Many defined contribution plan sponsors have gotten anxious about whether their participant fund lineups are optimal to helping meet their participants' future needs.
For starters, some investment menus have gotten overly complicated, as more and more investments were added in the honest pursuit of diversification; new products were added that were only separated by their style box flavor. Combined with behavioral biases, the unintended consequence of this is that participants are living in a mirage of asset diversification.
At the same time, most participants seem to be underinvested in risky assets. Participant wealth is primarily allocated to money market funds, stable value funds or sometimes target-date funds paired with self-selected investments in domestic core bond funds.
Further complicating the situation, plans have added passive index options to appease cost-conscious participants, who end up pairing them with other investments inefficiently.
The gap between eventual needs and the potential results of the current investment mix should worry every fiduciary, asset manager and consultant.
Additionally, most retirement saving plans conceived in the past overwhelmingly anchored long-term goals around the “magic retirement number,” a total return expectation of 7% to 8%. However, the reality is that most DC participants appear at risk of not achieving portfolio objectives over the long run. The net yield on a low-cost indexed 60/40 portfolio is about 2.1%, meaning capital appreciation would have to consistently make up the remaining 5% to 6%. Given the potential for rising rates, capital appreciation on bond portfolios might be muted in the coming years, if not negative. This would entail equities consistently posting mid-to-high single-digit returns for the foreseeable future, which might be difficult because of the slow-growth environment.
One solution might be to reorient participants' investment compass into meeting three simple needs: growth, income and protection from risks. Instead of simply adding alternatives as a “new asset class,” sponsors should understand exactly how different alternative investments can help generate growth, income and protection. This is an outcome-driven viewpoint of alternatives. For example, bank loans can help protect against inflation because of inflation-adjusted yields and can also help protect from interest rates moves due to their low duration. It is also an “income alternative.” Yields in some non-traditional real assets are typically higher than traditional bonds as well. For example, master limited partnerships and real estate investment trusts recently yielded 5.9% and 3.9%, respectively. They are also a “growth alternative” since they have long-term distribution growth characteristics built in as well.
How can DC plan sponsors implement alternatives that might help protect a portfolio from certain risks without making investment menus more complex? Consultants and plan executives can ask to augment a growth or income portfolio with such strategies into a single participant choice. One such possibility is a multistrategy alternatives fund considered to be “cash-plus,” which targets a steady return stream above a risk-free benchmark, meaning its volatility is managed to low levels while seeking an absolute level of return.
Plan participants have concerns that may be stopping them from allocating to alternatives, such as skepticism over volatility, liquidity, fees, transparency or even tax reporting.
Despite the historically high volatility of certain hedge fund strategies, it must be noted that today's alternative investments aren't “liquid hedge funds.” In fact, the universe of alternative investments available through the mutual fund structure represents diverse strategies and each requires their own analysis (the risks and returns for most alternatives strategies aren't directly tied to global growth or interest rate moves). The mutual fund structure actually helps solve the issues that historically limited alternatives investing to institutions. These mutual fund structures are simple, with daily liquidity, reasonable fees, full transparency and standard 1099 tax reporting.
Kamal Bhatia is senior vice president and head of fixed income and alternatives products at OppenheimerFunds, New York.