“Congratulations, you now run a hedge fund” is what your HR rep should really say when they hand you that stack of paperwork for your 401(k) or 403(b). The comparison of running a hedge fund to having to plan your 401(k)/403(b) may sound absurd but in reality there doesn’t appear to be much of a difference.

You, much like the billionaire hedge fund managers out there are responsible for choosing a basket of investments that will maximize the returns on the principal amount invested.

However, instead of enriching investors – you will be financing your retirement and you only get one chance.

A brief introduction to the 401(k)

The 401(k) as we know it was originally designed as a provision in the tax code to address uncertainty surrounding the taxable status of profit-sharing plans. It was generally an afterthought and considered a minor item in the tax code as a whole. However in 1980 one man, Ted Benna, figured out that he could use that insignificant item to create a way to save for retirement in a tax-advantaged way and the modern 401(k) was born.

A staggering 94% of private companies now rely on the 401(k) rather than pensions to fund their employee’s retirement. For them the advantage was that the responsibility for retirement funding was now on the employee rather than the company. They would just contribute a matching percentage and let the employees manage their own money.

For those workers it now means that what used to be a simple guaranteed pension is now dependent on their own investing skill. Employees are expected to determine the correct amount of the salary to put into a 401(k)/403(b), which funds to invest in, how to balance those funds, when to access those funds in retirement, and how to avoid any tax-penalties for accessing them improperly. Rather than leaving that work to a professional pension fund manager, the average American is now expected to know things such as:

  • The net asset fee and gross expense ratio of their investments and how this affects their returns.
  • The proper ratio of stocks to bonds for their age.
  • How often to re-balance their portfolio and why selling everything during a recession is a bad idea.
  • Proper diversification – difference between large cap, small cap, international, natural resources…etc.
  • How to research stocks, funds, bonds, and ETFs (this goes beyond putting everything into a real estate fund just because the guy down the street makes good money flipping houses).
  • The penalties for withdrawing money from your 401(k) early and on the opposite side of the spectrum the penalty for not withdrawing the proper amount after age 70.

And so on. Does this seem reasonable? For what its worth, Ted now believes he created a “monster” that should be “blown up”.

In the words of Marge Simpson, “I guess one person can make a difference. But most of the time, they probably shouldn’t.”

So what is a hedge fund?   

In simple terms, a hedge fund operates similarly to a mutual fund with the exception that hedge funds can invest in practically anything – stocks, bonds, currencies, even real estate or venture capital. Mutual funds generally only invest in a mixture of stocks and bonds. So having access to a hedge fund gives you a wide variety of exposure to different investments and each utilizes a different strategy – whether they be event driven, investing in emerging markets, owning distressed securities, etc…

Hedge funds are especially beneficial during times of a bear market (i.e. when stocks are down – think 2008). Because they are exposed to investments besides stocks, their diversification allows them to weather the effects of a downtown better than mutual funds or ETFs. For example, in 2008 the S&P 500 ended up being down -38.49% for the year, while hedge funds as a whole were only down -21.63%. However, hedge funds that used a Managed Futures strategy ( investing in commodities and futures contracts) actually ended being up +18.33% for the year. Imagine seeing those kinds of returns while everyone else is panicking.

 The SEC thinks you’re too stupid to invest in a hedge fund, yet you’re supposed to run your own  401(k)/403(b).

So let’s suppose that we’ve realized that we have no business running our own hedge fund and want to entrust an actual professional to invest our money for us. In theory, the situation sounds great – an opportunity to invest in a fund with access to a diverse variety of investments, run full-time by a professional who also invests in the fund and therefore has the incentive to perform, and to earn returns that outpace the S&P 500 and Dow Indexes even during a recession. However, there is one big obstacle standing in your way: the SEC (Securities & Exchange Commission).

Hedge funds can by law only accept funds from institutions or “accredited investors” or per Rule 506, a very limited number of “sophisticated investors.”

An accredited investor is basically defined as someone who has a net worth (not including the value of the primary residence) of over $1 million or has earned income exceeding $200,000 ($300,000 for married couples) in each of the prior two years. So, in the SEC’s eyes you have to already be rich to get rich and the sole act of being rich makes you smart enough to make complex financial decisions. I find this humorous because I know a lot of people who make that much money and constantly make terrible financial decisions.

Here comes the fun part – the “sophisticated investor” is defined as such:

“In this context, a sophisticated person means the person must have, or the company or private fund offering the securities reasonably believes that this person has, sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of the prospective investment.”

This means that the SEC expects you to be a CFO, bank manager, CPA, or something of the like. So you have to be “smart” according to their standards of what smart is. If you don’t fit into one of those above categories, you are not considered “sophisticated” and would not be allowed to invest in a hedge fund.

The idea behind this line of reasoning is that since hedge funds have unique risks, only investors who are wealthy and therefore smart enough should be allowed to invest in them.

However the infuriating thing here is that the SEC is really thinking that the average American investor is too stupid to be allowed to invest in hedge funds yet should be allowed to choose their own stocks, mutual funds, ETFs, or bonds to make up their 401(k)/403(b) and therefore fund the bulk of their retirement.

Seriously, I wish I was making this up. They prohibit us from giving our money to financial professionals and then expect us to do EXACTLY what hedge fund managers do to finance our own retirement AND expect us to be good enough at it (despite most of us not having any experience doing so) to retire comfortably. Does this system make any sense?

Now I’m not saying that everyone should run out, dump their 401(k)/403(b), and invest everything in a hedge fund. Hedge funds are risky vehicles that require intense research and scrutiny before investing – they are not to be taken lightly. All I’m saying is that if the SEC believes we’re intelligent enough to go out and invest our money in such a way that we will have millions (yes millions – anyone in their 20s or 30s today will need to have at least $1 million when they retire) available for retirement, they should open up additional avenues for those investments.

But realistically what options do ordinary people have when planning for retirement? The real objective is to be able to plot out how much money you will be able to pay yourself with each year, for the X amount of years that you will be retired. It sounds simple enough, but in practice it isn’t.

It is extraordinarily difficult to determine how much you will need to retire with in your 401(k)/403(b) – many of the online calculators vary wildly as to how much you’ll need and there is no guarantee that your returns will be what you expect. What people really need is something that can give them the opportunity to plan out their retirement ahead of time, receive decent returns on their money, and be guaranteed to be able to support themselves with those funds when they do retire.

There are products out there that fit this purpose and we’ll be exploring those products in later blog posts. But for now I hope you’ve enjoyed this first article and that you take time to think about how your retirement plans stack up – your future you is counting on it!