Increasingly, defined contribution plan sponsors are recognizing the benefits that private market investments can provide their plan participants, including improved diversification and the potential for enhanced risk-adjusted returns over the long term. While concerns about lack of liquidity and high perceived risks have been preventing DC plans from investing in private markets, recent market developments, as well as legal precedent and regulatory initiatives, have led sponsors toward closer evaluation of these assets.
Private Markets Get on the DC Plan Investment Menu
Rising allocations to private markets in recent years by defined benefit plans and other institutional investors have drawn the attention of DC plans, which are now delving into the ways that real estate, infrastructure, private equity and private debt could help improve retirement outcomes. They are considering using these assets within the default target-date fund as well as for managed accounts.
“Among plan sponsors, we see a greater appreciation of the risk characteristics of private markets. They have come to recognize they can be stabilizing assets in portfolios and have very low correlations to traditional asset classes,” said Tom Keck, head of research and portfolio management at StepStone Group, a private-market investment manager with $146 billion in assets under management, as of September 30, 2023.
For example, infrastructure investments provide a degree of current income and inflation protection, as well as low correlation with the public equity markets, said Jason Ment, StepStone’s president and co-chief operating officer. “This is an exposure, not often found in target-date funds, that can reduce risk for retirees. At the same time, the longer-term investment horizon of a TDF glidepath supports the inclusion of private equity as well, which can deliver meaningful asymmetric net-return benefits relative to public equities.”
Less than 1% of all DC plan assets are in private markets right now, which points to a long runway ahead to considerably boost that share given favorable policy, regulatory and technological changes in recent years.
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“Over the last 25 or 30 years, we’ve seen that private markets exhibit lower volatility over time, and they don’t usually have any quarters where all of a sudden the performance is just much worse,” Keck said.
A key reason that the long-term performance of private-market investments tends to be more stable is their accounting is typically based on quarterly valuations. “There is so much volatility in the public markets that’s driven by investor behavior and not necessarily by fundamental values,” he said. “In private markets, the last quarter’s valuation tends to be a pretty good estimate for what next quarter’s valuation is going to be. There are fewer surprises.”
Historically, private markets have been viewed as having more risk “for reasons that make sense intuitively: higher leverage, smaller businesses and typically more operational complexity,” Keck said. But recent history has demonstrated that private markets can deliver access to fundamental value-creating strategies that do not bear the brunt of volatility induced by shorter-term investors. “That’s been driving greater interest in private markets across the board.”
In addition, the outperformance of private markets has become more apparent to investors, including DC plan sponsors. “When looking at private equity, pretty much every fund vintage since the great financial crisis has outperformed its public markets equivalent,” Keck said.
Several of the challenges that have long confronted sponsors about integrating private markets investments into DC plans have largely been mitigated, Ment said. Among recent developments are the dismissal of a lawsuit against Intel for including alternative investments in its retirement offerings, as well as guidance from the Department of Labor early last year that outlines how plan fiduciaries may offer certain private equity strategies without violating ERISA regulations, he said, referring to the Employee Retirement Income Security Act of 1974. “As a result, including private markets in professionally managed retirement accounts no longer faces the same legal uncertainty that it may have in the past.”
Advances in platform and investment technologies have opened the way to more nimble portfolio construction for DC plans, and daily valuation and improved liquidity management have reduced operational complexities for sponsors while increasing transparency for participants, Ment said. To that end, DC clients can use StepStone’s “daily valuation engine,” which the firm developed to utilize its proprietary private-market data.
“There’s now a greater understanding of these assets and how to combine them in different ways to create a better liquidity profile. Having this ability to address any liquidity issues that may come up gives plan sponsors more confidence, which is also creating greater interest among DC plans,” Keck said.
The four major types of private-market investments — real estate, infrastructure, private equity and private credit — help achieve different portfolio objectives, and each delivers distinct benefits. They have different return, liquidity and risk characteristics in terms of diversification, inflation hedging and investment growth.
Real estate, for one, offers diversification away from publicly traded assets. It has only about a 30% to 40% correlation with the traditional 60/40 portfolio of public equities and bonds, Keck said. “It’s a very versatile asset class. The different property types tend to have very different dynamics, and you can actually create a nicely diversified portfolio using the different subsectors, which have a variety of return profiles,” he said.
Infrastructure is even less correlated with traditional portfolios, at about 5% to 10%. It’s often a longer-duration investment with higher-income potential and an even stronger hedge against inflation, Keck said. “As with real estate, you can put together a variety of return profiles, depending on the types of assets.”
Private equity has historically offered greatly enhanced returns. “Our research indicates that on average, general partners typically drive revenues in private equity buyouts about 400 basis points faster than the S&P 500,” Keck said. They can also deploy leverage and capital structures that allow more value to accrue to equity.
Of the private-market asset classes, private debt has, historically, the highest reward for the least risk, Keck said. It also has a higher correlation with the 60/40 portfolio, but it provides potentially enhanced returns and low volatility. Duration tends to be shorter, which provides repricing opportunities. In addition, since most private debt is floating rate, it doesn’t carry as much term or interest rate risk. “Private debt also tends to be more stable than public fixed income because its pricing is based more on its fundamentals than how the markets are moving,” he said.
For sponsors interested in adding private-market exposure to their plan lineups, the most prudent way is through either target-date funds or managed accounts, said Ment. “This is consistent with Department of Labor guidelines, and there are operational benefits from having the allocation sit within a broadly diversified portfolio.” Private-market investments can also now be accessed through a variety of structures that help meet the liquidity and duration needs of different investor types.
StepStone currently has several evergreen funds that strike monthly or daily net asset values, provide quarterly liquidity and support daily investments through the use of a ticker, Ment said. “For use within TDFs, we can structure a portfolio, manage liquidity, strike a daily NAV and support investment flows in a CIT,” he said, referring to a collective investment trust.
And while many plan sponsors may be familiar with private markets today, many are not, StepStone has found. As part of its educational outreach, the firm has rolled out a number of programs and tools to help educate DC plan investment committees, internal staff, plan advisers and participants about private markets.
“I think this evolution in thinking is going to be quick,” Keck said. “DC plan sponsors are climbing the learning curve quickly.”
Currently, DC plan sponsors are focused not on the specific investments themselves, but on making sure that private-market exposure will work for their plan participants. “Our conversations are really more about risk-management concerns, particularly around liquidity: How are we going to build this exposure? And how are we going to deliver liquidity, as it’s needed, to beneficiaries?” Keck said.
Facing a market environment that will be more challenging for traditional assets in the coming years, Keck expects that investors’ focus on private markets will continue to be quite favorable, particularly as they continue to see strong vintage years for private-market strategies, including those offered by StepStone. “Having historical data about how these different strategies perform through different cycles gives you an advantage in understanding their risk profiles and helps to construct portfolios that survive the market events to come.” ■
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