Alternative investments have failed to gain a foothold in defined contribution plans, retirement plan advisers say, for the same reasons that have kept them on the outside looking in all along — they are risky, illiquid, invite lawsuits and most employees aren’t interested enough to learn about them. But automatically excluding them could be a setback for investors.
Jonathan Epstein, president and founder of the Defined Contribution Alternatives Association, said he sees three reasons for an upswing in momentum for alternatives — the surge in private market capital formation, the fact that more companies are going private and staying that way for longer, and data from Apollo Global Management that showing that 87% of all U.S. companies with more than $100 million in revenue are privately held.
DC plan participants should have access, he said.
Epstein expects to see more DC plans using multiasset type solutions, like target-date funds, target-risk funds, managed accounts and balanced options, and pointed out that DCALTA doesn’t advocate for stand-alone private equity funds on a core menu. For smaller plans especially, some retirement plan advisers say the way to deliver alts is in target-date funds.
Epstein noted that Mercer and Callan have been constructing target-date funds with alts for a number of years, and that the Washington and Oregon state retirement systems have been allocating to alts in their DC plans via unitized DB fund structures for many years.
“A lot has changed over the past five to seven years,” he said. “Not considering alts, in my opinion, will be the next piece of litigation risk.”
More than a third of investors participating in 401(k), 403(b) and 457 workplace retirement plans expressed interest in investing in private market assets, according to the Schroders 2024 U.S. Retirement Survey.
However, half of the plan participants surveyed did not understand the benefits of adding alternatives to their retirement portfolios, which could limit adoption in defined contribution plans.
Defined benefit plans and other pools of capital have benefited from allocations to private real estate, private equity/debt, hedge funds and real assets for decades. And with companies staying private longer, some DC managers are saying it might make sense to consider adding investments in private markets to the plan. The question, however, is how best to do that.
Wall Street is itching to get into the game. Alts giants Apollo Global Management and Ares Management want a piece of the more than $11 trillion global defined contribution market through partnerships with traditional money managers. But some retirement plan advisers say alts and 401(k)s are a bad match.
'Scars that haven't healed yet'
“I just don’t think the mechanism of a 401(k) plan is the right vehicle,” said Charles Langowski, principal and CEO of Advanced Capital Group in Minneapolis. Since Sept. 1, ACG has been part of Alera Group, which has $34 billion in retirement plan assets and 1,100 retirement plan clients. The size range of the plans is $5 million to $4 billion.
“I got beat up 10 years ago by trying it, so I’ve got some scars that haven’t healed yet,” he said.
At the time, Langowski said he was probably managing 25 plans, with alternatives in half of those plans. Exposure to areas such as real estate and long/short equity was provided via stand-alone mutual fund options.
“Over time, we just attritioned out of those funds either due to just lack of usage, or frustration by the plan sponsor of just not understanding the performance profile of those funds and just wanting to eliminate them. Now I’ve got them fully out of all my plans,” he said.
The idea behind a 401(k), he said, is steadily saving for retirement, which runs counter to the nature of alternative investments, which can be volatile. “A 5% allocation to an alternative fund isn't going to make a difference for somebody who’s saving 3%. It's not going to move the needle on getting into retirement or not,” he said.
Langowski went on to cite a number of other reasons why the alts experiment didn’t work. First, high fees. “Back then fees were relatively higher than what you see today, since competition has heated up a little,” he said.
He also said making a change in a defined contribution plan for an underperforming fund is a much lengthier process than for a traditional pension plan, 90 days as opposed to three to five days in a defined benefit plan.
“The 90-day window is driven by regulatory notice requirements and record keeper timelines,” he said. “The funds have ample liquidity due to the fact they are ’40 Act funds. Private funds that are limited partnership in structure are not eligible for investment in a DC plan due to the need to mark-to-market on a daily basis,” he said.
That time difference is critical, he said, if a fund is underperforming. A company bears the risk for a lagging fund in its defined benefit plan and can make changes quickly. A 401(k), he said, would be stuck with 90 days of underperformance and the participants would bear the risk.
