Are your plan participants gaining the benefit of a truly broad diversification of retirement portfolio assets? The answer might depend on whether they’re covered by a defined benefit (DB) plan or a defined contribution (DC) plan. Here’s a look at why DB plans offering “alternative” investments, also known as alts, may make a big difference.

A Couple of Studies

Alts are assets other than publicly traded stocks, bonds and cash investments. However, ERISA places limits on permissible alt investments: Qualified retirement plans cannot invest in “collectibles” (such as antiques), S corporation stock and life insurance contracts.

According to a study by the Center for Retirement Research at Boston College, average annual returns between 1990 and 2012 of corporate DB portfolios were 70 basis points higher than those of DC plan portfolios. More recent data shows that this gap has narrowed somewhat, but was still at 50 basis points for the decade ending in 2016.

Why the disparity? Several factors account for it. But according to a study by Georgetown University’s Center for Retirement Initiatives, it’s partly attributable to the fact that DB plans are far more likely to have some alts in their portfolios. The 2018 Georgetown study, The Evolution of Target Date Funds: Using Alternatives to Improve Retirement Plan Outcomes, tackles this disparity. It notes that 15% of average portfolios of the largest corporate DB plans contain stakes in hedge funds, private equity holdings, real estate and other alts such as commodities.

Why Invest in Alts

One key purpose of investing in alts is to provide a buffer from the impact of stock and bond market volatility, to the extent that alts are “noncorrelated” assets. This means they don’t follow the same broad pattern as conventional investments, particularly in down markets. “The key for plan sponsors is to look ahead to better protect their participant portfolios against the inevitable drawdown that always occurs when the equity markets turn the other way,” according to the Georgetown study. “Because [DC] plan participants fully absorb the gains and losses of their accounts, market events can drastically impact their ability to retire,” it asserts.

Recognizing that target date funds (TDFs) are typically used as a DC plan’s qualified default investment alternative (QDIA), the study’s authors focused on issues surrounding incorporating alts into TDFs. Because some alts, such as hedge funds, private equity and direct investment in real estate, lack the liquidity of publicly traded securities, offering them to DC plan participants on a stand-alone instead of in a TDF may be practical. However, be sure to educate participants so they don’t get into trouble by investing heavily in alts without fully understanding them.

When DC plan participants have access to a self-directed brokerage “window,” they can invest in some “retail” alts, including:

• Real estate investment trusts (REITs),
• Mutual funds that deploy unconventional trading strategies such as hedging with futures contracts or that use leverage, and
• Exchange-traded funds (ETFs) focusing on precious metals and commodities.

But self-directed brokerage accounts haven’t caught fire in the DC plan world due partly to fiduciary concerns and lack of interest by participants. But some employers with a majority of highly compensated employees have seemed to show some interest.

The Bottom Line

According to the Georgetown study’s model projection, the annual inflation-adjusted retirement income for a full-career participant could be 17% higher if the participant had invested in a broadly diversified TDF containing some alts, instead of a TDF lacking that degree of diversification. While the idea of folding some alts into TDF portfolios might sound appealing from a theoretical perspective, it’s easier said than done.

The primary stumbling block identified in the study is a perception by some DC plan fiduciaries that the presence of alts in a TDF could elevate their exposure to litigation. That threat can be mitigated, the study suggests, with a “careful and prudent process focused on enhancing potential participant outcomes” while addressing “any concerns such as liquidity and pricing, benchmarking, fees and governance.” 

With respect to the liquidity challenge, “even over the short term and in a stressed environment, a diversified portfolio including alternative asset classes still has 72% to 76% of its assets available to satisfy daily liquidity, rising to 81% over a three-month period.” Also, the study points out that participants are more inclined to stay put in TDFs during periods of volatility than those invested in less diversified funds. The challenge of providing daily pricing for funds with some illiquid assets such as equity real estate also can be met, the study suggests, by using an “unbiased proxy” to estimate pricing daily between appraisals.

The Future

Alts often require more intensive management (and therefore higher fees) than standard liquid securities. Litigation over high plan fees is reasonably on the minds of plan sponsors and fiduciaries. But, the study argues, that concern can be allayed if participant outcomes are improved due to a “positive net-of-fee value proposition.” While one study is insufficient to motivate plan sponsors to jump into alts with both feet, it does provide food for thought that could ultimately lead to a concrete decision.