Defined contribution (DC) plans have been transformed in the past 10 years, as sponsors have moved away from offering participants a wide, and sometimes baffling, range of investment choices. The current fashion of plan design favors a first tier of diversified investment solutions accompanied by a simplified set of individual funds for those participants who want to structure portfolios on their own. In its 2015 defined contribution plan survey, consulting firm NEPC in Boston reports that, among 113 plans studied, over 10 years the median number of investment choices in the plans had dropped from 22 to 14.
Simplifying the second-tier choices can reveal gaps in the core menu, however, and to fill them sponsors are turning to diversified funds that invest across several asset classes, often in nontraditional ways. “Multi-asset funds fall somewhere between the pre-mixed options and the core menu,” notes Jay Kloepfer, director of capital market and alternatives research at consultants Callan Associates, San Francisco. “They make sense in theory,” he adds, “but they can be relatively expensive and challenging to explain to participants, so the sponsor needs to identify their purpose and the investment merits.”
Multi-asset funds have been around forever, first appearing as fairly tame balanced funds owning conventional bonds and equities. Going back 20 years, providers refined the balanced fund idea into target-risk funds, with choices of diversified portfolios of investment postures ranging from conservative to aggressive. The percentage of target-risk funds with greater than $200 million in assets stood at 18.0%, according to the upcoming 2016 PLANSPONSOR Defined Contribution Survey. There is a greater representation of these funds among plans with less than $5 million, with the adoption rate at 54.8%.
Newer multi-asset funds reflect the industry’s move to bring the sophistication of defined benefit (DB) investing to the DC world. “We believe in a broad opportunity set, and a dynamic and adaptive approach to portfolio management,” says Holly Verdeyen, director of defined contribution investments with Russell Investments in Chicago.
Consultants and providers cite as examples funds investing in diversified strategies such as global asset allocation, absolute return and risk parity. Global asset-allocation approaches invest broadly in the world’s stock, bond and currency markets, taking cues from trends in the macro economy. Absolute return, or liquid alternative, funds seek stable returns from a variety of global markets. Risk parity strategies weigh portfolio holdings of equities, bonds, currencies and other assets to balance the expected risk of each class: Thus, bonds would likely receive a far greater risk-adjusted weight than equities, for instance. “You’re adding these funds to increase diversification, or add alpha, or a combination of the two,” explains Ross Bremen, a partner at NEPC.
He points out, however, that these sorts of strategies are more often added to a target-date fund (TDF) than provided as stand-alone options. “These investment styles are not prevalent in the individual investor marketplace; they can be hard to understand; and the performance patterns are different from traditional markets. Adding these as core menu options can become a tough decision for an investment committee, particularly if a fund charges higher fees.” Consequently, just 10% of defined contribution plans have some sort of multi-asset offering in these categories, Bremen says.
Where multi-asset funds have gained the most traction, however, is in strategies meant to protect the value of retirement portfolio dollars against inflation, known as real return or real asset funds. “The question we’ve heard most from sponsors about a gap in their core menu is on multi-asset real return funds, because preserving purchasing power is critical for those participants coming close to retirement,” says Jason Shapiro, senior defined contribution investment consultant with Willis Towers Watson in New York City. In his firm’s surveys of clients, about one-third of plans say they offer such a fund.
“Sponsors have seen enough analysis to realize that participants who allocate, say, 10% of their assets from a traditional stock and bond portfolio into a real asset portfolio are going to see more stable returns and reduced risk over a market cycle,” notes Verdeyen.
A long list of assets are thought to fare well against rising prices: bonds indexed to inflation (U.S. Treasury TIPS), commodity futures, gold, equities of natural resource and infrastructure companies, real estate investment trusts (REITs) and bank loans, which earn variable yields. Accordingly, managers express a wide range of viewpoints in building their portfolios, as to which assets they include and in what proportions.
“Real assets are a great example of how stand-alone components may not serve a great purpose,” says Richard Davies, global head of defined contribution and multi-asset business development with AB also in New York City. He notes that REITs, a prevalent core menu option, have frequently gone from the top to the bottom of performance ranks, leaving sponsors and participants dissatisfied with the single asset choice. However, he says, “When you assemble the real assets into a package, you take the hard edges off some of the individual assets and get a return that looks more like a balanced portfolio.”
But how do sponsors make a reasoned prospective evaluation of the expected future performance of the 30 or so real asset funds in the market? Or even get an insightful read on their past performance? The concept of seeking real returns is fairly new, so funds have relatively short track records; moreover, inflation has been quiet lately, so their portfolio designs have not faced a severe test. Additionally, the underlying assets are less well-known.
“These strategies are all back-tested and so have some sort of validity in their approach,” observes David Blanchett, head of retirement research for Morningstar Investment Management in Chicago. “But, as to the correlation of these asset classes to inflation, even for TIPS, it isn’t very high—and most of their return comes from interest rate moves.”
“For real asset funds, a multi-asset approach makes more sense than just a rifle shot on TIPS or commodities, but how do you design it so it is risky enough, but not too risky and does the right things for the portfolio?” says Kloepfer.
Shapiro concedes, “There isn’t a silver bullet for inflation hedging, but multi-asset funds allow managers to construct a portfolio that could combat inflation over more economic scenarios, so there is a benefit to that way of thinking.”
Whatever the solution, there is a genuine need for protecting hard-won retirement assets from inflation. Therefore, providers see growing demand. “We’ve seen some search activity from sponsors on real return funds, and our view is that inflation-sensitive assets are cheap, so this may be a good time to add them,” says Davies.