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next issue no. 5: On the horizon
Remodeling with alternatives
Today, there are around 90,000 Americans age 100 or over. In 1980, that population was 32,000.1 As longevity continues to increase, the amount of time people spend in retirement looks increasingly similar to the amount of time they spend working. At the same time, we are in an economic environment that continues to rely on low interest rates for an extended period of time.2 Increased longevity, lower underlying rates and broad acceptance that they will remain low for longer underscore the critical importance of getting retirement planning right.
Sophisticated asset allocation across well-diversified, low-correlated asset classes is a key component to long-term investing; yet despite the best of intentions, 401(k) plans don’t always afford participants that opportunity. Originally designed as a supplement to defined benefit plans, defined contribution (DC) plans have gradually shifted to one of the primary employer-offered retirement savings vehicles in the U.S. However, advancements in DC plan design have not kept up the same pace. According to Callan, only around 5% of DC plans include alternatives as an asset class in their menu design,3 yet the demand for yield to sustain savings throughout longer periods of retirement could drive the need for investors to seek higher, broader diversification across investments. Fortunately, the U.S. Department of Labor (DOL) recently issued new guidance that paves the way to giving DC participants more exposure, prudently.
A closer look
First, we consider alternative investments in this context to be private, less-liquid asset classes, such as private real estate, private equity and hedge funds. The benefits of alternative asset classes within a sophisticated, long-term investment portfolio can be seen through performance comparisons over time.
For example, defined benefit (DB) plans tend to outperform DC plans over time. For the 10 years ended in 2016, DB plans saw annualized net returns of 5.4%, compared with DC plans’ annualized net returns of 4.9%, for a net return difference of approximately 50 basis points. Over a lifetime of saving and investing, such performance differences can add up. Much of that performance can be attributed to the inclusion of allocations to private alternative asset classes.
A separate report published by the Georgetown University Center for Retirement Initiatives indicates that a diversified target date fund (TDF) inclusive of alternatives has a higher probability of maintaining positive retirement assets after 30 years of retirement spending. It also provides higher expected returns and lower downside risk at the time of retirement and 10 years postretirement, mitigating the negative impacts of a short-term market shock for those participants at, or near, retirement.
The performance benefits of alternative strategies are clear, and adding them can complement traditional DC offerings and serve the interests of plan participants in a variety of ways. Some additional potential benefits of incorporating alternatives include:
- Reduced reliance on traditional equities and bonds.
- Enhanced portfolio diversification leads to lower correlation and potential risk reduction.
- Illiquidity leads to lower volatility.
- Broader investment universe outside of public markets.
Benefits of alternative investments
Opening the door
For the first time ever, the DOL issued an information letter outlining how private equity could be added to DC plans under existing rules set forth by the Employee Retirement Income Security Act (ERISA). Simply put, the guidance allows plan sponsors to allocate assets to private equity within a multi-asset class vehicle, likely used as a plan’s default investment option, citing examples such as a custom target date, target risk or balanced fund, but not as direct investments in private equity funds. Direct investments into private equity funds are typically the domain of qualified investors: affluent individuals or institutional investors. At a high level, anything that gives plan sponsors the ability to do what’s in the best interest of participants is a good thing, and this ruling clears a big hurdle in giving average investors exposure to an investment option that has the potential to enhance retirement outcomes.
That's not all
Lack of regulatory guidance and concern about litigation risk weren’t the only obstacles to offering private equity investments within a DC plan. Many DC plan sponsors have struggled with adding alternative investments to their menus because of operational complexities, such as liquidity and valuation needs. The DOL guidance addresses these, as well as other key considerations, including:
- Liquidity: Plan sponsors considering private equity should ensure that the diversified investment option with a private equity allocation provides sufficient liquidity to permit participants to seek a distribution of their benefits, and exchange investment options.
- Valuation: Valuation for private equity investments is more complex than for traditional public investments, and daily valuations are not the norm.
- Allocation limits: Based on a ruling from the SEC on illiquid investments, the DOL letter suggests capping the allocation to private equity at 15%.
- Expertise: Fiduciaries/plan sponsors overseeing the private equity allocation should have the skills to evaluate and monitor private equity investments or should hire a third party.
- Disclosures: Participants should be provided with information that discloses the character and risks of private equity so they can make an informed decision about whether to invest.
- Long-term impact: Plan sponsors are reminded to consider the effect of including a private equity allocation on the plan investment menu option in terms of diversification and expected return, net of fees.
Beyond the guidance from the DOL letter, plan sponsors who consider adding alternative investments to their plan need to take a variety of other considerations into account. One important consideration is to determine whether an allocation to alternatives aligns with the plan’s demographics, such as age, salary, years to retirement and financial sophistication. Since alternatives are illiquid, long-term investments, they may be better suited to participants with longer time horizons. Should a plan sponsor choose to add an allocation to alternatives, participant education will be important, as most plan participants may not be familiar with these strategies.
Another important consideration for DC plan sponsors is how to implement alternatives within the plan’s investment menu. One option is to select an off-the-shelf TDF that includes alternatives. Another option is to incorporate them into custom TDFs, managed accounts or other multi-asset class investments; this gives plan sponsors greater control over how they make alternatives available to plan participants.
Keys to gaining adoption
The DOL guidance opens up the conversation about the potential benefits that alternative investments may offer DC plan participants. But to be more widely accepted, more off-the-shelf TDF managers and large institutional plan sponsors will need to incorporate alternative investments into their TDFs or other qualified default investment alternative. For example, the number of plans employing real estate has steadily increased from 7% in 2006 to 22.9% as of first quarter 2020.4 When alternatives become more prevalent in the QDIA, we think they will become more mainstream and acceptable, as the benefits of adding them become more apparent.
1 United States Census.
2 NPR, Fed’s Jerome Powell: Jobless Rate Better Than Expected; Recovery To Take A Long Time, 4 Sep 2020.
3 Callan, The Id, Ego, and Superego: How Freud Can Help Sponsors Harness DC Plan Data for Better Outcomes, 2020 Mar.
4 Plansponsor, Alternatives in DC Plans: Key Considerations, 2020 Jul.
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