Hunt for diversification may get plans to rethink alts

The recent pandemic-induced market volatility could make the concept of adding alternative assets to defined contribution plan lineups more attractive for sponsors, but litigation concerns persist, sources said.

"I've seen over the years plan sponsors coming out of periods of extreme market stress in particular and take that as an opportunity to re-evaluate their portfolios," said Josh Cohen, Chicago-based head of institutional defined contribution at PGIM Inc., the investment management businesses of Prudential Financial. "Clearly we're seeing extreme volatility, extreme downside performance in most asset classes, and I have no doubt that this will lead to additional considerations of strategies."

Stuart Odell Jr., San Francisco-based managing director and senior consultant at Verus Advisory Inc., an investment consulting firm and provider of outsourced CIO services, said there hasn't been much clamor for adding alternative assets to DC plans in recent years because target-date funds have performed so well.

"But right now, I'd be looking under the cover of some of these off-the-shelf target-date funds and see what they're actually holding and whether those are really diversifying asset classes and strategies in market environments like this," Mr. Odell said. "I suspect that some plan sponsors or participants in particular will be surprised that they haven't provided true diversification particularly in volatile, down-market environments."

While Mr. Cohen is a proponent of adding alternatives assets to DC plans, he said it's unwise to draw major conclusions from the recent market volatility. And others said it can be difficult to value private assets.

"Just like you wouldn't want to just look at the last six or seven years of a low-volatility environment to say what worked and what didn't, you also don't want to take a four-week period of high volatility and say what works and what doesn't," he said. "I think you want to really have a robust process and look at this over the long term."

But in the coming months and years there will be data examining how private fund investments performed vs. public markets and how DC plans fared vs. defined benefit funds where alternative assets are a staple, said Joshua Lichtenstein, a partner at Ropes & Gray LLC. "The conversation is going to look different on the other side of this because you're going to have data on what extreme market stress did to the different types of portfolios," he said.

David Levine, principal at Groom Law Group LLP who works with the Defined Contribution Alternatives Association, an organization that seeks to expand the use of alternatives in DC plans, said a DC plan lineup featuring mainly public equity options isn't necessarily wrong. But "given the defined benefit plans and institutional endowments using a more diversified mix, maybe diversification is good."

There aren't many DC plans that currently offer real estate or private equity in their investment lineups. Of the defined contribution plans among the 200 largest U.S. plan sponsors, 39 indicated they invested in real estate investment trusts in their target-date funds as of Sept. 30, compared to 29 the year prior, according to P&I's annual survey of the largest retirement plans. Fifteen included real estate in 2019 compared to 16 the year prior, and no plans held private equity either year.

A 2018 member survey from the Committee on Investment of Employee Benefit Assets in Washington, whose members are chief investment officers responsible for nearly $2 trillion in retirement assets, found that 21.6% of DB plan assets were invested in alternatives. Alternatives made up 24.3% of DB allocations among the 200 largest retirement plans in P&I's survey as of Sept. 30.

One of the main reasons why alternative assets aren't more prevent in DC plans is plan sponsors' fear of litigation, sources said.

With today's "litigious environment I think most plan sponsors are not even inclined to look at (alternatives) as an option," said Dennis Simmons, executive director of CIEBA.

In recent years, plan sponsors have been hit with class-action lawsuits centering around excessive fees. Notably, a lawsuit against Intel Corp. reached the Supreme Court, whose ruling in February gave DC plan participants more time to file ERISA claims unless they have "actual knowledge" of the sponsor's investment decisions and actions. The 2015 lawsuit alleged that plan managers violated their ERISA fiduciary obligations by offering too many alternative investments and inadequate disclosures of investments.

The case, Sulyma vs. Intel Corp. Investment Committee et al., will head back to U.S. District Court in San Jose, Calif., to decide the merits of several claims raised on behalf of a potential class by Christopher Sulyma, a participant in two Intel defined contribution plans.

Before joining Verus Advisory in February, Mr. Odell served until early 2019 as Intel's assistant treasurer for retirement investments, where he oversaw the day-to-day management and operations of Intel's retirement plan investments.

In the current litigation landscape, "there isn't necessarily an incentive for plan sponsors to stick their necks out and do certain things," Mr. Odell said. "If they're offering a DC plan as an attract-and-retain benefit, then doing things differently that potentially introduce other risks isn't necessarily the first thing a plan sponsor is going to gravitate to."

Guidance from the Department of Labor would go a long way to making DC plan sponsors feel more at ease offering alternatives in their lineups, Mr. Simmons said. In a July 2019 comment letter to Labor Department officials, CIEBA said guidance should be issued stating that "alternative investments are not per se imprudent, and that there is no presumption of their imprudence. Additionally, the guidance should provide a framework consisting of factors fiduciaries should consider when evaluating alternative investments in defined contribution plans."

One of the issues CIEBA would specifically like the Labor Department to address involves valuation.

It can be difficult to get an accurate valuation of a private asset, especially in volatile periods, which has led U.K. real estate fund managers like BlackRock Inc. and Schroders PLC to suspend some funds recently. "This material uncertainty, in effect, means that the independent valuers are unable to rely on previous market experience to form an opinion of value in the current market conditions," Schroders said on its website.

With respect to valuation, CIEBA suggested the Labor Department framework for fiduciaries should include "the methodology that would be used for valuation, as well as the timing of valuations" for privately held securities.

Mr. Simmons said the Labor Department could put out an advisory opinion or even something less formal like an FAQ detailing the steps that a prudent fiduciary considering alternatives should take.

"It would definitely ease some (litigation) concerns," Mr. Simmons said. "We're hopeful that you would at least move on to the investment merits of having alternatives as opposed to right now (where) there almost is a general default to being ultraconservative in the defined contribution space."

Jonathan Epstein, New Orleans-based president of the Defined Contribution Alternatives Association, said the Labor Department is looking into this issue. The group in February met with Labor Department officials, including Preston Rutledge, assistant secretary of labor for the Employee Benefits Security Administration, to discuss what a fiduciary should consider if they were going to include private markets in their plans. In a proceeding letter to Mr. Rutledge in early March, DCALTA outlined issues such as fees, valuation and liquidity as things for fiduciaries to examine.

"DOL was interested in learning how we perceived things," Mr. Epstein said. "It showed to me that this is a lot further along than I thought."

He added, "I'm hoping that they provide some type of language, whether it's through a fiduciary ruling or some type of guidance that alleviates some of the plan sponsors' feelings about being innovative and including alternatives investments in their plans."