Investing June 23, 2022

Benchmark Properly for Access to Alternatives

After precedent-setting decisions, plan sponsors may have a clearer road ahead for incorporating alternative investments in defined contribution plans.
Reported by
Art by OYOW

For defined contribution plan sponsors to offer participants access to alternative investments, it’s all about—not the Benjamins—the benchmarks.

There is greater transparency for plan fiduciaries when incorporating alternative investments into DC plans after courts ruled in favor of Intel Corp. and its investment committees in a protracted Employee Retirement Income Security Act case, according to an ERISA expert.  

For more stories like this, sign up for the PLANSPONSOR NEWSDash daily newsletter.

The pair of court decisions from the U.S. Supreme Court and U.S. District Court for the Northern District of California helped to clarify key aspects of the pleading standards that apply to fiduciary breach claims brought under ERISA, says Kevin Walsh, principal at Groom Law Group.  

The rulings could lead to increased plan sponsor allocations to traditional alternatives—private equity, private credit, hedge funds and private real estate—in 401(k) plans, Walsh explains.

“The Intel decision has really done a great job of highlighting the importance of benchmarking in terms of adoption of funds that have allocations to these asset classes,” which was a legal issue that continued to arise before the Intel decision was settled, Walsh explains.

The courts made clear that ERISA lawsuits brought against plan sponsors were being based on inappropriate fee comparisons. Plaintiffs, in complaints, would often compare a target-date fund with an allocation “to traditional alternatives to a target-date fund that just was purely indexed,” he says.

“It seemed as though the [plaintiffs’] argument that was being made was ‘the fees are higher,’” Walsh says. “Since that decision, there’s been a better recognition that the key metric really is risk-adjusted performance net of fees. [Courts were] reminding plaintiffs that if you’re going to benchmark, don’t just pick the thing with the lowest fees, pick something that’s going to get you the same risk-adjusted performance net of fees.”

Walsh adds that this legal position was strengthened by the 6th U.S. Circuit Court of Appeals ruling this month in favor of the defendants in an ERISA lawsuit targeting CommonSpirit Health, a large not-for-profit corporation that provides hospital services across the United States.

“[That] case highlighted the importance of apples-to-apples benchmarking,” he explains.

The court rulings could lead to greater access to alternatives in DC plans. Walsh distinguishes traditional alternatives from “emerging” alternatives, such as digital assets and cryptocurrencies.

“In the long run, it makes it easier for there to be more adoption of products that allocate to traditional alts, and it does so because it reminds folks that when you benchmark, you need to benchmark something that is comparable, as opposed to benchmarking against just the lowest fee option, even if it’s not designed to get you some more investment performance,” Walsh says.

President Joe Biden’s administration has let stand Department of Labor guidance issued under the Trump administration that confirmed plan fiduciaries can allow select private equity strategies in DC plans without violating ERISA. Late last year, the Biden DOL issued a supplemental statement cautioning plan fiduciaries from including private equity investments that targeted smaller plan sponsors.

Retirement industry experts say that the DOL statement did not reverse policy or constitute a substantive change to the prior guidance.

Walsh explains that while alternatives have grown in DC plans, movement in the space is “incremental,” he says.

“The big shift that we’re seeing is that consultants are now talking about target-date funds that allocate to alternatives more broadly,” he says.

State and local government 457 DC plans, which are not governed by ERISA, can readily innovate by offering access to alternatives more easily. 

“Because of the different regulatory structures of governmental plans versus private pension plans, it’s a lot easier for governmental plans to allow defined contribution participants to essentially buy a slice of the defined benefit plan than it is for a private employer to do that, and that’s really the cutting edge,” he says.

Mega DC plans with a legacy DB plan, closed to new workers, are also innovating in the space by unitizing slices of the pension for access by 401(k) participants, Walsh adds.

“What they’re doing is they’re essentially allowing their defined contribution plan participants to put money into the basket that they’re already managing for the defined benefit plan,” he says. “It’s the most sophisticated plans that seem to be identifying the value. That DOL second letter was targeted more at the most sophisticated plan fiduciaries and so I think that’s where we’re seeing the most uptake.”

Investing June 23, 2022

Growing Inclusion of Alts in DC Plans

Defined contribution retirement plans are incorporating alternative investments in custom target-date funds, and access to alternatives has increased thanks to white-label funds.
Reported by
Art by OYOW

For defined contribution plan sponsors, alternative investments have become increasingly common.

Mega plans—with assets in the billions and hundreds of millions—were historically more likely to include alternatives such as core private real estate. The asset class was most prevalent among large corporate plans, but that has evolved, explains Jani Venter, executive director, defined contribution fund management, real estate Americas at JP Morgan.

Get more!  Sign up for PLANSPONSOR newsletters.

“Historically, it’s been large corporate and public plans with custom structures that made the decision to include real estate, because of the asset class benefits,” she says. “There’s also a smaller component of investors holding exposure through core menu white-label funds or operating portfolios.

