The Trump administration is opening up retirement funds to private equity — at workers’ expense
In the past two months, the Trump’s Labor Department has introduced two pending changes to deregulate vulturous private equity firms and multi-trillion dollar retirement managers like Vanguard, Fidelity, and BlackRock. A third proposed change would restrict retirement investments with an underlying environmental, social, or governance mission — mainly to boost the struggling fossil-fuel industry.
If finalized, the result will be death by a thousand cuts to Americans’ diminished retirement nest egg, amounting to an all-out Wall Street looting of American retirement.
Pushing this through is Secretary of Labor Eugene Scalia — son of the late Supreme Court Justice Antonin Scalia — who for many years was one of Wall Street’s most prominent litigators, representing corporations like Chevron, Walmart, and Facebook, as well as over a dozen banks and financial firms during his tenure at Gibson, Dunn & Crutcher, a law firm with a robust corporate lobbying wing.
“Secretary Scalia is still working for his former clients,” said Barbara Roper, director of Investor Protection at the Consumer Federation of America. “This is a multipronged attack on Americans’ retirement security.”
How Wall Street Works Over Workers
For the millennials and zoomers in the crowd, perhaps a quick review of the basics of retirement is helpful. “Retirement” refers to a period toward the end of a human life during which ordinary people could use money they’d saved and invested — combined with Social Security payments — to stop working but still live comfortably.
This used to be considered a core part of the American dream. But for reasons having very much to do with the growth of the financial sector, austerity budgets eroding the welfare state, and the decline of union membership (and having absolutely nothing to do with avocado toast), retirement as a concept has become more of a goal than a guarantee.
There are a few things still working in our favor, however, including federal rules aimed at making sure we get the most out of the money we save for retirement. The 1974 Employee Retirement Income Security Act (ERISA) gives the Labor Department control over all areas of retirement investing — including “defined contribution” plans like 401(k)s and “defined benefit” plans like union pensions.
Pensions are a retirement fund where employers guarantee a certain level of payout (a “defined benefit”) and agree to be on the hook for covering that payout, even if the pension fund’s investment returns can’t cover it. Also, financial professionals manage pensions, thus reducing the likelihood of retirees being confused or swindled by complex financial arrangements. This even allows pensions to take on higher-risk products like private equity funds. But today, only 27.3 percent of retirees, shrinking with nationwide unionization rates, have a pension.
For everyone else, there is a 401(k), where workers and retirees pay in their “defined contribution” — and then get payouts from it based on how well the investments perform. An employer’s human resources department usually provides the retiree with a menu of 401(k) investment options, but few HR managers are financial professionals so their menu is rarely curated to the workers’ wants or needs. Originally, 401(k)s were meant to supplement pensions, but today, only 6.8 percent of retirees have both types of plans, and Social Security, as intended.
The federal government, and the Labor Department in particular, have a big role making sure these plans work the way they’re intended, and in (at least in theory) preventing people from getting swindled by investment managers. One of the main guardrails aspiring retirees have is what’s known as “fiduciary duty,” a rule that requires managers of both pensions and 401(k)s to provide the best possible service — here, meaning the best quality investments for the lowest possible cost — or face liability.
The fiduciary duty combined with workers being on the hook make the 401(k) sector a fertile breeding ground for high-stakes, multiparty lawsuits, where employers fight off accusations by workers and retirees of selecting low-performing and/or high-fee funds for their 401(k)s. An employer may negligently choose a retirement investment manager because they were the most readily available, or they didn’t have the resources to find an optimal plan, or they were mistaken of a fund’s potential. Other times — as was alleged against the Massachusetts Institute of Technology’s retirement plan last year when the school received a $5 million donation from Fidelity Investments — the employer might have an incentive for choosing a certain fund.
For many years, one of the most prominent employer-side litigators was Eugene Scalia himself. “None of the prior secretaries of labor, either Democratic or Republican, have been people who have been on the firing line against workers and retirees,” said plaintiff’s attorney Jerome Schlichter, whose law firm pioneered retirement excessive-fee litigation. Schlichter directly butted heads with Scalia in an ongoing retirement fund suit right up until his secretarial appointment.
Andy Behar, CEO of As You Sow, a nonprofit that rates the financial sector for its ethical standards, said that Scalia’s three most recent DOL rulemakings suggest a personal vendetta. “He’s couldn’t win as an attorney, so he’s changing the rules,” Behar said.
The Private-Equity Exposure
One of the Trump administration’s planned changes to retirement rules will open up 401(k) investments to high-risk, high-fee private equity funds. It’s a major break with past practices, but it wasn’t done through a formal rule process that would allow for scrutiny and public input.
