Public pension funds are able to boost their returns by using alternative investments, including private equity. But you need big money—billions—to get into that game, which means 401(k) investors have been shut out. That's about to change.
Over the last decade, private equity, with an average return of 10 percent, has outperformed every other asset class for the biggest pension funds. Private equity firms now are targeting the more than $5 trillion dollars invested in 401(k)s and similar retirement plans.
Most defined contribution plans are run conservatively, limiting the mix to publicly traded stocks and bonds. There's good reason for that: Employers and plan sponsors don't want average individuals trading too often or taking too much risk.
But that approach is also part of the reason retirement plan participants are often left in the dust by big pension plan investors. Defined contribution plans generate average returns of just 5.8 percent, according to a study from the Private Equity Growth Capital Council.
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Pantheon Ventures, a global private equity firm with $24 billion in assets under management, claims to be the first to offer private equity exposure within target date funds, which have become the default investment in 401(k) plans.
The firm doesn't expect to be the last, though, as private equity firms race to find new sources of investor assets.
"I would be shocked if our competitors were not working on a program," said Michael Riak, head of defined contribution at Pantheon. "A lot of defined benefit money is drying up."
(Read more: Signs that your 401(k) really stinks)
Pantheon's is marketing its program to sponsors with custom target date funds—unlike employers who offer funds with ready-made target dates, from firms such as Fidelity and Vanguard—though it has begun talks with big fund companies.
"Some fund companies want to differentiate themselves; no one has this right now," Riak said.
While the private equity industry is looking for new asset streams as traditional client opportunities narrow, Riak said, private equity should be used in a 401(k) to deliver additional returns uncorrelated to stock and bond investments.
PE has proved over the past three decades that it can do exactly that, he added.
Pantheon's program would be designed to comprise an average 5 percent of asset allocation of a target date fund but could be more aggressive in funds with a longer timeline to retirement, such as a 2030 target date fund.
The private equity allocation is likely to perform best for younger people, Riak said, as it could take half a decade to see returns. That's why PE works well for big pension funds, which have the luxury of time.
"I don't believe that finding newer, sexier investment options—that are also more complex and harder to employ effectively—is the key to helping the majority of Americans. ..."
Just like any retirement investment, private equity carries risks. Because it is uncharted 401(k) investing territory, no data exist detailing the risks or rewards of PE within a target date fund.
Not all financial advisors are keen on the idea.
"I don't believe that finding newer, sexier investment options—that are also more complex and harder to employ effectively—is the key to helping the majority of Americans make better use of their elective, defined contribution 401(k) plans," said Tim Maurer, vice president at Financial Consulate.
Education is a significant hurdle for PE firms hoping to get products into sponsored plans. Both employers and workers will need a lot of hand-holding to deal with an investment class to which they have not had access since 401(k)s were created 30-plus years ago.
Pantheon is still looking for its first client: a large plan with enough scale to get the private equity platform operating cost effectively. Since Labor Day, Riak and his colleagues have met with 50 potential clients.
Looking longer term, firms probably will start offering stand-alone PE retirement funds. When those pitches come, plan sponsors will find themselves in a different ball game in terms of fiduciary responsibility, management and liquidity—an enduring problem with PE investments.
When a large swath of Americans face retirement shortfalls, Maurer said, plan sponsors should be focused on ensuring proper saving levels and reducing plan fees—rather than looking for new ways to jack up returns.
—Anthony Volastro, Segment Producer, CNBC