A New Role for EM Investments in Retirement Plans

“CREATE-Research Report 2014: Not All Emerging Markets Are Created Equal” examines whether emerging economies in the East and South, and developed economies in the West will converge or diverge over this decade. The demographics of aging populations with an eye toward retirement are also helping lead a fundamental change in the way investors make asset-allocation decisions.

Defined benefit (DB) and defined contribution (DC) plans have different goals, the report contends, which will lead DB and DC plans to different strategies as well as different asset classes.

Particularly in the U.S., most DB plans are increasingly turning to liability driven strategies, says Julia Lawler, senior vice president, global investment services of the Principal Financial Group. Many DB plans are also moving forward on derisking and adding fixed income to their strategies. But because of the lower interest rate environment, many of them are adding to that mix more of an alternative strategy to replace the risk of equity but avoid fixed income or real estate, Lawler tells PLANSPONSOR.

The biggest challenge in most countries is liquidity risk, says Barbara McKenzie, senior executive director, chief operating officer for Principal Global Investors. “DC is not friendly to illiquid assets,” McKenzie tells PLANSPONSOR. “The regulatory structure anywhere there’s a DC market wants daily pricing and daily liquidity.”

But this attitude has a downside, McKenzie says. “Unfortunately, DC investors are missing out on a whole swath of investments that are ideally situated for retirement savings because of the regulatory infrastructure,” she says. Many real asset classes such as property, private equity and infrastructure investing tend to have regular income, and a lot tend to have inflation protection, both good attributes in a retirement plan investment.

“They’re great investments when you’re thinking of dealing with longevity risk,” McKenzie points out, and DB plans still invest heavily in those sectors. But the regulation governing defined contribution plans means DC plan participants miss out on these opportunities.

To a limited extent, these can be “baked in” to a target-date fund, according to Lawler, but regulation still makes it difficult for many vehicles to be included. One reason is the possibility of another illiquidity scenario like the one in 2008. “People struggle when they’re in that environment,” she says.

“We’re working with behavioral science here,” says Lawler, which can explain why investors make the wrong move. Lawler feels that investors should in fact have more illiquid assets in their portfolios, because, by definition, retirement investing means a strategy of holding onto assets and investing for the long term. “During the crisis people took money out of things that had problems and put it in safe things, and then never put it back,” she says.

DC plans can have pieces of illiquid investments, Lawler says, but the regulation has no wording preventing a participant from taking the money out. “We have restrictions on taking things out of a 401(k) altogether, but transferring asset classes is not limited, and that is what we saw during the financial crisis.”

The collective investment trust (CIT) affords more flexibility, Lawler says, and can include a small percentage of illiquid assets, which can be one way of adding illiquidity to DC solutions.

Principal Global Investors and the Principal Financial Group partnered with CREATE-Research for its sixth annual asset management research report on international investing insights and trends. The study, written by Amin Rajan, chief executive of CREATE-Research, surveyed 704 asset managers, pension plans, pension consultants, fund distributors and fund administrators from more than 30 countries.

The report can be downloaded from the website of the Principal Financial Group.