This article provides a useful framework to help you spot risks embedded in a 401k plan caused by volatile financial markets.

Is my 401k plan at risk?

To understand the risk inherent in your 401k plan in a volatile or falling financial market, you must:

First, identify and understand the assets in your plan held in a collective investment trust.  These are the volatile assets that put your plan at the most risk in a down or volatile market.

Second, identify the valuation approach used to record the value of your plan assets.  Particularly be wary about assets recorded at net asset value (NAV). These will be about half of your plan assets, the ones held in the collective investment trust(s) you identified in step one, above.

Third, identify the withdrawal limitations and conditions set out in your plan.

Fourth, find out how much leverage your plan advisors use when trading in  assets valued at NAV. This will require a call or letter to your plan sponsor.

Fifth, find out the way your plan administrator deploys your assets as collateral. This will also require a call or letter to your plan sponsor.

This article addresses all these topics, and more, to help you better understand and manage your 401k plan.

Understanding how your plan’s assets are valued is the most important step in pension plan analysis. Plan advisors may present investment options as either “equities” or “fixed income.” But this distinction is too simplistic and ignores the characteristics and risks of assets buried in each general category.

The key thing to look for is which assets are valued at level 1, and which assets are valued at Level 2 or Level 3, or are valued outside the fair value hierarchy at net asset value.

The importance of this distinction is that Level 1 assets are valued at observable quoted prices in publicly-traded active markets. Levels 2 and 3 have a more vague value description. Net asset value is an entirely arbitrary valuation that tells you little, if anything, about fair market value.

LEVEL 1 ASSETS

The value of Level 1 assets (typically mutual fund equities) are marked to market at least daily, on an active public trading market with ample trading depth, such as NYSE or NASDAQ.

Thus, you can readily identify the fair market value of your mutual fund assets on a daily basis by its ticker symbol; and can make informed plan allocation decisions as your plan allows, based on a clear understanding of the asset’s fair market value.

This is a principal goal of ERISA: that you are given sufficient information to understand the composition of your plan to make informed allocation decisions.

So, if your pension plan holds mutual fund assets, you pretty much know where your plan stands, and what market risks you may expect. Importantly, the pension risk factors identified in this article will have less impact on mutual fund holdings or other assets held at fair market value (Level 1).

LEVEL 2 |NAV ASSETS

Assets valued at net asset value (NAV) are those typically held in a collective investment trust. NAV assets are not regularly marked to market, are typically valued at an arbitrary value, and therefore lack a clearly defined fair market value. These include holdings in hedge funds, private equity funds, real estate, asset backed securities, structured notes and other complex products.

TYPICAL DISTRIBUTION: LEVEL 1 | NAV

Typical 401k plan options are distributed about  half-and-half: with about half of a plan’s offered investment options built around mutual funds, valued at Level 1; and the remaining half of a plan’s offered investment options built around assets held at Net Asset Value (sometimes, Level 2) in a collective investment trust.

A plan option that includes alternative investments in a collective trust may be nominally described as “fixed income”–but if the assets in this option are not marked to market daily, they are high risk assets succeptible to evaporating liquidity in a down or volatile market.

Again, these include holdings in hedge funds, private equity funds, real estate, asset backed securities, structured notes and other complex products. Compare, for example, standard bonds, with a fixed duration and coupon, that are traded on a public market: these are liquid fixed income assets, which are much safer investments than the illiquid variety of fixed income assets.

It is not unusual for plan fiduciaries to carry losses on a plan’s balance sheet as “unrealized losses.” This means that a plan has actually lost value, but the investment manager doesn’t want to report this loss.

When a loss is realized, the value of plan holdings drop, exposing plan fiduciaries to consequences they would rather avoid. Chief among these adverse consequences is that an asset write-down requires marking the assets to market. This decreases collateral value used for leveraged trades. So if collateral decreases, the fund may be required to sell assets to maintain required leverage limits. Decreased collateral value also impacts any discounted cash flow analysis the fund may undertake.

While the temptation to avoid asset write-down (to avoid collateral value decrease) is high–that strategy only works in transitory markets, where a value bounce-back is foreseeable. However, in today’s market, no reliable indicators suggest that market stability is anywhere on the horizon. Rather, failures are looming almost daily.

 A big reason the risk factors are different for Level 1 assets vs. Level 2 | NAV assets is the potential for leveraged transactions.

MUTUAL FUND LEVERAGE LIMITS: LIQUID ASSETS

Mutual funds can only borrow against 33.33% of the plan’s total value in leveraged purchases. This modest leverage limits puts a cap on potential losses in the event of a market downturn.

