Asset Diversification in DC Plans: Opportunity for Tremendous Growth, Study Finds

A lack of diversification in defined contribution plans has been a significant missed opportunity for plan sponsors, according to a new report produced by Georgetown University’s Center for Retirement Initiatives, in conjunction with CEM Benchmarking Inc., which argued that adding illiquid assets to target-date funds is a strategy that plan sponsors should explore. 

Incorporating illiquid assets, such as private equity, real estate and infrastructure, in TDFs could result in a 0.15% increase in return per year over a decade, the report stated.  

“The total TDF market as of 2021 held about $3.27 trillion in assets, according to Morningstar data, so a 15 basis point improvement on all target date options over the next 10 years would be at least $5 billion,” said Angela Antonelli, research professor and executive director of Georgetown’s CRI, in an emailed statement.  

Illiquid Assets Show Potential for High Returns 

The analysis, which focused on the period 2011 through 2020, leveraged CEM’s U.S. database of reported DC TDF allocations and returns in combination with reported DB plan allocations and return data. It assessed how DC plan participants’ experiences would have changed had DC TDFs made higher allocations to illiquid assets during this time period. 

CEM presented three DC investment scenarios: adding a 10% private equity sleeve, adding a 10% real assets sleeve (real estate and infrastructure) and adding smaller allocations of both, all substituted for traditional stocks and bonds.  

The analysis concluded that the allocation of a mixture of both private equity and real assets resulted in the highest percentage of returns, with 82% better outcomes over a 10-year period.  

For an individual participating in a DC plan, this improved return on investment, if obtained over the course of a career, would result in an additional $2,400 per year in spending power for a retiree with $48,000 per year in retirement income, according to the report.  

The report’s authors—Antonelli, along with CEM Benchmarking contributors Chris Flynn, Quentin Spehner and Kevin Vandolder—argued that there are significant benefits to adding private equity and real assets to TDFs.  

“Private equity has provided return enhancement while offering greater diversification among equity sub-asset classes and improved outcomes for investors,” the report stated. “Real assets have served as a diversifier alongside stocks and bonds, with an additional benefit of offering inflation sensitivity.” 

Bang for Buck? 

Flynn, head of product development and research for CEM Benchmarking, said the study was net of all costs, including staff costs, rather than only considering fees and performances fees. He argued that a diversified TDF has more potential for higher returns than a traditional TDF, even though illiquid assets tend to require investors to pay higher fees. 

“A higher cost portfolio that delivers better risk adjusted returns, net of costs, delivered the better bang for the buck,” Flynn wrote in an email.  

Another argument against illiquid assets is that it is difficult for investors to get daily pricing and regularly check their balances for those assets. These assets tend to be harder to sell quickly because there is low trading activity or interest in the issue. Illiquid assets also tend to have greater price volatility. 

In response to this concern about a lack of daily pricing, Flynn said, “participants see their balances, but the change in balance due to revaluation of private assets is happening quarterly, although it could change more frequently. It is important to keep in mind that the study examines adding only a small sleeve to private assets which would be expected to be held for decades.” 

Opportunity for Plan Sponsors, TDF Providers 

Many North American plan sponsors are implementing or considering the merits of private equity and real asset strategies in their DC plans. For example, the $12 billion Public Employees Pension Plan in Saskatchewan has invested in Canadian private real estate in its target-date and risk strategies for many years. In addition, the $32 billion University of California Retirement Savings Program is also studying the merits and drawbacks of including alternative investments in its TDFs, according to the report.  

The authors suggested that DC plan sponsors take notice of their defined benefit counterparts, as many DB plans have been increasing allocations to private equity and real estate asset classes. Currently, most TDFs in DC plans do not contain these alternative assets. 

In addition, the authors wrote that large providers of TDFs can use their scale and buying power to deliver above-average value in these asset classes via offerings to plan sponsors and their participants.  

“Plan sponsors should continue to further demand that their service providers, specifically their investment managers, TDF providers, and investment consultants, create, find, and deliver compelling real asset and private equity investment vehicles that can deliver successes like those achieved by DB plans,” the report stated.  

Regulators also have an opportunity to provide a clear framework for how plan sponsors could include private assets within DC plans. This would remove a key barrier to adoption by prudent sponsors who see a compelling case for investing in private assets, the authors argued.