A major focus of our work is to educate prospective plan sponsors about the differences between the (mostly) liquid pension investments valued at Level 1, and illiquid alternative investments, typically valued at an arbitrary (non-market-based) net asset value. Investment decisions designed to “avoid the risk of large losses,” as ERISA requires, must prioritize liquid assets and be extremely cautious in deploying illiquid assets. This article insight addresses the difference:
Level 1 assets trade on a public exchange at a publicly-disclosed fair market value. These are investments that can be valued at fair market value on a daily basis.
However, alternative investments are a very different animal: nearly all alternative assets are illiquid–assets that cannot be valued daily, may have significant withdrawal limitations and may have a value far different than the nominal values reported in your pension statement. These are things like cryptocurrencies, structured products, complex products, asset-backed securities, hedge funds, private equity funds, and the like (see FAQ).
Alternative pension assets are typically traded “over the counter” between two parties that assign value to the asset based on their own assessment, without the benefit of public market valuation. These assets are typically valued at net asset value instead of fair market value, which means the actual fair value of the asset, at any point in time, involves a fair amount of guesswork. NAV valuation involves mark to “model”–instead of mark to “market.” Invariably, then, the asset valuation is only as good as the model used to value it. And, unfortunately, in volatile markets where uncertainty is rampant, the models used to value assets at NAV are far more likely to obfuscate fair market value, rather than reveal it.
Thus, the single biggest distinction between standard pension investments and alternative pension investments is the challenge of assigning fair market value to an alternative investment asset. And if you really don’t know the fair market value of your investment, it will not likely be available to you, if needed.
Put another way, if your 401(k) plan holds alternative assets, the value of your plan cannot be readily controlled, re-balanced or cashed out. Instead, your plan is at mercy of powerful market forces beyond your control. Today, in 2023, the majority of defined contribution plans hold a high percentage (~50%) of alternative investments–commitments of your money that very few plan participants understand.
Alternative Pension Investments
What are alternative investments in a pension plan?
Alternative investments are investments in non-standard assets like cryptocurrencies, hedge funds, private equity funds and complex products.
A distinguishing feature of alternative assets is the valuation method. Importantly, alternative assets typically do not have a readily available trading market and are therefore valued at “net asset value.”
Compare this to “standard” investments held in pension plans, such as stocks, bonds and mutual funds that are bought and sold at an established “fair market value” on a public securities market.
What’s the difference between “fair market value” and “net asset value," and why should I care?
For assets valued at “fair market value,” the current asset value can be readily determined at least daily, as published by a stock ticker on a public securities market (such as NYSE).
But for assets valued at “net asset value,” the current asset value is not published on a public securities market and must be approximated from book value, or some other valuation method the pension plan’s board establishes “in good faith.”
Therefore, net assete value is inherently less reliable than fair market value, and the valuation process takes longer. So, 401(k) plan investors needing to access cash from plan assets may face a difficult time accessing the actual current value of their plan assets if valued at net asset value than if valued at fair market value.
Are alternative investments safe?
Alternative investment assets are more risky than standard assets (such as mutual funds).
But each 401(k) investor has his or her own risk profile. Therefore, alternative assets are neither “bad” nor “good.” It all depends on market conditions and the investor’s desired risk profile.
In a stable or rising stock market, the risk inherent in alternative investments is relatively low. “A rising tide lifts all boats,” as the saying goes.
But in a volatile or falling stock market, alternative investments may underperform and cause liquidity problems that will make it difficult to withdraw your money when you need it.
The important thing is to understand the risk profile of the investment assets held in your 401k plan, so you can make an informed decision.