Commentary: Proposed fiduciary rule highlights need to consider alternatives in target-date funds

The Biden administration recently proposed a new fiduciary rule. It is designed to lead to greater protections for employers and their employees. There will be plenty of debate and comment before the rule is finalized, and there will surely be court battles for years to come. This continues the back-and-forth and litigation that has existed since the new fiduciary rule was originally proposed by the Obama administration in 2015. In the meantime, however, any iteration of the fiduciary rule — including current fiduciary standards — should lead to the increased use of alternative assets in 401(k) plans and other defined contribution retirement plans. Fiduciary duty requires that retirement plan advisers strongly consider using alternative assets in the DC plan.

For years, politicians and regulators have battled over a simple question: In what situations must an adviser put clients' best interest first? Disputes about this topic range from fees to the recommendation of "house" products, conflicts of interest, the nuances of five-part tests, and competing DOL and SEC regulations. The argument is often focused on an individual adviser's investment advice to individual investors. But the recently proposed rule is a reminder that this fiduciary obligation also applies to retirement plan advice. This will bring heightened scrutiny to all kinds of recommendations made by advisers, including advice regarding the assets included in target-date funds.

In exercising this fiduciary duty, consultants and other advisers should seriously consider the use of alternative investments. Alternative assets may not be right for the do-it-yourself 401(k) menu, but they are entirely appropriate for professionally managed target-date funds. The Department of Labor made this clear in advisory letters in June 2020 and December 2021.

And rightly so. There are many arguments in favor of the use of alternative assets in target-date funds inside DC plans. High-net-worth investors have this access through their portfolios; why not the middle class 401(k) participant? The employer can use these investments in its defined benefit plan (assuming it still has one); why not allow the DC participants the same advantage? And with the declining number of public companies and the increase in the number of companies owned by private equity firms, shouldn't DC participants have access to this larger investable universe?

These are all good points, but they do not go to the heart of the fiduciary rule. The fiduciary duty requires a best-interest-of the-participant standard for anyone who is advising a plan sponsor about what investments to make available in the DC plan. So if there is a class of investments that demonstrably increases diversification and therefore can enhance returns and /or mitigate risk, then a fiduciary that is properly carrying out its fiduciary duty must certainly include consideration of those categories of investments in its advice.

Numerous studies indicate that alternative investments are likely to enhance outcomes. For example, a 2018 policy report written by Willis Towers Watson for the Georgetown Center for Retirement Initiatives concluded that a target-date fund that included a modest allocation to alternative assets would support 11-19% greater income in retirement.

A 2019 academic paper sponsored by the Defined Contribution Alternatives Association modeled thousands of portfolios using actual asset returns and reached two important conclusions. First, returns are consistently higher for portfolios that incorporate private equity funds and, second, that Sharpe ratios are consistently higher for portfolios with private equity funds.

And last year, the Defined Contribution Institutional Investment Association published a paper that explained that private real estate has a low correlation to traditional investments and enhances risk-adjusted return.

Alternative assets sometimes have higher fees, and some advisers may feel that it is their fiduciary duty to avoid these fees at all costs. They may feel that they must select the lowest-fee option, and that will satisfy their fiduciary duty. This is wrong. The real fiduciary measure should be the likely risk-adjusted performance after fees. As a fiduciary, which would you recommend: an investment with an expected gross return of 7.5% and a net return of 7%? Or one with an expected gross return of 9% and a net return of 8%?

Fear of trial lawyers drives some fiduciaries to focus only on fees. But what happens when the trial lawyers focus on ultimate risk-adjusted returns to participants?

This is a crucial question that is posed by the fiduciary rule as now drafted: If we are putting participants' interests first, how can we not consider the use of the kinds of alternative investments that can demonstrably improve risk-adjusted retirement outcomes?

The proposed fiduciary rule has a lengthy comment period and may change in many ways before it becomes a final rule, and it will surely end up in court. One focus that will surely remain is the duty to seek the best actual outcomes for 401(k) and other DC plan participants. That should include the consideration of the alternative investments that can enhance retirement security for millions of Americans.

Charles E.F. Millard is the former director of the U.S. Pension Benefit Guaranty Corp., and a senior adviser for Ares Management. He is based in New York. 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.