The Hidden Downsides of Adding Private Investments to Your 401(k)
In recent years, there’s been a growing push from certain investment managers and retirement plan providers to open the door for private equity, private credit, real estate partnerships, and other “private market” investments in 401(k) plans. On paper, the pitch sounds compelling: “Private investments can offer diversification, access to institutional-quality opportunities, and the potential for higher returns.” But as with many financial innovations, what sounds good in a sales deck doesn’t always hold up in practice—especially when applied to a retirement account that’s meant to be the backbone of your long-term financial security.
At Pape Financial, we help clients evaluate investment options based on transparency, cost, risk, and alignment with their goals. And when it comes to adding private investments to a 401(k), there are significant drawbacks that deserve careful attention—drawbacks that can quietly erode retirement readiness if not understood.
Below, we’ll explore three major issues with private investments in 401(k) plans:
1. Higher Fees and Opaque Cost Structures
2. Lower Liquidity and Restricted Access to Your Money
3. Diminishing Returns in a Crowded and Competitive Market
Along the way, we’ll examine why these challenges are magnified inside a tax-advantaged retirement account and what it means for investors.
Higher Fees: The Drag You Can’t See (Until It’s Too Late)
One of the most overlooked aspects of private market investments is just how expensive they can be compared to traditional public market options.
Layered Fee Structures
When you invest in a low-cost S&P 500 index fund inside your 401(k), you might pay as little as 0.03% annually in expenses. That means $3 per year for every $10,000 invested. Over decades, that low drag compounds in your favor. Private investments, on the other hand, often come with multiple layers of fees:
- Management fees (often 1–2% annually)
- Performance fees (commonly “20% of profits” above a certain threshold, known as “carry”)
- Fund-of-funds structures that add yet another layer of costs
- Transaction and administrative fees buried in offering documents
A real-world example: a private equity fund might charge a 2% management fee and a 20% performance fee on gains. If the fund returns 10% gross, the investor could end up netting only around 6–7% after fees—a massive difference compared to low-cost index funds.
The Compounding Cost of Higher Fees
Fees are not just a one-time hit—they compound against you over time.
Let’s compare:
Low-cost index fund: 7% annual return, 0.05% expense ratio over 30 years → $10,000 grows to ~$76,000.
Private investment: 7% annual return before fees, 2% management fee + performance fee → net return of ~4.5% → $10,000 grows to ~$38,000.
That’s a 50% difference in ending value, purely due to fees.
Opacity and Disclosure Issues
Public mutual funds and ETFs are required by law to present fee disclosures in a standardized, easy-to-read format. Private investments are not subject to the same SEC and DOL disclosure standards in 401(k) contexts, making it harder for participants to understand exactly what they’re paying.
Lower Liquidity: A Poor Fit for the Flexibility You May Need
Liquidity—the ability to sell an asset and access cash—is a cornerstone of retirement investing. Even though 401(k)s are meant for the long term, participants still benefit from having investments that can be rebalanced, diversified, or accessed (subject to plan and IRS rules) without excessive friction.
Private investments often break this flexibility.
Lock-Up Periods
Many private funds require that capital be committed for 5, 7, or even 10 years. If you want to exit early, you may:
- Face steep penalties
- Be forced to sell at a discount through a secondary market (if one exists)
- Simply be told “no,” as the investment is illiquid
Inside a 401(k), this means that a portion of your retirement savings could be effectively frozen, limiting your ability to adjust allocations based on:
- Changing personal circumstances
- Market conditions
- New investment opportunities
Difficulty in Rebalancing
A key principle in retirement investing is periodic rebalancing to maintain your target asset allocation. If 15% of your portfolio is locked up in an illiquid private investment, you may have to over- or underweight other assets for years, increasing portfolio risk.
Emergency Access Complications
While early withdrawals from a 401(k) come with tax consequences and potential penalties, life events do happen—job loss, disability, or other financial needs. In such cases, public investments can be liquidated quickly. Private investments cannot, which can turn a difficult financial period into a crisis.
