Incorporating Alternatives Into DC Plans Brings Challenges, Opportunities for Plan Sponsors

While plan sponsors face challenges to including alternative investments among their defined contribution plans, as well as legal barriers to providing access, researchers at the Defined Contribution Institutional Investment Association Academic Forum last week argued that these illiquid asset classes provide participants a significant opportunity for growth. 

Rashay Jethalal, CEO of CEM Benchmarking Inc., said the U.S. is falling behind other countries when it comes to offering alternative asset class investments in DC plans, as other countries allocate more than 10 times more assets to alternatives than do U.S. DC plans. 

On average, Jethalal explained that U.S. plans allocate about 1.1% of assets in target-date funds to alternatives and 1.9% of assets in balanced options to alternatives. 

In comparison, Australian DC plans—the most competitive DC market in the world—allocate about 25.3% of assets under management in alternatives.  

Defined benefit plans, on the other hand, tend to have higher allocations to alternatives. Out of 150 DB plan sponsors in the U.S., the average allocation to alternatives is 23.6%, according to CEM Benchmarking. Similarly, DB plans in the U.K. have an average allocation of 25% to alternatives.  

Australia’s Size Advantage 

Hannah Schriner, managing principal and investment consultant at Meketa Investment Group, explained that pension funds typically involve more staff in charge of overseeing the plans, allowing them to invest more in alternatives than DC plans.  

“With the [Australian superannuation system], they’re such large plans that they operate very similar to U.S. pensions when it comes to having a well-built-out staff and good oversight,” Schriner said.  

Schriner added that the “participant-directed nature” of DC plans is a factor preventing usage of alternative assets in U.S. DC plans. She pointed out that many plan sponsors today are consolidating investment menu options to help control the diversification benefits that participants are receiving, instead of letting them fend for themselves and choose from a large number of asset classes. 

“We have seen a lot of behavioral biases coming into play in those plan designs, especially with the large and mega [plans] to help mitigate some of the risks of participant-directed plans,” Schriner said. “We’re likely not going to get away from that. If we can take away some of that participant-directed aspect, then yes, we can absolutely add all the alternatives that our plans can handle. But I think that’s a big challenge that we’re really not going to be able to overcome in the U.S., unless we can really get traction with PEPs, MEPs and very large plans, [to] get to a scale that Australia is currently experiencing.” 

AustralianSuper, one of the country’s largest superannuation plans, has about $198.6 billion in assets. 

Will Goetzmann, a professor of finance and management studies at the Yale School of Management, argued that alternative investments, almost by definition, are “going to expand the efficient frontier.” The efficient frontier is a set of investment portfolios are expected to provide the highest returns at a given level of risk, according to the Corporate Finance Institute.  

“No matter what [alternatives] you add, it’s not going to shrink the frontier; it’s going to extend it,” Goetzmann said. 

Value Add of Alternatives 

In collaboration with Georgetown University’s Center for Retirement Initiatives, CEM created three scenarios to determine the “value add” of incorporating alternative assets, such as private equity and real estate, into target-date funds.  

The first scenario, for example, replaced a 10% allocation to public equity with 10% to private equity in a series of TDFs. CEM found that this resulted in 80% better outcomes and a median increase in annual return of 0.22%. 

From studying all three scenarios, CEM concluded that a 0.15% per year improvement in net return represents an additional $2,400 per year in spending power for a retiree already drawing $48,000 per year in retirement income.  

“Imagine [if a participant gets] payments twice a month,” Jethalal said. “[They would] get more than an extra payment. We’re really looking at historical returns, net of all fees.” 

In order to move the needle and have more plan sponsors offer alternative assets in their DC plans, Jethalal said it is important to consider the current mindset of plan sponsors and participants. Fees tend to be a primary concern for plan sponsors, and he said there has been a significant migration toward indexing.  

In the next year or two, Jethalal said it is important to “get the facts out” and show plan sponsors how the rest of the world is ahead of the U.S. in terms of its allocations to alternatives. 

“I think there’s a communications piece that has been lost,” Jethalal said. “I think the message of cheaper is better is not necessarily true. … Cost does not necessarily equate to benefit.” 

If plan sponsors were more easily able to “plug and play” alternative options into their plans, Schriner said there would likely be more access to these asset classes. 

“If [alternatives] were components that could easily go in and out of target-date funds without all the operational headaches, great,” Schriner said. “The challenge for the asset managers is that [in order to] create products, you need investors. That is one way to move the needle—by making [implementation] easier.” 

The other way to move the needle would be to “change the rules,” Schriner said. Legislation like the Pension Protection Act, for example, led to the growth of TDFs. While a safe harbor that allows for alternatives in DC plans may not be likely in the near future, Schriner said it is important for plan sponsors to start focusing more on fiduciary risk, as opposed to litigation risk.  

“If we can get plan sponsors to recognize the difference and really focus on it, then maybe they can spend more of [their] time with that fiduciary risk and not get distracted by the noise about litigation risk,” Schriner said.