhance participant outcomes and mitigate litigation risks.

Legislative Progress: The Pension Protection Act and SECURE Act

Despite these challenges, there have been significant legislative efforts to improve 401(k) plans and structure them more like DB plans in terms of features and benefits.

The Pension Protection Act of 2006 was a major milestone. Among other things, it encouraged the use of automatic enrollment, which helped boost participation rates. Importantly, it also clarified that employers could use TDFs as a default investment option. This made it much easier to provide professional asset allocation in 401(k) plans, a key feature of DB plans.

More recently, the SECURE Act of 2019 made several important changes to facilitate the inclusion of annuities in 401(k) plans. It created a safe harbor for the selection of annuity providers, addressing a key concern that had previously held back adoption. It also made it easier for plan sponsors to include annuities as a default investment option.

These legislative changes have helped 401(k) plans evolve to better meet the needs of participants. However, the inclusion of private market investments remains a notable missing piece.

The Power of Private Markets

Private market investments, ranging from private equity and credit to real estate and infrastructure, historically have been a significant component of DB plan portfolios. This has been for good reason—these investments have delivered attractive returns and valuable diversification. (2) According to a 2021 survey by the Pew Charitable Trusts, the average allocation to alternative investments among state pension plans was approximately 26 percent. (3)

This allocation has paid off. A 2021 study by Cambridge Associates found that over the 20-year period ending December 31, 2020, private equity delivered an annualized return of 12.3 percent, compared to 8.5 percent for the S&P 500— outperformance of 3.8 percentage points per year. However, 401(k) plans have largely been left out of these opportunities, creating inferior outcomes for participants in the form of lower account balances and a higher risk of outliving their savings.(4)

The Changing Public Market Landscape

The case for private markets in 401(k) plans is particularly compelling given the changing landscape of public markets. In recent years, there has been a trend of companies staying private longer or forgoing public listings altogether. This means that an increasing share of economic growth and investment opportunity is happening outside of the public markets that 401(k) plans can access.

This trend is driven by a number of factors. Private capital markets have grown deeper and more sophisticated, making it easier for companies to raise large sums of money without going public. Many companies also want to avoid the regulatory burdens and short-term pressures of being a public company.

As a result, the public markets increasingly are dominated by older, slower-growing companies and much of the innovation and growth is happening in the private sphere. For 401(k) participants to fully benefit from economic growth, they need access to these private opportunities.

Operationalizing Private Markets in 401(k) Plans

Including private markets in 401(k) plans is not without its operational challenges. Private market investments are less liquid than public market securities, and 401(k) plans need to be able to accommodate participant transactions such as contributions, withdrawals, and loans.

However, we believe these challenges are manageable, especially within TDFs, which are already the default investment option in many 401(k) plans. These funds are professionally managed, making them an ideal vehicle for including private market investments.

Within a TDF, private market investments can be blended with more-liquid public market investments to create a diversified portfolio that meets liquidity needs. The private market allocation can be higher for younger participants with a longer investment horizon and lower for those nearing retirement who may need more liquidity.

Several 401(k) providers and asset managers already are exploring these types of structures. For example, State Street and BlackRock both have filed for regulatory approval for a TDF that includes private markets, whereas J.P. Morgan, Prudential, and TIAA already have launched products that incorporate private real estate into a target-date structure.

These innovations suggest that the operational barriers to private markets in 401(k) plans are starting to come down. However, wider adoption likely will require clearer regulatory guidance and a shift in the way plan sponsors and participants think about fees and value.

Conclusion: A Call to Action

The 401(k) plan has come a long way since its accidental beginnings. Through legislative changes and industry innovation, it has started to adopt some of the key features that made DB plans a path to retirement security, such as professional asset allocation and guaranteed lifetime income.

However, the job is not finished. The next frontier is access to private market investments, which have the potential to significantly improve retirement outcomes. Making these investments more widely available in 401(k) plans could be a game changer, particularly given the changing landscape of public markets.

To make this a reality, we need action from all stakeholders. Policymakers and regulators need to provide clearer guidance and stronger safe harbors to alleviate the fear of litigation and encourage innovation. Plan sponsors, who are dedicated to improving participant outcomes, can build on their efforts by embracing private market investments as regulatory guidance evolves to reduce litigation risks. With clearer safe harbors, they can confidently evaluate higher-fee investments that offer strong net-of-fee returns and diversification benefits. Asset managers and 401(k) providers need to continue developing innovative products that operationalize private markets within a 401(k) context.

The stakes could not be higher. With millions of Americans relying on 401(k) plans for retirement security, we have an obligation to continue improving these plans and equipping them for success. Unlocking access to private markets is the critical next step in this evolution. It’s time to finish the job we started with the accidental 401(k) and build a retirement system that can deliver security and dignity in retirement for all.

Chip Castille is head of product strategy at Wilshire. He earned a BA in journalism from Louisiana State University and an MBA from Loyola University New Orleans.

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Nate Palmer, CFA^®, is managing director, head of portfolio management at Wilshire. He earned a BA in business administration from the University of Washington and an MBA in corporate finance from the New York University Stern School of Business.

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ENDNOTES

(1) See https://news.bloomberglaw.com/litigation/suits-over-401k-fees-nab-150- million-in-accords-big-and-small.

(2)Past performance is not indicative of future results.

(3)See https://www.pew.org/en/research-andanalysis/issue-briefs/2022/05/state- publicpension-fund-returns-expected-to-decline.

(4)See https://www.cambridgeassociates.com/insight/us-pe-vc-benchmark- commentarycalendar-year-2020/.