The Defined Contribution Institutional Investment
Association outlined the benefits and challenges defined contribution plan
sponsors might face when considering if they should include alternative
investments in plans, and explained how several types of alternative
investments can be used.
The new information resource, titled “Alternative
Investments in Defined Contribution Plans,” examined including three
alternatives: hedge funds, private real estate and private equity investments.
DCIIA explains that defined benefit plans have benefited for
decades from including alternatives in their plans, beginning in the 1970s, and
some DC plans have included alternative sectors for over 30 years.
Coming out of the pandemic, plus the corresponding recession
and rebound, DC plan sponsors might be able to boost participant returns
through greater exposures to alternatives, and mitigate lower return
expectations for traditional asset classes, DCIIA notes.
“As the economy begins to move toward a new business cycle,
the downward shift in traditional asset class return expectations, in addition
to the risk of inflation and continued volatility, creates new challenges for
participants to reach retirement goals,” DCIIA states. “Private real estate,
private equity and hedge funds may offer a range of benefits, including a
source of enhanced returns that could help investors mitigate the impact of
macro challenges and support stronger retirement outcomes over the next cycle.”
DC plan sponsors providing participants with exposure to
alternatives are presented with several considerations—depending on the
alternative asset—including cost, valuation, liquidity, benchmarking and
participant communication.
Nonetheless, DCIAA says alternatives can bring portfolio
diversification, through reduced correlation to traditional equity and bond
markets; income in stable yield; stability and downside protection, by reduced
overall portfolio volatility; enhanced returns, with the potential for
additional returns versus traditional public markets; and absolute return
potential unrelated to market performance.
DCIIA also explains how each alternative can be implemented
within DC plans.
Hedge funds are prevalent in multi-asset strategies:
target-date funds (off-the-shelf and custom) and standalone options—using
liquid alternatives funds. Private equity is most implemented in multi-asset
strategies and TDFs (off-the-shelf and custom); and private real estate is in
multi-asset strategies, TDFs (off-the-shelf and custom), white label funds
(real assets, risk-based), income funds/retirement tier and standalone options.
DCIIA also outlined challenges for implementing
alternatives, as well as corresponding potential mitigants.
The paper noted that alternative investments are typically
more expensive than traditional asset classes in DC plans. Fees may manifest in
higher administrative expenses for the plan’s custodial services and the
attendant need for investment advisers to help evaluate and monitor the
investments.
Concerning fees, DCIIA states that costs have “compressed”
over recent years, as DC private real estate exposure is supported by
“aggregation discounts.”
Further, “Modest allocations can limit impact on fees while
maintaining meaningful impact of alts in multi-asset portfolios; and adjusting
[the] active/passive portfolio mix can provide ‘funding’ for higher-cost alts,”
DCIIA adds.
DCIIA advises that DC plan sponsors can mitigate daily
valuation challenges with independent third-party valuation services to
appraise the investments. For liquidity concerns, one possible mitigant is to
implement alternatives within fund vehicles, such as target-date funds and
multi-asset funds that can manage liquidity “within the context of the fund’s
broader portfolio allocation and periodic rebalancing.”
The 2020 Department of Labor letter on the use of private
equity in DC plans affirmed that private equity investments could be included
as a component of a professionally managed multi-asset class vehicle structured
as a target-date, target-risk or balanced fund. A supplemental letter from the
DOL’s Employee Benefits Security Administration clarified that stance by
cautioning plan fiduciaries against the perception that private equity is
generally appropriate as a component of a designated investment alternative in
a typical DC plan, in response to stakeholder concerns.
Furthermore, evidence in a study published by Neuberger
Berman research partner the Defined Contribution Alternatives Association, in
collaboration with the Institute for Private Capital, suggests that including
private equity funds in a defined contribution plan can improve performance and
has diversification benefits that lower overall portfolio risk.
“Pension plans and other institutions include private equity
as a source of additional diversification and returns, and over the last decade
or so, DC plan sponsors have also looked to include private investments to get
return enhancement and smooth volatility over time,” Ross Bremen, a partner in
NEPC’s defined contribution practice in Boston, previously said.
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