Avoiding alternatives assets in defined contribution plans, including in target-date funds, lowered plan participants’ returns and retirement income, new research has found.

Modest asset diversification in TDFs can improve long-term expected retirement income for individuals—factoring in the cost of fees—by between 6% and 8%, according to the report, “Can Asset Diversification and Access to Private Markets Improve Retirement Income Outcomes?”

The December 2022 research showed higher accumulated retirement income amounts were achieved for an expanded TDF exposed to private markets that included greater diversification by allocating to alternatives, as compared with a so-called typical TDF comprised of a sole stock/bond mix.

“Greater diversification and the inclusion of alternative assets in DC portfolios can help drive greater returns and deliver improved retirement outcomes for the millions of U.S. workers who rely on them,” stated the conclusion of the report from the Georgetown University Center for Retirement Initiatives at the McCourt School of Public Policy and WTW.

Drawing From 5,000 Unique Ending Scenarios

The research generated retirement income projections by simulating a participant’s working life in 5,000 paths. In each path, the full-career employee contributes to the retirement plan, while other variables fluctuate around the expected values, such as salary growth, market returns and inflation, according to the section of the report on enhancing retirement income.

“At retirement, the participant has 5,000 unique ending DC balances, each of which is converted into an annuity amount,” the report states.

The researchers found the following for the three TDF structures:

• Stock/bond only: Under adverse scenarios (5th percentile), the DC plan may replace $24,400 or less per $100,000 of pre-retirement annual wages; in favorable scenarios, (75th percentile), it may replace $89,300 or more, with the expected outcome (50th percentile) $60,900.
• Typical TDF: Under adverse scenarios ( 95th percentile), the DC plan may replace $24,600 or less per $100,000 of pre-retirement annual wages; in favorable scenarios (25th percentile), it may replace $90,300 or more, with the expected outcome (50th percentile) $61,600; and
• Expanded TDF: Under adverse scenarios (95th percentile), the DC plan may replace $26,200 or less per $100,000 of pre-retirement annual wages; in favorable scenarios (25th percentile), it may replace $98,000 or more, with the expected outcome (50th percentile) of $66,700.

Researchers categorized TDFs into three types for examination: a stock and bond mix only; a so-called “Typical TDF,” comprising modest amounts of real assets and private credit; and an expanded TDF with the greatest allocations to alternatives.

Multiple Glide-Path Scenarios

With the three target-date types, researchers also extrapolated glide-path scenarios of 40 years to retirement, 20 years to retirement, at retirement and in retirement, according to the report.

“Ultimately it is in these more moderate-risk portfolios in the mid-to-retirement dated funds where using alternatives provides the greatest advantage over the TDF industry average, because it is possible to maintain expected returns while reducing portfolio risk using alternatives when the more common approach in TDFs is to add allocations to lower yield core fixed income during this period,” the report stated.

According to the report, just as a diverse diet is necessary for healthy, productive development, a “wider and more diverse selection of asset classes within DC plans can also help foster better development and growth of  the retirement assets within those retirement accounts,” states the report.

The glide paths and analysis of the report focused on three primary alternative asset classes: real assets, private equity and private credit.

Glide paths used by the researchers incorporated modest allocations to real assets to reflect the TDF industry averages of the largest TDF providers; used private credit rather than hedge funds; and broadened the modeled real assets allocation beyond core real estate, as were studied, for example, in 2018 and 2020 reports.

The glide paths and analysis of the report focused on three primary alternative asset classes: real assets, private equity and private credit.

The TDF’s glide path assigns the asset allocation between equity and fixed income assets for each year or the age of the worker, but for most participants, it is not personalized to their individual family and financial circumstances.

The researchers measured retirement success as “the ability of income in retirement through accumulating assets over a working career by converting simulated DC balances at retirement into inflation-adjusted lifetime annuities,” according to the report.

In the model using the expanded TDF, 20 years to retirement invested 75% of the assets in public equities, 7.5% in credit strategies, 7.5% in real assets, 5% in core fixed income and 5% in private equity; the model of a typical TDF invested 81.4% in public equities, 13.8% in core fixed income and 2.8% in real assets and 2.0% in credit strategies; the stock/bond only mix TDF invested 85% in public equities and 15% in core fixed income.

The report defined alternative assets as any assets other than traditional stocks, bonds and cash.

Trying New Ingredients for Success

For several years, research from investment managers, recordkeepers and retirement industry associations has examined how to bolster allocations to alternatives and has urged greater adoption for DC plans—whereas alternatives are often used in long-term investment pools such as defined benefit plans—with some successes among employers.

The report concluded that plan sponsors providing typical TDFs—with very small amounts allocated to real assets and private credit, or in funds allocated only to a stock and bond mix—have narrowed the range of ingredients, thereby limiting investment returns for workers saving for retirement.

“There are only so many ‘meals’ that can be created out of the same narrow range of ‘ingredients,’” the authors wrote. “Typical TDF providers that use enhanced portfolio construction techniques and other areas of the bond market, such as high-yield and emerging-market debt, improve long-term retirement income expectations and worst-case results by approximately 1%.”

The researchers’ example for a typical TDF was drawn from an average of the largest TDF providers, the report noted.

Although fear of litigation and fiduciary risks has prevented plan sponsors from greater adoption of alternative assets in defined contribution plan TDFs, the research showed asset-diversified TDFs exposed to private markets can boost the retirement income that could be generated by converting a participant’s balance into a guaranteed stream of income at retirement.

“Expanding the opportunity set to include private equity, private credit, and real assets provides a richer selection of ‘ingredients’ for building portfolios, which further enhances participant outcomes,” the authors wrote. 

The contributing authors, each from WTW, were David O’Meara, head of defined contribution investment strategy; Bill Batiste, defined contribution plan specialist; and Daniel Hohwald, defined contribution specialist.