David Skinner:One development that stands out to me is that DC decision-makers are asking themselves different questions today as opposed to five years ago. In the past, these decision-makers would focus on daily liquidity and daily valuation when evaluating an alternative asset class. These are mechanical issues, not investment issues. Today you hear about maximizing participant outcomes from an investment standpoint. The next series of questions are also related to maximizing participant outcomes. Do these strategies meet regulatory standards? How does cash flow within the DC plan work with an illiquid structure? How much can I afford to allocate to maximize the return? Can I still meet the liquidity needs of the plan? The fact that these questions are being asked is the first thing that had to happen. From a fiduciary standpoint, the thinking has evolved markedly. ERISA requires that a fiduciary use a prudent standard of care when selecting investments. The three issues that a fiduciary must be cognizant of are diversification, liquidity and the funding status of the plan. You can add an illiquid investment to a professionally managed portfolio like a target-date fund and still be in full compliance with ERISA as long as you have factored in those three variables. And as we discussed earlier, liquidity is defined in shades of grey. In 2009 for example, traditionally liquid asset classes such as stable value and fixed income were not as liquid as expected. The bottom line is that ERISA supports both liquid and illiquid asset classes as long as prudent thresholds have been met. So ERISA would support any type of alternative, just as it does with stable value, as long as the sponsor has gone through an appropriate and thoughtful analysis that factors in issues around cash flow and diversification.
Bon French: American regulators and plan sponsors should look at Australia's experience with alternatives as an example of how very large pension schemes, including DC-type retirement plans, can implement alternatives successfully. Australian DC plans have long held real estate, hedge funds, and private equity in their portfolios. We have had clients there since the mid-1990s, and because these are large sponsors, with large numbers of employees in each plan, they can afford to have some illiquid alternatives, and there isn't anything unusual about it in terms of prudence. On the valuation front, asset managers have made significant strides in accommodating the needs of DC plan sponsors in areas like valuation. Granted, daily valuation is much more difficult in private equity because we issue financial statements quarterly, and within a particular investment there could be some great lumpiness during the quarter—for example, if a company goes public, then the fund's valuation could be much higher than in the previous quarter. But in a large private equity portfolio, returns are pretty smooth, and the correlation with public markets is about .65 to .75, something in that range. So we can provide estimates that pretty well approximate what's going on in a private equity portfolio, based on movement in public markets. Again, these things have been done for years in other countries, like Australia. As for fees, the true measure of the value of alternatives will be the net-of-fee return, and the potential improvement in risk-adjusted performance of the portfolio. If all you are looking at is fees, you are looking at only a small part of the overall equation.
David Skinner: That is an important point. DC sponsors can be very sensitive about fees. Some sponsors will shy away from adding asset classes with higher fees even if these asset classes can help maximize the plan's total return. The issue centers on how incremental return that can be realized by alternatives compares with the incremental cost. I like to say that the most expensive things we buy in life are the things that don't work for us, which we then have to replace.
Rob Capone: Fortunately, the industry is increasing the investment vehicle options available to DC plan sponsors, across the fee spectrum—notably zero revenue share class mutual funds and bank collective trusts. And I think it makes sense to offer investment strategies across the vehicles given that we deal with different segments of the market and different sizes of sponsored plans. If we are focusing on target-date funds as the most appropriate landing place for alternatives, we need to take note of the utilization trends. According to Casey Quirk, target-date assets project to be 37% off-the-shelf passive, 26% off-the-shelf active and 37% custom by the year 2020. An all-passive solution will be relatively inexpensive and therefore any alternative strategy to be considered as add-on or a replacement will need to fit both the type and cost structure. For DC plans with more actively managed, custom target-date options, the premium will be placed on net-of-fee returns and potential value added in terms of lower managed volatility and a higher probability of reaching the desired investment outcome. If a 5%, 10%, or even a 20% allocation to alternatives can make a positive impact on stability of income and returns, then I think cost becomes less of a factor. It gets back to the overall issue of plan sponsor philosophy, and goals in designing the investment strategy menu.