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Special Report

Illiquids: Many see potential, but few take action

Execs like diversification and return prospects, but focus on daily valuation, fees hurts illiquids

Illiquidity illustration

Updated with correction

Illiquid investments are getting a closer look from some defined contribution executives seeking plan diversification as well as higher potential long-term returns. However, few DC asset owners are dipping their toes in the water, let alone diving in.

Such hesitation doesn't surprise consultants, who note that the DC industry's focus on daily valuation, liquidity and fees can act as a headwind to adding illiquids.

Over the past few years, the broad DC landscape has been “gravitating toward simplicity and a focus on fees, and those things aren't necessarily synonymous with DC illiquids,” said Brian Donoghue, Boston-based partner at NEPC LLC.

“Particularly, when you think about the legal environment and litigation space we've been in recently, many sponsors have opted to stay away from the operational complexity that comes with DC illiquids,” he said.

But seeing the growing emphasis on DC plans as an opportunity too big to ignore, some managers — namely real estate, private equity and hedge fund — have developed strategies to work in daily valued and liquid environments.

For there to be a big movement into illiquid investments, record keepers will have to “embrace some of the alternatives managers,” said Jonathan Epstein, New Orleans-based founder and president of the Defined Contribution Alternatives Association, a group of DC stakeholders focused on advancing the use of alternatives in DC plans. Mr. Epstein also believes that there will need to be “some type of regulation or safe harbor or anything put out by the Department of Labor to appease plan sponsors from a fiduciary standpoint.”

As of March 31, private real estate — the illiquid asset class sources believe has had the most traction — was only present in 9.4% of the 64 unique, off-the-shelf target-date glidepaths that investment consulting firm Callan Associates tracks. That's up from 5.5% in 2014.

Callan does not track direct real estate in custom target-date funds, but James Veneruso, Summit, N.J.-based vice president and defined contribution consultant in Callan Associates Inc.'s fund sponsor consulting group, said that more plans are likely to include direct real estate on the custom side.

It is no surprise, then, that large DC plans with the staff and scale to build custom options are generally the ones showing interest in incorporating illiquid investments. Drawing them in are illiquid investments' potential diversification benefits and higher expected returns over their more liquid counterparts. According to an analysis by NEPC, when a 5% allocation each to private real estate, hedge funds and private equity is added to the average target-date fund in Morningstar Inc.'s U.S. Fund Target-Date 2050 universe, the portfolio's overall expected return rises to 6.1% from 6% and the risk falls to 13.6% with an expected Sharpe ratio of 0.32, from 14.7% and a Sharpe ratio of 0.29.

Already investing with DB

Those sponsors quickest to warm to including illiquid assets in a DC plan are already investing in such assets in their DB plans, consultants said. Others include sponsors that are beefing up their DC plans as their DB plans freeze or close.

When adopted, illiquid investments most frequently appear as sleeves in a target-date fund or other multiasset-class strategies where participant transactions can be managed with liquidity from other asset classes, consultants said. Allocations might range from an aggregate 5% to 15% across various types of illiquid investments, with 15% being on the high end, Mr. Donoghue said.

Since much of the current DC system relies on the ability of different vehicles to be valued daily, Lew Minsky, Palm Beach Gardens, Fla.-based president and CEO of the Defined Contribution Institutional Investment Association, said he believes people reflexively assume that “all components of that investment structure have to be daily liquid.”

However,  a sponsor can have a daily valued investment vehicle, like a default target-date fund, that is not 100% liquid on a daily basis in all  of its underlying investment components, he said. On any given day, flows are less than 100% of the fund, he said.

JM Family Enterprises Inc. started adding less-liquid investments to its defined contribution plans around the same time its defined benefit plan started investing in illiquid assets.

“Currently, plan sponsors are very motivated by fear to be alike and to be very simple, but being plain vanilla does not protect you. Doing what is best for your participants and documenting it protects you,” said Ronald Virtue, Deerfield Beach, Fla.-based director, investments. “If we believe it is better to incorporate some illiquids and alternative investments into the DB plan for better risk/return, it should make sense for the DC plans if we can satisfy administrative requirements,” Mr. Virtue said.

The automotive company's $320 million 401(k) plan and its $599 million profit-sharing plan include investments in direct real estate, hedge funds and globalsovereign debt.