In addition, Langowski said many times plan sponsors just don’t have time to adopt new strategies, and frankly, have no incentive to “as long as the plan is running fine and participants aren’t clamoring for anything. They (plan sponsors) aren’t interested in the shiny new object of the day.”
He acknowledged that the argument "am I providing the highest return possible for participants?” is always present, “but so is the ERISA mandate of acting in a manner consistent with that of a prudent person. Just because an investment may potentially derive a higher rate of return, the risk level or complexity of it may not be deemed appropriate for the average investor.”
Finally, said Langowski, legal challenges are on the rise, and plan sponsors don’t want to give participants ammunition.
“If having an asset class that participants don't understand may heighten their scrutiny, plan sponsors aren’t interested in that,” he said. “And we've actually seen plan sponsors wanting to reduce the number of funds in their plans and the number of asset classes to simplify and not complicate.”
Often misunderstood
Craig Stanley, financial adviser and lead partner for retirement plan consulting at Summit Group of Virginia, also part of Alera Group, said the challenge with having alternatives in plans is that they're often misunderstood and misused by plan participants.
“Some alts can be high flyers in certain years and the worst performers in other years — an extremely volatile asset class,” he said. "Sometimes we find participants wanting to go to certain alts, like precious metals, during periods of either market stress or political uncertainty. We've certainly seen some additional questions around gold lately, as an example. The problem is that, as stand-alone options, participants often misuse these as a way to 'time the market' or 'chase the winners,' which are methods that are rarely successful in retirement plans.”
Because of the volatility, Stanley said diversification via alts doesn’t really work because people will look at last year's returns and pick the highest performer, which may have been due to an extraordinary situation.
“So it becomes a fiduciary risk to offer these types of things in plans more often than not because it's not common that participants use them correctly, meaning as a small piece in their overall portfolio,” he said.
Stanley said including alts in target-date funds, or other premade asset allocation strategies, certainly could help address the risk of the asset class being misused by participants. Of course, the target-date funds and the underlying investments still need to be scrutinized by the plan fiduciaries to ensure that the performance, expense and risk level are appropriate for the participants, he said.
Stanley said his clients that do use them tend to be professional organizations where the participants likely have greater access to their own personal financial advisers, who help them create portfolios and avoid misuse.
For these clients, Stanley said the most common alts are real estate funds, specifically REITs, which are generally '40 Act mutual funds and liquid. “Broad basket commodities and precious metals are close behind, though,” he said.
He said another option for getting alternatives into a plan is a self-directed brokerage window where people can make selections vs. having them available on the core menu.
“That’s an extra layer of protection from keeping more novice plan participants from making bad decisions,” he said. “Illiquidity on a core menu never would be suggested by our team or most plan advisers.”
That’s why Stanley said he doesn’t see alts really gaining momentum in the DC space as a separate asset class. But, he added, “if alts can provide a meaningful enhancement to target-date funds or other asset allocation strategies, without being a stand-alone option for participants to choose, that is where alts could potentially gain momentum in qualified plans.”
As for the value of alts as hedges, he said that is not that relevant for DC plans because where pension plans have to make sure they’re funded and can provide distributions, DC plans do not. Also, people there are invested for the long term.
As diversifiers, he said offering alts as a standalone investment option is outweighed by their volatility and potential for misuse by the majority of participants, who are likely novice investors.
He said people getting closer to retirement may be more comfortable using bonds and more traditional defensive investments rather than alts to manage volatility.
Brett Fisher, head of retirement investment product strategy at Principal Financial Group, said he sees alts being used as an option in the mega end of the market, plans with $500 million or more in assets, but not in smaller plans.
“Those plan sponsors just aren't as sophisticated. They don't have as many resources available to them to take on that fiduciary liability and provide those solutions to participants,” Fisher said.
He did say Principal has an allocation in its active target-date and hybrid target-date funds to a real asset portfolio, a liquid way to get access to natural resources and commodities. “But only our near-dated target-dates, those five years before the normal retirement age of 65, have an allocation to the Principal Diversified Real Asset Fund,” he said. “Currently, exposure in those near-dated portfolios is less than 1% after recently reducing the weight.”
