What Kind of Near-Term Future Do Alts Actually Have in DC Plans?

The proposed Department of Labor rule outlining a regulatory safe harbor for defined contribution plans to include alternative assets in their target-date funds is more than a simple regulatory tweak. It has the potential to introduce new providers to the defined contribution market, while changing the business model for veteran firms.

The proposed rule outlines a process-based way for 401(k) plan fiduciaries to benefit from a regulatory safe harbor by objectively and thoroughly evaluating six core factors (performance, fees, liquidity, valuation, benchmarking and complexity) when selecting investments. Experts expect the rule could reduce litigation risk and make it easier, in practice, for plan sponsors to include alternative assets in DC plan lineups, potentially through vehicles such as target-date funds or managed accounts.

“It really opens the door to some of these new, innovative solutions and gives [plan sponsors] a road map to bring them into the conversation, instead of just saying, ‘No, I’m worried about being sued for doing this,’” says Chris Bailey, a director in Cerulli’s retirement practice.

The DOL estimated that the rule could unlock up to $178 billion in annual inflow to TDFs. The predicted inflow may take time to materialize, given historically limited plan sponsor interest in alternative investments. MFS Investment Management’s recent DC Plan Sponsor Survey found that most sponsors and their participants report “little to no” appetite for incorporating alternatives into retirement plans.

“We have not heard plan sponsors giving us feedback that this is a change they’re looking to embrace in the very near term,” says Winfield Evens, vice president of financial services at Alight Solutions. “But my suspicion is that over time, we’ll see more and more funds that fit in this broad category of alternative assets making their way into DC plans of all sizes.”

Supply Outpacing Demand

For now, potential increases in supply of such products tend to drive buzz, rather than demand.

“The headlines are more coming from asset managers—or maybe consultants—who are interested in getting these assets in the plan, rather than the other way around, with sponsors thinking this is something they need to have for their participants,” says Jon Barry, senior managing director of the strategy and insights group at MFS Investment Management.

Alternative asset managers, historically locked out of retail retirement pipelines, could be among the primary beneficiaries of such a shift. Meanwhile, asset managers that focus on public market investments may find themselves having to defend current allocation strategies.

“We’re going to have to get better and better at making the case as to why public assets still belong, in meaningful allocations, in target funds or any other structure,” Barry says “It’s a case our firm strongly believes in.”

The introduction of alternative assets into DC plans could benefit consultants, including 3(21) fiduciary advisors and 3(38) fiduciary managers, with some seeing a boost in demand for services, but their role would not transform dramatically.

“Advisors and consultants are already helping most plan sponsors make decisions about their plan lineup,” Bailey says. “The rule may change the process and factors used to evaluate target-date and other QDIA options, but their fundamental role remains the same.”

Plan sponsors interested in incorporating alternatives may turn to 3(38) managers to administer their plan investments—either individually or by joining a pooled employment plan that incorporates alternatives—to reduce their own legal exposure.

“[In a PEP], plan menu decisions reside with the pooled plan provider and [with] a 3(38) who may be less concerned with litigation and more inclined to fight against it,” Bailey says. “For [an employer] interested in private markets and alternatives, a PEP that provides access through a target-date or managed account may be an attractive option, given the other benefits PEPs offer.”

Advisers Split

In the short term, consultants will likely fall into two camps: Some fiduciary managers and advisers will take on such work, while others determine that it is not right for their clients—at least for now.

Clare Adams, a partner in and manager of corporate retirement plan services at MCF Advisors, says her firm falls into the latter camp.

“We’re a little wary of it,” she says. “We’ll let other people figure out the downfalls and be the guinea pig, and [we’ll] let our clients stay safe until this beta test is over and we feel more comfortable with it.”

Even for the plan sponsors interested in being among the first to introduce alternatives, cost remains a significant barrier.

Alternatives are significantly more expensive than traditional index funds. While fees for traditional TDFs in employer funds are often less than 1%, alternative investment management fees frequently run at least 2%, according to data from RSM US. That is likely to feel like sticker shock, even for plan sponsors who decide the cost is justified to include them to increase investment returns.

Given such impediments, the plan sponsors structurally positioned to best capitalize on the shift include larger employers with active retirement plan investment committees and those that have used alternative investments in their defined benefit plans, says Craig Copeland, director of wealth benefits for the Employee Benefit Research Institute.

Even if advisers do not move to introduce alternatives into their clients’ plans right away, Adams expects to field plenty of questions regarding the proposed rule. Advisers and plan sponsors that are more bullish on the proposal will likely spend a lot of time preparing documentation for the selection and monitoring process.

More widely introducing alternative investments into DC plans will increase the fiduciary burden on plan sponsors, especially in the short term, Copeland says, as they seek new benchmarks and implement new plan policies to comply with updated regulations.

“In the long run, there is another set of investments that would need to be evaluated when making any investment lineup changes or deciding to keep them the same,” Copeland says. “The long-term additional impact could be relatively small, depending on whether the benchmarks and policies surrounding alternative investments quickly adopt industry standards.”

More on this topic:

	Private Assets in DC Plans: What to Expect in the Year Ahead
	What’s at Stake in the DOL Proposal Directing Assets to TDFs That Include Alts?