Other DC asset owners that have taken the plunge into illiquid investments include Intel Corp., Santa Clara, Calif.; Washington State Investment Board, Olympia; Tennessee Consolidated Retirement System, Nashville; and Microsoft Corp., Redmond, Wash., according to data from the Pensions & Investments Research Center.

Looking at design

Mr. Minsky believes other large plan sponsors are increasingly thinking about the way they designed the investment structure of their defined benefit plans “and naturally thinking, why would we design (the) glidepath and investment structure of target-date funds differently than we do (our) DB investment structure?”

The New Mexico Public Employees Retirement Association's Smart Save Deferred Compensation Plan is currently searching for its first private real estate manager, hoping that will reduce volatility of real estate investment trusts now held in its custom target-date funds, said Karyn Lujan, Santa Fe-based deferred compensation plan manager.

Each of the $553 million plan's nine target-date funds has an 8% to 12% allocation to global real estate investment trust manager Invesco (IVZ) Ltd. The private core real estate manager would replace Invesco in the target-date fund, while Invesco would continue to manage a stand-alone global REIT option in the plan's core lineup.

The selected private real estate strategy must be set up to provide daily valuation, such as in a collective investment trust or insurance company separate account. “Daily liquidity of regular redemptions of up to 10% per quarter” is also required, Ms. Lujan said. A hiring decision could be made as early as May 25. Investment consultant Meketa Investment Group is assisting. Callan's Mr. Venerusopointed to the number of real estate managers launching DC-friendly private real estate strategies and noted the Defined Contribution Real Estate Council's efforts promoting the asset class and presenting a unified front on liquidity and implementation as reasons for private real estate's pickup over other illiquid investments.

He also cited the public's familiarity with real estate as a potential driving factor.

“I think real estate at a very basic level is easy to understand, so it's an asset class that the general public does have exposure to,” Mr. Veneruso said.

Other consultants pointed to fees and the longer history of direct real estate offerings as reasons for its greater pickup.

If plan executives are moving from actively managed real estate investment trusts to actively managed direct real estate, the fee differential might not be all that significant, said Liana Magner, Boston-based partner and U.S. DC investment leader at Mercer LLC.

To help meet plan executives' daily valuation and liquidity demands, many real estate managers are including allocations to real estate investment trusts, cash and/or credit in their private real estate strategies, consultants said.

PGIM Real Estate offers two private real estate strategies for DC plans with an aggregate of approximately $1.4 billion in assets under management.

Both offerings are fund of funds that invest in PGIM's open-end private real estate strategies and REITs. They are structured as insurance company separate accounts.

The flagship strategy, launched in 2006, has a core-plus profile and includes a roughly 25% allocation to REITs.

The second strategy, launched in 2015, has more of a core profile and a roughly 15% allocation to REITs. A daily valuation is calculated by “allocating pro-rata shares of projected income and appreciation of the underlying direct real estate fund(s) and then combining with REIT pricing.  The income/appreciation projections are adjusted as needed to reflect macroeconomic events, major transactions, property specific events, etc.,” said David Skinner, executive director, defined contribution practice leader at PGIM Real Estate, Madison, N.J.

Mr. Skinner said the strategies are primarily being included as sleeves in multiasset-class strategies, including target-date funds, and that the second strategy is garnering more interest because of its lower REIT exposure. Some $950 million is invested in the flagship strategy and $450 million is invested in the second strategy.

Prudential's Day One Funds target-date series includes a roughly 5% allocation to the flagship strategy.

Outside of Prudential, one target-date provider includes the flagship strategy in an off-the-shelf series and another includes the second strategy. Mr. Skinner declined to name the two target-date providers.

“There is an amount of concern about future returns in equity and bond markets. I think plan sponsors as well as the target-date community are starting to say we need to expand the way we are(thinking) about asset allocation. Those practitioners are looking at other asset classes that can help returns or protect the downside even more. That's one trend that bodes extremely well for private real estate,” Mr. Skinner said.

Mr. Skinner believes fees remains a hurdle for DC illiquids and that valuation and liquidity concerns have come down.

If one of the proprietary target-date funds invests in private real estate, it's a “signal to the rest of the marketplace that it's a core asset class DC plans are investing in and could reduce some of the litigation risk concern,” he argued.

PGIM Real Estate is a member of the Defined Contribution Real Estate Council.

