A Case for Prudent Diversification in DC Plans

It has been three and a half years since the Department of Labor published its letter indicating that alternative investments can play a useful role in target-date funds. It has been two years since the DOL reiterated that guidance in December 2021. Yet alternative assets are still underutilized.

The law requires that 401(k) plans and other defined contribution retirement plans be invested prudently and in a diversified portfolio; yet this obvious source of diversification is missing from most DC plans. Alternative assets, such as real estate, private credit and private equity, enhance diversification. Fiduciaries who want to improve their participants’ diversification can use them in a prudent way.

The Employee Retirement Income Security Act is the law that governs the investment of DC plans. It states that a fiduciary must act “with the care, skill, prudence, and diligence … that a prudent [person] acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.” ERISA also states that a fiduciary should act “by diversifying the investment of the plan.” Prudent diversification is the law of the land.

Nobel laureate Harry Markowitz famously said that “diversification is the only free lunch” in investing. By that he meant that diversification can enhance returns for the same level of risk, or it can mitigate risk with the same expected return. In 1952, when Markowitz made that famous remark, most individual investors had never heard of “alternative assets,” such as private equity and private credit. While they had of course heard of real estate, they had difficulty accessing real estate as an investment class, other than in their own homes. Besides which, the 401(k) plan had not been invented.

The 401(k) has only been around since 1978. In the last 46 years, a lot has changed. With the demise of defined benefit pension plans, the 401(k) and other DC plans have become the principal avenue for workplace retirement savings, and target-date funds have become the norm for investing in DC plans. In 2022, 85% of the assets that went into 401(k) plans went into target-date funds.

But since the advent of DC plans, alternative assets have become mainstream investments. They are regularly used in the portfolios of the defined benefit plans that still exist. They are accessible to individual investors through public stock in large alternative investment managers and through structures available to wealthy (“qualified” or “accredited”) investors .

Additionally, the Department of Labor has confirmed, in a June 2020 information letter (supplemented further in December 2021), that alternatives can play a role in target-date funds and that fiduciaries should consider whether including those assets “would offer plan participants the opportunity to invest their accounts among more diversified investment options.”

Why all this interest in alternative assets? Because they increase diversification! The teams of consultants and target-date-fund providers charged with the “prudent person” test and legally required to diversify the investments of the plan can meet those legal requirements through the inclusion of alternative assets, in the same way that any prudent person would.

The evidence that alternative investments increase a portfolio’s diversification is compelling.

For example, a well-diversified portfolio should have less volatility than a less-well-diversified portfolio, assuming the two portfolios target the same return. When alternative investments are used, the resulting portfolios are less volatile. Compare a portfolio with a 20% allocation in diversified alternatives (a mix of private equity, private credit, core private real estate and infrastructure) with a traditional 60/40 portfolio. The 60/40 portfolio has a volatility of 8.5%, while the portfolio with alternatives has a volatility of 7.25%.

Or let’s put it in broader terms: The Georgetown Center for Retirement Initiatives published an exhaustive paper last year in conjunction with CEM Benchmarking. The paper compared results for target-date funds with alternatives to target-date funds without alternatives. “The analysis considered the change in annual volatility of returns for every scenario path” in comparison with the volatility of a typical target-date fund. “[The results] can be summarized very simply …: Every option, in every scenario, showed less volatility in 100% of outcome paths.”

Recently, Fidelity published research that compared the efficient frontiers of two portfolios, one with alternatives and one without. The portfolio with alternative assets had an efficient frontier that moved up and to the left from the frontier of the traditional portfolio. “The improved efficiency in the efficient frontier … is the result of including additional alternative asset classes with diversification benefits or higher historical returns at an equal or lower expected level of risk.”

And if “volatility” and “efficient frontiers” seem too academic, consider this: A paper written by Willis Towers Watson with Georgetown in 2018 compared likely outcomes between a typical target-date fund and a target-date fund that makes use of alternative investments. The typical target-date fund was likely to provide $53,000 annually in retirement income; the portfolio with alternatives was projected to provide $62,000.

There is a reason that ERISA mandates diversification. It can mitigate risk or enhance return for the same amount of risk. Using alternatives can increase diversification in defined contribution portfolios, and prudent fiduciaries should do so.

Charles E.F. Millard is the former director of the U.S. Pension Benefit Guaranty Corporation; he is a senior adviser for Ares Management. This content represents the individual views of the author.

This feature is to provide general information only, does not constitute legal or tax advice and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS Stoxx or its affiliates.