Instead, in early June, the DOL sent a high-profile information letter to Pantheon Ventures, a private equity firm, codifying conditions, such as a 15 percent cap, for a 401(k) to invest in private equity. The letter formalized private equity’s entry into the 401(k) marketplace, creating a blueprint for copycats and sending shockwaves throughout both sectors.
Private equity is a type of hedge fund comprising private investors who buy privately held, struggling companies in order to rehabilitate or liquidate them, collecting extremely high fees and enriching shareholders either way. Direct investments in private equity and other types of hedge funds are typically restricted to high-net-worth individuals or institutions. This is because high-net-worth individuals and large institutional investors have extra, discretionary money to handle private equity’s huge risks, long-term illiquidity, astronomical fees, and “capital calls,” investor fundraisers demanded at the drop of a hat. In other words, high-net-worth individuals and huge institutional investors can afford to burn that money if the investment goes south.
The average retirement investor, however, has always been considered uniquely reliant on their savings, which is why ERISA’s fiduciary duty requires a very conservative investment strategy. Considering private equity’s many risks and costs, the government, until now, and 401(k) plaintiffs’ attorneys have largely opposed it in retirement plans.
According to Wally Okby, a senior analyst at Aite Group, the pool of available capital from high-net-worth investors for private equity has recently dried up. And considering the shrinking state of pensions, private equity is chomping at the bit to enter the $8.9 trillion 401(k) marketplace. “They’re looking for cash anywhere they can get it,” Okby said. “Therefore, they go to 401(k)s, where investors typically don’t understand what they’re investing into.”
In an ensuing press release, Secretary Scalia said the Pantheon letter helps “level the playing field” for ordinary investors. Securities and Exchange Commission Chairman Jay Clayton also praised the letter as improving “investor choice.”
Investor advocates disagreed. “The use of private equity in retirement plans is fraught with peril. It was a vehicle that was created for wealthy, sophisticated investors, not for average people,” Schlichter said.
The letter is part of a broader private-equity lobbying, pressure campaign, and creation of complicated fund structures designed to prey on more of Americans’ hard-earned savings. Clayton and other lawmakers have made several moves to lower barriers for private fund access to Main Street investors. On July 28th, one senior SEC director at a conference openly solicited the financial-industry attendants on what SEC rules should be changed to open up working people’s money to hedge funds and private equity.
The letter also comes in light of a recent SEC warning that some retail fund managers have been receiving undisclosed kickbacks from private-equity investments.
The industry has supported the letter on the disputed belief that private-equity investments outperform the stock market at large. George Gerstein, an attorney for the financial industry and co-chief of fiduciary governance at Stradley Ronon, believes that increased private-equity exposure will increase performance of retirement plans, especially as a counterweight to other economic headwinds. But a recent study at Oxford University found that, after fees, top private-equity funds have performed no better for pension funds over 15 years than if the money were passively indexed to the stock market.
Further, private-equity disclosures lack any standard date or metrics, so its disclosed performance data is inherently misleading, Roper argued.
A 401(k) was designed to allow a worker to select different investments in the employer-provided menu to suite their wants and needs: shorter-term or longer-term growth funds, high or lower risk, smaller- or larger-sized company exposure. But in reality, workers overwhelmingly do not make any changes to their 401(k) investment lineup, Roper said. That means that even if private equity did disclose its risks, most people probably wouldn’t change anything. Plus, any disclosure could be found on the 40th page of dense legalese. “Maybe because the typical worker isn’t a financial analyst,” Roper understated.
Undoing the Fiduciary Duty
On June 29th, 2020, the Department of Labor unveiled its second major shift, a proposed update to the breadth and depth of the retirement professional’s fiduciary duty — money managers’ requirement to provide the best possible service or face liability.
The proposed rule would reduce the fiduciary duty to cover fewer transactions and parties, opening up enormous loopholes wherein a retirement professional has to uphold their fiduciary duty.
Shockingly, it would also allow any retirement professional to receive third-party payments for their recommendations, so long as they adhered to an undefined “best interest” standard and didn’t “materially” mislead investors. This part of the rule is perhaps akin to a doctor being allowed to take kickbacks in exchange for prescribing certain pharmaceuticals. Scalia said his rule expanded “investor choice.”
Once again, investor advocates disagreed. “[T]he proposal is designed to preserve financial firms’ ability to place their own interests ahead of their customers’ interests and profit unfairly at their expense,” argued a public letter co-signed by several investor advocate groups.
