Expected to gather more defined contribution assets than all other choices combined in major pension markets, the next generation of age-based default investment options will likely be constructed using many more defined benefit building blocks.
Taking a cue from U.S. target-date funds, which are going through a transformation period themselves, default options being launched overseas are increasingly using alternative investments, manager diversification and risk management tools to optimize performance.
At stake is how to better design and implement the asset allocation strategy of default options.
“We think plan sponsors should be putting the bulk of their resources into building a better default,” said Richard Davies, managing director for defined contribution at Russell Investments, New York.
While the U.S. leads globally in target-date fund innovations, other nations are catching up, particularly in capturing the illiquidity premium and using derivatives to lower volatility.
Mark Fawcett, chief investment officer of NEST Corp., London, the trustee group for the U.K.'s national DC plan, said one key focus worldwide is how to incorporate illiquid assets into the investment portfolio.
At NEST, two main barriers exist — cost and daily pricing, Mr. Fawcett said. “Providing that you can manage those two issues, we don't see any reason why we shouldn't invest in illiquid assets to get access to the different risk premiums,” Mr. Fawcett said. NEST issued an RFP earlier this year to hire direct real estate and global REITs managers, and is currently conducting research into how infrastructure could be added to the target-date default fund.
NEST officials are exploring “what is an appropriate proxy between valuation periods” for infrastructure, Mr. Fawcett said. “Because (infrastructure) is not going to be massive part of the fund, any difference (from the true value) will likely be a rounding error. At the fund level, this error will be negligible. We need to make sure that any differences are within an acceptable tolerance level, and members won't be disadvantaged.”
“If we can work through these issues, infrastructure will be the first truly illiquid asset” to be added to the default fund. In the long term, illiquid assets could potentially account for 20% of the portfolio, depending on cost and the relevant risk/return characteristics.