While DB plans have benefited from alternative investments for years, a new paper suggests that DC plan fiduciaries may want to consider such investments as part of a multi-asset portfolio.
In Alternative Investments in Defined Contribution Plans, the Defined Contribution Institutional Investment Association (DCIIA) addresses the investment case for private real estate, hedge funds and private equity in DC plans, with a focus on related opportunities, considerations and challenges. The 43-page paper, in a slide-deck format, also covers potential next steps for fiduciaries interested in implementing alternatives.
Noting that DB plans have included alternatives in their investment lineups since the 1970s, the paper observes that DC plans still have insignificant allocations to these asset classes. However, the June 2020 information letter from the Department of Labor on the use of private equity in DC plans was an important development in the broader conversation around the inclusion of alternatives in DC plans. And while the DOL issued a supplemental statement to the information letter in December 2021 cautioning plan-level fiduciaries of small plans about the use of private equity, the supplemental statement did not change the terms of the letter, the organization notes.
“Alternative investments present a range of considerations and challenges depending on the asset class, including cost, valuation, liquidity, benchmarking and participant communication,” DCIIA emphasizes.
Positioning for Next Business Cycle
One reason to consider alternatives is to help mitigate lower return expectations for traditional asset classes post-COVID. As the economy begins to move toward a new business cycle, the downward shift in traditional asset class return expectations, in addition to the risk of inflation and continued volatility, creates new challenges for participants to reach retirement goals, the paper argues.
As such, private real estate, private equity and hedge funds may offer a range of benefits, including a source of enhanced returns and yield, as well as enhanced portfolio diversification to reduce volatility and natural inflation hedge.
Low Take-up Rates
Yet, while professionally managed multi-asset funds, such as risk-based funds or TDFs, may be more viable implementation structures for inclusion of alternatives, there still is a low take-up rate.
DCIIA notes that its 2020 Custom Target Date Survey looked at the holdings of $312 billion in custom target date funds across 14 fund managers and found that as of year-end 2018, only 11% of the assets were in private real estate, 2% in hedge funds and 1% in private equity.
As for near-term predicted usage by asset managers, the paper points to Cerulli’s 2020 DCIO Asset Manager Survey showing that 16% will consider adding private real estate and 15% will consider adding private equity to their funds that may serve as the plan’s QDIA, if they are approached by consultants, advisors or plan sponsors.
Another 15% indicated they are still in the fact-finding stage for considering the inclusion of private equity in their QDIA funds and 3% for private real estate. Only 3% indicated that they plan to add private real estate to their QDIA funds in the next 24 months.
Mitigating Factors
While much of the paper reviews the potential benefits of including alternatives, it does review some of the tradeoffs, noting that plan fiduciaries will need to determine if alternatives are a “good fit” for their plans and, if so, how they can be effectively implemented and managed over the longer term.
As such, plan fiduciaries will need to assess their risk appetite and willingness to monitor and evaluate options, along with liquidity needs and potential cost impact, among other things. Since alternative asset classes are typically more costly than traditional asset classes in DC plans, the paper suggests that modest allocations are one way to limit the impact on fees while maintaining meaningful impact of alternatives in multi-asset portfolios.
Moreover, implementing alternatives within multi-asset fund vehicles can help manage liquidity within the context of the fund’s broader portfolio allocation and periodic rebalancing, the paper suggests. Similarly, limiting allocations to manageable percentages can help with liquidity.