She adds that public DC 457 plans have also increased access to alternatives.   

Plan Prevalence: TDFs Dominate

Plan sponsors are including alts like private real estate through multi-asset strategies situated within target-date funds, says Jennifer Perkins, managing director and defined contribution portfolio manager at LaSalle Investment Management.

“Multi-asset strategies are the biggest accumulator of assets within defined contribution plans; by and large, the target-date fund,” she says.

She explains that alternatives’ inclusion within DC plans is growing.

“The increased use of outsourced CIOs from the consultant community is also a way in which plan sponsors are using white-label funds that consultants would put together through their OCIO teams,” Perkins says.

Venter explains that the largest growth for private real estate alts in DC plans is from plans that operate under the Employee Retirement Income Security Act, a 1974 federal law governing defined benefit and DC plans.

“Our DC real estate solutions are only available to qualified plans, so as a result we’ve experienced most growth from ERISA plans,” she says.

ERISA sets minimum standards for retirement plans’ participation, vesting, benefit accrual and funding, and requires accountability of plan fiduciaries.

Plan fiduciaries are defined as anyone who “exercises discretionary authority or control over a plan’s management or assets, including anyone who provides investment advice to the plan,” according to the Department of Labor.

Fiduciaries who abrogate ERISA’s dual principles of loyalty and prudence to plan participants can be held responsible for restoring losses to the plan, and participants have a right to sue the plan for benefits and breaches of fiduciary duty. While public 457 non-ERISA plans have also included real estate, “it’s mostly the ERISA plans as the market has evolved to this point,” Venter explains.

For plan sponsors that are interested in but have not implemented alts, the greatest inhibitor has been and remains fees, according to Venter. Excessive fee claims often feature in ERISA lawsuits against retirement plan sponsors. 

In an era of cost compression among major investment product providers, Venter says, fees have decreased.

“The biggest concern is the fee impact because we’ve been in a market environment where fees compressed significantly in the post Great Financial Crisis cycle and stocks and bonds performed stronger than anyone expected, Venter says. “That era of post-Great Financial Crisis growth is over and you’re looking at solutions that offer the potential for growth in a portfolio, but you have to decide how active and how passive will your solution be to balance out the impact of fees.”

Fees and liquidity have been “a couple of the inhibitors to date,” Perkins adds, “because of the sheer amount of people and the number of boots on the ground that are needed to run an effective and high-performing private real estate offering. There’s a lot of human capital that’s involved with that that then comes with a higher fee for the investment offering itself.”

Venter urges plan sponsors interested in private real estate to find the right fee figure, as the headline cost of the asset class can be misleading. She says that plan sponsors should examine and present the investment fee by incorporating the cost of the investment with the total return, net of fees, to obtain a clear picture of the value for participants.

“The way you get them comfortable with that is you expand the conversation to [clarify] where the money is coming from,” she says. “What is your access budget? Once that conversation is undertaken, it’s very tangible for plans to move forward and understand that their fee concerns are relevant, this makes sense and any litigation that’s coming out of that is noneventful.”

Plan Sponsors’ Path

For plan sponsors looking to include alternatives in DC plans, the past may prove prologue.

The rising interest rate environment and down market for equities mean that new plan participants, near-retirees, and retirees must protect their retirement investments from “a strong inflation number,” says Perkins.

The purpose of private real estate in plans is “diversification first and foremost,” she says, “but private real estate can be really helpful with inflation because of the inflation-hedge effects.”

Plan sponsors may be looking afresh at alternatives and private real estate to help boost participants’ returns.  

“The last decade, it has really been pretty easy for people to save for retirement with the bull equity market that we have experienced with not a whole lot of volatility,” she says. “It was nice to see the run up in your retirement savings through that time period.”

Perkins notes that “it looks a little bumpier [now], and we’ve experienced some of those bumps as of late, so just highlighting the importance of diversification and lower risk strategy is pretty compelling at this particular time in the market.” She cites this as a reason “for professional multi-asset solutions providers … to incorporate private real estate and alts in .”

To protect participants’ retirement assets and help to improve their retirement readiness, employers may want to investigate the history of DB plans and borrow from the pension management playbook, she says. “The institutionalization of real estate as an asset class in the late 70s and early 80s really came about as defined benefit plans, at that point in time, were looking for an inflation hedge,” she explains.

Plan sponsors may also be enticed by the increased risk-adjusted returns of using private real estate. It can be a “great inflation hedge, [which is] particularly of importance in today’s environment,” Perkins adds.

DC plan sponsors have traveled a winding road since the 1970s—and when it comes to alternatives and private real estate, she says, that road might lead right back to the beginning. 

“With private real estate having served the defined benefit community [as] an inflation hedge, which kickstarted the asset class from an institutionalization standpoint, [it] feels a little bit like déjà vu now in terms of people trying to figure out how they’re going to protect their retirement investment,” Perkins explains.

«