What would it take to bring defined contribution plan performance into line with defined benefit plans? While the gap has narrowed in recent years, defined contribution plan performance still lags behind. A 2018 white paper by CEM Benchmarking calculates that defined benefit plans' return advantage has declined to 46 basis points from 2007 to 2016, compared with 180 basis points from 1998 to 2005.
This progress is encouraging, but even a small difference in performance over many years can result in significantly lower account balances for retirement plan participants. To achieve parity, defined contribution plans may want to consider another piece in the retirement security puzzle: private alternative investments.
Private equity, private credit and real estate have long been a mainstay of institutional portfolios, making up more than 20% of holdings in 2018, according to the Center for Retirement Research at Boston College. Defined contribution plans, by contrast, have largely been shut out of the private alternative asset class. This is unfortunate because private alternatives provide a number of benefits, particularly to retirement investors whose time horizon is often measured in decades, rather than in months or even years.
Over the past 20 years, private alternatives have produced higher returns and lower volatility vs. publicly traded markets. They offer strong diversification benefits, too. Private equity has a 0.75 correlation to public equity. Other private alternatives have even lower correlations, including private real estate at 0.18 and private debt at 0.27 for the same period.
Individual retirement plan investors typically don't have access to private alternatives, which have high minimums, long lockup periods and other restrictions on investor qualifications. Even pooled alternative funds present difficulties, since retirement plan participants usually invest in small, regular amounts over time and expect daily liquidity. By incorporating private alternatives into target-risk or custom target-date funds, it is possible to overcome these obstacles and bring defined contribution portfolios more in line with institutional defined benefit plans.
Adding private alternatives to target-risk or custom target-date funds diversifies investment holdings and aims to help individuals achieve exposure to asset classes comparable to institutionally managed portfolios — without adding complexity or disrupting liquidity. From the retirement plan participant's perspective, investing remains simple. As with any target-date fund, participants may simply pick the fund with the date closest to their retirement and stay the course.
Defined contribution plans have long looked for ways to incorporate private alternatives into their investment options so participants can have access to the benefits of institutional-style strategies that are the hallmark of defined benefit plans. It's one of the last remaining pieces in the retirement security puzzle for defined contribution plan investors, and it may help them close the performance gap with defined benefit plans.
Flora Li Hedrick is managing vice president of investments at Vantagepoint Investment Advisers LLC and is responsible for developing alternative investment strategies and incorporating alternatives into the firm's investment products and solutions. Vantagepoint is the investment arm of Washington-based ICMA-RC. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.