Diminishing Returns: The Reality Behind the Private Investment Hype
Much of the marketing around private investments rests on the claim that they have historically outperformed public markets. And while there’s truth in selective time periods and certain strategies, the broader reality is more nuanced—and less rosy.
The Golden Era Is Likely Behind Us
In the 1980s and 1990s, private equity firms could find underpriced companies, apply operational improvements, and sell them for large gains. But as trillions of dollars have flowed into the space, competition has intensified:
- Valuations for private deals are often as high—or higher—than comparable public companies.
- Opportunities for “easy wins” have been largely arbitraged away.
- Many private funds now rely more on financial engineering (leverage) than genuine operational improvement to generate returns.
Survivorship Bias in Reported Data
Private investment performance data is not as transparent as public market data. Funds that perform poorly may not report results, and databases tend to overweight surviving, successful funds—making the average returns look better than what a typical investor might actually receive.
After-Fee, After-Tax Reality
Even if a private investment achieves a higher gross return than a public fund, the combination of:
- Higher fees
- Illiquidity risk
- Possible tax inefficiencies if held outside a retirement account (though inside a 401(k), UBTI could still be an issue)
… often reduces the net advantage to the point where it disappears entirely.
Why These Negatives Are Magnified Inside a 401(k)
401(k) plans were designed to be:
- Cost-effective
- Transparent
- Diversified
- Liquid enough to manage risk
Introducing private investments undermines several of these pillars.
Fiduciary Concerns for Employers
Plan sponsors have a fiduciary duty under ERISA to act in the best interest of participants. Adding high-fee, opaque, and illiquid investments increases the risk of fiduciary breach claims—especially if returns don’t justify the risks.
Complexity for Participants
Most employees are not equipped (nor interested) in conducting due diligence on a private fund’s strategy, fee structure, and liquidity provisions. This complexity can lead to poor decision-making and misalignment with individual retirement goals.
The Sales Pitch vs. Reality
Sales Pitch Reality
Access to exclusive, high-return opportunities Many deals are picked over; competition is intense
Diversification into non-public markets Illiquidity and valuation uncertainty can increase portfolio risk
Professional, active management Higher fees and performance hurdles eat into returns
Historically higher returns Much of the historic outperformance was in earlier decades; recent results are less compelling
When Private Investments Might Make Sense in Retirement Planning
To be clear, private investments are not inherently bad. For high-net-worth individuals with:
- Ample liquidity outside retirement accounts
- Access to top-tier managers
- Tolerance for higher risk and longer lock-ups
… these investments can play a role in a diversified portfolio.
But for the average 401(k) participant—or even for sophisticated investors inside the constraints of a qualified plan—the negatives often outweigh the potential benefits.
Practical Takeaways for Plan Participants and Sponsors
- Scrutinize the Fees – Demand full, transparent disclosure and calculate the all-in cost compared to traditional options.
- Evaluate Liquidity Terms – Understand exactly when and how you can access your money.
- Be Skeptical of Projected Returns – Ask whether performance assumptions are realistic given current market conditions.
- Consider Simpler, Proven Options First – Low-cost index funds and target-date funds remain powerful tools for compounding wealth over decades.
- Remember Your Goals – The purpose of a 401(k) is not to swing for the fences; it’s to reliably build wealth for retirement.
Final Word
Adding private investments to a 401(k) can sound exciting—exclusive deals, sophisticated strategies, the chance to “invest like institutions.” But the reality is that higher fees, lower liquidity, and diminishing returns make them a questionable fit for most retirement savers.
When it comes to your retirement plan, boring is often beautiful. Steady contributions, low costs, and broad diversification may lack the sizzle of a glossy private equity pitch deck—but they have a far better track record of delivering results you can count on when you need them most.
At Pape Financial, we help our clients plan for the retirement they envision. If you would like to see if you are on track to meet your goals, click here to schedule a time to talk.