The first mutual fund target-date series to provide direct real estate exposure is Nuveen's Lifecycle Funds. The direct real estate allocation, now 1%, is expected to be boosted to 5% and is managed by TH Real Estate via a private fund.

Having an allocation to direct real estate in a target-date fund “provides enhanced diversification, reduces volatility and improves long-term investment outcomes,” said John Cunniff, New York-based managing director and portfolio manager at TIAA.

Noting that the majority of target-date assets today are held in mutual funds, Erin Donnelly, New-York based executive vice president and head of defined contribution investment only at Nuveen, TIAA's asset management unit, said that the firm is able to target a broader segment of the investor and plan sponsor universe by incorporating direct real estate into a mutual fund target-date series.

The Securities and Exchange Commission has a 15% limit on illiquid investments in mutual funds, which Callan's Mr. Veneruso said has been a “big hurdle” for the '40 Act space.

Similar to the real estate managers, Partners Group Ag and Pantheon Ventures LLC include allocations to liquid assets in their DC private equity strategies, which launched in 2015. However, both firms are still waiting on their first U.S. DC clients.

“I think it's important to outline the pros and cons” of adding illiquid investments to DC plans, said Mr. Veneruso. “There are definite advantages there. It's up to plan sponsors to weigh whether those advantages outweigh the fees and added operational complexity.”

David O'Meara, New York-based senior investment consultant at Willis Towers Watson PLC, said the firm “strongly encourages” DC plan executives to evaluate adding illiquid investments, although “it's not necessarily something that we are pushing in the marketplace.”

“Plan sponsors need to be aware of (their options), especially as DC plans grow and get to be a larger part of the retirement puzzle,” Mr. O'Meara added. “If there is a way to get better outcomes for participants, it deserves a hard look, regardless of the complexity involved.”

Christopher Lyon, Norwalk, Conn.-based partner and head of defined contribution at Rocaton Investment Advisors LLC, added: “We believe in providing participants with broadly diversified strategies in their default option and their ability to build broadly diversified portfolios through their core menu. Considering alternatives and less-liquid strategies is certainly a reasonable consideration. Maybe it's not right for every plan and circumstance, but we are open-minded.”

Regarding some plan executives' concerns on the potential dampening effects of adding liquidity buckets to illiquid strategies, Mr. Lyon said in most cases, plan executives are “starting with pretty liquid target-date funds already.”

The real question is “Does this move the needle? ... Does illiquidity add something as opposed to taking away from it?” he said.

Can't focus on fees

For there to be widespread adoption of illiquid investments by DC plans, Mercer's Ms. Magner believes we'll need to be “in an environment where the low cost is not the end-all, be-all.”

“There's been a really strong focus on low fees in the (marketplace), just sort of excluding everything else,” Ms. Magner said. “I think this need to be taken into context with services delivered, rather than going with what's cheap and cheerful.”

While sources agreed from an investment perspective, it would be better if DC investors were not in a daily valued and liquid environment, several believed that would remain the status quo.

The Washington State Investment Board's total allocation portfolio, an option in its hybrid DB/DC plan, includes a roughly 43% allocation to illiquid assets.

The $7.5 billion total allocation portfolio is a unitized version of the state's defined benefit plans and is valued monthly. Tracy Guerin, Olympia-based director of the Washington State Department of Retirement Systems said the plan's record keeper Empower Retirement “really had to bend over backwards to meet (our) needs on TAP.”

Washington doesn't fall under ERISA, but many of the plan executives who record keepers serve do, and they do daily valuation and liquidity, Ms. Guerin said.

“It's hard for record keepers to build out a separate platform for what they see as a limited market,” according to Ms. Guerin.

The Tennessee Consolidated Retirement System's treasury managed fund, an option in its defined contribution plans, includes a roughly 16% allocation less liquid investments — 8% private real estate and 4% each private equity and semi-illiquid investment grade bonds.

Similar to Washington, the approximately $6 million treasury managed fund is a unitized version of the retirement system's pension plan. Unlike Washington, however, the treasury managed fund provides daily valuation and trading, said Mike Brakebill, Nashville-based chief investment officer.

Noting that the Washington plans are larger and have more invested in illiquid assets, Mr. Brakebill said providing participants with daily valuations and liquidity is a much “harder task for them than for us.” The treasury managed fund first became available in 2015.

This article originally appeared in the May 1, 2017 print issue as, "Many see potential, but few take action".