DB Plans’ Experience Provides No Playbook for DC Plans to Incorporate Private Equity

For U.S. defined contribution plan sponsors looking to include private equity assets among their investments, the country’s largest private defined benefit pension funds offer few insights, according to new research from the Morningstar Center for Retirement and Policy Studies.

Morningstar researchers considered information from the 20 largest defined benefit plans that allocated to private equity over a 12-year span—2009 through 2020. The research found no consistent approach that defined contribution plan sponsors can implement.

“There’s not a consistent approach that can be taken from the DB pension side and immediately implemented in the defined contribution or 401(k) side,” explains Lia Mitchell, a senior analyst of government affairs at Morningstar. “There’s not just one solution, one answer [informing DC sponsors] ‘This is going to be the correct allocation,’ the correct way to go about doing it on the 401(k) side, which I’m sure is not the answer plan sponsors want to hear.”

Morningstar’s analysis paired data on pension plans with additional data and insights from PitchBook on PE funds, which allowed Morningstar researchers to identify the PE funds in the DB plans’ portfolios. The methodology was designed to provide a more holistic measure of performance than internal rate of return, performance quartiles or benchmarking a single fund in a strategy, according to the paper.

The report ultimately determined that it is difficult, with the tools available, to determine the best way to include PE in DC plans.

“Under [the Employee Retirement Income Security Act], the prudential duty for pension and DC plans must meet a high bar, and the lack of transparency in the PE market makes this duty difficult to meet,” the authors wrote. “If a PE index fund existed, such an option could potentially be a great addition to a DC or pension plan.”

DB Learnings for DC?

Morningstar’s analysis, “Does Private Equity Enhance Retirement Investment Outcomes? Evidence from the Experience of Pension Funds,” found significant variations in DB plans’ allocations to PE, ranging from less than 1% to nearly 30%.

Investigating the returns of PE funds selected by pension plans mirrors the PE fund universe at large, the paper found.

The “actual results of pension plans that invest in PE indicate that there is no single approach that can be broadly applied to DC plans,” the report’s authors concluded.

PitchBook developed a quantitative framework for assessing the history of private-market managers called the PitchBook Manager Performance Score. Scores range from a low of 0 to a high of 100, and fund families—funds from a manager following the same strategy, potentially across multiple vintage years and unique funds—are distributed across the spectrum in roughly a bell curve, with a center around 50.

“The score allows for more accurate comparisons between managers, as it accounts for variation in vintage years and benchmarks performance against a reasonable peer group,” according to Mitchell.

Examining the fund families found in the 20 pension funds, Morningstar’s data analysis, showed clustering around the middle, with more than 72% of the fund families scoring between 45 and 65.  

Although data show pensions are not clustering below the mean with poor performers, “they are also not consistently selecting the best strategies,” Mitchell wrote. ”While this is not a particularly surprising finding, it does not bode well when contemplating how private equity could show up in defined contribution plans like 401(k)s,” she says.

Notwithstanding the operational challenges involved with incorporating PE into DC plans, Mitchells says examining the potential risk-reward benefits of private equity and how such assets could be incorporated into DC plans did reveal “pension plans were not better than average at identifying the best performing PE fund families; and plans generally did not concentrate their positions with specific PE managers,” she wrote in the report.

Meanwhile, swapping target-date-fund equity allocations for private equity investments in DC retirement plans resulted in more participants being able to retire at age 65 without running short of money in retirement, found Employee Benefit Research Institute research published in 2022.

Research and Methods

The Morningstar research was authored by Jasmin Sethi, associate director of policy research and government affairs at Morningstar, and Mitchell.

Researchers identified the largest 20 pension plans with PE exposure, as measured by AUM reported under Schedule H on the Department of Labor’s Form 5500 in 2020 and used other fields on the Form 5500 to capture investments in private equity, Mitchell explains.

“We took the largest plans by assets from those that passed this filter,” she says. “Then, to calculate the specific private equity allocation for each plan, we reviewed the financial statements attached to each year’s filings to avoid overestimating by using solely the data available in the structured Form 5500.”