While it may not happen overnight, next-generation target date funds will soon start to look a bit different thanks to recent regulatory developments, according to a new report by Cerulli.
The SECURE Act’s provision to facilitate the inclusion of lifetime income products in 401(k) plans, along with the Department of Labor’s guidance allowing the use of private equity within professionally managed strategies will help pave the way for TDFs to include these investment products, the firm suggests in its latest Cerulli Edge—U.S. Asset and Wealth Management Edition.
“For firms looking to gain a foothold or distinguish themselves from the pack, the strategic incorporation of lesser used investment products, such as lifetime income and alternative investments, could potentially help providers deliver superior long-term outcomes for plan participants and differentiate themselves in a market dominated by a small handful of low-cost providers,” the report suggests.
In the second quarter of 2020, Cerulli asked DC asset management firms to rate the likelihood of various attributes being included in the development of next-generation target date products. According to the findings, a majority (92%) of firms expect managed payout options and annuity allocations will be incorporated into future TDF series. Moreover, in conversations with Cerulli, target date managers indicate they are in the process of developing new target date products with a guaranteed component or are holding conversations with insurers in search of the right partnership.
Additionally, the report notes that the first quarter 2020 market volatility may also serve as a catalyst for lifetime income adoption by DC plans, as nearly two-thirds (63%) of target date managers suggest this period of heightened market volatility will increase client demand for guaranteed investments.
In addition to annuitization, the use of alternative investments such as private equity funds may change, based on the DOL’s June 2020 information letter allowing private equity investments in professionally managed funds within 401(k)s.
While a 2020 survey of TDF managers conducted prior to the DOL’s information letter found that no respondents reported allocating to private equity within an off-the-shelf target date series, and only 8% planned to incorporate private equity products within the next 12 months, Cerulli believes the DOL’s clarifying position will likely encourage broader adoption over the long term.
“Although the letter represents a key step toward giving private equity a larger presence within the DC product landscape, adoption will likely occur at a gradual pace as providers look to craft products, educational materials, and messaging for the DC market,” says Cerulli senior analyst Shawn O’Brien.
In the coming months, Cerulli expects plan sponsors and retirement plan providers to engage in more detailed exploratory discussions regarding the inclusion of private equity in multi-asset-class products such as TDFs. With that in mind, providers looking to incorporate allocations to private equity should remain aware of the unique demands and constraints of the DC market, the report suggests.
“Private equity funds are typically characterized by infrequent pricing events, low liquidity, relatively high management fees, and complex investment structures,” O’Brien emphasizes. “Conversely, the DC market—litigious in nature—is notoriously fee-sensitive, and the product landscape is dominated by simple, transparent, low-cost investment vehicles.”
Perhaps most critical for providers is to clearly demonstrate to plan fiduciaries how allocating to a certain private equity strategy within a professionally managed product can improve long-term outcomes for plan participants on a risk-adjusted, net-of-fees basis, according to Cerulli.
To that end, asset managers, consultants and advisors looking to offer professionally managed products that allocate to private equity should be prepared to educate plan sponsors on the fundamentals of private equity investing, the firm advises. For example, private equity funds often include both limited partner and general partner stakes, capital calls, carried interest and hurdle rates—terminology with which DC plan sponsors and participants may not be familiar. Moreover, while certain national investment consultants that work with DB plans may have in-house expertise necessary to evaluate private equity offerings, many DC intermediaries that operate further down-market may lack this experience or expertise, Cerulli further emphasizes.
“Taking all this into consideration, it may take time for many plan fiduciaries to gain a sense of comfort with private equity investments, and therefore, thorough educational and informational engagements may be a necessary precursor to adoption in a DC market where private market investments are rare,” says O’Brien.
Private Real Estate
In the meantime, even though the DOL’s letter primarily addresses the use of private equity in professionally managed products, some private real estate managers suggest to Cerulli that the DOL letter, along with the performance of private real estate relative to other asset classes during the market downturn, may prompt fiduciaries and asset managers to revisit private real estate.
According to the report, approximately one-quarter of target date managers indicate they currently allocate to private real estate (17%) or plan to incorporate an allocation to private real estate (8%) in the next 12 months.
“Private real estate has been used by DC plans for over 20 years, but adoption has been hindered by the 10-year bull market in traditional stocks and bonds,” Cerulli cites one asset manager specializing in real estate as saying.
Cerulli expects in the coming months that plan sponsors and plan providers will engage in more detailed discussions regarding private equity, but given private real estate’s “more established presence” within the DC market and less complex investment structures, the firm anticipates that private real estate funds are more likely to experience uptake from DC plans in the near term.