The global expansion we have experienced has provided investment conditions in which a relatively simple combination of stocks and bonds has achieved sufficient diversification to manage risk. As economic conditions change further diversification may need to play a bigger role in managing portfolio risk. Accordingly, defined contribution plans, (such as 401(k), 403(b) 457(b), etc.,) may want to look beyond the traditional stock and bond offerings within their plan menus and expand into other opportunities.
Coming out of the market downturn of 2008, the retirement plan industry began to consider the broader use of alternatives such as real estate and commodities but did not make significant changes to their lineups.
More recently, interest in alternatives has returned and also expanded into other markets. There is something intuitively appealing about investors, (employees,) having access to a wider range of investment choices, and time will tell whether alternatives, both liquid and illiquid, will play a larger role in core menus or default investment options.
Below are some of the pros and cons to consider when looking at alternatives for retirement plans:
The PROS
- The time horizon for a plan participant is often compatible with that of illiquid asset classes. The majority of employees will have a decade or more time horizon and participants ideally cannot access their funds until some point in the future. Therefore, investors do not need to limit their opportunity set to those investment options that have daily valuation and pricing.
- With the use of auto-enrollment, the closure of defined benefit plans and regulatory changes under consideration (such as Pooled Employer Plans and Rothification), employer retirement plans have become the most robust retirement savings vehicle available. With the increased level of fiduciary oversight by retirement plan sponsors, retirement plan committees are better positioned today to deal with the complexities of including alternatives within plan lineups.
- There is a general trend toward bringing the best of pension plan thinking over to defined contribution plans, and for many years pension plans have embraced alternatives as an important component of their asset allocation. At face value this is fine, but we have to recognize that there are important differences between the two types of plans, such as time horizons, risk pooling, the impact of interest rates on funded status and liquidity requirements, that should influence what is appropriate.
- The retirement plan industry has been talking about alternatives and illiquid asset types for some time, and maybe now we are at a point where there is enough scale and sophistication in the marketplace that this can become a reality. In addition to illiquid investment options, many alternative investments have been packaged as mutual funds and have been around now for at least five years. This is important to note because many Investment Policy Statements require various data points on mutual funds at the one, three- and five-year increments. The retirement plan industry is much more familiar with mutual funds offerings and this may provide an easier passage into investment menus for employees.
The CONS
- Alternative investments tend to have higher fees than traditional equity and fixed income investments. With the attention given to fees the past 8 years, and law suits in both the 401(k) and 403(b) space over a few basis points, retirement plan committees could be a little leery about adding higher expense investment options. Will there be any appetite for paying much more than 50 to 60 basis points in fees for any investment, even if, in theory, it can add value to plan participants?
- Alternatives and illiquid assets are by definition opaque and harder to understand, monitor and manage. For good reason, the defined contribution industry has placed an emphasis on transparency, and many alternatives may have a hard time meeting investors’ expectation of transparency.
- Do alternative investments really add value over the long run? While the long-time horizon of most retirement plan participants may argue for some allocation to illiquid assets or alternative investments, there is a counterargument that can be made against alternatives. Do very long-horizon investors really need diversification?
- From a fiduciary and governance perspective, there may be reluctance among plan sponsors to include alternatives as part of core menus or self-select options for fear of misuse. Furthermore, in many cases plan fiduciaries themselves have a limited understanding of alternatives, and would not be in a position to determine if adding alternatives to a plan is in the best interest of the plan participants. To the extent that sponsors are comfortable including alternatives in their lineup, they may want to impose an overall limit, (10% of total portfolio), which could create administrative complexity.
- Over the past few years, sponsors have focused more on behaviors that lead to good outcomes such as contributing at the right rate, not overreacting to volatility, default investments, etc., and less on specific investments. Educating participants on the use and potential benefits of alternatives may be a challenge that many sponsors do not want to take on. The need to encourage employees to simply save more, could prove to be more impactful for employees when they retire.
- 401(k), 403(b) and similar plans have ongoing cash flows, which could make it hard for a manager to put that cash to work in an illiquid investment. Contrast this with a pension plan that can make a dedicated alternative allocation and deal with capital calls. Alternative investment programs that allow quarterly withdrawals or packed into mutual funds may be able to alleviate some, if not all, of these concerns.
Overall, I still think “less is more” in the retirement plan menu for employees and solving the investment menu nuances probably sit as a secondary concern to the primary reasons why the</div><div>average person is not accumulating enough wealth during their working years. I believe helping employees save more and not cashing out their retirement accounts along the road before they want to retire will dramatically help them produce more income during their retirement years. </div><div>I do think this topic is here to stay and as more alternative investments pop up in the mutual fund world and have clear and transparent information, I think they will help maximize risk adjusted returns for investors.