That Scalia is the one proposing the rule is, to many, an inverted justice. When Scalia was a Wall Street attorney, in one of his most notorious cases, he led litigation for Wall Street groups in successfully overturning an Obama DOL rule that enhanced the scope of a financial professional’s fiduciary duty to retirees.
Given Scalia’s role in the prior rulemaking, both Schlichter and Roper believe Scalia’s role in its replacement was conflicted, and that many believe he should have recused himself from fiduciary rulemaking. Gerstein disagreed with both assertions.
A spokesperson for the Department of Labor noted that Scalia sought advice from the DOL’s career ethics attorneys, who also consulted the U.S. Office of Government Ethics, and they determined that neither relevant ethics rules nor the Trump administration’s Ethics Pledge required his recusal from the rulemaking.
A Fossil-Fueled 401(k)
The investment world has recently been choosing to invest heavily in renewable energy, diverse workplaces, and companies with fair-labor practices. So-called environmental social governance (ESG) investing has become incredibly popular, with US SIF estimating that today one-quarter of all U.S. dollars invested have some form of an ESG mandate, an 18-fold increase between 1995 and 2018. Financial firms have been working doggedly to create new funds and products that meet customers’ growing demand.
And it’s popular not just because of some charitable spirit. Performance data shows that not only does ESG investing outperform traditional investments in a good economy, but it also loses less in a downturn, though there is some disagreement. Most ESG-sector growth has remained outside of retirement due to retirement’s need for perceived low-risk investments, but given ESG’s growth, it was inevitable that it would eventually enter retirement investing.
Or at least, it was inevitable, until mid-June, when the DOL unveiled its third monumental retirement rule proposal, this time from authority from a Trump executive order promoting fossil fuels. The Labor Department’s slash-and-burn rule will subject all ESG in retirement plans to the stigma of heightened scrutiny. While on its face, the rule clarifies what is already the law — that retirement investments must meet fiduciary-level scrutiny — it also forbids retirement plans from having investments that promote some “non-pecuniary” purpose, such as not destroying the planet, no matter retirees’ wishes.
“Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan,” Scalia said in a press release.
The consensus in the financial sector is that this rule will have a chilling effect on ESG and benefit the Trump-allied fossil-fuel sector.
“Basically the rule that they proposed is deeply internally conflicted. On the one hand, you have to make decisions on financial returns, and yet if you did that, you’d have to exclude fossil fuels,” Behar from As You Sow said. “Why is the DOL saying that fiduciaries should steer clear of less risk, steer clear of outperformance?”
Like the other regulatory shifts, the DOL is not acting alone. The SEC has scrutinized and criticized ESG, alongside the New York branch of the DOL and the White House itself. Despite this antagonism to ESG, European regulators, Democratic lawmakers, investor advocates, and even the investment industry itself support expanding and standardizing the ESG sector.
“The ESG rule is just straight political,” Roper said.
Foxes Guarding the Retirement Coop
Together, the Trump administration’s plans contribute to a remaking of a retirement system that gives financial firms new opportunities to cash in at the expense of greater risk to workers, while making it harder for us to use our money to build the kind of world we’d like to retire into.
The most perplexing aspect of these rules is their open contradictions. The Labor Department’s justifications for the private equity letter and the standard of conduct rule were to expand “investor choice.” While the rule on environmentally and socially conscious investing effectively shuts out investor choice. The rules allow a retiree to “choose” a high-risk, high-fee investment, or to “choose” a retirement adviser who gets a kickback for their imprudent recommendations. But retirees may not choose an investment that promotes the idea that cutting carbon emissions or increasing diversity are in and of themselves good investments.
“You could understand if they took a laissez faire approach to both.… or if they took a restrictive approach to both,” Roper said. “This is about picking winners and losers. And the losers are going to be retirement savers.”
“They just don’t like transparency; they want to put us in the most risky, nontransparent vehicles they can find,” Behar said. “I guess that kind of squares with this administration.”
Discouragingly, the rules seem likely to go forward. The private-equity letter effectively lets the horse out of the barn. And while the two formal rules haven’t been finalized, there’s little to stand in their way, as legal challenges seem unlikely after a related SEC decision was upheld in June.
In theory, individuals could sue their retirement-investment managers on a case-by-case basis if they felt the money was being mismanaged, but that’s no substitute for a system that works to protect them in the first place — something Scalia seems hell-bent on trying to dismantle.
Then again, Scalia’s only calling the shots so long as Trump is in the White House.…