Alternatives in DC Plans: Key Considerations

With the recent issuance of an Information Letter on private equity in defined contribution (DC) plans, alternative investments are once again in the spotlight for DC plan sponsors and industry service providers. Generally speaking, in addition to private equity, this would include real estate—public and private—and hedge funds.

DCIIA has been discussing this topic since our founding 10 years ago. In “Institutionalizing DC Plans: Reasons Why and Methods How” (2011), we noted that, using defined benefit (DB) plans as the institutional retirement model, one of the many practices DC plans might consider is “improving diversification by offering exposure to alternative asset classes.”

Two years later, we expanded on that point by asking in a subsequent paper, “Is It Time to Diversify DC Risk with Alternative Investments?” That paper notes that, in addition to the potential for enhanced returns, plan sponsors may consider adding alternatives in order to diversify risk and reduce volatility. Private securities may also provide a liquidity premium that can benefit long-term investors such as DC plan participants.

However, uptake thus far has been limited. The most recent data available for the Callan DC Index, which tracks over 90 large DC plans representing approximately $250 billion in assets, shows that less than 1% of DC assets are allocated to alternatives and, separately, real estate. The prevalence of real estate in DC plans has made a jagged but steady climb up to 22.9% (as of March 2020) from 7.5% (as of March 2006), while “alternatives/other” has mostly held below 2% since 2006, aside from very recently reaching 3.8% and a brief spike in 2009 to almost 3%.

These figures are understandable given the challenging environment DC plan sponsors must navigate—including juggling multiple priorities, navigating evolving guidance from the Department of Labor (DOL) and the ongoing litigious environment for DC plans. In addition, any change to an employee benefit plan can be subject to internal organizational hurdles.

A plan sponsor that does wish to move ahead with investigating alternatives for its plan needs to take a variety of considerations into account, including fees, fiduciary responsibility, due diligence process and resources, implementation considerations, participant education, legal documentation, benchmarking, and integration with financial advice tools. Additional considerations include:

• Where to offer alternatives within the plan menu: One option is to select an off-the-shelf target-date fund (TDF) that includes alternatives. Or, incorporate them into custom TDFs, managed accounts or other multi-asset class investments; this gives plan sponsors greater control over how they make alternatives available to plan participants. Another option is to incorporate alternatives on a standalone or index basis so that DC participants can allocate from the plan menu. In this second case, it may be most effective to bundle multiple alternative strategies into one offering on the menu.
  
  
• Quality of alternatives managers: Plan sponsors will need to dedicate significant time to both the initial search for a manager within each category of alternatives, and to ongoing evaluation of the chosen managers. As with all strategies, taking steps to ensure a quality, repeatable investment process is critical. It may be a good idea to use the services of an investment consultant or adviser in the selection and monitoring process.

• Liquidity: A plan sponsor should evaluate the liquidity of any alternative being considered, as the liquidity of these products can vary from periods of months to, in some cases, over 10 years. Plan sponsors should pay particular attention to any restrictions on exiting the investment during a period of market distress.

• Fair value: Due to the illiquidity features of some alternatives, daily fair market value may not currently be available in offerings that report periodic net asset values (NAV). Various valuation methodologies can be used to establish adjusted daily fair value with third-party validation.

• Leverage: Leverage is a complex element in some alternative strategies (e.g., swaps, structured notes, options and futures/forwards), especially those of the absolute-return variety. In other alternatives strategies, leverage is a means of optimizing the capital structures in underlying companies that constitute the investment portfolios. Leverage is an investment strategy of using borrowed money to increase the potential return of an investment. Plan sponsors should understand the different forms of leverage; they may want to consider adopting guidelines that optimize the amount of leverage a particular strategy can use.

• Transparency: Managers of some alternatives strategies, in particular, may limit information shared with investors in order to reduce the likelihood that others will mimic their approach. Plan sponsors need to be comfortable with the amount of information disclosed, and confident that they have established skill sets to evaluate the strategies.

In light of the potential benefits that alternative investments may offer DC plan participants in terms of diversification and performance—and in spite of the numerous related factors that must be considered—we maintain that plan sponsors may be well served by opening the door to discussing these options as part of broader investment menu design conversations.

Peg Knox is the chief operating officer (COO) of the Defined Contribution Institutional Investment Association (DCIIA) and is a former plan sponsor. Additional resources on this topic are available in DCIIA’s Resource Library in “Investment Options and Best Practices” and “Plan Design Matters.”