COLLECTIVE INVESTMENT TRUST LEVERAGE: NAV ASSETS

By contrast, collective investment trusts, in which NAV-valued assets are held, typically have no leverage limits. Investment trusts can, and do, hold NAV-valued assets such as hedge fund interests, private equity interests, derivative investments, ABS (asset backed securities) investments and real estate without regulatory leverage limits. These alternative investment assets can, and some do, transact trades using massive leverage. Some hedge funds use up to 100:1 leverage.

It is easy to see that highly-levered assets with an uncertain valuation are likely to fall faster and farther than modestly-levered mutual funds, in falling or volatile financial markets.

Many investment managers prefer high leverage investments since leverage (in a stable or growing market) can create a greater return on investment. Further, levered alternative investments involve a higher degree of managerial complexity, thereby allowing a higher active management fee.

Understanding the leverage applied by your pension fund manager in plan asset transactions is an essential step to understanding your overall plan risk.

If your plan assets are highly levered assets held at net asset value, in the current down market, you are likely losing fund value farther and faster than if were you invested in liquid mutual funds.

Historically, interest rates in the range of 5% – 6% have been considered normal. This interest rate range has provided for stability of the global financial system.

An important consideration in understanding a plan’s risk factors is withdrawal restrictions and penalties — that are now commonplace. It is common for a plan to be invested in long-term bonds that cannot be transferred to another asset type except at designated withdrawal dates, or with significant withdrawal penalties.

Needless to say, committing to a long-term investing portfolio in a volatile market carries its own risk. But it is important to understand that any long-term investment with withdrawal limitations poses a liquidity risk to your pension plan.

Why do so many pension plans have heavy investments in illiquid assets in collective investment trust structures?

It’s easy to see who benefits: the plan managers and investment advisors who have far greater income potential by maximizing illiquid plan investments. This is because illiquid assets are exceedingly complex, allowing for many obfuscations that, in turn, maximize an investment manager’s opportunity for high fees and carried interest accruals. Plan managers tend to make much more money managing illiquid assets than liquid assets. Consider these comparisons among investment advisors:

PASSIVE INVESTMENT ADVISORS

Index Fund. If you invest your 401k plan only in an index fund, such as the S&P 500, you don’t need an investment advisor to plan out asset allocations. Rather, your holdings will automatically move with the S&P 500 index. Notably, fees for an index fund investment are exceptionally low.

ETF Fund. Passively-managed ETF funds, such as those provided by Vanguard, are funds that bundle various indexes, equities or bonds, without active management.  Again, fees are exceptionally low.

ACTIVE INVESTMENT ADVISORS

Active investment advisors tout their ability to beat a passive investment in market returns.  Some do. Many do not. But these are the advisors that stand to gain the most by steering funds to complex products embedded in collective investment trusts, using significant leverage, often without considering collateral quality. Complex transactions equate to higher fees and related trading benefits and profits.

As a plan participant, it is your right to understand the motives of your plan advisors and fiduciaries, and act accordingly, based on your own best judgment, possessing all the salient facts.

Market risk is the inherent risk of investing that cannot be avoided by any pension plan or other market participant, irrespective of other the specific risk factors discussed in this article. Market risk is something that must be evaluated by each plan participant, most often based on financial news, such as Bloomberg.

But, financial news tends to hyper-focus on one risk factor at a time, as though a single factor can explain the totality of market risk.  For example, last week (March 8-17, 2023), coincident with the failure of Silicon Valley Bank, financial news focused on bank deposit problems caused by interest rate risk. This week (March 20), after the Federal Reserve/Treasury publicly backstopped all bank deposits, traders are piling into long-term bonds and equities, expecting that interest rate risk has been absorbed by government lending programs.

At the exact time of this writing, the Federal Reserve has just raised its federal fund rate by 25 basis points. This caused another round of repositioning, as traders tried to account for general market risk inherent in owning any financial investment. Some, but not all, investors are worried again about interest rate risks. The Federal Reserve and Treasury, for their parts, proclaim vague statements that signal intentions to push or pull a specific risk factor–or do they? It seems everyone is left guessing about the direction the Fed and Treasury are taking the economy, and Mr. Powell and Ms. Yellen like that confusion just fine. And this is a basic description of market risk–a risk that the market may rise or fall over time.

Pension risk is a structural set of risk factors that can set your plan up for success in the long term. If pension risk is properly accounted for, the daily impulse of market risk will be survivable.

Pension risk is not just a function of one thing; rather, it depends on a multi-factor risk profile that plays out with different variations in any given market situation.

Liquidity risk, interest rate risk, collateral risk and leverage risk must all be systematically evaluated–and acted upon–to achieve and sustain long-term gains.