Complexity Requires Balanced Approach to Adding Private Assets to DC Plans

Jared Gross

Momentum is continuing to build for defined contribution  plan sponsors to consider adding private investments to their investment menus, but many are rightly wondering if the benefits outweigh the risks. As gatekeepers to the retirement savings of millions of workers, sponsors have a duty to evaluate the trade-offs and craft an approach that supports improved outcomes for their plan participants. Amid both the clamor of alternative investment managers seeking access and seemingly profound shifts in the regulatory landscape, a thoughtful, balanced approach is essential.

As a starting point, modern DC plans already offer an effective platform for building retirement wealth. Adding private investments should be seen as a complement to—not a replacement for—the traditional building blocks of stocks and bonds.

Various types of alternative investments can add value in different ways: Private equity has traditionally offered the highest relative returns, real assets (such as real estate or infrastructure) the greatest level of risk diversification, and private credit the highest level of yield. A prudently scaled and appropriately diversified private allocation could therefore offer considerable benefits to participants.

Higher returns, compounded across long time horizons, could materially increase account values at retirement. Reduced downside risk in volatile markets could smooth performance over time. Finally, high, stable income could dampen volatility in the critical years leading up to retirement, while also delivering steady cash flow to retirees.

But there are real downsides as well. These include a lack of access to liquidity, wide performance dispersion across managers, limited transparency into valuations and consistently higher fees. Notably, other types of sophisticated institutional investors, including those who have used alternative investments for decades, limit their overall private asset exposure and devote significant resources to implementing these allocations effectively. DC plans operate within a particularly complex regulatory environment, while also facing the ever-present risk of litigation.

What Private Assets in DC Plans Will Look Like

Considering the balance of benefits and risks, many DC plan sponsors will likely introduce private investments within a professionally managed and well-diversified target-date fund. These strategies are designed to align portfolio risk with a participant’s investment horizon, while maintaining asset diversification and ample liquidity across time. An experienced target-date-fund manager, with expertise in top-down asset allocation and bottom-up manger selection, is best suited to the task.

However, many DC plans have chosen to limit their target-date funds to passive investments only. While this may be a viable approach in public markets, it is impossible to implement across private markets, where all investments are active and where passive strategies simply do not exist. Indeed, benchmarks in private markets generally represent the aggregated performance reported by the managers themselves. This makes benchmark performance an unattainable “average” outcome that may vary widely from actual experience.

Building a target-date allocation that incorporates private investments requires specific skills. First, a manager needs the ability to assess the long-term potential returns, risks and correlations across the full asset allocation using unbiased capital market assumptions. Second, a manager needs expertise in selecting underlying individual managers that can deliver strong performance. Finally, managing an investment strategy with private assets requires experience in rebalancing across public and private markets, as well as within private market sectors.

For the plan sponsor, identifying an appropriate investment vehicle is only half the battle. The law requires that any investment decision be made solely in the interests of plan participants, determined through an objective, thorough, analytical and well-documented process. The process must consider not only the investments themselves, but also whether they are suitable for the specific characteristics of the plan participant population. Sponsors should move carefully, and where they lack internal skill to manage the process, they should seek external advice.

What’s New

There are some signs that the lack of regulatory clarity may be diminishing. President Donald Trump’s recent executive order directed the Department of Labor  and the Securities and Exchange Commission to consider regulatory changes to facilitate the inclusion of private assets in DC plans. Importantly, while the order does not carry the force of law or change any existing law or regulation on its own, it is expected to lead to supportive agency guidance and/or regulatory changes. In fact, the DOL has already rescinded prior cautionary guidance and recently issued a supportive advisory opinion. Ultimately, the executive order is an invitation to consider private investments, not a mandate to include them.

At the same time, the investment management industry now offers sponsors an array of new investment vehicles that are better adapted to the DC plan model. Instead of legacy closed-end funds, many managers are offering “evergreen” funds that combine private and public assets within a single vehicle—improving transparency and liquidity, as well as potentially reducing fees. The presence of new investment vehicles does not fundamentally alter the risk-and-return calculus of the asset allocator. But it can streamline implementation once a decision has been made.

Deciding whether or not to add private investments to a DC plan is not an academic “white board” exercise. Rather, it involves a real-world process that seeks to deliver tangible value to plan participants over the long term, while ensuring that sponsors effectively manage operational, regulatory, legal and litigation risks along the way. A patient, thoughtful and balanced approach will produce the best outcomes.

Jared Gross is the head of institutional portfolio strategy at J.P. Morgan Asset Management.

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS STOXX or its affiliates.