Alternative assets can play a very useful role in 401(k) plans and other defined contribution plans. And plan sponsors are increasingly considering using them in target-date funds, multiasset funds and managed accounts.
However, there are a few governance-related and operationally-related steps that sponsors should be aware of that can ease the implementation of alternative assets in those defined contribution plans.
The case for alternative investments in retirement plans is strong. They increase diversification, which can enhance returns or mitigate risk, or both. For example, the Georgetown Center for Retirement Initiatives recently published a paper on this topic. One conclusion: Based on a set of very reasonable assumptions, a 10% allocation to alternative assets could increase returns by 0.15%. This may seem small at first, but that translates into $2,400 per year in additional income for a retiree who would otherwise receive $48,000 in annual retirement income.
Similarly, most alternative assets offer lower observed volatility than publicly traded stocks and several types have had low correlation to public markets. The Defined Contribution Alternatives Association (DCALTA) and Institute for Private Capital released a study with the University of North Carolina that shows risk/reward efficiency — using multiple metrics of risk — can be improved 25% when private investments are included.
Additionally, today there are about half as many publicly traded companies as there were 20 years ago. Around 3,600 companies are publicly traded while more than 11,000 are privately held. The private universe is growing, and this area of investment opportunity should be available to DC participants.
Finally, institutional investors such as defined benefit plans and wealthy U.S. investors — as well as everyday Chinese, U.K., and Australian savers — have access to these kinds of U.S. investment opportunities. Some large public plans have extended their defined benefit alternatives portfolios to their DC participants. The middle-class worker who will be dependent on a 401(k) in retirement should have access to alternative investments as well.
These arguments and data points are well-known and widely accepted, and the Department of Labor has twice in recent years published guidance indicating that alternatives can prudently play a role in target-date funds.
The industry is rapidly addressing some challenges, such as valuation, liquidity and fees. But there are other hurdles that are not as widely discussed. There are five topics plan sponsors can address even before adding alternatives to target-date funds or to the DC menu. Most of these relate to needed updates to the investment policy statement.
- Who makes the decision to include private investments should be made clear. If the sponsor makes the decision to include private investments, it is a settlor decision, leaving the fiduciary committee to determine which private opportunities to invest. Or the sponsor could delegate to the fiduciaries both whether and which private investments to include. Sponsors may want to further empower fiduciaries to potentially outsource some decisions to experts in private investing, such as an outsourced chief investment officer.
- Besides addressing valuation and liquidity as strategic or tactical questions from an investment management perspective, the plan sponsor must address some operational questions. Is daily valuation required? If so, what proxies will be used? Does the sponsor want to provide for those aspects itself or does the sponsor want individual alternative asset managers to provide them? Does the plan sponsor want to have a custom target-date fund within which these items are addressed? Or does the plan sponsor wish to leave those issues to the target-date fund provider?
- How will fiduciaries select benchmarks or compare to peers? Who is a peer when, at least in the near-term future, most target-date funds do not contain alternatives? Short-term “watch-list” rules may need adjusting (or eliminated as ineffective) to reflect the long-term private investment components of multiasset target-date funds.
- The investment policy statement should allow for appropriate investment architecture. For example, the statement should call for diversification but should also make clear that various investment vehicles and account types are permitted. Some alternative investment vehicles may be separately managed accounts or drawdown funds. Some IPS provisions may limit investments to "public markets" or "investment-grade" securities, and these provisions could hamstring a decision to include alternative assets and structures. Language that focuses on “prudence” might work better than “public."
- Compliance. If you are thinking of including alternative assets in your DC plan, target-date fund, or managed account, loop in compliance early. They will have plenty of questions regarding suitability, complexity, default, menu items, fees and disclosure. All those questions can be answered but best to include compliance early in the process.
- (We know: We said “five.” Just want to make sure you are paying attention!) Remember your fiduciary duty. That duty is carried out when you consider the best interests of the participants. So if alternatives can mitigate risk, enhance returns, and increase diversification in a way that a prudent investor would do so ... then do so.
Charles E.F. Millard is the former director of the U.S. Pension Benefit Guaranty Corp. and senior adviser for Ares Management Corp. He is based in New York. Clinton S. Cary is the former CIO of Aon’s OCIO business and co-chair of the DCALTA Implementation and Operations Committee. He is based in Chicago. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I’s editorial team.
