TDFs Can Be the Vehicle for Alternatives in DC Plans

As plan sponsors search for ways to find value and diversify asset classes in their defined contribution (DC) plans, many have considered offering alternative assets as an option. These assets provide the benefits of diversification and low correlation to traditional asset class performance. However, concerns about the scalability, liquidity and valuation needs of DC plans have inhibited their use as a viable investment option.

In “Adding Alternatives to DC Plans,” Northern Trust explores the operational and plan structure options available to plan sponsors that wish to include alternative assets in their plans.

Three possible solutions—target-date funds (TDFs), a combining of defined benefit (DB) and DC assets into a unitized structure, and indexation—are explored in the paper.

Target-date funds are one of the best ways to incorporate alternative asset classes into DC plans, says the Defined Contribution Institutional Investment Association (DCIIA), which also recommends using a bundled alternative assets portfolio, or adding alternatives on a standalone or index basis.

White labeling, or moving away from brand-name mutual funds to more generically named ones customized to a specific defined contribution plan, is a path that is gaining traction among these plans. It can increase the plan’s flexibility, help it cut costs, streamline investment menus and reduce participant confusion over investment choices. This approach can also let plans use their existing plan managers and potentially achieve higher alpha.

Alternative assets are increasingly held inside target-date maturity funds, including white labels. Commingled DB/DC structures are increasingly used to house more alternative investments—real estate investment trusts (REITs), currencies and commodities wrapped into investment vehicles such as hedge funds, private equity, mutual funds, exchange-traded funds (ETFs) or separate accounts. This also can be structured so that the alternatives are excluded from the cash flow of the target-date fund, which is necessary because alternatives do not accommodate daily liquidity.

According to Tom Lauer, defined contribution asset servicing consultant at Northern Trust, a number of clients want to put alternatives into TDFs for their defined contribution plans but for various reasons can’t get it done. Some solutions can allow these clients to work around perceived challenges.

Clients ask about the best methods for dealing with liquidity and valuation challenges as interest in including alternatives has increased, Lauer says. “We tell our clients that there are ways to structure their plans that allow them to take advantage of alternative assets,” he says. “Some clients find it appropriate to integrate defined benefit and defined contribution plan assets in order to leverage scale and provide participants with access to alternatives.”

“The key to increasing the mix of options plan sponsors offer is having a well-defined operational strategy that focuses on the needs of the plan participants,” says Pete Cherecwich, head of corporate and institutional services in the Americas at Northern Trust.

“Adding Alternatives to DC Plans” can be downloaded from Northern Trust’s website.